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Liquidity and Treasury Risk


Measurement and Management

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Copyright © 2023, 2022, 2021, 2020 by the Global Association of Risk Professionals All rights reserved.
This copyright covers material written expressly for this volume by the editor/s as well as the compilation its
itsel
elf. It does not cover the individual
selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pear
earson Education, Inc. for this edition only.y Fu
Further
reproduction by any means, electronic or mechanical, including photocopying and recording,, or b by any information storage or retrieval syst
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Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled
led by them:
“Liquidity Risk,” by John C. Hull, reprinted from Risk Management and 3rd Edition (2011), by permission of John Wiley & Sons, Inc. All rights
Financial Institutions, 5th Edition (2018), by permission of John Wiley & Sons, reserved. Used under license from John Wiley & Sons, Inc.
Inc. All rights reserved. Used under license from John Wiley & Sons, Inc.
“Liquidity Transfer Pricing: A Guide to Better Practice,” Financial
“Liquidity and Leverage” by Allan M. Malz, reprinted from Financial Risk Stability Institute Occasional Paper No. 10, by Joel Grant, June 2011,
Management: Models, History, and Institutions (2011), by permission of by permission of the Bank for International Settlements. Information
John Wiley & Sons, Inc. All rights reserved. Used under license from John retrieved from the Bank for International Settlements is freely available at
Wiley & Sons, Inc. their website: www.bis.org.

“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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Management & Financial Services, Ninth Edition (2013), by permission of


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the McGraw Hill Companies, Inc.


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00022446-00000004 / A103000319406
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“Repurchase Agreements and Financing,” by Bruce Tuckman and Angel


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Serrat, reprinted from Fixed Income Securities: Tools for Today‘s Markets, EEB/AM
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ISBN 10: 013802801X


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IISBN 13: 9780138028015

  


Contents

Chapter 1 Liquidity Risk 1 Chapter 2 Liquidity and


Leverage 17
1.1 Liquidity Trading Risk 2
1.1.1 The Importance of Transparency 3 2.1 Funding Liquidity Risk 18
1.1.2 Measuring Market Liquidity 4 Maturity Transformation 18
1.1.3 Liquidity-Adjusted VaR 5 Liquidity Transformation 19
1.1.4 Unwinding a Position Optimally 5 Bank Liquidity 20
1.1.5 Other Measures of Market Liquidity 6 Structured Credit and Off-Balance-Sheet
Funding 22
1.2 Liquidity Funding Risk 6
Funding Liquidity of Other Intermediaries 23
1.2.1 Sources of Liquidity 6
Systematic Funding Liquidity Risk 24
1.2.2 Reserve Requirements 9
1.2.3 Regulation 9 2.2 Markets for Collateral 26
1.3 Liquidity Black Holes 11 Structure of Markets for Collateral 26
1.3.1 Positive and Negative Feedback Economic Function of Markets for Collateral 28
Traders 11 Prime Brokerage and Hedge Funds 29
1.3.2 Leveraging and Deleveraging 12 Risks in Markets for Collateral 29
1.3.3 Irrational Exuberance 13 2.3 Leverage and Forms of Credit
1.3.4 The Impact of Regulation 14 in Contemporary Finance 31
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1.3.5 The Importance of Diversity 14


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Defining and Measuring Leverage 31


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Summary 14 Margin Loans and Leverage 33


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Short Positions 34
Further Reading 15
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Derivatives 35
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Practice Questions and Problems 15


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Structured Credit 36
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Further Questions 16 Asset Volatility and Leverage


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2.4 Transactions Liquidity Risk 37 4.3 Popular Money Market
Causes of Transactions Liquidity Risk 37 Investment Instruments 57
Characteristics of Market Liquidity 38 Treasury Bills 57
Short-Term Treasury Notes and Bonds 59
2.5 Liquidity Risk Measurement 38
Federal Agency Securities 59
Measuring Funding Liquidity Risk 38
Certificates of Deposit 59
Measuring Transactions Liquidity Risk 39
International Eurocurrency Deposits 59
2.6 Liquidity and System Risk 41 Bankers’ Acceptances 59
Funding Liquidity and Solvency 41 Commercial Paper 60
Funding and Market Liquidity 42 Short-Term Municipal Obligations 60
Systemic Risk and the “Plumbing” 42
“Interconnectedness” 43
4.4 Popular Capital Market
Investment Instruments 60
Further Reading 43 Treasury Notes and Bonds 60
Municipal Notes and Bonds 60
Corporate Notes and Bonds 61
Chapter 3 Early Warning 4.5 Investment Instruments
Indicators 45 Developed More Recently 61
Structured Notes 61
Securitized Assets 61
3.1 Early Warning Indicators:
Mechanism to Signal Upcoming 4.6 Investment Securities Held
Liquidity Crisis 46 by Banks 63
Introduction: Dashboard and Beyond 46 4.7 Factors Affecting Choice
Regulatory Emphasis in Recent Times 46 of Investment Securities 64
Key Supervisory Guidelines 46 Expected Rate of Return 65
Risk Identification and EWIs 47 Tax Exposure 65
Framework Components: M.E.R.I.T. 47 Interest Rate Risk 69
Illustrative EWI List 51 Credit or Default Risk 69
Business Risk 70
Conclusion 54
Liquidity Risk 71
Call Risk 71
Prepayment Risk 71
Chapter 4 The Investment
Inflation Risk 72
Function in Pledging Requirements 72
Financial-Services
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4.8 Investment Maturity


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Management 55
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Strategies 73
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4.9 Maturity Management Toolss 76


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4.1 Introduction 56 The Yield Curve 76


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Duration 77
4.2 Investment Instruments
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Available to Financial Firms 57 Summary 78


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

Internet Exercises 82 5.8 Central Bank Reserve


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

Selected References 85 Key Terms 112


Problems and Projects 113
Internet Exercises 116
Chapter 5 Liquidity and
Case Assignment
Reserves for Chapter 5 116
Management:
Selected References 118
Strategies and
Policies 87
Chapter 6 Intraday Liquidity Risk
5.1 Introduction 88 Management 119
5.2 The Demand for and Supply
of Liquidity 88
6.1 Introduction 120
5.3 Why Financial Firms Often
Face Significant Liquidity Problems 90 6.2 Uses and Sources of Intraday
Liquidity 121
5.4 Strategies for Liquidity Managers 91
Asset Liquidity Management (or Asset
6.3 Risk Management,
Conversion) Strategies 91 Measurement and Monitoring
Borrowed Liquidity (Liability) Tools for Financial Institutions 125
Management Strategies 92 Governance of Intraday LRM 125
Balanced Liquidity Management Strategies 93 Measurement of Intraday Liquidity 126
Guidelines for Liquidity Managers 93 Measures for Understanding Intraday
Flows 127
5.5 Estimating Liquidity Needs 94 Measures for Quantifying and
The Sources and Uses of Funds Approach 94 Monitoring Risk Levels 127
The Structure of Funds Approach 97 Role of Stress Testing 128
Liquidity Indicator Approach 100
6.4 Risk Management,
The Ultimate Standard for Assessing
Measurement, Monitoring Tools
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Liquidity Needs: Signals from the


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for FMUs 12
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Marketplace 101
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Overview of FMU Risk Management


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5.6 Legal Reserves and Money


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FMU Tools to Manage Intradayy


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Position Management 103


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Settlement Risk 130


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Regulations on Calculating Legal Reserve


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Requirements 103 Conclusion 131


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Factors Influencing the Money Position 106 Glossary 131


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Chapter 7 Monitoring Chapter 9 Liquidity Stress
Liquidity 133 Testing 171

7.1 A Taxonomy of Cash Flows 134 9.1 Measuring Contingent


7.2 Liquidity Options 135 Liquidity Requirements 173

7.3 Liquidity Risk 137 9.2 Overview of the Model 174


7.4 Quantitative Liquidity Risk 9.3 Design of the Model 175
Measures 138 Organizational Scope 175
7.4.1 The Term Structure of Expected Cash Planning Horizon 176
Flows and the Term Structure of Expected 9.4 Testing Techniques 176
Cumulated Cash Flows 138
7.4.2 Liquidity Generation Capacity 141 9.5 Baseline Scenario 177
7.4.3 The Term Structure of Available Assets 143 9.6 Scenario Development 177
7.5 The Term Structure of Historical Scenarios 177
Expected Liquidity 149 Hypothetical Scenarios 177

7.6 Cash Flows at Risk and the 9.7 Development of Assumptions 178
Term Structure of Liquidity at Risk 150 9.8 Outputs of the Model 180
9.9 Governance and Controls 181
9.10 Liquidity Optimization 182
Chapter 8 The Failure Mechanics 9.11 Funding Optimization 183
of Dealer Banks 155
9.12 Establishing a Sustainable
Infrastructure 183
8.1 What Large Dealer Banks Do 157 9.13 Integration of Liquidity
Securities Dealing, Underwriting, and Trading 158 Stress Testing with Related Risk
Over-the-Counter Derivatives 158 Models 184
Prime Brokerage and Asset Management 160 Conclusion 185
Off-Balance-Sheet Financing 160
8.2 Failure Mechanisms for
Dealer Banks 161 Chapter 10 Liquidity Risk
The Flight of Short-Term Creditors 161
Reporting and Stress
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The Flight of Prime Brokerage Clients 162


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Testing 187
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When Derivatives Counterparties Duck


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for Cover 164


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Loss of Cash Settlement Privileges 165


10.1 Liquidity Risk Reporting
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8.3 Policy Responses 165


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Deposit Tracker Report 188


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References 167 Daily Liquidity Report 188


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

11.3 Design Considerations 210 12.4 Pricing Deposit-Related


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

11.4 Framework and Building 12.7 Using Marginal Cost to Set


Blocks 211 Interest Rates on Deposits 232
Governance and Oversight 212 Conditional Pricing 233
Scenarios and Liquidity Gap Analysis 213 12.8 Pricing Based on the Total
Contingent Actions 214 Customer Relationship and
Monitoring and Escalation 215 Choosing a Depository 237
Data and Reporting 218 The Role That Pricing and Other
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11.5 Additional Considerations 218 Factors Play When Customers Choose ea


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Depository Institution to Hold Theirr


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Different Types of Institutions 218


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Accounts 237
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Organizational Structure of the CFPs 218


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12.9 Basic (Lifeline) Banking:


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Liquidity and Capital 219


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Services for Low-Income e Cu


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Conclusion 219
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References 219 Summary 240


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


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Key Terms 267 15.1.1 A Summary of the Major


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Lessons Learned 288


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Problems and Projects 268


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15.1.2 Regulatory Developments


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Internet Exercises 269 15.1.3 The Need for More Guidance


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


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Basis 333
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15.5 Conclusion 305


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17.1 A Framework 334


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LTP Principles and Demand for Currency Hedges:


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Recommendations 307 Why the Basis Opens Up


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


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the Greatest Management 19.3 Illiquid Asset Markets 38


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Challenges 351 Sources of Illiquidity 383


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Forces Determining Interest Rates 351 Characteristics of Illiquid Markets 383


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The Measurement of Interest Rates 352 Summary 385


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

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Contents ■ xi

  


PREFACE

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,
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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,
ce strructu
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and people risk have all moved up the list of considerations


derration that
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It’s been our objective to assure exam candidates we will do


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need to be embedded into the daily thought processes cesse of any


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everything in our power to assist them in furthering their career


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good risk manager. These require a shift in thinking


nking and raise
thin
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objectives in what is and remains a very uncertain and trying


questions and concerns about whether a firm’s m’s daily
rm’s d processes
professional environment. Although we could not control the
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xii ■ Preface

  


are really fine-tuned, or if its data and information flows are fully FRM candidates are aware of not only what is important but also
understood. what we expect to be important in the near future.

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

  


®
FRM
COMMITTEE

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

Richard Brandt William May


MD, Operational Risk Management, Citigroup SVP, Global Head of Certifications and Educational Programs,
GARP
Julian Chen, FRM
SVP, FRM Program Manager, GARP Attilio Meucci, PhD, CFA
Founder, ARPM
Chris Donohue, PhD
MD, GARP Benchmarking Initiative, GARP Victor Ng, PhD
Chairman, Audit and Risk Committee
Donald Edgar, FRM
MD, Head of Risk Architecture, Goldman Sachs
MD, Risk & Quantitative Analysis, BlackRock
Matthew Pritsker, PhD
Hervé Geny
Senior Financial Economist and Policy Advisor/Supervision,
Former Group Head of Internal Audit, London Stock Exchange
Regulation, and Credit, Federal Reserve Bank of Boston
Group
Samantha C. Roberts, PhD, FRM, SCR
Aparna Gupta
Instructor and Consultant, Risk Modeling and Analytics
1

Professor of Quantitative Finance


60
5

A.W. Lawrence Professional Excellence Fellow Til Schuermann, PhD


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Co-Director and Site Director, NSF IUCRC CRAFT Partner, Oliver Wyman
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Lally School of Management


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Sverrir Þorvaldsson, PhD, FRM


Rensselaer Polytechnic Institute
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Senior Quant, SEB


-9 ali
58 ak

John Hull
11 ah
41 M

Senior Advisor
Maple Financial Professor of Derivatives and Risk Management,
20

Joseph L. Rotman School of Management, University of Toronto


99

xiv ■ FRM® Committee

  


Liquidity Risk 1
■ Learning Objectives
After completing this reading you should be able to:

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

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

1
60
5
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65 ks
06 oo
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11 ah
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Excerpt is Chapter 24 of Risk Management and Financial Institutions, 5th Edition, by John C. Hull.
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The credit crisis that started in the middle of 2007 has empha- every day. The quoted price of the shares is very close to the
sized the importance of liquidity risk for both financial institu- price that the financial institution would be able to sell the
tions and their regulators. Some financial institutions that relied shares for. However, not all assets are as readily convertible into
on wholesale deposits for their funding experienced problems cash. For example, a $100 million investment in the bonds of a
as investors lost confidence in financial institutions. Moreover, noninvestment-grade U.S. company might be quite difficult to
financial institutions found that some instruments for which sell at close to the market price in one day. Shares and debt of
there had previously been a liquid market could only be sold at companies in emerging markets are likely to be even less easy
fire-sale prices during the crisis. to sell.

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
1
60

completely dry up. opposite pattern to that in Figure 1.1. Consider, for example, e,
5
66
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an individual who approaches a branch of a bank wanting g to do


1- nt
20
66 Ce

a foreign exchange transaction or invest money for 90 0 days.


days. As
A
1.1 LIQUIDITY TRADING RISK
65 ks
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the size of the transaction increases, the individual is likely


kely to
lik
ikely
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get a better quote.


If a financial institution owns 100, 1,000, 10,000, or even
58 ak
11 ah

100,000 shares in IBM, liquidity risk is not a concern. Several The price that can be realized for an asset often
n depends
dep
41 M

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

  


Metallgesellschaft. In the case of Long-Term Capital Manage-
ment positions were unwound slowly over a period of time
under the supervision of the Federal Reserve to avoid preda-
tory trading.
Another problem in the market for financial assets is that,
Offer price
when one financial institution finds that it needs to unwind a
position, it is often the case that many other financial institutions
with similar positions need to do the same thing. The liquid-
ity normally present in the market then evaporates. This is the
Bid price “liquidity black hole” phenomenon that will be discussed later in
this chapter.

1.1.1 The Importance of Transparency


Quantity
One thing that the market has learned from the credit crisis of
Figure 1.1 Bid and offer prices as a function of 2007 is that transparency is important for liquidity. If the nature
quantity transacted. of an asset is uncertain, it is not likely to trade in a liquid market
for very long.
It had become common practice in the years prior to 2007 to
environment. Suppose you want to sell your house. Sometimes form portfolios of subprime mortgages and other assets and to
the real estate market is referred to as a “seller’s market.” create financial instruments by securitizing, re-securitizing, and
Almost as soon as you put the house on the market, you can re-re-securitizing the credit risk. Many of the financial instru-
expect to get several offers and the house will be sold within a ments were even more complicated. Sometimes the ABS CDOs
week. In other markets, it may take six months or more to sell that were created included non-mortgage assets and even
the house. In the latter case, if you need to sell the house imme- tranches from other ABS CDOs. After August 2007, market par-
diately, you will have to reduce the asking price well below the ticipants realized that they knew very little about the risks in the
estimated market value. instruments they had traded. Moreover, it was very difficult for
them to find out very much about this. Belatedly, they realized
Financial assets are similar to real assets as far as this is con-
they had been using credit ratings as a substitute for an under-
cerned. Sometimes liquidity is tight (e.g., after the Russian
standing of the instruments.
default of 1998 and after the subprime crisis of 2007–2008).
Liquidating even a relatively small position can then be time- After August 2007, the instruments created from subprime
consuming and is sometimes impossible. On other occasions, mortgages became illiquid. Financial institutions had no idea
there is plenty of liquidity in the market and relatively large posi- how to mark to market investments that they had been scram-
tions can be unwound without difficulty. bling to buy a few months earlier. They realized that they had
purchased highly complicated credit derivatives and that they
Liquidating a large position can be affected by what is termed
did not have the tools to value them. They lacked both the
predatory trading. This occurs when a market participant, say
necessary models and solid information about the assets in the
Company X, has a large position and other market participants
portfolios underlying the derivatives.
guess that it will have to be unwound in the near future. The
other market participants attempt to profit by doing similar Other well-defined credit derivatives, such as credit default
trades to those they expect from Company X. For example, if it swaps, continued to trade actively during the credit crisis. The
1

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-
60
5

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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65 ks

for Company X to exit from its position at competitive prices. disappears. When the products do trade again, prices
rices are likely
n, pr
06 oo

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
58 ak
11 ah

future trading plans confidential. Predatory trading was an tranches (previously rated AAA) to Lone
one Star Funds for
41 M

issue for the trader known as the London Whale in 2012 and for 22 cents on the dollar.
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Chapter 1 Liquidity Risk ■ 3

  


1.1.2 Measuring Market Liquidity Another measure of liquidity is the cost of liquidation in
stressed market conditions within a certain time period. Define
One measure of the market liquidity of an asset is its bid–offer mi and si as the mean and standard deviation of the propor-
spread. This can be measured either as a dollar amount or as a tional bid–offer spread for the ith financial instrument held.
proportion of the asset price. The dollar bid–offer spread is Then:
p = Offer price - Bid price n (mi + lsi)ai
Cost of liquidation (stressed market) = a (1.2)
The proportional bid–offer spread for an asset is defined as i=1 2
Offer price - Bid price The parameter l gives the required confidence level for the
s =
Mid@market price spread. If, for example, we are interested in considering “worst
where the mid-market price is halfway between the bid and the offer case” spreads that are exceeded only 1% of the time, and
price. Sometimes it is convenient to work with the dollar bid–offer if it is assumed that spreads are normally distributed, then
spread, p, and sometimes with the proportional bid–offer spread, s. l = 2.326.

The mid-market price can be regarded as the fair price. In liqui-


dating a position in an asset, a financial institution incurs a cost Example 1.2
equal to sa/2 where a is the dollar (mid-market) value of the Suppose that in Example 1.1 the mean and standard devia-
position. This reflects the fact that trades are not done at the tion for the bid–offer spread for the shares are $1.0 and $2.0,
mid-market price. A buy trade is done at the offer price and a respectively. Suppose further that the mean and standard
sell trade is done at the bid price. deviation for the bid–offer spread for the commodity are
One measure of the liquidity of a book is how much it would both $0.1. The mean and standard deviation for the pro-
cost to liquidate the book in normal market conditions within a portional bid–offer spread for the shares are 0.01111 and
certain time. Suppose that si is an estimate of the proportional 0.02222, respectively. The mean and standard deviation for
bid–offer spread in normal market conditions for the ith finan- the proportional bid–offer spread for the commodity are both
cial instrument held by a financial institution and ai is the dollar 0.006645. Assuming the spreads are normally distributed,
value of the position in the instrument. Then the cost of liquidation that we are 99% confident will not be
n sa
exceeded is
i i
Cost of liquidation (normal market) = a (1.1)
i=1 2 0.5 * 900 * (0.01111 + 2.326 * 0.02222)
+ 0.5 * 752.5 * (0.006645 + 2.326 * 0.006645) = 36.58
where n is the number of positions. Note that although diversifi-
cation reduces market risk, it does not necessarily reduce liquid- or $36.58 million. This is almost five times the cost of liquidation
ity trading risk. However, as explained earlier, si increases with in normal market conditions.
the size of position i. Holding many small positions rather than
a few large positions therefore tends to entail less liquidity risk.
In practice, bid–offer spreads are not normally distributed and it
Setting limits to the size of any one position can therefore be
may be appropriate to use a value of l that reflects their empiri-
one way of reducing liquidity trading risk.
cal distribution. For example, if it is found that the 99 percentile
point of the distribution is 3.6 standard deviations above the
Example 1.1 mean for a particular category of financial instruments, l can be
Suppose that a financial institution has bought 10 million shares set equal to 3.6 for those instruments.
of one company and 50 million ounces of a commodity. The Equation (1.2) assumes that spreads in all instruments are
shares are bid $89.5, offer $90.5. The commodity is bid $15, perfectly correlated. This may seem overly conservative, but
1

offer $15.1. The mid-market value of the position in the shares


60

it is not. When liquidity is tight and bid–offer spreads widen, en


5

is 90 * 10 = $900 million. The mid-market value of the position


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they tend to do so for all instruments. It makes sense for orr a


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in the commodity is 15.05 * 50 = $752.50 million. The propor-


66 Ce

financial institution to monitor changes in the liquiditytyy off its


65 ks

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)
06 oo

proportional bid-offer spread for the commodity is 0.1/15.05 or


82 B

on a regular basis. As we have seen, the bid–offer spread


offer spre
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0.006645. The cost of liquidation in a normal market is


58 ak

depends on how quickly a position is to be liqui


liquidated.
liqu date The
uidate
11 ah

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
41 M

be decreasing functions of the time period assumed for the


od as
or $7.5 million.
20

liquidation.
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4 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


1.1.3 Liquidity-Adjusted VaR Suppose that the mid-market price changes are normally distrib-
uted with a standard deviation of s per day and trading takes
Market value at risk is designed to calculate an estimate of a place at the beginning of a day. The variance of the change in
“worst case” change in the mark-to-market valuation of the the value of the traders position on day i is s2x2i . Assuming that
trading book. The measures in equations (1.1) and (1.2) are price changes on successive days are independent, the vari-
designed to calculate the cost of liquidating a book if market ance of the change in the value of the position applicable to the
prices do not change. Although VaR and liquidity risk measures unwind is therefore
deal with different types of risks, some researchers have sug- n

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

with the xi being calculated from V and the qi, as indicated


1.1.4 Unwinding a Position Optimally
above. The parameter l measures the confidence level in the
A trader wishing to unwind a large position in a financial instru- VaR estimate. For example, when the confidence level is 99%,
ment has to decide on the best trading strategy. If the position and daily price changes are assumed to be normally distributed,
is unwound quickly, the trader will face large bid–offer spreads, l = 2.326. Once the p(q) function has been estimated, Excel’s
but the potential loss from the mid-market price moving against Solver can be used for the optimization.
the trader is small. If the trader chooses to take several days to
unwind the position, the bid–offer spread the trader faces each
day will be lower, but the potential loss from the mid-market
Example 1.3
price moving against the trader is larger. A trader wishes to unwind a position of 100 million units in an
asset over five days. Suppose that the bid–offer spread p (mea-
This type of problem is discussed by Almgren and Chriss
sured in dollars) as a function of the daily trading volume is
(2001).2 Suppose that the size of a position is V units and that a
trader has to decide how to liquidate it over an n-day period. In p(q) = a + becq
this case, it is convenient to define the bid–offer spread in dol-
where a = 0.1, b = 0.05, and c = 0.03 and the amount traded,
lars rather than as a proportion. Define the dollar bid–offer
q, is measured in millions of units.
spread when the trader trades q units in one day as p(q) dollars.
Define qi as the units traded on day i and xi as the size of the The standard deviation of the price change per day is $0.1. A
trader’s position at the end of day i (1 … i … n). It follows that spreadsheet for calculating the optimal strategy can be down-
xi = xi - 1 - qi for 1 … i … n where x0 is defined as the initial loaded from the author’s website: www2.rotman.utoronto.ca/
position size, V. ~hull/riskman. When the confidence level is 95%, the amounts
that should be traded on days 1, 2, 3, 4, and 5 are 48.9, 30.0,
Each trade costs half the bid–offer spread. The total of the costs
1
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14.1, 5.1, and 1.9 million units, respectively. As the VaR confidence
o dence
5

related to the bid–offer spread is therefore


66
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level is reduced, the amounts traded per day show less vari-
sss var
ri--
ri
1- nt
20
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n p(qi) ability. For example, when the confidence level is 90%,90%


0%%, they are
0%,
a qi 2
65 ks

i=1 45.0, 29.1, 15.6, 7.0, and 3.3 million units, respectively.
pectivvely. When
ively.
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the confidence level is 75% they are 36.1, 26.2 26.2,


2, 17.7
2, 17.7, 11.6, and
-9 ali
58 ak

1 8.4 million units, respectively. In the limit


it when
mit wh en the
hen t confidence
This was suggested in A. Bangia, F. Diebold, T. Schuermann, and
11 ah

level is set equal to 50%, so that the trader


der is interested only in
rad
41 M

J. Stroughair, “Liquidity on the Outside,” Risk 12 (June): 68–73.


2
See R. Almgren and N. Chriss, “Optimal Execution of Portfolio Trans- expected costs, not in the standard deviat
deviation of costs, 20 million
devia
20

actions,” journal of Risk 3 (Winter 2001): 5–39. units should be traded each day.
99

Chapter 1 Liquidity Risk ■ 5

  


As this example illustrates, when a position is to be closed out Often, when a company experiences severe liquidity problems,
over n days, more than 1/n of the position should be traded on all three of these have occurred at the same time. The key to
the first day. This is because the longer any part of the position managing liquidity risk is predicting cash needs and ensuring
is held, the greater the risk of adverse market moves. that they can be met in adverse scenarios. Some cash needs
are predictable. For example, if a bank has issued a bond, it
knows when coupons will have to be paid. Others, such as
1.1.5 Other Measures of Market Liquidity
those associated with withdrawals of deposits by retail custom-
So far we have focused on bid–offer spread as a measure of ers and drawdowns by corporations on lines of credit that the
market liquidity. Many other measures have been proposed. The bank has granted, are less predictable. As the financial instru-
volume of trading per day (i.e., the number of times the asset ments entered into by financial institutions have become more
trades in a day) is an important measure. When an asset is highly complex, cash needs have become more difficult to predict. For
illiquid, the volume of trading in a day is often zero. The price example, downgrade triggers, guarantees provided by a finan-
impact of a trade of a certain size is another measure. A mea- cial institution, and possible defaults by counterparties in deriva-
sure somewhat similar to this, but more easily calculated, was tives transactions can have an unexpected impact on
proposed by Amihud (2002).3 It is the average of cash resources.
Absolute value of daily return
Daily dollar volume 1.2.1 Sources of Liquidity
over all days in the period considered. This measure is widely The main sources of liquidity for a financial institution are:
used by researchers. Amihud shows that an asset’s expected
1. Holdings of cash and Treasury securities
return increases as its liquidity decreases. In other words, inves-
tors do get compensated for illiquidity. 2. The ability to liquidate trading book positions
3. The ability to borrow money at short notice
1.2 LIQUIDITY FUNDING RISK 4. The ability to offer favorable terms to attract retail and
wholesale deposits at short notice
We now move on to consider liquidity funding risk. This is the
5. The ability to securitize assets (such as loans) at short notice
financial institution’s ability to meet its cash needs as they arise.
As mentioned at the outset of this chapter, liquidity is not the 6. Borrowings from the central bank
same as solvency. Financial institutions that are solvent (i.e., We now consider each of these in turn.
have positive equity) can, and sometimes do, fail because of
liquidity problems. Northern Rock, a British mortgage lender, is Cash and Treasury Securities Cash and Treasury securities are
a case in point (see Business Snapshot 1.1). excellent sources of liquidity. Cash is of course always avail-
able to meet liquidity needs and Treasury securities issued by
Liquidity funding problems at a financial institution can be countries such as the United States and the United Kingdom
caused by: can generally be converted into cash at short notice without any
1. Liquidity stresses in the economy (e.g., a flight to quality problem. However, cash and Treasury securities are relatively
such as that seen during the 2007 to 2009 crisis). Investors expensive sources of liquidity. There is a trade-off between the
are then reluctant to provide funding in situations where liquidity of an asset and the return it provides. In order to be
there is any credit risk at all. profitable, a financial institution needs to invest in assets such as
loans to corporations that provide a higher rate of return than
2. Overly aggressive funding decisions. There is a tendency
Treasury instruments. There is therefore a limit to the cash and
for all financial institutions to use short-term instruments to
Treasury securities that can reasonably be held.
fund long-term needs, creating a liquidity mismatch. Finan-
1
60

cial institutions need to ask themselves: “How much of a Liquidating Trading Book Positions Liquidity funding risk is
5
66
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mismatch is too much?” related to liquidity trading risk, considered in Section 1.1,
1- nt
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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
65 ks
06 oo

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
82 B

fore important for a financial institution to quantify


tify the
the liquidity
liq
-9 ali

rolling over funding.


58 ak

of its trading book so that it knows how easyy it would


wo be to use
11 ah
41 M

3
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
20
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6 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


BUSINESS SNAPSHOT 1.1 NORTHERN ROCK
Northern Rock, a British bank, was founded in 1997 when to access due to the volume of customers trying to log on.
the Northern Rock Building Society floated shares on the On Monday, September 17, worried savers continued to
London Stock Exchange. In 2007, it was one of the top withdraw their funds. An estimated £2 billion was withdrawn
five mortgage lenders in the United Kingdom. It had 76 between September 12 and September 17, 2007.
branches and offered deposit accounts, savings accounts,
Depositor insurance in the UK guaranteed 100% of the first
loans, and house/contents insurance. The bank grew rapidly
£2,000 and 90% of the next £33,000. Late on September
between 1997 and 2007. Some of its mortgages were secu-
17, 2007, the British Chancellor of the Exchequer, Alistair
ritized through a subsidiary, Granite, that was based in the
Darling, announced that the British government and the
Channel Islands.
Bank of England would guarantee all deposits held at North-
Northern Rock relied on selling short-term debt instru- ern Rock. As a result of this announcement and subsequent
ments for much of its funding. Following the subprime crisis advertisements in major UK newspapers, the lines outside
of August 2007, the bank found it very difficult to replace Northern Rock’s branches gradually disappeared. Northern
maturing instruments because institutional investors became Rock’s shares, which had fallen from £12 earlier in the year to
very nervous about lending to banks that were heavily £2.67, rose 16% son Mr. Darlings announcement.
involved in the mortgage business. The banks assets were During the months following September 12, 2007, Northern
sufficient to cover its liabilities so it was not insolvent. To Rock’s emergency borrowing requirement increased. The
quote from the Financial Services Authority (FSA) in Septem- Bank of England insisted on a penalty rate of interest to dis-
ber 2007: “The FSA judges that Northern Rock is solvent, courage other banks from taking excessive risks. Northern
exceeds its regulatory capital requirement, and has a good Rock raised some funds by selling assets, but by February
quality loan book.” But Northern Rock’s inability to fund itself 2008 the emergency borrowing reached £25 billion. The
was a serious problem. It approached the Bank of England bank was then nationalized and the management of the bank
for funding on September 12, 2007, and borrowed about was changed. It was split into Northern Rock plc and North-
£3 billion from the Tripartite Authority (Bank of England, the ern Rock (Asset Management), with the company’s bad debt
Financial Services Authority, and HM Treasury) in the follow- being put in Northern Rock (Asset Management). In Novem-
ing few days. ber 2011, Northern Rock plc was bought from the British
On September 13, 2007, the BBC business editor Robert government for £747 million by the Virgin Group, which is
Peston broke the news that the bank had requested emer- headed by the colorful entrepreneur Sir Richard Branson.
gency support from the Bank of England. On Friday, Septem- The Northern Rock story illustrates just how quickly liquidity
ber 14, there was a run on the bank. Thousands of people problems can lead to a bank spiraling downward. If the bank
lined up for hours to withdraw their funds. This was the first had been managed a little more conservatively and had paid
run on a British bank in 150 years. Some customers held their more attention to ensuring that it had access to funding, it
funds in an “Internet-only” account, which they were unable might have survived.

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-
1
60

leads to higher interest rates, shorter maturities for loans, and in pare interest rates offered by different financial institutions
io s and
tion
5
66
98 er

some cases a refusal to provide funds at all. Financial institutions make transfers via the Internet. Unfortunately, liquiditydity problems
p
prob
1- nt
20
66 Ce

should monitor the assets that can be pledged as collateral for tend to be market-wide rather than something that hatt affects
affect one
a
65 ks
06 oo

loans at short notice. A financial institution can (at a cost) miti- or two financial institutions. When one financialial institution
in
nstitu
stitu wants
82 B

gate its funding risks somewhat by arranging lines of credit. For to increase its retail or wholesale deposit base e for liquidity rea-
-9 ali
58 ak

example, Countrywide, an originator of mortgages in the United sons by offering more attractive rates of interest,
intteres others usually
11 ah
41 M

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.
20
99

Chapter 1 Liquidity Risk ■ 7

  


Securitization Banks have found the “originate-to-distribute”
model attractive. Rather than keep illiquid assets such as loans BUSINESS SNAPSHOT 1.2 ASHANTI
on their balance sheet, they have securitized them. Prior to GOLDFIELDS
August 2007, securitization was an important source of liquidity
Ashanti Goldfields, a West African gold-mining company
for banks. However, this source of liquidity dried up almost over- based in Ghana, experienced problems resulting from
night in August 2007 as investors decided that the securitized its hedging program in 1999. It had sought to protect
products were too risky. “Originate-to-distribute” was no longer its shareholders from gold price declines by selling gold
a viable strategy, and banks had to fund their loans. Not surpris- forward. On September 26, 1999, 15 European central
banks surprised the market with an announcement that
ingly, banks became a lot less willing to lend.
they would limit their gold sales over the following five
Securitization led to other liquidity problems in August 2007. years. The price of gold jumped up over 25%. Ashanti was
Banks had entered into liquidity backstop arrangements on the unable to meet margin calls and this resulted in a major
restructuring, which included the sale of a mine, a dilution
asset-backed commercial paper (ABCP) that was used to fund
of the interest of its equity shareholders, and a restructur-
debt instruments, such as mortgages, prior to their securitiza- ing of its hedge positions.
tion. When buyers could not be found, they had to buy the
instruments themselves. In some cases, in order to avoid their
reputations being adversely impacted, they had to provide
financial support to conduits and other off-balance-sheet vehi-
to access the ECB.) By September 2008, the ECB had lent
cles that were involved in securitization, even though they were
467 billion euros and announced that it would apply larger
not legally required to do so.
haircuts in the future.
Central Bank Borrowing Central banks (e.g., the Federal
Banks try to keep their borrowing from a central bank a secret.
Reserve Board in the United States, the Bank of England in the
There is a danger that the use of central bank borrowings will
UK, or the European Central Bank) are often referred to as
be interpreted by the market as a sign that the bank is experi-
“lenders of last resort.” When commercial banks are experienc-
encing financial difficulties with the result that other sources of
ing financial difficulties, central banks are prepared to lend
liquidity dry up. As Business Snapshot 1.1 discusses, news that
money to maintain the health of the financial system. Collateral
Northern Rock required emergency borrowing led to an imme-
has to be posted by the borrowers and the central bank typi-
diate run on the bank, exacerbating its liquidity problems.
cally applies a haircut (i.e., it lends less than 100% of the value
of the collateral) and may charge a relatively high rate of inter- Hedging Issues Liquidity problems are liable to arise when
est. In March 2008, after the failure of Bear Stearns (which was companies hedge illiquid assets with contracts that are sub-
taken over by JPMorgan Chase), the Federal Reserve Board ject to margin requirements. Gold-mining companies often
extended its borrowing facility to investment banks as well as hedge their risks by entering into agreements with financial
commercial banks.4 Later, it also made the facility available to institutions to sell gold forward for two or three years. Often
Fannie Mae and Freddie Mac (which were taken over by the the gold-mining company is required to post margin and the
government in September 2008). amount of the margin required is calculated every day to
reflect the value of its forward agreements. If the price of gold
Different central banks apply different rules. Following the
rises fast, the forward agreements lose money and result in
credit crisis of August 2007, the haircuts used by the Euro-
big margin calls being made by the financial institution on the
pean Central Bank (ECB) were lower than those of other
gold-mining company. The losses on the forward agreements
central banks. As a result, some British banks preferred to
are offset by increases in the value of the gold in the ground—
borrow from the European Central Bank (ECB) rather than the
but this is an illiquid asset. As discussed in Business Snap-
Bank of England. (There are even stories of North American
shot 1.2, Ashanti Goldfields was forced to undertake a major
banks contemplating the setting up of subsidiaries in Ireland
1

restructuring when it could not meet margin calls after a sharp


560
66

rise in the price of gold.


98 er
1- nt
20
66 Ce

Another extreme example of a liquidity funding problem em caused


cause
ca
65 ks
06 oo

4
Central banks are concerned about the failure of investment banks by hedging is provided by a German company, Metallgesell-
tallg
gesell
82 B

because of systemic risk. Investment banks have derivatives contracts schaft, that entered into profitable fixed-price oilil and
an
ndd gas
ga
-9 ali
58 ak

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
11 ah

danger that, because of the huge amount of trading between banks, a


41 M

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
20
99

8 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


1.2.3 Regulation
BUSINESS SNAPSHOT 1.3
Basel III introduced two liquidity risk requirements: the liquidity
METALLGESELLSCHAFT
coverage ratio (LCR) and the net stable funding ratio (NSFR).
In the early 1990s, Metallgesellschafi: (MG) sold a huge
volume of 5- to 10-year heating oil and gasoline fixed- The LCR requirement is
price supply contracts to its customers at six to eight cents
High@quality liquid assets
above market prices. It hedged its exposure with long Ú 100%
positions in short-dated futures contracts that were rolled Net cash outflows in a 30@day period
forward. As it turned out, the price of oil fell and there The 30-day period considered in the calculation of LCR is one
were margin calls on the futures positions. MG’s trading
of acute stress involving a downgrade of three notches (e.g.,
was made more difficult by the fact that its trades were
very large and were anticipated by others. from AA + to A + ), a partial loss of deposits, a complete loss of
wholesale funding, increased haircuts on secured funding, and
Considerable short-term cash flow pressures were placed
on MG. The members of MG who devised the hedging drawdowns on lines of credit. LCR was implemented in stages
strategy argued that these short-term cash outflows were between 2015 and 2019. (The required ratio was 60% in 2015
offset by positive cash flows that would ultimately be real- and 100% in 2019.)
ized on the long-term fixed-price contracts. However, the
company’s senior management and its bankers became The NSFR requirement is
concerned about the huge cash drain. As a result, the com- Amount of stable funding
pany closed out all the hedge positions and agreed with Ú 100%
Required amount of stable funding
its customers that the fixed-price contracts would be aban-
doned. The outcome was a loss to MG of $1.33 billion. The numerator is calculated by multiplying each category of
funding (capital, wholesale deposits, retail deposits, etc.) by an
available stable funding (ASF) factor, reflecting their stability. The
for hedging, but rather that they should ensure that they have denominator is calculated from the assets and off-balance-sheet
access to funding to handle the cash flow mismatches that items requiring funding. Each category of these is multiplied by a
might arise in extreme circumstances. required stable funding (RSF) factor to reflect the permanence of
the funding. The implementation date for the NSFR requirement
1.2.2 Reserve Requirements is January 1, 2018.

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.
1
60

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
5
66
98 er

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
1- nt
20
66 Ce

20%, a $100 deposit leads to $80 of lending, which leads to $64 financial system.
65 ks
06 oo

of lending, and so on. The total increase in the money supply is


82 B

80 + 64 + 51.2 + c or $400. Most countries do not use the


-9 ali
58 ak

reserve requirement as a way of controlling the money supply.


11 ah
41 M

An exception appears to be China, where the reserve require- 5


See Bank for International Settlements, “Principles
Princip
rincip for Sound Liquidity
ment is changed frequently, ptemb 2008.
Risk Management and Supervision,” September
20
99

Chapter 1 Liquidity Risk ■ 9

  


3. Senior management should develop a strategy, policies, 10. A bank should conduct stress tests on a regular basis for a
and practices to manage liquidity risk in accordance with variety of short-term and protracted institution-specific and
the risk tolerance and to ensure that the bank maintains market-wide stress scenarios (individually and in combina-
sufficient liquidity. Senior management should continuously tion) to identify sources of potential liquidity strain and to
review information on the bank’s liquidity developments ensure that current exposures remain in accordance with
and report to the board of directors on a regular basis. A a bank’s established liquidity risk tolerance. A bank should
bank’s board of directors should review and approve the use stress test outcomes to adjust its liquidity risk manage-
strategy, policies, and practices related to the management ment strategies, policies, and positions and to develop
of liquidity at least annually and ensure that senior manage- effective contingency plans.
ment manages liquidity risk effectively.
11. A bank should have a formal contingency funding plan
4. A bank should incorporate liquidity costs, benefits, and risks (CFP) that clearly sets out the strategies for addressing
in the internal pricing, performance measurement, and new liquidity shortfalls in emergency situations. A CFP should
product approval process for all significant business activi- outline policies to manage a range of stress environments,
ties (both on- and off-balance-sheet), thereby aligning the establish clear lines of responsibility, include clear invoca-
risk-taking incentives of individual business lines with the tion and escalation procedures, and be regularly tested and
liquidity risk exposures their activities create for the bank as updated to ensure that it is operationally robust.
a whole.
12. A bank should maintain a cushion of unencumbered, high-
5. A bank should have a sound process for identifying, mea- quality liquid assets to be held as insurance against a range
suring, monitoring, and controlling liquidity risk. This of liquidity stress scenarios, including those that involve
process should include a robust framework for comprehen- the loss or impairment of unsecured and typically available
sively projecting cash flows arising from assets, liabilities, secured funding sources. There should be no legal, regula-
and off-balance-sheet items over an appropriate set of time tory, or operational impediment to using these assets to
horizons. obtain funding.
6. A bank should actively monitor and control liquidity risk 13. A bank should publicly disclose information on a regular
exposures and funding needs within and across legal enti- basis that enables market participants to make an informed
ties, business lines, and currencies, taking into account judgment about the soundness of its liquidity risk manage-
legal, regulatory, and operational limitations to the transfer- ment framework and liquidity position.
ability of liquidity.
Recommendations for banks supervisors are:
7. A bank should establish a funding strategy that provides
effective diversification in the sources and tenor of funding. 14. Supervisors should regularly perform a comprehensive
It should maintain an ongoing presence in its chosen fund- assessment of a bank’s overall liquidity risk management
ing markets and strong relationships with funds providers framework and liquidity position to determine whether they
to promote effective diversification of funding sources. deliver an adequate level of resilience to liquidity stress
A bank should regularly gauge its capacity to raise funds given the bank’s role in the financial system.
quickly from each source. It should identify the main factors 15. Supervisors should supplement their regular assessments of
that affect its ability to raise funds and monitor those fac- a bank’s liquidity risk management framework and liquidity
tors closely to ensure that estimates of fund-raising capacity position by monitoring a combination of internal reports,
remain valid. prudential reports, and market information.
8. A bank should actively manage its intraday liquidity posi- 16. Supervisors should intervene to require effective and timely
tions and risks to meet payment and settlement obligations remedial action by a bank to address deficiencies in its
1

on a timely basis under both normal and stressed conditions liquidity risk management processes or liquidity position.
5 60
66

and thus contribute to the smooth functioning of payment


98 er

17. Supervisors should communicate with other supervisors ors


1- nt
20
66 Ce

and settlement systems.


and public authorities, such as central banks, both h within
wit
wiith
hin
65 ks

9. A bank should actively manage its collateral positions, dif-


06 oo

and across national borders, to facilitate effectiveve coopera-


coope
cco
82 B

ferentiating between encumbered and unencumbered tion regarding the supervision and oversight htt of liquidity
liquid risk
-9 ali
58 ak

assets. A bank should monitor the legal entity and physical management. Communication should occur ccur regularly
rregu during
11 ah
41 M

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
20
99

10 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


1.3 LIQUIDITY BLACK HOLES a more reasonable level. The result is that the market is liquid
with reasonable prices and a good balance of buyers
It is sometimes argued that technological and other develop- and sellers.
ments have led to an improvement in the liquidity of financial When positive feedback traders dominate the trading, market
markets. This is questionable. It is true that bid–offer spreads prices are liable to be unstable and the market may become
have on average declined. But there has also been an increasing one-sided and illiquid. A reduction in the price of an asset
tendency for situations to develop where almost everyone causes traders to sell. This results in prices falling further and
wants to do the same type of trade at the same time. The result more selling. An increase in the price of an asset causes traders
has been that what are referred to as “liquidity black holes” to buy. This results in the price of the asset increasing further
occur with increasing frequency.6 A liquidity black hole and more buying.
describes a situation where liquidity has dried up in a particular
There are a number of reasons why positive feedback trading
market because everyone wants to sell and no one wants to
exists. For example:
buy, or vice versa. It is sometimes also referred to as a
“crowded exit.”7
1. Trend trading. Trend traders attempt to identify trends in
In a well-functioning market, the market may change its opinion
an asset price. They buy when the asset price appears to be
about the price of an asset because of new information. How-
trending up and sell when it appears to be trending down.
ever, the price does not overreact. If a price decrease is too
A related strategy is breakout trading, which involves trad-
great, traders will quickly move in and buy the asset and a new
ing when an asset’s price moves outside an established
equilibrium price will be established. A liquidity black hole is
range. For example, if a stock has been trading in the range
created when a price decline causes more market participants to
of $25 to $30 for the last six months, traders might be
want to sell, driving prices well below where they will eventually
inclined to buy it as soon as it moves above $30 and sell it
settle. During the sell-off, liquidity dries up and the asset can be
as soon as it moves below $25.
sold only at a fire-sale price.8
2. Stop-loss rules. Traders often have rules to limit their
losses. When the price of an asset that is owned falls
1.3.1 Positive and Negative
below a certain level, they automatically sell to limit their
Feedback Traders losses. These rules are known as “stop-loss” rules and are
Changes in the liquidity of financial markets are driven by the a source of positive feedback trading that is always present
behavior of traders. There are two sorts of traders in the market: in the market.
negative feedback traders and positive feedback traders.9 Neg- 3. Dynamic hedging. Hedging a short option position (call
ative feedback traders buy when prices fall and sell when prices or put) involves buying after a price rise and selling after
rise; positive feedback traders sell when prices fall and buy a price decline. This is positive feedback trading that has
when prices rise. the potential to reduce liquidity. (By contrast, dynamically
In liquid markets, negative feedback traders dominate the hedging a long position in a call or put option involves sell-
trading. If the price of an asset gets unreasonably low, trad- ing after a price rise and buying after a price decline. This
ers will move in and buy. This creates demand for the asset is negative feedback trading and should not interfere with
that restores the price to a more reasonable level. Similarly, if market liquidity.) Any situation where banks have a large
the price of an asset gets unreasonably high, traders will sell. short option position has the potential to destabilize the
This creates supply of the asset that also restores the price to market and cause illiquidity. At one point banks sold a huge
volume of options on long-term interest rates to British
insurance companies. As the banks hedged their risks, the
1

behavior of long-term interest rates in the UK was dramati-


mati-
ati-
60

6
See A. D. Persaud, ed., Liquidity Black Holes: Understanding, Quantify-
5

ing and Managing Financial Liquidity Risk (London: Risk Books, 1999). cally affected.
66
98 er
1- nt
20
66 Ce

7
See, for example, J. Clunie, Predatory Trading and Crowded Exits: New 4. Creating options synthetically. Hedging a short hortt position
p
posit in
65 ks

Thinking on Market Volatility (Petersfield, UK: Harriman House, 2010).


an option is equivalent to creating a long g position
06 oo

possition in the
8
82 B

Liquidity black holes tend to be associated with price decreases, but it


same option synthetically. It follows that
hat a financial
fina institu-
-9 ali

is in theory also possible for them to occur when there are price increases.
58 ak

tion can create a long option position


tion synthetically
ssynth by doing
11 ah

9
This is a simplification of reality to help understand the dynamics of
41 M

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
20
99

Chapter 1 Liquidity Risk ■ 11

  


trading that can cause market instability and illiquidity. The 7. LTCM. The failure of the hedge fund Long-Term Capital
classic example here is the stock market crash of October Management (LTCM) provides an example of positive
1987. In the period leading up to the crash, the stock mar- feedback trading. One type of LTCM’s trade was “relative
ket had done very well. Increasing numbers of portfolio value fixed income.” LTCM would take a short position
managers were using commercially available programs to in a liquid bond and a long position in a similar illiquid
synthetically create put options on their portfolios. These bond, and wait for the prices to move close together.
programs told them to sell part of their portfolio immedi- After the Russian default in 1998, the prices of illiquid
ately after a price decline and buy it back immediately after instruments declined relative to similar liquid instruments.
a price increase. The result, as indicated in Business Snap- LTCM (and other companies that were following similar
shot 1.4, was a liquidity black hole where prices plunged on strategies to LTCM) were highly leveraged and unable
October 19, 1987. In this case, the liquidity black hole was to meet margin calls. They were forced to close out their
relatively short-lived. Within four months the market recov- positions. This involved buying the liquid bonds and sell-
ered to close to its pre-crash level. ing the illiquid bonds. This reinforced the flight to quality
5. Margins. A big movement in market variables, particularly and made the prices of illiquid and liquid bonds diverge
for traders who are highly leveraged, may lead to margin even further.
calls that cannot be met. This forces traders to close out
their positions, which reinforces the underlying move in the 1.3.2 Leveraging and Deleveraging
market variables. It is likely that volatility increases. This A phenomenon in the market is leveraging and deleverag-
may exacerbate the situation because it leads to exchanges ing. This is illustrated in Figures 1.2 and 1.3. When banks are
increasing their margin requirements. awash with liquidity (e.g., because they have developed ways
6. Predatory trading. This was mentioned in Section 1.1. If of securitizing assets or because deposit levels are higher
traders know that an investor must sell large quantities of a than usual), they make credit easily available to businesses,
certain asset, they know that the price of the asset is likely investors, and consumers. Credit spreads decrease. The easy
to decrease. They therefore short the asset. This reinforces availability of credit increases demand for both financial and
the price decline and results in the price falling even further nonfinancial assets and the prices of these assets rise. Assets
than it would otherwise do. To avoid predatory trading, are often pledged as collateral for the loans that are used to
large positions must usually be unwound slowly. finance them. When the prices of the assets rise, the collateral

BUSINESS SNAPSHOT 1.4 THE CRASH OF 1987


On Monday, October 19, 1987, the Dow Jones Industrial sales amounted to 21.3% of all sales in index futures markets.
Average dropped by more than 20%. Portfolio insurance It is likely that the decline in equity prices was exacerbated
played a major role in this crash. In October 1987, portfolios by investors other than portfolio insurers selling heavily
involving over $60 billion of equity assets were being man- because they anticipated the actions of portfolio insurers.
aged with trading rules that were designed to synthetically
Because the market declined so fast and the stock exchange
create put options on the portfolios. These trading rules
systems were overloaded, many portfolio insurers were
involved selling equities (or selling index futures) when
unable to execute the trades generated by their models
the market declined and buying equities (or buying equity
and failed to obtain the protection they required. Needless
futures) when the market rose.
to say, the popularity of portfolio insurance schemes has
During the period Wednesday, October 14, 1987, to Friday, declined significantly since 1987. One of the lessons from
October 16, 1987, the market declined by about 10%, with this story is that it is dangerous to follow a particular trading
much of this decline taking place on Friday afternoon. The strategy—even a hedging strategy—when many other mar-
1
60

portfolio insurance rules should have generated at least ket participants are doing the same thing. To quote from a
5
66
98 er

$12 billion of equity or index futures sales as a result of this report on the crash, “Liquidity sufficient to absorb the limited mited
1- nt
20
66 Ce

decline. In fact, portfolio insurers had time to sell only selling demands of investors became an illusion of liquidity diity
65 ks

$4 billion and they approached the following week with huge by massive selling, as everyone showed up on the same ame side
s
06 oo

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
82 B
-9 ali

mated that on Monday, October 19, sell programs by three which led certain similarly motivated investors, such h as port-
58 ak

portfolio insurers accounted for almost 10% of the sales on folio insurers, to adopt strategies which call for liquidity
lliquid far in
11 ah
41 M

the New York Stock Exchange, and that portfolio insurance excess of what the market could supply.”
20
99

12 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Hedge funds are particularly affected by the leveraging-
deleveraging cycle. Consider a hedge fund that is able to borrow
20 times its equity during the pre-2007 period. Soon after the mid-
dle of 2007, the hedge fund might get a call from its prime broker
telling it to reduce leverage to, say, five times equity. It can only
do this by selling assets. Asset prices decrease as a result of what
this hedge fund, and other hedge funds, are doing. The hedge
fund’s equity declines and further sales are necessary.

1.3.3 Irrational Exuberance


The term “irrational exuberance” was used by Alan Greenspan,
Figure 1.2 Leveraging. Federal Reserve Board chairman, in a speech in December 1996
when, in reference to the stock market, he asked, “How do we
know when irrational exuberance has unduly escalated asset
values?” (The phrase has been remembered because the speech
was followed by declines in stock prices worldwide.) Most liquid-
ity black holes can be traced to irrational exuberance of one sort
or another. What happens is that traders working for many dif-
ferent financial institutions become irrationally exuberant about
a particular asset class or a particular market variable. The bal-
ance sheets of financial institutions then become overextended
through the accumulation of exposure to this asset class or mar-
ket variable. Often the process is self-reinforcing. When many
financial institutions choose to take a particular position, prices
increase, making the position look profitable. This creates extra
Figure 1.3 Deleveraging. desire on the part of financial institutions to take the position
and yet more profits. Risk managers working for the financial
institution should (and probably will) complain about the risks
underlying loans (when measured at market prices) is greater being taken, but in many instances senior management are likely
and borrowing can increase further. This leads to further asset to ignore their concerns because high profits are being made.
purchases and a repeat of the cycle. This cycle is referred to as To quote Chuck Prince, ex-CEO of Citigroup, on July 10, 2007:
“leveraging” because it leads to more borrowing throughout “When the music stops, in terms of liquidity, things will be com-
the economy. plicated. But as long as the music is playing, you’ve got to get
up and dance. Were still dancing.”
Deleveraging is the opposite process to leveraging. Banks find
themselves less liquid for some reason (e.g., because there is At some stage the bubble must burst. Many traders then try
less demand for the products of securitization). They become to get out of their positions at the same time, causing illiquid
more reluctant to lend money. Credit spreads increase. There is markets and huge losses. Volatility increases and the risk man-
less demand for both nonfinancial and financial assets and their agement procedures used within the financial institution (e.g.,
prices decrease. The value of the collateral supporting loans the calculation of market VaR from historical data) can cause
decreases and banks reduce lines of credit. This leads to asset many financial institutions to try to unwind a wide range of
1

sales being necessary and a further reduction in asset prices. risky positions at the same time. This can lead to further losses
sses
60
5

and more serious illiquidity problems. There may be e failures


failu
ures
66
98 er

The period leading up to 2007 was characterized by leverag-


1- nt
20
66 Ce

(or rumors of failures) by some banks. Most banksks are


e likely
like to
ing for many of the world’s economies. Credit spreads declined
65 ks

experience liquidity funding problems and as a result


esult lending
res l
06 oo

and it was relatively easy to borrow money for a wide range of


82 B

may be curtailed.
different purposes. From the middle of 2007 onward, the situa-
-9 ali
58 ak

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
11 ah
41 M

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
20
99

Chapter 1 Liquidity Risk ■ 13

  


Asian monetary crisis, and the 1998 Long-Term Capital Manage- portfolios when volatilities and correlations increase. These
ment failure. Irrational exuberance is part of human nature and to parameters tend to be mean reverting and so they eventually
some extent is inevitable. It is exacerbated by the way traders are decrease again.
paid. A large part of the compensation comes from a bonus at
year-end, which depends on performance during the year. A trader 1.3.5 The Importance of Diversity
may be savvy enough to know that a market is irrationally exuber-
ant and that there will be a correction. However, if there is a good Models in economics usually assume that market participants act
chance that the correction will be delayed until next year, the trader independently of each other. We have argued that this is often
is motivated to continue building up his or her position to maximize not the case. It is this lack of independence that causes liquid-
short-term compensation. ity black holes. Traders working for financial institutions tend to
want to do the same trades at the same time. To solve the prob-
lem of liquidity black holes, we need more diversity in financial
1.3.4 The Impact of Regulation markets. One way of creating diversity is to recognize that dif-
In many ways it is a laudable goal on the part of regulators to seek ferent types of financial institutions have different types of risks
to ensure that banks throughout the world are regulated in the and should be regulated differently.
same way. Capital requirements and the extent to which they were Hedge funds have become important market participants. They are
enforced varied from country to country prior to Basel I. Banks were much less regulated than banks or insurance companies and can
competing globally and as a result a bank subject to low capital follow any trading strategy they like. To some extent they do add
requirements, or capital requirements that were not strictly enforced, diversity (and therefore liquidity) to the market. But, as mentioned
found it easier to take risks and was therefore able to be more com- earlier, hedge funds tend to be highly leveraged. When liquidity
petitive in the pricing of some products. tightens as it did in the second half of 2007, all hedge funds have
However, a uniform regulatory environment comes with costs. All to unwind positions accentuating the liquidity problems.
banks tend to respond in the same way to external events. Con- One conclusion from the arguments we have put forward is
sider for example market risk. When volatilities and correlations that a contrarian investment strategy has some merit. If mar-
increase, market risk VaR and the capital required for market kets overreact for the reasons we have mentioned, an investor
risks increase. Banks then take steps to reduce their exposures. can do quite well by buying when everyone else is selling and
Since banks often have similar positions to each other, they try to there is very little liquidity. However, it can be quite difficult for
do similar trades. A liquidity black hole can develop. a financial institution to follow such a strategy if it is subject to
There is a similar issue as far as credit risk is concerned. During short-term VaR-based risk management.
the low point of the economic cycle, default probabilities are rel-
atively high and capital requirements for loans under the Basel II
internal-ratings-based models tend to be high. As a result, banks
SUMMARY
may be less willing to make loans, creating problems for small
There are two types of liquidity risk: liquidity trading risk and
and medium-sized businesses. During the high point of the busi-
liquidity funding risk. Liquidity trading risk is concerned with the
ness cycle, default probabilities are relatively low and banks may
ease with which positions in the trading book can be unwound.
be too willing to grant credit. (This is similar to the phenomenon
The liquidity trading risk of an asset depends on the nature of
described in Figures 1.2 and 1.3.) The Basel Committee has rec-
the asset, how much of the asset is to be traded, how quickly it
ognized this problem and has dealt with it by asserting that the
is to be traded, and the economic environment. The credit crisis
probability of default should be an average of the probability of
of 2007 emphasizes the importance of transparency. Assets that
default through the economic or credit cycle, rather than an esti-
are not well defined or well understood are unlikely to trade in
mate applicable to one particular point in time.
a liquid market for long. The liquidity of an asset at a particu-
1
60

Should other financial institutions such as life insurance compa- lar time can be measured as the dollar bid–offer spread or ass
5
66
98 er

nies and pension funds be regulated in the same way as banks? the proportional bid–offer spread. The latter is the difference ence
1- nt
20
66 Ce

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
65 ks
06 oo

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
a
82 B

be “no.” These financial institutions have longer time horizons is half of the bid–offer spread. Financial institutions
ons should
shou
s moni-
-9 ali
58 ak

than banks. They should not be penalized for investing in illiq- tor the cost of unwinding the whole trading bookk in both b normal
11 ah
41 M

uid assets. Also, they should not be required to adjust their market conditions and stressed market conditions.
dittions
ions
20
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14 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


A trader, when faced with the problem of unwinding a large posi- Brunnermeier, M. K., and L. H. Pedersen. “Market Liquidity and
tion in an asset, has a trade-off between the bid–offer spread and Funding Liquidity.” Review of Financial Studies 22, no. 6 (2009):
market risk. Unwinding quickly leads to high bid–offer spreads, but 2201–2238.
low market risk. Unwinding slowly leads to lower bid–offer spreads,
Brunnermeier, M. K, and L. H. Pedersen. “Predatory Trading.”
but more market risk. The optimal trading strategy depends on
Journal of Finance 60, no. 4 (2005): 1825–1863.
(a) the dollar bid–offer spread as a function of the quantity traded
in a day and (b) the probability distribution for daily changes in Clunie, J. Predatory Trading and Crowded Exits: New
the asset price. For any particular unwind strategy, the trader can Thinking on Market Volatility. Petersfield, UK: Harriman
choose a confidence level and calculate the unwind cost that will House, 2010.
not be exceeded with the confidence level. The unwind strategy Persaud, A. D., ed. Liquidity Black Holes: Understanding, Quan-
that minimizes this cost can then be determined. tifying and Managing Financial Liquidity Risk. London: Risk
Liquidity funding risk management is concerned with being able Books, 1999.
to meet cash needs as they arise. It is important for a financial
institution to forecast its cash needs in both normal market con-
ditions and stressed market conditions to ensure that they can be
PRACTICE QUESTIONS
met with almost total certainty. Cash needs depend on deposi-
tor withdrawals, drawdowns on lines of credit, guarantees that
AND PROBLEMS
have been made, defaults by counterparties, and so on. Sources
1.1 What was the transparency problem in the subprime cri-
of cash are instruments that can be readily converted into cash,
sis of 2007?
borrowings in the wholesale market, asset securitizations, new
depositors, cash itself, and (as a last resort) borrowings from a 1.2 An asset is quoted bid 50, offer 55. What does this
central bank. In June 2008, bank regulators issued a list of mean? What is the proportional bid–offer spread?
17 principles describing how banks should manage their liquidity 1.3 Suppose that an investor has shorted shares worth
and indicated that they would be monitoring the liquidity man- $5,000 of Company A and bought shares worth $3,000
agement procedures of banks more carefully in the future. of Company B. The proportional bid–offer spread for
The most serious liquidity risks arise from what are sometimes Company A is 0.01 and the proportional bid–offer spread
termed liquidity black holes. These occur when all traders want for Company B is 0.02. What does it cost the investor to
to be on the same side of the market at the same time. This unwind the portfolio?
may be because they have similar positions and manage risks 1.4 Suppose that in Problem 1.3 the bid–offer spreads for
in similar ways. It may also be because they become irrationally the two companies are normally distributed. For Com-
exuberant, overexposing themselves to particular risks. What pany A the bid–offer spread has a mean of 0.01 and a
is needed is more diversity in the trading strategies followed standard deviation of 0.01. For Company B the bid–offer
by market participants. Traders who have long-term objectives spread has a mean of 0.02 and a standard deviation of
should avoid allowing themselves to be influenced by the short- 0.03. What is the cost of unwinding that the investor is
term over reaction of markets. 95% confident will not be exceeded?
1.5 A trader wishes to unwind a position of 60 million units
in an asset over 10 days. The dollar bid–offer spread as
Further Reading a function of daily trading volume, q, is a + becq where
a = 0.2, b = 0.1, and c = 0.08 and q is measured in mil-
Almgren, R., and N. Chriss. “Optimal Execution of Portfolio lions. The standard deviation of the price change per day
Transactions.” Journal of Risk 3 (Winter 2001): 5–39. is $0.1. What is the optimal strategy that minimizes the
e
1
60

Bangia, A., F. Diebold, T. Schuermann, and J. Stroughair. 95% confidence level for the costs?
5
66
98 er
1- nt
20

“Liquidity on the Outside.” Risk 12 (June 1999): 68–73. 1.6 Explain the difference between the liquidityy coverage
covvera
66 Ce

ratio (LCR) and the net stable funding ratio


tio (NSFR).
atio ((NSF
65 ks

Bank for International Settlements. “Liquidity Risk Management


06 oo
82 B

and Supervisory Challenges,” February 2008. 1.7 Why is it risky to rely on wholesale deposits
dep
ep
po
osits for
f funding?
-9 a
58 ak

Bank for International Settlements. “Principles for Sound Liquid- 1.8 What was the nature of the funding
ding
g risk problems of
11 ah
41 M

ity Risk Management and Supervision,” September 2008. Ashanti Goldfields and Metallgesellschaft?
ges
esellsc
sellsc
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Chapter 1 Liquidity Risk ■ 15

  


1.9 What is meant by (a) positive feedback trading and and offer $60, and 200 shares of B, which is bid $25 and
(b) negative feedback trading? Which is liable to lead to offer $35. What are the proportional bid–offer spreads?
liquidity problems? What is the impact of the high bid–offer spreads on the
1.10 What is meant by liquidity-adjusted VaR? amount it would cost the trader to unwind the portfolio?
If the bid–offer spreads are normally distributed with
1.11 Explain how liquidity black holes occur. How can regula-
mean $10 and standard deviation $3, what is the 99%
tion lead to liquidity black holes?
worst-case cost of unwinding in the future as a percent-
1.12 Why is it beneficial to the liquidity of markets for traders age of the value of the portfolio?
to follow diverse trading strategies?
1.15 A trader wishes to unwind a position of 200,000 units in
an asset over eight days. The dollar bid–offer spread, as
a function of daily trading volume q, is a + becq where
FURTHER QUESTIONS a = 0.2, b = 0.15, and c = 0.1 and q is measured in
thousands. The standard deviation of the price change per
1.13 Discuss whether hedge funds are good or bad for the day is $1.50. What is the optimal trading strategy for mini-
liquidity of markets. mizing the 99% confidence level for the costs? What is the
1.14 Suppose that a trader has bought some illiquid shares. In average time the trader waits before selling? How does
particular, the trader has 100 shares of A, which is bid $50 this average time change as the confidence level changes?

1
560
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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16 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Liquidity and
Leverage
2
■ Learning Objectives
After completing this reading you should be able to:

● 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.

● Describe the relationship between leverage and a firm’s


return profile (including the leverage effect) and distin-
guish the impact of different types of transactions on a
firm’s leverage and balance sheet.
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 12 of Financial Risk Management: Models, History, and Institutions, by Allan M. Malz.
20
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17

  


One of the most important aspects of the subprime crisis was These types of liquidity risk interact. For example, if a counter-
the sudden reluctance of financial institutions to lend money, party increases collateral requirements or otherwise raises the
and the increased reluctance to borrow on the part of financial cost of financing a long position in a security, the trader may
as well as nonfinancial businesses and households, a develop- have to unwind it before the expected return is fully realized. By
ment called “The Great Deleveraging.” It contributed to the shrinking the horizon of the trade, the deterioration of funding
rapid decline in the market prices of risky assets and was self- liquidity also increases the transaction liquidity risk. The interac-
perpetuating. In this chapter, we try to disentangle the concepts tion also works the other way. If a leveraged market participant
of liquidity and leverage. We give definitions of each, showing is perceived to have illiquid assets on its books, its funding will
how they are related. be in greater jeopardy.
The term “liquidity” has been defined in myriad ways that ulti- We begin our discussion of liquidity risk by discussing its credit
mately boil down to two properties, transactions liquidity, a aspect, funding liquidity risk, and the ways in which this risk can
property of assets or markets, and funding liquidity, which is manifest itself, in more detail. Later sections discuss transactions
more closely related to credit-worthiness. Transaction liquidity liquidity. The discussion of liquidity risk will provide important
is the property of an asset being easy to exchange for other background for understanding financial panics.
assets. Most financial institutions are heavily leveraged; that
is, they borrow heavily to finance their assets, compared to
the typical nonfinancial firm. Funding liquidity is the ability to 2.1 FUNDING LIQUIDITY RISK
finance assets continuously at an acceptable borrowing rate.
For financial firms, many of those assets include short positions Maturity Transformation
and derivatives.
Funding liquidity risk arises for market participants who bor-
As with “liquidity,” the term “liquidity risk” is used to describe
row at short term to finance investments that require a longer
several distinct but related phenomena:
time to become profitable. Many traders and investors, such as
Transaction liquidity risk is the risk of moving the price banks, securities firms, and hedge funds, are largely short-term
of an asset adversely in the act of buying or selling it. borrowers, so their capacity to maintain long-term positions
Transaction liquidity risk is low if assets can be liquidated and their flexibility when circumstances or expectations change
or a position can be covered quickly, cheaply, and with- is limited. The balance-sheet situation of a market participant
out moving the price “too much.” An asset is said to funding a longer-term asset with a shorter-term liability is called
be liquid if it is “near” or a good substitute for cash. a maturity mismatch.
An asset is said to have a liquidity premium if its price
Managing maturity mismatches is a core function of banks
is lower and expected return higher because it isn’t
and other financial intermediaries. All financial and economic
perfectly liquid. A market is said to be liquid if market
investment projects take time, in some cases a very long time,
participants can put on or unwind positions quickly,
to come to fruition. To provide the needed capital, financial
without excessive transactions costs and without
intermediaries effect a maturity transformation and possi-
excessive price deterioration.
bly also a liquidity transformation; they obtain shorter-term
Balance sheet risk or funding liquidity risk. Funding funding and provide longer-term funding to finance projects.
liquidity risk is the risk that creditors either withdraw Funding longer-term assets with longer-term debt is called
credit or change the terms on which it is granted in such matched funding.
a way that the positions have to be unwound and/or
Intermediaries engage in maturity mismatch because it is gener-
are no longer profitable. Funding liquidity can be put at
ally profitable. Every market participant has a cost of capital,
risk because the borrower’s credit quality is, or at least
the rate of return on all its liabilities, including equity. The most
1

perceived to be, deteriorating, but also because financial


60

“expensive” capital is equity, because it takes the most risk;


5

conditions as a whole are deteriorating.


66
98 er

it has no contractually stipulated remuneration and is the first irst


1- nt
20
66 Ce

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

may be impaired. ceived to be low.


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18 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The spread between the interest intermediaries pay—their of currencies under pressure can rise to extremely high levels,
funding cost—and the interest they earn is called the net interest limited only by uncertainty about whether and when the depre-
margin. Yield curves are typically upward sloping. Intermediaries ciation will take place.
therefore have a powerful incentive to introduce maturity mis-
Some forms of very short-term debt serve the means-of-
matches into their balance sheets. In the aftermath of economic
payment function of money, particularly those forms that are
downturns and financial crises, the yield curve typically has a
checkable, that is, can be very easily transferred to a third party:
sharper upward slope, increasing net interest margin, which
demand deposits and money market mutual fund (MMMF)
becomes an important part of banks’ rebuilding following the
liabilities. These types of debt have even lower yields than can
downturn.
be explained by their short maturities because of their useful-
Because short-term rates are generally lower than long-term ness as means of payment and settling debts. Providing liquidity
rates, there is a powerful incentive to borrow short-term if pos- and payment services contributes to intermediaries’ net interest
sible. Funding long-term assets with short-term debt exposes margin. The liquidity transformation bundled with maturity trans-
an intermediary to rollover risk, the risk that the short-term debt formation has long made banks more efficient intermediaries.
cannot be refinanced, or can be refinanced only on highly disad-
The process by which financial intermediaries use their balance
vantageous terms. In a rollover risk event, cash flow can become
sheets to create assets that can be used as money goes back
negative. For example, an investor may be financing bonds with
to the origins of banking. Prior to the mid-1970s, this activity
short-term borrowing at a positive spread. If the debt cannot
was the almost exclusive province of commercial banks. Nowa-
be refinanced at an interest rate below the bond yield, negative
days, the money supply is defined to include certain nonbank
cash flow and losses result.
liabilities such as those of MMMFs, as well as banknotes and
Funding conditions can change rapidly. A firm or investor can, bank deposits. They have in common that, in contrast to other
after a long period of short-term funding with positive cash short-term debt instruments, their values don’t depend on
flow, suddenly find himself in a negative cash flow situation from interest rates, and they can be used to buy both goods and
which there is no obvious escape if short-term funding is sud- assets. To the extent that an asset has the characteristics of
denly closed to him or its costs escalate. Because of this binary immediacy and certainty, they resemble money and are said
character, rollover risk is sometimes called “cliff risk.” The liquid- to be liquid.
ity condition of a market participant relying heavily on short-
Deposit liabilities of banks were at one time the main form of
term funding can reach a state of distress very quickly.
money not created by central banks. In the contemporary finan-
cial system, the core banking functions of maturity and liquidity
transformation are increasingly carried out by other means and
Liquidity Transformation other institutions, such as the commercial paper markets and
Intermediaries earn net interest margin from maturity transfor- MMMFs. With the introduction and growth of money market
mation because short-term debt generally carries lower interest funds, an important new type of short-term assets that could be
than longer-term debt. Very short-term yields—money-market used as money was created. In the United States, retail MMMF
rates—are almost invariably lower. But the short-term funding of balances are included in the M2 measure of the money sup-
an intermediary is the short-term asset of the lender, and may ply, accounting for roughly 10 percent of the total. Institutional
provide liquidity and payment services to the investor as well as MMMF balances are about twice as large as retail, but are not
a flow of interest payments. Money-market instruments such as included in U.S. monetary aggregates.
short-term interbank loans to sound banks, commercial paper of
Market participants hold money to conduct transactions and for
creditworthy issuers, repos with adequate haircuts, and govern-
speculative reasons. In Keynes’ well-known explanation of the
ment bills, are not generally classified as money, but have cer-
demand for money, balances held for the purpose of conduct-
tain characteristics of money. They can be readily exchanged for
1
60

ing transactions include a portion attributable to uncertainty


ta y
5

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
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are lower because short-term debt partially satisfies the need for
66 Ce

pants also hold money out of a speculative motive vee which


wh ch is
hich i a
liquidity as well as having far less interest-rate risk.
65 ks

function of current asset prices, especially interest


erestt rates,
rate uncer-
06 oo
82 B

The major exception to this general observation are short-term tainty about future asset prices, and risk preferences.
eference Keynes
refe
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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
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Chapter 2 Liquidity and Leverage ■ 19

  


because they expect asset prices to be lower in the future, thus The balance sheet of a “classic bank,” that is, one chiefly reliant
driving prices lower in fact.1 on deposits for funding, might look like this:

Uncertainty of value is a property even of assets that have mini-


mal credit risk, but mature in the future, such as U.S. Treasury Assets Liabilities
bills, because their values depend on interest rates. Interest rates Cash and government bonds $15 Common equity $10
fluctuate, and affect the price even of short-term T-bills; hence
5-year corporate loans $85 Deposits $90
T-bills are not money. However, if, like T-bills, their interest-rate
risk is very low, and they also have little or no credit risk, they are Banks and similar intermediaries are depository institutions,
viewed as relatively liquid and thus close in character to money. that is, institutions that borrow from the public in the form
Keynes’s term for the demand for money, liquidity preference, of liabilities that must be repaid in full on demand, instantly,
has become particularly pertinent during the subprime crisis. In in cash, on a first-come first-served basis. This aspect of the
normal times, the desire for liquidity is counterbalanced by the deposit contract is called the sequential service constraint, and
zero or low yields earned by cash and liquid assets. In crises, contrasts sharply with bankruptcy, in which claims are paid pro
risk-aversion and uncertainty are high, so market participants rata. Deposits pay zero or relatively low rates of interest, though
wish to hold a much larger fraction of their assets in liquid form, one of the main areas of financial innovation over the past few
and are relatively indifferent to the yield. In the terminology of decades has been in making it possible for lenders to earn inter-
economics, the velocity of money declines drastically. Market est while still enjoying such benefits of liquidity as check-writing,
participants desire larger liquidity portfolios, they prefer cash to for example, in MMMFs.
money-market instruments, and become abruptly more sensitive Banks can also tap the broader capital markets and raise funds
to even the relatively low credit and counterparty risk of instru- by issuing bonds, commercial paper, and other forms of debt.
ments other than government bills.2 These sources of wholesale funding are, on the one hand, gen-
erally of longer term than deposits, which can be redeemed at
short notice. However, deposits are considered “sticky.” Deposi-
Bank Liquidity
tors tend to remain with a bank unless impelled to switch by a
The core function of a commercial bank is to take deposits and life change such as moving house; bankers joke that deposi-
provide commercial and industrial loans to nonfinancial firms. tors are more apt to divorce than remove deposits. Depositors
In doing so, it carries out a liquidity and maturity, as well as a are also a naturally diversified set of counterparties, so a large
credit, transformation. It transforms long-term illiquid assets— deposit base reduces reliance on a small number of lenders.
loans to businesses—into short-term liquid ones, including
Shorter-term forms of wholesale funding such as commercial
deposits and other liabilities that can be used as money.
paper are less reliable and potentially more concentrated
sources of longer-term liquidity than a solid deposit base.
Liquidity Transformation by Banks These funding decisions are nowadays also heavily influenced
Banks carry out their functions through operations on both sides by regulatory capital requirements, which can favor or disfavor
of the balance sheet. Prior to the advent of shadow banking particular types of assets and thus influence their funding costs
and the incursion of commercial banks into investment banking, as liabilities.
depository institutions generally earned most of their revenues
The borrowing firms invest the loan proceeds in physical and
from net interest margin. In contemporary finance, banks earn
other capital. A span of time and many stages are needed, in
a higher proportion of revenues from origination, investment
addition to the capital resources, before these projects produce
banking, and other fees. They also have important revenues
goods and services that can be sold to repay the loans that
from market making, that is, earning the bid-ask spread on
finance them. Until then, the invested capital can be sold only at
transactions executed for customers, and proprietary trading,
1

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

interest margin remains a crucial source of revenues.


66 Ce

The bank could borrow at a longer term to match the maturity


maatu
turity
65 ks
06 oo

of its assets, but this would reduce its net interest margin.
marggin. The
T
82 B

bank would still be rewarded for another important tant set of


o bank-
-9 ali

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
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20 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


the extent that the banks’ delegated monitoring function does bank run. Depositors and other short-term creditors are aware
not produce added value, borrowers could turn directly to the the banks cannot meet large-scale redemption requests. If they
bond markets themselves. are concerned about banks’ liquidity, they will endeavor to
redeem before other depositors and lenders.
The investments on the asset side of the bank’s balance sheet
not only have longer terms to maturity than their liabilities, they No asset-liability management system can protect a fractional-
are also less liquid; deposits in contrast are very close substi- reserve bank against a general loss of confidence in its ability to
tutes for cash. The liquidity transformation function of banks pay out depositors. As long as the bank carries out a liquidity
has been described as “turning illiquid assets into liquid ones.” and maturity transformation, and has liabilities it is obligated to
However, this transformation depends on confidence in the repay at par and on demand, no degree of liquidity that a bank
bank’s solvency. can achieve can protect it completely against a run. Fragility can
How, then, can the liquidity and maturity transformations be be mitigated through higher capital, which reduces depositors’
made to work? Only a small fraction of deposits and other short- concern about solvency, the typical trigger of a run, and higher
term funding are expected to be redeemed at any one time. reserves, which reduces concern about liquidity. Historically,
Banks engage in asset-liability management (ALM). This is a banks have also protected themselves against runs through
technique for aligning available cash and short-term assets with individual mechanisms such as temporary suspension of convert-
expected requirements. A well-managed bank leaves an ample ibility, and collective mechanisms such as clearing-houses.
buffer of cash and highly liquid assets for unexpected redemp- Because banking is fragile, there have from time to time been
tions of deposits and other funding. calls to abolish traditional, deposit-dependent commercial bank-
ing, and replace it with a more robust type of financial institu-
Fragility of Commercial Banking tion. An alternative view is that depository institutions must be
The classic depository institution we have been describing is a restricted in their activities and closely supervised to prevent
fractional-reserve bank, that is a bank that lends deposits. The them from taking risks that could jeopardize their ability to meet
alternative to a fractional-reserve bank is a 100 percent reserve withdrawals. Under the rubric “Volcker Rule,” it has been incor-
bank, which lends only its own capital, or funds raised in capital porated in the regulatory restructuring mandated by the 2010
markets, and keeps a reserve of cash and highly liquid securities Dodd-Frank Act.
equal to its entire deposit base. Throughout the history of bank- Apart from deposits, banks are generally dependent on short-
ing, almost all banks have been fractional-reserve banks. Bank- term financing, exposing them to rollover risk events that,
ing originated in the Low Countries, and a bit later in Italy, in while less extreme than runs, can be costly or increase fragility.
the thirteenth century. In its earlier stages, customers of banks Commercial banks’ main source of funding is deposits; in the
deposited money in the form of gold and silver coin for safe- United States, deposits account for about 60 percent of banks’
keeping. The warehouse receipts the bank issued as evidence liabilities. Banks rely on capital markets for much of the rest of
of a deposit could be used as money, as long as the bank was their funding. Commercial paper is an important component
trusted to return the coin on demand, and receipts were easier and accounts for roughly 1.5 percent of U.S. banks’ liabilities.
and safer to transport and exchange.
The commercial paper market in the immediate aftermath of
As long as warehouse receipts were issued only against the coin
the Lehman bankruptcy provides an example of how quickly
brought to the bank for safekeeping, commercial loans could
funding conditions can change, and of the fragility of bank
only be made with the owners’ equity or with capital-market
funding. The upper panel of Figure 2.1 displays the volume
borrowing. Eventually, banks discovered that they could issue
outstanding of commercial paper by AA-rated financial firms, a
warehouse receipts, and later private banknotes, in a greater
category comprised mostly of banks, but also including nonbank
volume than the amount of coin deposited with them; that is,
intermediaries such as GE Capital. Financial firms’ issuance of
1

loans were made by issuing banknotes. In a fractional-reserve


60

commercial paper had grown rapidly between 2004 and d the


nd the
5

banking system, if depositors wish to make withdrawals in


66
98 er

end of 2007, as their leverage and balance-sheet expansion


xpans
nsion
1- nt
20
66 Ce

excess of a bank’s reserves, and the bank cannot liquidate


increased. The amount borrowed via commercial all paper
pa
apper became
b
65 ks

enough loans or other assets to meet the demand immediately,


06 oo

more volatile, but continued to grow, as banks


ks sought
ought to finance
so
82 B

it is forced into suspension of convertibility; that is, it will not be


previously off-balance-sheet assets and credit
edit lines they granted
-9 ali

able to convert its deposits and notes into money immediately.


58 ak

earlier were drawn upon. Commercial paper


pape er borrowing
bo declined
11 ah
41 M

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

Chapter 2 Liquidity and Leverage ■ 21

  


The Federal Reserve intervened following the
Lehman bankruptcy and amid subsequent fears
of a run on MMMFs to support liquidity via the
Commercial Paper Funding Facility (CPFF), which
purchased commercial paper from issuers unable
to roll paper over, and the Asset-Backed Commer-
cial Paper Money Market Mutual Fund Liquidity
Facility (AMLF), which lent to financial institutions
purchasing ABCP from MMMFs.

Structured Credit and


Off-Balance-Sheet Funding
Structured credit products per se do not face
funding liquidity problems, as they are maturity
matched. Asset-backed securities (ABS), mortgage-
based securities (MBS), and commercial mortgage-
based securities (CMBS) themselves primarily carry
out a credit and liquidity, rather than a maturity
transformation. They can be viewed as providing
matched funding for the assets in the collateral
pool. The securities issued typically include at least
some longer-term bonds.

The way the securitization liabilities themselves


are financed by investors can, however, introduce
liquidity risk. The difficulties experienced by securi-
tization have been related not only to the question-
able credit quality of underlying assets such as real
Figure 2.1 Short-term commercial paper of financial institutions.
estate loans. Prior to mid-2008, the liabilities were
Upper panel: Amount outstanding of AA financial commercial paper, weekly, beginning held substantially by investors relying on short-term
of 2001 to end-April, 2011, trillions of US$.
financing, increasing the fragility of the financial
Lower panel: Shares (summing to 1) of total dollar amount issued of AA financial com-
mercial paper with original maturities between one and nine days (solid line, marked system.
“ 610 days”) and maturities of 10 days or more (dashed line, marked “ Ú10 days”), weekly.
The short-term financing of securitizations played a
Source: Federal Reserve Board, available at www.federalreserve.gov/releases/cp/. crucial role in the subprime crisis and in the opaque
increase in financial system leverage prior to the
The lower panel displays the shares in total issuance of shorter- subprime crisis. There were two major forms of such financing,
and longer-term commercial paper. With the onset of the securities lending, the use of structured credit products as col-
subprime crisis, financial firms attempted to reduce the volume of lateral for short-term loans, which we discuss in detail later in
both, and to “term out” the issuance, that is, increase the average this chapter, and off-balance-sheet vehicles.
term of the smaller total. The share of very short-term paper in
Like securitizations themselves, off-balance-sheet vehicles are
total issuance declined from about 80 to about 60 percent during
1

“robot companies” or special-purpose vehicles (SPVs) that are


60

the 18 months preceding the Lehman bankruptcy. After the


5
66

defined by their assets and liabilities. They issue asset-backed com-


d comm-
98 er

Lehman event, banks faced difficulty in rolling over longer-term


1- nt
20
66 Ce

mercial paper (ABCP), which, in contrast to most commercial al paper,


cia p
paper
aper
commercial paper, and more generally in obtaining funding with
65 ks

is secured rather than unsecured debt. The two major types es are:
ypes are
06 oo

maturities of more than a few weeks. The share of very short-term


82 B

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
20
99

22 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


from the sponsors in the form of credit guarantees and These examples focus on the liquidity risk events they experi-
liquidity support should the conduit be unable to roll over enced during the subprime crisis.
the debt. Because of the guarantees, ABCP conduits gener-
ally have little equity. Securities Firms
2. Structured investment vehicles (SIVs) are similar to ABCP Securities firms hold inventories of securities for sale, and
conduits in some respects, but differ in the crucial matter finance them by borrowing at short term. The collapse of Bear
of credit and liquidity support. SIVs typically did not enjoy Stearns in March 2008 was an extreme case of a securities firm’s
full explicit support by sponsors. They invested primarily lenders abruptly withdrawing credit. Bear Stearns, like other
in highly rated securitized credit products, and to a lesser large broker-dealers, had relied to a large extent on short-term
extent in whole loans. Their funding mix was also generally borrowing. Bear was particularly dependent on free cash depos-
somewhat different from that of ABCP conduits. In addi- its of the firm’s large base of brokerage and clearing customers,
tion to ABCP, many SIVs issued medium-term notes (MTNs), including many hedge funds. These cash deposits were often
which are at least somewhat less vulnerable to rollover risk. collateralized, but generally not by better-quality collateral.
They also typically had larger equity cushions. Hedge funds withdrew deposits—and their business—rapidly
In spite of their differences, the two types were economically simi- towards the end of Bear’s existence, in what was essentially a
lar in many ways. Both types of vehicles profited from the spread run. Bear also issued MTNs and commercial paper to fund its
between the asset yields and the funding cost. Another similarity activities. We discuss these forms of borrowing in more detail
is their economic function of maturity and liquidity transformation. later in this chapter.
The assets in the vehicles have longer, and possibly much longer,
maturities than the commercial paper with which they are funded.
Money Market Mutual Funds
This is typical for a bank; indeed, this maturity intermediation is MMMFs provide instant liquidity for their investors by giving
the essence of what a bank does. However, instead of carrying them the ability to draw on their accounts via checks and
out this function on its own balance sheet, the sponsoring bank electronic bank transfers. MMMFs are designed to invest in
has been able to reduce its balance sheet and its regulatory capi- money market securities of high credit quality with just a few
tal, while still deriving the economic benefits. weeks or months to maturity. In this design, the market and
credit risks of the assets are low, but still material. The assets
The vehicles also carried out liquidity transformation, creating
can fluctuate in value, so the ability to offer unlimited instanta-
ABCP, which is not only a much shorter-term, but, until the sub-
neous withdrawals is potentially limited if asset values fall. They
prime crisis, was a more liquid asset than the underlying assets
are thus similar to banks in that their investments are less liquid
in the conduit or SIV. The final step in the liquidity transforma-
than their liabilities. The liabilities of an MMMF are, however,
tion was the purchase of ABCP and money-substitute creation
quite different from those of banks. The account holders’ claims
by MMMFs.
are not first-priority unsecured debt, like those of bank deposi-
These financial innovations were accompanied and enabled by tors, but rather equity. A further structural feature is therefore
changes in regulatory capital and accounting rules that permit- required for these liabilities to become money substitutes.
ted firms to hold less capital against given levels of economic
MMMFs are similar in many ways to other mutual funds, which
risk. The use of these vehicles did not lead to bona fide risk
are organized in the United States under the Investment
transfer. Even in the absence of explicit guarantees, sponsors
Company Act of 1940. This permits the instantaneous with-
that were large intermediaries felt obliged to provide support
drawal of equity. But in contrast to other mutual funds, equity
or assume the assets onto their balance sheets when the ABCP
is not added or withdrawn at a fluctuating market-determined
could no longer be rolled over. In spite of the fact that the vehi-
net asset value (NAV). Under the U.S. Securities and Exchange
cles were off-balance-sheet from an accounting and regulatory
Commission’s (SEC) Rule 2a-7, they are permitted to use a
perspective, they contributed greatly to the leverage and fragil-
1
60

form of accounting, the “amortized cost method,” thatt further ffu ther
5

ity of the sponsors, largely banks.


66
98 er

reduces the tension—in normal times—between instant tant with-


stant with
1- nt
20
66 Ce

drawal and fluctuating asset value. The rule permits mitss MMMFs
M
MMM to
65 ks
06 oo

use the historical or acquisition cost of the money-market


oneyy-ma paper
Funding Liquidity of Other Intermediaries
82 B

they purchase, plus any accrual gains. The e reasoning


reas
rea sonin is that, as
asonin
-9 ali
58 ak

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

Chapter 2 Liquidity and Leverage ■ 23

  


paper is short-term, these fluctuations are likely in any case to These redemptions hit not only those hedge funds experiencing
be relatively small. or expected to experience large losses. Redemption requests
were submitted also to hedge funds that were profitable or
Other mutual funds must mark assets to market each day. This
had low losses. Investors sought at the onset of the crisis to
daily NAV is the price at which investors can contribute and
marshal cash balances from all possible sources, among which
withdraw equity. MMMFs, in contrast, are able to set a notional
were intact hedge fund investments. Hedge funds were obliged
value of each share equal to exactly $1.00, rather than an
to liquidate assets, or impose barriers to redemptions so far as
amount that fluctuates daily. The residual claim represented by
offering documents permitted. Hedge funds were in essence
the shares is paid the net yield of the money market assets, less
being asked to become liquidity providers to investors, a func-
fees and other costs. MMMF shares thereby become claims on
tion for which they are not well-designed and were never
a fixed nominal value of units, rather than proportional shares
intended, rather than to the markets.
of an asset pool. Their equity nature is absorbed within limits by
fluctuations in the net yield. Like other intermediaries, hedge funds also face short-term
funding risk on their assets. Hedge funds typically have no
This structure only works if market, credit, and liquidity risks are
access to wholesale funding and rely entirely on collateral mar-
managed well. Some losses cannot be disregarded under the
kets, short positions, derivatives, and other mechanisms we
amortized cost method, particularly credit writedowns. These
describe below to take on leverage.
losses can cause the net asset value to fall below $1.00, a phe-
nomenon called “breaking the buck.”
Liquidity risk can also jeopardize the ability of an MMMF to
Systematic Funding Liquidity Risk
maintain a $1.00 net asset value. In this respect, it is much like Funding liquidity is a latent risk factor in major corporate finan-
a classic commercial bank, and similarly vulnerable to runs. If a cial transactions. A dramatic example are leveraged buyouts
high proportion of shareholders attempt to redeem their shares (LBOs). LBOs are generally financed by large loans, called lever-
simultaneously under adverse market conditions, the fund may aged loans. As LBOs and private equity funds grew, leveraged
have to liquidate money market paper at a loss, forcing write- loans became the dominant type, by volume, of syndicated
downs and potentially breaking the buck. An episode of this loans, originated by banks, but distributed to other inves-
kind involving credit writedowns by an MMMF, the Reserve tors and traded in secondary markets. Many leveraged loans
Fund, was an important event in the subprime crisis. became part of CLO pools, and tranches of CLOs were impor-
tant in CDO pools. The shadow banking system and the “CDO
Hedge Funds machine” were important providers of funding to private equity
Hedge funds face liquidity risk all through their capital struc- and LBOs. Other corporate events, such as mergers and acquisi-
tures. In contrast to the equity capital of corporations, which tions, are also dependent on financing.
may be traded but not withdrawn, but much like mutual fund The funding liquidity risk in corporate transactions is both idio-
investments, hedge fund capital can be redeemed. Hedge funds syncratic and systematic. Funding for a particular LBO or merger
permit investors to withdraw their funds at agreed intervals. might fall through, even if the deal would otherwise have been
Quarterly withdrawals are the rule, though some funds have consummated. But funding conditions generally can change
annual and a very small number of monthly withdrawals. These adversely. This occurred in mid-2007 as the subprime crisis took
withdrawal terms, colloquially called the “liquidity” of the fund, hold. Many LBO and merger deals fell apart as financing came
are subject in general to additional restrictions called “gates,” to a halt. Banks also incurred losses on inventories of syndicated
that permit a suspension or limitation of withdrawal rights if loans, called “hung loans,” that had not yet been distributed to
investors collectively request redemptions in excess of other investors or into completed securitizations. As risk aver-
some limit.3 sion and demand for liquidity increased, the appetite for these
1

loans dried up, and their prices fell sharply.


60

The potential extent of liquidity demands by investors is


5
66
98 er

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

result of both investment losses and redemptions of capital.


06 oo

also experienced losses. Mergers typically result in an increase


ncrea in
in
82 B

the target acquisition price, though not usually all the


he way
th wa to the
-9 ali
58 ak

announced acquisition price, and in a decrease


ase in
n the acquirer’s
11 ah

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

  


gap between the current and announced prices. The risk arises develops an aversion to the product during a period of market
from uncertainty as to whether the transactions will be closed. In stress, it is difficult to move the product smoothly into new
the early stages of the subprime crisis, merger arbitrage strate- hands without large price declines.
gies generated large losses as merger plans were abandoned
Figure 2.2 displays a measure of arbitrage opportunities in
for lack of financing.
the convertible bond market: the cheapness of bonds to their
Investors taking on exposure to such transactions are therefore theoretical replicating portfolios. At the height of the pre-crisis
exposed not only to the idiosyncratic risk of the deal, but to the boom, the gap had not only disappeared, but became negative.
systematic risk posed by credit and funding conditions generally. In a sense, investors were overpaying for the package in their
This risk factor is hard to relate to any particular time series of asset search for yield. As the subprime crisis evolved, the positive
returns. Rather, it is a “soft factor,” on which information must be discount to theoretical was first reestablished, and eventually
gathered from disparate sources ranging from credit and liquidity widened to an unprecedented extent. Viewed from a different
spreads to quantitative and anecdotal data on credit availability. angle, under conditions of severe liquidity stress, even a large
gap between convert prices and their replicating portfolio did
Systematic funding liquidity risk is pervasive. Other asset
not bring arbitrage capital into the market.
types or strategies that are good examples of sensitivity to the
“latent” factor of economy-wide financing conditions include A similar problem occurred for securitized credit products in the
real estate, convertible bonds, and statistical arbitrage. Real fall of 2008. The clientele for the bonds had relied to a large
estate is one of the longest-lived assets. Mortgages—loans extent on short-term finance via repo, SIVs, and other mecha-
collateralized by real estate—are therefore traditionally and nisms. When financing for the SIVs disappeared, a new inves-
most frequently originated as long-term, amortizing, fixed-rate tor base for the bonds could not be established quickly, and
loans. The typical home mortgage, for example, is a 30-year spreads on securitized credit products widened dramatically.
amortizing, fixed-rate loan. When lending practice departs from A final example is statistical arbitrage. Like convert arbitrage,
this standard and shorter-term loans predominate, lenders and statistical arbitrage requires some degree of leverage for profit-
borrowers both face funding liquidity risk, as borrowers are ability. In August 2007, as the subprime crisis got underway, one
unlikely to be in a position to repay unless they can refinance. of its first effects was on statistical arbitrage strategies. Curtail-
This risk is primarily systematic, as it is likely to affect all borrow- ing the liquidity of these strategies caused losses and return
ers and lenders at the same time. volatility that were extremely far outside the range of historical
Convertible bond prices are generally only slightly lower than experience. In fact, this episode was one of the first overt signs
their theoretical prices based on the replicating of how severe the crisis could potentially become.
portfolio of plain-vanilla equity options and bonds
that should mimic convert bonds’ values. Traders,
many of them at hedge funds and dependent on
credit extended by broker-dealers, take advantage
of this gap to earn excess returns. The strategy is
only attractive with leverage, as it has relatively low
unlevered returns, but is generally also relatively
low-risk given the arbitrage relationship between
the convert bonds and the replicating portfolio.

Convert returns do, however, have a systematic


extreme-loss risk. When the financing becomes
unavailable because of credit conditions in the
1

economy, converts cheapen dramatically. This


5 60

effect is compounded by redemptions from


66
98 er
1- nt
20

convertible-bond funds, compounding the funding


66 Ce

Figure 2.2 Convertible bond cheapness.


65 ks

liquidity problem with a market liquidity problem.


06 oo

Difference between theoretical and market prices of convertible bo bonds


ondss in th
the Merrill
82 B

These episodes of convert bond illiquidity also


-9 ali

Lynch All U.S. Convertibles Index (VXA0), weekly through 1997 and daily d through July
58 ak

illustrate the effect of concentrated positions. plicatiing


ng p
2010, in percent. The theoretical price is the value of the replicating portfolio, taking the
11 ah

unt.
credit, risk-free rates, and the embedded option into account.
41 M

Convertible bonds have a limited “clientele”


among investors. When the existing clientele Source: Bank of America Corp.
20
99

Chapter 2 Liquidity and Leverage ■ 25

  


2.2 MARKETS FOR COLLATERAL lent. A haircut of 10 percent, for example, means that if the bor-
rower of cash wants to buy $100 of a security, he can borrow
Markets for collateral are formed when securities are used as only $90 from the broker and must put $10 of his own funds in
collateral to obtain secured loans of cash or other securities. The the margin account by the time the trade is settled. Similarly,
loans are used to finance securities holdings or otherwise invest, the lender of cash will be prepared to lend $90 against $100 of
often as part of a larger trade. Securities used as collateral “cir- collateral.
culate,” since the borrower of securities can typically lend them Borrowing may be at short term, such as overnight, or for longer
to another, a practice called rehypothecation or repledging of terms. Overnight borrowing may be extended automatically
collateral. In this way, the supply of securities that can be used until terminated. As the market value of the collateral fluctuates,
as collateral is an important element in facilitating leverage in variation margin may be paid. Most collateralized borrowing
the financial system. arrangements provide for such remargining. The total margin at
Collateral has always played an important role in credit transac- any point in time, if adequate, provides a liquidation cushion to
tions by providing security for lenders and thus ensuring the the lender. If, for example, the loan has a maturity of (or cannot
availability of credit to borrowers. The role of collateral has be remargined for the duration of) one week, a 10 percent hair-
changed and expanded in contemporary finance, hand in hand cut ensures that the value of the securities held as collateral can
with the development of securitization, but also with the grow- fall 10 percent and still leave the loan fully collateralized. The
ing volume and transactions liquidity of securities trading. variation margin protects the lender of cash against fluctuations
in the value of the collateral.
The obvious and direct effect of securitization is to remove
credit intermediation from the balance sheets of financial Markets for collateral have existed for a long time in three basic
intermediaries. However, it also creates securities that can be forms that are economically very similar, although they differ in
pledged as collateral in further credit transactions. Securities legal form and market practice.
have additional economic value to the extent that they not only
throw off cash flows and may appreciate in value, but can be Margin Loans
used as collateral to obtain credit. Margin lending is lending for the purpose of financing a security
Collateral markets are an important institutional element sup- transaction in which the loan is collateralized by the security. It is
porting the growth of nonbank intermediation. Participants in generally provided by the broker intermediating the trade, who
these markets include: is also acting as a lender. Margin lending is generally short term,
but rolled over automatically unless terminated by one of the
• Firms such as life insurance companies may own portfolios of
counterparties.
high-quality securities that can be used as collateral to bor-
row cash at the low interest rates applicable to well-collater- Collateralization for the loan is achieved by having the broker
alized loans. The motivation is to borrow cash at a low rate, retain custody of the securities in a separate customer account,
which it can then reinvest, earning a spread. but in “street name,” that is, registered in the name of the
• Firms such as hedge funds have inventories of securities that broker rather than in the name of the owner. This simplifies the
they finance by pledging the securities as collateral. The process of seizing the securities and selling them to cover the
motivation is to obtain financing of the portfolio at a lower margin loan if it is not repaid timely. But registration in street
rate than unsecured borrowing, if the latter is available at all. name also lets the broker use the securities for other purposes,
for example, lending the securities to other customers who want
• Firms may have excess cash that they are willing to lend
to execute a short sale.
out at a low interest rate, as long as they are appropriately
secured by collateral. In practice, the most important purpose for which the broker
is likely to use the customer’s collateral is to borrow money in
1

The securitization process relied heavily on rating agencies to


60

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

gin customers. The repledged securities become the collateral ateraal


1- nt
20

be lent, repoed out, or pledged as collateral by their owners.


66 Ce

for a margin loan to the broker, and the collateral is moved oveedd to
65 ks
06 oo

the broker’s customer account with its creditor. Collateral


laterral may,
m
82 B

however, also be repledged in order to borrow anotheranotther ssecurity


-9 ali

Structure of Markets for Collateral


58 ak

rather than cash collateral. This will typically be done


d in order
11 ah
41 M

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
20
99

26 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


crisis, the practice of rehypothecation of securities can become dividend and interest cash flows from the security. A common
quite important, as it introduces additional risk for the broker’s type of securities lending is stock lending, in which shares of
customers. stock are borrowed.

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

a hedge fund, to establish a synthetic short stock


sto
stocck position,
ock po
Securities Lending
82 B

economically similar to that of a borrower er off stock.


stoc The
-9 ali
58 ak

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

Chapter 2 Liquidity and Leverage ■ 27

  


Economic Function of Markets • Reverse repo transactions are similar, in that they are often
used to finance long positions in securities, typically bonds.
for Collateral
Repo transactions, in contrast, are usually intended to borrow
There are two main purposes served by collateral markets. First, cash by owners of bonds.
they create the ability to establish leveraged long and short • However, in some instances, a repo or reverse repo transac-
positions in securities. Without these markets, there would be tion is focused on the need of one counterparty to establish
no way to short a cash security; short positions could only be a long position in a particular security. An important example
created synthetically. is the U.S. Treasury specials market, in which a scarcity arises
Second, collateral markets enhance the ability of firms to borrow of a particular bond. The mechanism by which the market is
money. In collateral markets, cash is just another—and not cleared is a drop in the implied interest rate for loans against
necessarily the primary—asset to be borrowed and lent, along- a bond “on special,” which can become zero or even nega-
side securities of all types, hence the term “cash collateral.” tive. Recently issued U.S. Treasury notes typically go on spe-
cial when dealers sell them to customers prior to the issue
It helps in understanding the risks of securities lending and
date on a when-issued basis, and have underestimated the
its role in the financial system to flesh out how it is embed-
demand. Following the next U.S. government bond auction,
ded in and has supported a number of important activities in
when the bond is issued, the dealer must borrow it to deliver
finance. Repo and securities lending are mechanically distinct,
to the customer at a penalty rate, expressed in the cheap
but economically similar. They both enable market participants
rate at which the dealer must lend cash collateral to borrow
to finance assets with borrowed funds using the assets as
the security.
collateral. They are both structured in such a way that the party
investing in the assets appears to have “borrowed” the assets, • Securities lending has typically been focused on the securi-
though economically having bought them. However, in a repo ties rather than the cash collateral, typically to establish short
transaction, the assets are financed directly, while in a securi- positions. In recent years, the focus of their use has shifted to
ties lending transaction, the investor starts off owning liquid borrowing cash collateral.
assets that are “good currency” and can be used to obtain High-quality bonds that can be readily used as collateral com-
cash collateral with a relatively low haircut. The investor can mand higher prices than bonds that cannot be used in this way.
then step forward as a lender of cash against the securities in This creates additional demand for high-quality collateral; their
which he wants to invest, or as an outright buyer, rather than, utility as collateral adds to the value of securitized credit prod-
as would be the case in a repo, as a borrower of cash to pur- ucts, and provided an additional incentive to create them.
chase the securities.
Collateral markets bring owners of securities, such as institu-
Fixed-income securities lending, like repo programs, has histori- tional investors and insurance companies, into the financing
cally functioned primarily as a source of short-term financing for markets. They lend their securities to earn extra return. Whether
financial firms, and as an additional source of revenue for institu- through repo or securities lending, they earn an extra return by
tional investors and insurance companies. In more recent years, making their securities available for other market participants to
it has been an important element facilitating credit creation in use as collateral.
the bank and nonbank intermediation systems. It supported
A crucial element in permitting bonds to serve as collateral is
the “manufacturing system” for securitized credit products.
their credit quality. Credit-rating agencies are important partici-
The ability to finance positions in securitized credit products
pants in collateral markets because of the need for highly rated
via securities lending made the bonds more marketable and
bonds. Conversely, awarding high ratings to lower-quality bonds
increased their value, that is, decreased their required credit
added a large volume of collateral to these markets that evapo-
spreads. These programs also provided a channel through which
rated almost overnight during the subprime crisis.
firms using cash collateral to invest in higher-risk bonds could
1
60

increase leverage and returns. These markets grew tremendously in volume in the years
5
66
98 er

preceding the subprime crisis, as the range and amount nt of


1- nt
20

Different forms of collateral markets serve different trading


66 Ce

collateral that could be lent expanded. Figure 2.3 shows


how
owwss net
65 ks

motivations, but these forms are economically so similar that no


repo market borrowing by U.S. broker-dealers. The he volumes
vvo
volum
06 oo

hard-and-fast distinctions can be drawn:


82 B

displayed in the graph are likely much smallerr than


than the gross
-9 ali
58 ak

• 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
20
99

28 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Prime brokerage businesses have been valuable to
large intermediaries not only because of the fees
and spreads they earn on the services and lend-
ing they provide. As noted above in discussing
the run on Bear Stearns, the intermediaries also
benefit from the cash balances the hedge funds
hold. Typically, even highly leveraged hedge funds
maintain cash balances with prime brokers, so the
prime brokerage business becomes an important
funding source, akin to retail deposits, but far less
“sticky.” The cash balances at prime brokers are
part of the intermediaries’ general liquidity pool.
They are available to finance any of the intermedi-
aries’ other activities. Short positions also gener-
Figure 2.3 U.S. broker-dealer repo 1980–2011.
ate cash, not all of which can be freely devoted to
Net liabilities under security repurchase agreements of U.S. broker-dealers, billions making additional investments.
of dollars.
The interest rates paid on these cash balances
Source: Federal Reserve Board, Flow of Funds Accounts of the United States (Z. 1),
Table L.129. are generally somewhat higher than the funds
could obtain from alternative money market
investments, such as Treasury bills, commercial
which a dealer hypothecates one security in order to borrow
paper, and money market mutual funds. They are also, from the
a different security. Broker-dealers carry out a large volume of
standpoint of the funds, riskier than the alternatives, as they
such transactions on behalf of customers. Net repo use more
are unsecured claims against the intermediary, or are secured
than tripled between mid-2004 and its peak in mid-2007.
by possibly inadequate collateral. Conversely, prime brokers
During the subprime crisis, net repo liabilities contracted by
are important intake points for banks and broker-dealers to
about two-thirds. The three-year spike is likely due in large
gather collateral and cash that can be used to finance their
part to the expansion in use of non-Treasury securities as
activities. Earlier in this chapter, we observed that hedge funds
collateral and the growth in hedge fund funding business,
were drawn on as sources of liquidity by their investors during
which we now briefly discuss.
the subprime crisis. Their prime brokerage relationships are
an equally counterintuitive instance of the “peacetime” role of
Prime Brokerage and Hedge Funds hedge funds as liquidity providers.
Much of the growth in volume in collateral markets is intermedi-
ated through prime brokers, subsidiaries of large banks and bro-
Risks in Markets for Collateral
ker dealers that have emerged as important service providers to
the hedge fund industry. They serve as a single point of service The risks in markets for collateral are similar to those of other
that provides trading, clearing, custody, financing, and other leveraged positions. They comprise market, credit, and coun-
services. In some cases, prime brokers have been involved in the terparty risks. There are some risks in common for the borrower
hedge fund business itself through “capital introduction,” that and lender of securities, and some that are unique to only one
is, arranging contact between funds and potential investors. side of the transaction. The risks vary widely, depending on the
motivation of the trade, what type of collateral is involved, and
Hedge funds often maintain portfolios of long and short posi-
how the cash generated is deployed. For example, the market
tions. For both the hedge fund and the prime broker providing
1

risk of reversing in a bond is a rise in long-term interest rates.


s.
60

the financing, the net value may be quite small compare to the
5
66

A trader selling borrowed equities short will gain if the


he stock
sttock
98 er

gross volume of lending. Within a firm’s account with a broker,


1- nt
20
66 Ce

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
20
99

Chapter 2 Liquidity and Leverage ■ 29

  


products, as they had AAA ratings, thus satisfying investment
mandates, but had somewhat higher yields than the bonds lent.
These programs were intended to earn a narrow but steady
interest margin, but had severe losses during the crisis, as secu-
ritized product prices collapsed.
Another major market risk in markets for collateral is changes
in lending rates or other terms of margin, repo, or securities
loans. The loans themselves are generally short-term, so losses
to a borrower of securities in a decline in rates are generally
small. However, the transactions liquidity risk can be high. We
have already discussed one important example, the Treasury
specials market.
Another example is the phenomenon of hard-to-borrow securi-
ties in equity markets. In order to establish a short position, even
one expressed via TRS, stock must be located and borrowed.
Smaller stocks and stocks under price pressure can be difficult
to borrow, as many owners will not be willing to lend.
Collateral markets permit owners of high-quality collateral—or
collateral perceived by the market as high-quality—to borrow
or to finance positions in high-quality collateral at low interest
rates. The upper panel of Figure 2.4 displays the overnight repo
rate at which market participants can borrow against collateral
consisting of U.S. Treasury obligations, the highest-quality col-
lateral available even after the S&P downgrade of the U.S.
long-term credit rating. In normal times, the repo rate is very
close to the yield of T-bills or other short-term lending rates,
and the spread between them is close to zero. However, when
times are not normal, for example during the subprime crisis,
rates on loans collateralized by the highest-quality securities
drop even faster than interest rates generally. Having the very
best collateral in a stressed market is almost as good as hav-
ing cash, because you can then borrow cash at a low or even
zero rate using such collateral. Lenders will provide cash at a
low rate to gain custody of such collateral. This is evident in
the upper panel, where one can see downward spikes in the Figure 2.4 Repo rates and spreads 2006–2010.
Treasury repo rate following the inception of each phase of the
Upper panel: Overnight repo rates collateralized by U.S. Treasury
subprime crisis.
securities, daily.
The center and lower panels of Figure 2.4 display the spread Center panel: Spread between one month OIS and overnight Treasury
repo rates (OIS minus Treasury repo), daily.
between overnight Treasury repo and interbank rates (center
Lower panel: Spread between overnight repo rates collateralized by
panel), and the spread between Treasury repo and repo rates for U.S. Treasury securities and by agency MBS (agency repo minus Treasury
loans collateralized by a different type of collateral, agency MBS repo), daily.
1
60

(lower panel). Agency MBS are also highly creditworthy, but not
5

Source: Bloomberg Financial L.P.


66
98 er

quite as unquestionably so as Treasuries, and are also not as


1- nt
20
66 Ce

liquid. In times of stress, rates on loans with agency MBS collat-


65 ks

spreads. The data illustrate a key point regarding funding


unding
ngg liquid-
liq
06 oo

eral will not fall quite as low as for the very best collateral. Both
B

ity risk: The higher the quality of the securities a market


ma ket
mark partici-
p
spreads are close to zero in normal times, widening and becom-
82

pant owns unencumbered, the more liquid he e is.


ing highly volatile during the crisis. Questions about the solvency
-9
58

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
20
99

30 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


position, since haircuts on the collateral lent are typically small. The leverage ratio is defined as4
When the subprime crisis began, and values of low-quality col- A E+D D
lateral began to fall, investors engaged in this trade suffered L = = =1 +
E E E
large losses via forced sales. The lenders demanded variation
The lowest possible value of leverage is 1, if there is no debt.
margin in cash as specified in margin agreements. If the investor
For a single collateralized loan, such as a mortgage or repo,
was unable or unwilling to meet that demand, positions had to
leverage is the reciprocal of one minus the loan-to-value ratio
be liquidated.
(LTV). The borrower’s equity in the position is one minus the LTV.
The size and structure of collateral markets also contributes to The equity at the time a collateralized trade is initiated is the ini-
systemic risk. Owners of lower-quality collateral may suddenly tial margin. For a firm, equity is also referred to as net worth.
have their loans terminated, or have the loans be subjected to
Leverage is important because it provides an opportunity to
sudden and large increases in the margin demanded by lend-
increase returns to equity investors, the so-called leverage
ers of cash. Drastic remargining is tantamount to drastically
effect, which can be exploited whenever the return on the firm’s
decreasing the loan proceeds available to the borrower on the
assets is expected to exceed the cost of debt capital. The lever-
strength of the collateral. The owners of the collateral may then
age effect is the increase in equity returns that results from
be forced to liquidate the assets. In a distressed market, this
increasing leverage and is equal to the difference between the
contributes to the rapid decline in asset prices.
returns on the assets and cost of funding.
Calling and remargining loans collateralized by securities gives
The leverage effect can be seen by writing out the relation-
rise to a phenomenon similar to classic bank runs, but involv-
ship between asset returns ra, equity returns re, and the cost
ing nonbank intermediaries as well as banks, and focused on
of debt rd:
wholesale funding rather than deposits. One instance was the
March 2008 collapse of Bear Stearns. Bear had large expo- r e = Lr a - (L - 1)r d
sures to subprime residential mortgage debt in a number of The effect of increasing leverage is
forms, and its vulnerability in this respect had become clear
∂r e
in mid-2007 when several hedge funds that it sponsored col- = ra - rd
∂L
lapsed. Once its solvency was called into question, providers
Increasing leverage by one “turn,” that is, increasing assets and
of funding began to withdraw. As noted above, these included
taking on an equal amount of additional debt that increases
commercial paper lenders and hedge funds with free cash
leverage from an initial value L0 to L0 + 1 increases equity
balances at Bear as part of its clearing and prime brokerage
returns by ra - rd. By the same token, leverage will amplify
businesses.
losses should the asset return prove lower than the cost of debt.
In foreign exchange trading, leveraged trades, called carry
trades, involve borrowing (going short) a low-interest rate cur-
2.3 LEVERAGE AND FORMS
rency, and using the proceeds to buy (go long) a higher-interest
OF CREDIT IN CONTEMPORARY rate currency. The net carry is ra - rd, with ra representing the
FINANCE higher and rd the lower interest rate. Carry trades lose money
when the low-yielding currency appreciates enough to more
Defining and Measuring Leverage than offset the net carry.

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

the firm is equity. Hybrid capital can be included or excluded from


rom the
ed fro
fr t
65 ks

denominator of a leverage ratio depending on the he purpose


th pu of
06 oo
82 B

the analysis. Regulators have invested considerable


nsideerable effort in
side
-9 ali

Assets Liabilities
58 ak
11 ah

Equity (E)
41 M

Value of the firm (A)


Debt (D) 4 D
The leverage ratio is sometimes defined
ed as tthe debt-to-equity ratio .
20

E
99

Chapter 2 Liquidity and Leverage ■ 31

  


ascertaining the capacity to absorb losses and thus nearness to sense of reaching a given hurdle rate, or required rate of return
pure equity of these securities. on equity. This orientation has surfaced in the debates on bank
regulatory capital, in which some bankers and observers have
For a hedge fund, the appropriate equity denominator is the
stated that increased capital requirements will oblige banks to
net asset value (NAV) of the fund, the current value of the inves-
reduce their return-on-equity (ROE) targets.
tors’ capital. For any investment firm or investment vehicle,
the leverage of individual positions or of subportfolios can be
calculated using the haircut, margin, or risk capital, as the equity
denominator. Example 2.2 Leverage and Required Returns

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

return with leverage of 2 will be a loss of 5 percent, and with


98 er
1- nt
20
66 Ce

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

The effect of leverage depends as much on the cost of funding


82 B

leverage, it could be turned into a substantial return


rn stream.
n st
stre
ream.
eam.
as on the asset return. Investors sometimes choose a degree of
-9 al
58 ak

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

  


borrowed at least part of the purchase price by means of a Although it is difficult to state an unambiguous definition of
mortgage loan. The down payment is the household’s equity leverage, it is an important concept. Most severe losses suffered
and is a form of haircut. The leverage is the ratio of the value by financial intermediaries involve leverage in some way, and
of the house to the down payment (and inversely related to it is important to understand the extent to which borrowing is
the LTV). During the decade preceding the subprime crisis, the being used, implicitly or explicitly, to boost returns. To do so, we
terms on which mortgage credit was granted were loosened can construct an economic balance sheet for a firm or an inves-
to permit higher leverage and low initial interest rates, which tor that captures the implicit or embedded leverage in short
amplified the impact of the prevailing low-interest rate environ- positions, swaps, and options. This can at least provide a rea-
ment. As discussed, analysis of credit risk in residential mort- sonable answer to the question of how much he has borrowed
gage loans assumed rising house prices. For households, equally to finance positions.
confident that house prices would rise, or at least not fall, easy
We’ve reviewed some of the financial instruments by which
credit terms created strong incentives to make leveraged invest-
credit is extended outside the traditional bank lending and
ments in housing, as shown in Example 2.3.
bond markets in our discussion of collateral markets earlier in
this chapter. Here, we show, using T-accounts, the great extent
to which a financial firm can use them to take on leverage. Some
Example 2.3 Leveraged Returns to Housing of these forms of credit are by no means new, but their volume
Suppose house values are expected to rise 10 percent a year, has grown enormously in recent decades with the rise in the
including, for simplicity, rental income and net of property main- volume of trading in securities and OTC derivatives. Among the
tenance costs. The following table shows the resulting annual reasons for their growth are:
rate of return to the homeowner for different down payments • They have lower transactions costs than traditional bank or
and loan rates (all data in percent): capital markets debt. Originating a bank loan or security is a
cumbersome, slow, and expensive process. It requires under-
Loan Rate % writing, syndication, and distribution by banks or securities
Down Payment % 5.5 8.0 firms. Most of the forms of credit discussed here require only
a counterparty. But along with that cost saving, counterparty
10.0 50.5 28.0 risk has become more prevalent.
20.0 28.0 18.0 • The granting of credit is an inherent part of trading in the
assets being financed, and the amount of credit granted
The returns are calculated as
adjusts naturally to the size of the position being financed.
House price appreciation - (1 - Down payment)Loan rate • Collateralization of the loan and adjustments to the amount
100
Down payment lent occur naturally as part of trading and brokering trades.
Lowering the lending rate and the down payment or haircut These forms of borrowing are generally collateralized in
increases the leveraged return from 18 to over 50 percent per some way, which also affects the economic leverage. When
annum. borrowing is explicit, as for example through taking loans
or deposits, or issuing bonds, the impact on leverage is
Leverage ratios can amplify sensitivity to changes in cash flow. If straightforward. In other forms of borrowing, some analysis
the net cash flow on a leveraged trade or of a leveraged firm is is required to measure leverage. For each of these forms, we
positive, but small, a small change in interest rates can make the see how to determine the amount of borrowing or leverage
cash flow negative. implicit in the position.

These relationships show why firms or investors employ lever-


1
60

age. It also illustrates why leverage is often used as a measure of Margin Loans and Leverage
5
66
98 er

risk, and why leverage is sometimes considered to be an inde-


1- nt
20
66 Ce

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

haircut determines the amount of the loan that att is made:


made at a
m
06 oo

Leverage is not a well-defined risk measure. Part of the difficulty


B

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

is the borrower’s equity in the position. T lleverage on a posi-


n. The
58

example, accurately recognizing profits, or accurately capturing


11

1
the explicit liabilities of the firm. tion with a haircut of h percent is .
41

h
20
99

Chapter 2 Liquidity and Leverage ■ 33

  


Haircut (%) Amount Borrowed (%) Leverage Example 2.5 Leverage and Short Positions

10 90 10 Our starting point, as in Example 2.4, is a hedge fund with $100


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

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

Lever Brothers’ full economic balance sheet is


Assets Liabilities

Equity $50 Assets Liabilities


Stock value $100
Margin loan $50
$50 Cash Equity $100
The broker retains custody of the stock as collateral for the $150 Due from broker Borrowed stock $100
loan. Lever Brothers’ full economic balance sheet, including the
entries in its margin account, is now The firm has gone from leverage of 1 to 2. Notice that the lever-
age in this example is higher than in the example of a long posi-
Assets Liabilities tion via margin lending. The reason is that in establishing a short
position, the securities must be borrowed; leverage is inherent
Cash $50 Equity $100 in short positions, but is a choice for long positions. In the exam-
Stock value $100 Margin loan $50 ple of the long position, only half the value of the purchased
stock was borrowed, so the leverage was 1.5. Here, the entire
The firm’s leverage has risen from 1 to 1.5. stock position must be borrowed to execute the short. The fund
could reduce its overall leverage by reducing its borrowing to
1
60

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

of the borrowed short securities and the cash generated by their


06 oo

Gross and Net Leverage


82 B

sale appear on the balance sheet. They therefore increase lever-


-9 ali
58 ak

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
99

34 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


they are positively correlated, or other short positions with contract represents is set once and for all at the initiation of
which they are negatively correlated. If short positions play a the contract, even though the net present value (NPV) may
hedging role in the portfolio, leverage will overstate the risk, vary over time. The cash-equivalent market value of futures,
since adding the short positions increases leverage, but reduces forwards, and swaps can be represented on an economic
market risk. balance sheet by the market value of the underlying security,
rather than the NPV.
This leads to a distinction between gross and net leverage.
Gross leverage is defined as the sum of all the asset values, Options have a nonlinear relationship to the underlying
including cash generated by shorts or assets acquired with asset price and must be hedged dynamically. Therefore,
that cash, divided by capital. It can be thought of as the total the amount of the underlying that the derivatives contract
“length” of the balance sheet divided by the capital. Net lever- represents varies over time. It can be fixed approximately at
age is computed as the ratio of the difference between the mar- any point in time by the option delta, or by a delta-gamma
ket values of the long and short positions to the capital. approximation. In general, volatility is important in the value
of an option, so option contracts cannot generally have a
The balance sheet alone will not tell the risk manager whether
zero NPV at initiation. Rather, it has a market value that can
the short positions are risk-augmenting or risk-reducing. Other
be decomposed into an intrinsic value, which may be zero,
information in addition to the long and short leverage, such as
and a time value, which is rarely zero.
VaR and stress test reports, or a qualitative examination, are
needed. For this reason, in reporting leverage, long positions The cash-equivalent market value of options can be
and short positions should be reported separately. Leverage represented on an economic balance sheet by their delta
reporting is important, but far from a complete view of the risks equivalents rather than their market values. As the underly-
of a portfolio. ing price varies, the amount of the economic balance sheet
exposure, and the leverage, will vary. Measured this way, the
cash-equivalent market value doesn’t take the time value and
Derivatives
volatility of the option into account, except insofar as it influ-
Derivative securities are a means to gain an economic exposure ences the option delta.
to some asset or risk factor without buying or selling it outright.
Like margin arrangements, derivatives also generate counter-
One motivation for market participants to use derivatives is as a
party credit risk. If the derivative creates a synthetic long (short)
means of increasing leverage. Leveraged ETFs are an example
position, the economic balance sheet entries mimic those of a
of an investment product that uses derivatives in order to create
cash long (short) position. The implicit assets and liabilities cre-
the economics of leveraged investment in, say, an equity index.
ated on the economic balance sheet are vis-à-vis the derivatives
Although derivatives are generally off-balance-sheet items in counterparties.
standard accounting practice, they belong on the economic bal-
In the rest of this section, we illustrate these principles of how
ance sheet, since they may have a large impact on returns. Each
best to represent derivatives positions for purposes of comput-
side of a derivatives contract is synthetically long or short an
ing leverage.
asset or risk factor. But the market values of derivative securities
are not equal to the value of the underlying asset, or the riski-
ness of the positions. Therefore, their market values or NPVs
Example 2.6 Leverage and Derivatives
are generally not the best values to represent them. Rather,
for purposes of measuring economic leverage, we wish to find, We again take as the starting point a hedge fund account with
for each type of derivative, a cash-equivalent market value. As $100 in cash, corresponding to an initial placement of $100 in
with most issues around the measurement and interpretation of equity by investors. Suppose Lever Brothers now adds:
leverage, as much judgment as science is involved. • A one month currency forward, in which Lever Brothers is
1
60
5

As we discussed, there are two basic types of derivatives, short $100 against the euro
66
98 er
1- nt
20

futures, forwards, and swaps on the one hand, and options on


66 Ce

• An at-the-money (currently 50-delta) three month


ntth long
llo
ong call
65 ks

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
20
99

Chapter 2 Liquidity and Leverage ■ 35

  


return on $100 market value of Intel and the short rebate, or Note that the leverage in each of these transactions, if there is
cost of borrowing Intel stock no initial margin requirement, is infinite.
• Short protection on Ford Motor Co. via a five-year credit Now let’s put these positions together to get Lever Brothers’
default swap, with a notional amount of $100 complete balance sheet. Recall that the account starts with $100
We assume that the nonoption positions are initiated at market- placed by investors. We make the additional assumption that the
adjusted prices and spreads, and therefore have zero NPV. We’ll initial margin on the portfolio of these derivatives positions is $50.
also assume that the counterparty is the same for all the posi-
tions, namely the prime broker or broker-dealer with which they Assets Liabilities
are executed.
Cash $50 Equity $100
Let’s look at the economic balance sheet for each position, $150 due from broker
assuming there is no initial margin. Then we’ll consolidate the $50 margin $150 short-term
positions and add a margin requirement to find Lever Brothers’ $100 short sale proceeds broker loan
overall leverage, as if margin were being assessed by a single
$100 equivalent of $100 term loan
broker or counterparty on a portfolio basis.
€ 80 bank deposit Borrowed stock
We start with the currency forward, which is implicitly a pair of
$50 long S&P 500 position (5 sh INTC)
money market positions, a long one-month euro-denominated
bank deposit with a value of $100, financed by borrowing $100 $100 Ford FRN
for one month. Assuming the one month forward exchange rate
The fund has attained leverage in its long positions of 3.5, plus
is $1.20 per euro, we have:
a short position with a magnitude equal to its NAV. It has thus
gained economic exposure to securities valued at $450, using
Assets Liabilities
only $50 in cash.
$100 equivalent of € 80 bank $100 broker loan
deposit
These examples illustrate a serious issue in computing and
The equity option, with a delta of 50 percent, is equivalent to interpreting leverage ratios, which we alluded to in the context
having bought $50 worth of the S&P 500 index with a broker of gross and net leverage: how to treat routine hedges such as
loan of $50: currency hedges for foreign currency-denominated positions,
and risk-free rate hedges for credit-risky fixed-income positions.
Assets Liabilities In general, these currency and rate exposures can be neutral-
ized quite accurately and reliably. The currency and rate hedges,
$50 long S&P 500 position $50 broker loan
however, are of the same order of magnitude as the underlying
The Intel TRS is equivalent to a short position in Intel stock exposures themselves, and if carried on the economic balance
(ticker INTC), established with no initial margin. If the price of sheet will bloat it, distort the resulting leverage reports, and
INTC is $20, we have: obscure the more material risks in the portfolio.

Assets Liabilities Structured Credit


$100 due from broker (short Borrowed stock (5 sh INTC) Structured credit also provides embedded leverage. The bond
sale proceeds) tranches take losses only in more extreme default and cor-
relation scenarios. The mezzanine tranche is relatively thin, so
The short CDS protection position, finally, is equivalent to a long
1

while it takes an extreme default scenario to cause any loss


60

position in a par-value five-year Ford floating-rate note (FRN),


5

at all to the mezzanine tranche, if a loss occurs, it is likely to


66
98 er

financed by borrowing at a floating rate at five years’ term. We


1- nt
20
66 Ce

be large. This property of thin subordinated securitization tio


on
assume that the financing can be terminated early without pen-
65 ks

tranches is called “cuspiness,” since it materializes when en the


06 oo

alty if there is a credit event. Its economic balance sheet is


82 B

attachment point of the bond is at the cusp of default


defa
efa ult losses
au los
lo in
-9 al

the pool.
58 ak

Assets Liabilities
11 ah
41 M

The equity note bears most of the risk of loss.


ss. It has,
ha however,
$100 Ford FRN $100 term loan a notional amount of only $5,000,000, while
ile the
th underlying
20
99

36 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


collateral pool is $100,000,000, financed long-term through the assets other than money do not completely share these charac-
bond tranches. Implicitly, the balance-sheet leverage used is a teristics of immediacy and certainty. They cannot be exchanged
bit less than 20 turns, once we take account of the residual risk directly for other goods and assets, because we don’t live in a
borne by the bonds. If the equity note itself is financed in the barter economy; only money can do that. Nonmoney assets
repo markets, with, say, an 80 percent haircut, the economic must be sold or liquidated before they can be exchanged for
leverage could easily reach 100. other goods or assets. This takes at least some time, and the
proceeds from the sale are uncertain to at least some extent.

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

tinguish perfectly between offers to trade arising


arisiing from
arisin fr the
82 B

counterparty’s wish to reallocate into orr out


utt of cash,
ou c or
-9 ali
58 ak

responses to non-fundamental signals als such


uch as
su a recent returns
11 ah

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
20
99

Chapter 2 Liquidity and Leverage ■ 37

  


cannot be sure for which of these reasons he is being shown The latter two characteristics of markets are closely related
a trade and therefore needs to be adequately compensated to immediacy, the speed with which a market participant can
for this “lemons” risk through the bid-ask spread. A dealer execute a transaction.
does, however, have the advantage of superior information
Lack of liquidity manifests itself in these observable, if hard-to-
about the flow of trading activity, and learns early if there is a
measure ways:
surge in buy or sell orders, or in requests for two-way prices.
Bid-ask spread. If the bid-ask spread were a constant, then
Differences of opinion. Investors generally disagree about the
going long at the offer and short at the bid would be a pre-
“correct” price of an asset, or about how to interpret new
dictable cost of doing the trade. However, the bid-ask spread
information, or even about whether new information is impor-
can fluctuate widely, introducing a risk.
tant in assessing current prices. Investors who agree have less
reason to trade with one another than investors who disagree. Adverse price impact is the impact on the equilibrium price
When agreement predominates, for example, when important of the trader’s own activity.
and surprising information is first made public, or during times Slippage is the deterioration in the market price induced by
of financial stress, it is more difficult to find a counterparty. the amount of time it takes to get a trade done. If prices are
These fundamentals take different forms in different types of trending, the market can go against the trader, even if the
market organization: order is not large enough to influence the market.

• 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

Tightness refers to the cost of a round-trip transaction, and


5

Goldman Sachs, for example, describes its liquidity risk manage-


anage
nage-
66
98 er
1- nt
20

is typically measured by the bid-ask spread and brokers’


66 Ce

ment policy as maintaining a “Global Core Excess”


commissions.
65 ks
06 oo

to pre-fund what we estimate will be our likely cash h


82 B

Depth describes how large an order it takes to move the


needs during a liquidity crisis and hold such h excess
exccess
-9 ali

market adversely.
58 ak

liquidity in the form of unencumbered, highly lyy liquid


liqu secu-
11 ah
41 M

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
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38 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


without needing to sell other assets or depend on addi- was also impaired during the crisis, as seen for agency debt in
tional funding from credit-sensitive markets. Figure 2.4. Haircuts on such debt were reportedly also rising.
The liquidity buffer accounts for about 20 percent of the balance Assets can be sold rather than pledged. This alternative
sheet. It includes cash and a portfolio of securities that can be route to liquidity is limited by the likely proceeds from a sale.
pledged as collateral rather than sold.6 In a distressed market, these may be far lower than recent
market prices or a model-based fair value. Thus, as a source
Apart from cash, liquidity portfolios can contain cash equiva- of funding liquidity, unpledged assets are subject not only
lents, defined in the International Accounting Standards as to fluctuations in the amount of borrowing they can support,
“short-term, highly liquid investments that are readily convert- but also to transactions liquidity risk.
ible to known amounts of cash and which are subject to an insig- Unused borrowing capacity on pledged assets can be used
nificant risk of changes in value.” to finance additional positions. Like unpledged assets, this
form of liquidity is not unfettered. Rather, it is subject to
Funding Liquidity Management for Hedge Funds revocation by counterparties, who may raise haircuts or
Hedge funds, even if only moderately leveraged, are vulner- decline to accept the securities as collateral when the time
able to the withdrawal of liquidity, either by counterparties or comes to roll over a collateralized securities loan. Since most
through withdrawals of investor capital. Both have the same of these collateralized loans are very short term, credit can
effect of potentially obliging the fund manager to unwind posi- disappear rapidly. This occurred for many lower-quality forms
tions rapidly and generating exposure to transactions liquidity of collateral during the subprime crisis.
risk. When this happens to many funds at the same time, it can However, a systemic risk event, in which hedge fund investments
contribute to “fire sales.” are regarded as potential sources of liquidity by investors, will
Hedge funds have a number of sources of liquidity that can be be a challenge even for most effective liquidity risk manage-
monitored as part of overall risk management: ment. We referred to this phenomenon earlier in this chapter:
Many hedge funds that had not experienced large losses
Cash provides unfettered liquidity. It can be held in the form
received redemption requests for precisely that reason from
of money market accounts or Treasury bills. Excess cash
investors who were themselves seeking liquidity.
balances with brokers and money market accounts are not
entirely riskless and therefore are not perfectly liquid. Broker
balances carry with them the counterparty risk of the bro- Measuring Transactions Liquidity Risk
ker; in the event the broker fails, the cash balances will be
There are two major types of quantitative liquidity risk measures.
immobilized for a time and only a fraction may ultimately be
They focus on the available data that are pertinent to liquidity risk:
paid out. Money market funds, as was demonstrated during
the subprime crisis, may suspend redemptions or “break the • Bid-ask data
buck” and pay out at less than 100 percent of par. • Transaction or turnover volume data
Unpledged assets (or assets “in the box”) are unencumbered • Data on the size outstanding of securities issues
assets not currently used as collateral. They are generally also
Quantitative measures of transactions liquidity risk are not as
held with a broker, who in this case is acting only as a custo-
widely used as funding liquidity risk measures, and quantitative
dian and not as a credit provider.
liquidity risk measurement is generally less widely practiced than
This source of liquidity is limited by the price volatility quantitative market and credit risk. Partly, this is because they
of the assets and the ability to use the assets as collateral. In have not been incorporated into the regulatory framework to
a financial crisis, only U.S. Treasuries, particularly short-term the same extent as have standard models of market and credit
Treasuries, will be liquid enough to serve as near-cash assets.
1

risk measurement. Regulators have focused more intently on


560

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

collateral and the ability to obtain funding by pledging them


82

These measures focus on the risk of variation


riatio
onn in transactions
-9
58

onnal hypothesis
costs. The starting point is a distributional hy regarding
11

6
the future bid-ask spread.
41

See Goldman Sachs Group, Inc. (2010).


20
99

Chapter 2 Liquidity and Leverage ■ 39

  


Daily changes in the relative bid-ask spread, that is, the spread The T-day VaR would be estimated by the familiar square-root-
as a fraction of the price, can be assumed as a starting point to of-time rule:
be normally distributed with a mean of zero and a constant vari-
ance (estimated by the sample variance of the spread ss). The 1
VaRt aa, b 1X2 * 212 + 12 + g + 12 = VaRt 1a, t21X2 * 2T
zero-mean assumption at least is unobjectionable, since bid-ask 252
spreads cannot rise indefinitely or shrink to zero. The expected However, this would be an overstatement of the VaR; the VaR
transactions cost is the half-spread or mid-to-bid spread has to be greater than the one-day position VaR, but less than
s the one-day position VaR * 2T. We will be holding a sequence
E3Pt + 1 4 T - 1 T - 2 T - 2
2 of position sizes 1, , ,c, , rather than 1,
T T T
where 1, . . . , 1, all with the same variance. The VaR is therefore
ask price - bid price ask price - bid price
s=2 = 1 T - 1 2 T - 2 2 1 2
ask price + bid price midprice VaRt aa, b 1X2 * 1 + a b + a b + g + a b
252 B T T T
s is an estimate of the expected or typical bid-ask spread, and P
is the asset midprice. 1 T t - 1 2
= VaRt aa, b 1X2 * a t = 1 a1 - b
Under the zero-mean normality hypothesis, we set s = s, the 252 B T
most recent observation on the relative spread. The 99 percent which simplifies to
confidence interval on the transactions cost, in dollars per unit
of the asset, is then 1 11 + T211 + 2T2
VaRt aa, b 1X2 *
252 B 6T
1
{P 1s + 2.33ss 2
2 For example, suppose the trader estimates that a position can
where P is an estimate of the next-day asset midprice. We typi- be liquidated in T = 5 trading days. The adjustment to the over-
cally set P = P, the most recent observation on price. night VaR of the position is then 1.48324, that is, we increase
1 the VaR by 48 percent. For T ≈ 10, the liquidity risk adjustment
We refer to ¢s + 2.33ss ≤ as the 99 percent spread risk factor.
2 doubles the overnight VaR of the position. These adjustments
The transactions cost risk at a 99 percent confidence level is are large by comparison with the transaction cost liquidity risk
then measured by the current value of the spread risk factor, measures of the previous section. Estimates of the time to liqui-
that is, by the 99th percentile of the actual proportional daily date or “time to escape” are usually based on a comparison of
changes in the half-spread over a given historical period, say, the position size with the daily transactions volume.
the past two years. It represents the worst case, at a 99 per- In extreme cases, or during financial crises, there may be several
cent confidence level, of the bid-ask spread cost of changing constraints on liquidation decisions. There may be trade-offs
a position. among adverse price impact, funding liquidity, and solvency.
An example is that of a hedge fund facing redemptions. It must
liquidate some positions to meet redemptions. Suppose it liq-
Measuring the Risk of Adverse Price Impact
uidates those with the smallest adverse price impact first, but
A tool for measuring the risk of adverse price impact is liquidity- redemptions continue. The fund may face collapse because it
adjusted VaR. The starting point is an estimate of the number of cannot meet the ongoing withdrawals by quickly selling the
trading days, T, required for the orderly liquidation of a position. remaining, relatively illiquid positions. If, on the other hand,
If the position is liquidated in equal parts at the end of each day, it sells the least liquid positions first, it will incur losses due to
the trader faces a one-day holding period on the entire position, adverse price impact, and likely post NAV losses earlier on,
T - 1
1
60

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

Liquidation decisions may also interact with the incentive e struc-


stru
uc-
66 Ce

a three-day holding period on a fraction of the posi-


T ture of credit markets. An example of this is the “sellers’
ers’ strike”
strike
s
65 ks

tion, and so forth if he wishes to liquidate the position with no


06 oo

observed early in the subprime crisis, in which banks


nk
nks
ks were
w
82 B

adverse price impact.


-9 ali

reluctant to reduce leverage by selling certain positions,


posit tions often
itions
58 ak
11 ah

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

  


falling rapidly, and the banks were reluctant to realize losses at be insolvent, yet able to continue for some time to roll over its
market valuations many considered to be well below fundamen- debts, or may funded largely by long-term debt, and thus not
tal value. The paradox of this phenomenon is that it was stron- face illiquidity. A firm may be solvent, that is, able to pay its long-
ger banks that were the most active sellers, while the weaker term debt, because its assets will ultimately be worth more than
banks were more inclined to hold back. By avoiding sales, weak its liabilities, but illiquid, since it cannot roll over short-term debt
banks increased the probability of illiquidity and possibly failure or raise enough cash to repay it timely. Liquidity and solvency are
in the short run, but increased the potential profit from these linked by asset values; large changes in the mark-to-market value
assets in the long run once their prices recovered. In other of assets can expose a solvent financial intermediary to illiquidity.
words, they had an option-like position in the assets. The longer-
Illiquidity can become insolvency if it is extreme enough, as a
term profit was conditional on the banks’ survival through the
debtor can become unable to either borrow or realize the funds
crisis and on the fundamental values of the assets proving to be
required to meet debt obligations by selling assets. Because
higher than their current market prices.
intermediaries are not transparent, liquidity and solvency are
also linked by market perceptions about the state of intermedi-
aries. The suspicion by market participants that a financial firm
2.6 LIQUIDITY AND SYSTEM RISK
is insolvent can lead to that firm becoming illiquid. At the time
Systemic risk, the risk of severe, widespread financial stress and of the bankruptcies of Bear Stearns and Lehman Brothers, and
intermediary failure, possibly including disruption of payment sys- to this day, there was a great deal of debate of whether one or
tems, is a function among other things of economy-wide liquidity. both firms were insolvent, or merely illiquid.

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

intermediary cannot instantly liquidate its remaining g assets


a
as ets
5
66
98 er

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.
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Chapter 2 Liquidity and Leverage ■ 41

  


Funding and Market Liquidity The tri-party repo system is a relatively recently developed
infrastructure that has rapidly gained in importance in the past
A key mechanism linking funding and market liquidity is lever- decade. It differs from conventional repo in that securities are
age. A market participant with a long position for which it can held in custody by a third party, almost always one of two major
no longer obtain funding is forced to sell. If funding has become clearing banks, Bank of New York Mellon (BNY) and JPMorgan
tight in the market as a whole, the set of potential holders of Chase. In the tri-party repo cycle, the counterparty borrowing
the asset will be reduced. This mechanism depresses the asset cash collateralized by securities deposits the securities with the
price, regardless of its expected future cash flows. The effect custodian, while the counterparty lending cash deposits the
may only be transitory, but “transitory” may be a relatively long funds with the custodian. The custodian sees to it that the funds
time, and may affect the solvency of the initial holder of the are made available to the borrower and maintains the securi-
asset during that period. This mechanism becomes most evident ties in a segregated account so that they can be seized without
during financial crises. Rapid deleveraging causes a “debt- delay by the lender should the borrower default.
deflation crisis.”
Most tri-party repo transactions are short-term, often overnight.
Mark-to-market risk combines aspects of market and credit risk. However, they are typically renewed regularly at maturity, so
It is often the case that the holding period of an asset, or the they become a part of the longer-term financing mix of the
time horizon of a trade, is quite long. The investor or trader, borrower. Tri-party repo is typically used by securities firms to
however, may be required to report frequently the values of finance securities portfolios. Funding, that is, cash collateral,
assets and liabilities. is typically provided by money market mutual funds, insurance
Market liquidity can constrain funding liquidity. As we saw just companies, and other institutional investors.
above in describing the liquidation dilemma of a hedge fund Tri-party repo has grown enormously over the past two decades,
facing redemptions, a market participant obliged to sell assets along with repo markets in general, as seen in Figure 2.3, reach-
in order to raise cash faces a choice about what assets to sell ing a volume of $2.8 trillion of securities financed by early 2008,
first: those with the greatest or the least market liquidity. Such encompassing a wide range of security types as collateral. Two
situations are most liable to arise during times of heightened reasons for this growth are economies of scale in clearing, which
financial fragility and distress, when there are many other trad- are generated in part by the greater scope for book-entry trans-
ers in a similar situation, and possibly with a similar portfolio. actions rather than delivering securities, and the desirability of
The key trade-off is that by selling the most liquid assets first, third-party custody of securities.
the market participant incurs the smallest adverse impact, but
However, the mechanics of tri-party repo also involve liquidity
left with a more illiquid portfolio with which to face any con-
risks. Like most repo contracts, much tri-party repo has a one-
tinuing funding liquidity pressure. If, instead, he sells illiquid
day term. Regardless of the term of the repo, each transaction
assets first, the realized losses increase the real or perceived
is unwound daily. The clearing bank returns the securities to
risk of insolvency, and may therefore worsen the funding liquid-
the account of the securities lender/borrower of cash, gener-
ity pressure.
ally a large broker-dealer, and the cash to the account of the
securities borrower/lender of cash. The clearing bank in effect
Systemic Risk and the “Plumbing” finances the dealer, generally a broker-dealer financing its secu-
rities inventory, by permitting a daylight overdraft. Thus, apart
An important channel through which liquidity risk events can
from clearing and custody services, the custodial bank provides
become systemic risk events is through problems in the pay-
intraday credit to the borrower of cash, collateralized by the
ments, clearing, and settlements systems. Disruptions in these
securities. The custodial bank thereby assumes an exposure to
systems, often called the “plumbing” of the financial system,
the cash borrower; that is, the counterparty credit risk that the
can be systemic risk events in their own right, or amplify an ini-
value of the collateral, if liquidated, will not be enough to cover
1

tial market or credit risk event into a systemic problem. These


60

the debt.
5

systems, called financial market infrastructures or utilities in


66
98 er
1- nt
20

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
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42 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


accounted for 38 percent of outstanding tri-party repo in early of the literature on intermediation tries to explain why commer-
2010. The default of a large dealer would likely trigger the cial banks are so prominent in the financial landscape. Diamond
immediate sale of the securities in its account that collateral- and Dybvig (1983) and Diamond (1984) are classic papers on
ize its intraday overdraft. The mere possibility that the dealer’s depository institutions. Diamond (1984) explains banks’ promi-
account is undercollateralized would also call the clearing bank’s nence in intermediation from an information cost viewpoint.
liquidity and solvency into question. While these systemic risk Diamond and Dybvig (1983) focuses on random fluctuations in
events have not materialized, the risks were among the back- households’ need for cash to explain the susceptibility of banks
ground factors in the Federal Reserve’s introduction to the to panics and runs. Diamond (1996, 2007) are accessible presen-
Primary Dealer Credit Facility (PDCF) on March 17, 2008, during tations of the theory in these papers. A counterpoint is provided
the run on Bear Stearns. The PDCF provided primary dealers by Calomiris and Kahn (1991) and Randall (1993), which argue
with access to collateralized overnight funding. that uninsured depositors also provide some restraint on exces-
sive risk-taking by banks. Acharya, Gale, and Yorulmazer (2009)
presents a model of rollover risk and an application to the sub-
“Interconnectedness” prime crisis. Goodhart (1990), and Cowen and Kroszner (1990)
Credit transactions, as we have now seen, take myriad forms. discuss payment services provided by mutual funds with varying
The set of market participants involved as either borrowers or market values as an alternative to deposit banking based on par-
lenders in at least some credit transactions includes most adults value redemption.
and every firm, including nonfinancial firms, even in less-devel- Allen and Santomero (1997) and Dowd (1992) are critical surveys
oped economies. Credit relationships form a network in which of this literature, testing its relevance against the evolution of
each entity is a creditor and debtor of numerous other entities. finance from a banking-focused to a market-focused system.
Each entity’s creditworthiness depends, therefore, in part on the
creditworthiness of its obligors. If debts owed to a firm become The treatment of money as an asset among others in explaining
uncollectible, it may become unable to pay its own creditors. the demand for money—or, in any event, the term “liquidity pref-
erence”—goes back at least to Keynes (1936). Haberler (1958) is
Financial intermediaries are the most enmeshed entities in this
a history, by a participant, in the debates on the theory of money
network, since they specialize in intermediating savings between
in their relationship to business cycles, up to and including
lenders and borrowers and have leveraged balance sheets in
Keynes. The classic “modern” exposition is Tobin (1958).
which the bulk of the assets are debt of another entity. We have
discussed the counterparty risks that arise from these networks, Developments in the commercial paper market leading up
focusing on the standpoint of an individual firm managing these to and during the subprime crisis are discussed in Anderson
risks. Counterparty risk also has an important systemic risk and Gascon (2009), and in Adrian, Kimbrough, and Marchioni
aspect; a decline in the creditworthiness of its borrowers imper- (2010). Pozsar, Adrian, Ashcraft, and Boesky (2010); Covitz,
ils the financial intermediaries’ own creditworthiness. Liang, and Suarez (2009); Arteta, Carey, Correa, and Kotter
(2010); and Acharya and Schnabl (forthcoming) provide details
Another aspect of interconnectedness is the prevalence in con-
on leverage through ABCP conduits and SIVs and examples of
temporary finance of long intermediation chains involving secu-
specific vehicles. These papers also chronicle the unraveling of
ritization, off-balance sheet vehicles, and MMMFs, in addition
these vehicles during the subprime crisis and their contribution
to traditional intermediaries. Some observers view these chains
to its intensification.
as proliferating potential points of failure in the financial system.
The complexity of intermediation can make itself known in sur- Examples of the role of liquidity in the impact of the subprime
prising ways, drawing attention to vulnerabilities that had not crisis on specific investment strategies can be studied in Mitch-
previously been widely identified, such as the hedge fund losses ell, Pedersen, and Pulvino (2007) (convertible bond arbitrage)
on securities in custody with Lehman during its bankruptcy. The and Khandani and Lo (2008) (statistical arbitrage). Case stud-
1
60

web of credit thereby makes credit risk a matter of public policy em


m nts
ies of the relationship of payments, clearing, and settlementsts
5
66
98 er

and concern. system to systemic risk include Bernanke (1990) and d Copeland,
Coppelan
1- nt
20
66 Ce

Martin, and Walker (2010).


65 ks
06 oo

Further Reading th
heirr role in financial
The development of collateral markets and their
82 B
-9 ali

developments leading up to the subprime me crisis


cri
cr
risis are
a reviewed
58 ak
11 ah

Greenbaum and Thakor (2007) provides a textbook introduction (200


008,
08, 2009),
in a series of papers including Gorton (2008, 2 and Gorton
41 M

to financial intermediation by banks and other institutions. Much and Metrick (2010). The role of rehypothecation
othec in financial
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Chapter 2 Liquidity and Leverage ■ 43

  


markets is emphasized in Singh and Aitken (2010). Shin (2009b) institutional background of transactions liquidity. Amihud, Men-
discusses the impact of the supply of securitizations on the vol- delson, and Pedersen (2005) is an extensive survey focusing on
ume of credit and of aggregate leverage. transactions liquidity. Chordia, Roll, and Subrahmanyam (2001)
focuses on volume data. Committee on the Global Financial
Institutional aspects of collateral markets, particularly the
System (1999b) is an introductory survey and review of policy
mechanics of shorting and lending stock, are discussed in Weiss
issues, while Basel Committee on Banking Supervision (2000)
(2006) and D’Avolio (2002). Institutional and legal aspects of
presents recommendations on liquidity risk management.
rehypothecation are discussed in Johnson (1997).
Several papers, for example, Almgren and Chriss (2000, 2001),
Breuer (2002) discusses the measurement of derivatives lever-
discuss trading and investment in the presence of market liquid-
age. Carry trades in currency markets are discussed in Brun-
ity risk. Duffie and Ziegler (2003) treat the problem of whether
nermeier, Nagel, and Pedersen (2009), and in Clarida, Davis,
to liquidate more- or less-liquid assets first in a liquidity risk
and Pedersen (2009). Adrian and Shin (2009a, 2009b), and King
event. Diamond and Rajan (2010) discuss the 2008 sellers strike.
(2008) discuss the increase in broker-dealer leverage during the
See also Acerbi and Finger (2010).
years leading up to the subprime crisis. King (2008) in particular,
explains how these transactions can be kept off-balance sheet, Hicks (1962) is an early treatment of the relationship between
and provides a guide to extracting additional information on funding and market liquidity. Brunnermeier and Pedersen
repo exposures from the footnotes to broker-dealer disclosures (2009) present a model of their interaction in stress scenarios.
other than the balance sheet. Brunnermeier, Nagel, and Pedersen (2009) discusses funding
liquidity, together with fat-tailed returns, as an explanation of
Introductions to market microstructure are provided by Stoll
the option biases.
(2003) and O’Hara (1995). Demsetz (1968), Kyle (1985), and
Amihud and Mendelson (1986) are important early papers on See Morgan Guaranty Trust Company (1996) and Marrison
transactions liquidity. See Black (1986) and Shleifer and Sum- (2002) for a discussion of asset-liability management. Senior
mers (1990) on noise versus information trading. Madhavan Supervisors Group (2009b) discusses liquidity risk management
(2000) and Madhavan (2002) are good starting points for the lessons from the subprime crisis.

1
560
66
98 er
1- nt
20
66 Ce
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

  


Early Warning
Indicators
3
■ Learning Objectives
After completing this reading you should be able to:

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

● Identify EWI guidelines from banking regulators and


supervisors (OCC, BCBS, Federal Reserve).

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
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45

  


3.1 EARLY WARNING INDICATORS: from the catastrophic impacts of not having enough liquidity is
offset by a significant drag on earnings if the buffer is too high.
MECHANISM TO SIGNAL UPCOMING A minimum standard for the liquidity buffer is set in accordance
LIQUIDITY CRISIS with the risk appetite of the bank. However a basic “set and for-
get” approach does not allow for the strategic management of
As an integral part of liquidity risk management (LRM), bank this risk against a dynamic market.
leadership has the responsibility to both identify and manage
underlying liquidity risk factors. One of the critical aspects of a Increasing buffers before times of stress can extend the survival
bank’s LRM involves first devising and then monitoring a set of horizon in a cost-effective manner as a bank does not want to
indicators to enable the risk identification process to spot the be caught short of liquidity when the market freezes. Indeed,
emergence of new or increasing vulnerabilities. Negative trends being in a strong balance sheet position during times of stress
serve as early indicators that may warrant an assessment and opens opportunities for significant gains in market share as well
also a potential response by management in order to mitigate a as acquisitions that may not be otherwise available in the nor-
bank’s exposure to any emerging risk. mal course of business. Strongly positioned companies can take
advantage of rare instances of market disruption. The manage-
This chapter provides an overview of the key aspects associated ment tool that gives rise to this strategic advantage is the LRM
with early warning indicators (EWIs). EWI framework.

Introduction: Dashboard and Beyond Regulatory Emphasis in Recent Times


Dashboard The global financial crisis of 2007–08 has put the spotlight on
EWIs may be viewed as analogous to warning lights on an auto- LRM. The Basel Committee on Banking Supervision (BCBS)
mobile dashboard. The turning signals, low oil, and check engine issued its “Principles of Sound Liquidity Management and
lights alert the driver of driving conditions. Continuing this anal- Supervision”1 (Sound Principles) in September 2008, followed
ogy, a turn signal or “blinker” indicates an intentional risky activ- closely by details on standardized metrics such as the LCR and
ity of making a purposeful directional change. In the realm of the Net Stable Funding Ratio (NSFR). This overarching frame-
LRM, this might mean, for example, running a deposit special to work includes the use of EWIs.
raise rate-sensitive liabilities. A low engine oil light indicates to Table 3.1 is a non-exhaustive list of EWIs recommended by the
the driver that direct action may be needed in the near future to BCBS. It includes key indicators that are both qualitative and
prevent the engine from seizing up. Again in an LRM context, this quantitative in nature.
is analogous to noticing that the bank’s Liquidity Coverage Ratio
(LCR) has dropped below a specified threshold. A check engine
light indicates further investigation is warranted for a yet to be Key Supervisory Guidelines
determined reason; the application of this aspect of the analogy
National regulators have started to benchmark financial institu-
may mean, for example, that a dramatic increase in call center
tions against these sound principles. The regulatory expecta-
volumes may portend a shift in the bank’s liquidity position.
tions for banks have gone up as a result. In particular, the data
Most importantly EWI triggers are used to initiate management needed to support a modern LRM framework, in terms of
discussions and actions that should be formally documented. quantity, quality, and timeliness, is an expensive investment. The
This could be as simple as an acknowledgment that the bank’s responses from banks span a range from those who aim to mini-
treasury is aware that a deposit campaign is underway by one mize the cost of compliance to those who believe it can become
of the business lines so it can orchestrate a corrective action, a strategic tool to guide future management decisions.
for example, by increasing the high quality liquid assets buffer
Table 3.2 summarizes key supervisory guidelines, which should
1
60

in a cost-efficient manner and continuing to comply with LCR


5

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

Holding liquid assets to ensure a bank can meet its financial 1


BCBS, “Principles of Sound Liquidity Managementt and
d Supe
Supervision,”
58 ak
11 ah

obligations is ultimately a cost-benefit decision. The protection Sept 2008, Early Warning Indicators.
41 M
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46 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 3.1 BCBS Recommended EWIs (EWIs may include but are not limited to the items listed below)
Rapid asset growth, especially when funded with potentially volatile liabilities
Growing concentrations in assets or liabilities
Increases in currency mismatches
Decrease of weighted average maturity of liabilities
Repeated incidents of positions approaching or breaching internal or regulatory limits
Negative trends or heightened risk associated with a particular product line
Significant deterioration in the bank’s financial condition
Negative publicity
Credit rating downgrade
Stock price declines
Rising debt costs
Widening debt/credit-default-swap spreads
Rising wholesale/retail funding costs
Counterparties requesting additional collateral or resisting entering into new transactions
Drop in credit lines
Increasing retail deposit outflows
Increasing redemptions of CDs before maturity
Difficulty accessing longer-term funding
Difficulty placing short-term liabilities
Source: BCBS, “Principles of Sound Liquidity Management and Supervision,” Sept 2008, Early Warning Indicators.

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


It is important to ensure that EWIs align to and are a natural The EWI framework can be summarized as M.E.R.I.T. (Mea-
extension of the enterprise LRM framework. sures, Escalation, Reporting, Integrated systems, and Thresh-
olds). While an appropriate set of measures is the first essential
According to Federal Reserve Board Supervisory Letter (FRB SR)
building block for a robust EWI framework, it will be a mere
12-7 requirements, the LRM framework should be end-to-end
academic exercise if the framework is eventually not linked to
and ensure that the bank will “sufficiently capture the banking
escalation processes. The journey from measures to escalation
organization’s exposures, activities, and risks.”
is facilitated by timely reporting with the support of integrated
A comprehensive LRM framework begins by identifying liquid- systems and data as well as relevant and properly calibrated
ity and funding risks that are inherent in the business activities thresholds.
of the institution (Figure 3.1). These risks are then memorial-
ized in the firm’s liquidity risk inventory and subjected to a risk
assessment process that includes the businesses, corporate
Measures
1
60

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

response framework. liquidity positions, taking into account


unt (c)
(cc) off-balance
off
of sheet
41 M
20
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Chapter 3 Early Warning Indicators ■ 47

  



Table 3.2 Key Supervisory Guidelines

OCC-20122 BCBS-20083 BCBS-20124 SR 10-65

• 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

Liquidity and Funding Retail Deposits LRM Risk Assessments


Funding Playbook
Early Warning
Commercial Deposits RCSA Process Indicators
Market
Escalations/ Notifications

Operational Brokered Deposits Stakeholders


Limits and EWI
Line of Business Thresholds
Engagement
Model Unsecured Wholesale
Corporate Treasury
Secured Funding and
Business Securitization
Risk/2nd LoD

Pension Parent Funding

Derivatives and
Reputation Collateral Exposure

Credit and Liquidity


Strategic Facilities

Figure 3.1 Risk identification and EWIs.

risks.” These measures should span vulnerabilities across


business-as-usual and stressed conditions over various time
horizons.”6 Within Deteriorating asset Increased debt
the bank quality spreads
Forward Looking Bias/View
A suite of EWIs that includes internal and external metrics is
required for prudent risk management. These measures ideally need
to be leading (forward looking) and sharp (sufficiently granular). Outside Asset class
Country default
the bank liquidity failure
A leading indicator is one that will provide information and sig-
nal potential stress prior to the occurrence of an actual event.
This is particularly important in preparing for systemic scenarios.
“main “Wall
Rather than using lagging indicators which report on events street” street”
that have already occurred, such as government reported GDP
Figure 3.2 Early warning indicator dimensions.
figures, a bank can develop proxies for the performance of the
general economy from internal loan portfolio metrics.

The granularity and specificity of a particular indicator as it per- understanding of risk drivers and trends than broad, lagging
tains to an institution’s profile is known as its sharpness. Sharp indicators may otherwise provide.
indicators are signals that do not go unnoticed within the mass In additional to developing sharp leading indicators, banks
of data. For example, detecting a drop in overall deposit bal- should also strike a balance between external and internal
ances is an acceptable EWI; however, detecting drops in deposit measures (Figure 3.2). Internal measures are customized to the
balances of more volatile segments, such as high-net worth bank’s balance sheet and activities while external measures sig-
customers or rate-sensitive products balances, brings into focus
1

nal systemic changes in the economy or market.


5 60

that certain important classes of customers are leaving the bank.


66
98 er

It is important to recognize that liquidity events can n start


starrt either
eith
eit
1- nt
20
66 Ce

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

more time for management to take corrective or mitigating


06 oo

resulting from the environment within which the bankb operates.


B

actions; it also helps to ensure that managers have a better For example, an idiosyncratic deposit run mayy result
resu from either
82

the disclosure of poor performance or due e to a systemic failure.


-9
58

6
BCBS, “Principles of Sound Liquidity Management and Supervision,” EWIs should be positioned to capture emerg
emerging
emerg internally-
11

driven stress events before they become


come public knowledge, for
41

Sept 2008.
20
99

Chapter 3 Early Warning Indicators ■ 49

  


example, through monitoring of loan performance, planned sig- Reporting
nificant accounting adjustments, and operational losses. Alter-
EWI reporting needs to be timely in order to provide manage-
natively, a systemic crisis such as a sovereign default or banking
ment with sufficient lead time to make adjustments in response to
system crisis may trigger liquidity dislocations in parts of the
potential crisis events. It is common practice to have the EWI dash-
financial market system, disrupting the funding of any institu-
board reported on a daily basis. While most institutions perform
tions that are exposed to those markets.
some level of daily liquidity reporting, leading institutions are mov-
ing toward intraday reporting of certain measures. Firms with a sig-
Environments, Both Normal and Stressed
nificant trading focus are more likely to use intraday reporting as a
EWIs are meant to provide signals or to act as a heads-up for an result of their increased exposure to external market conditions.
upcoming potential disaster. Tracking appropriate EWI metrics dur-
Reporting also needs to strike a balance between being
ing a business as usual environment is essential as any deteriora-
(a) broad enough to provide wide coverage, and (b) specific
tion in these metrics will alert the bank’s leadership of weaknesses
enough to communicate only key messages.
in the bank’s balance sheet or of the emergence of challenging
circumstances in the markets that the bank operates within.
Integrated Systems
In addition, institutions should include stressed measures and
Metrics and reporting are feasible and meaningful only when
limits into their EWI lists in order to gauge the adequacy of the
they are backed by the bank’s ability to calculate the selected
firm’s liquidity buffer for a stressed environment. Additionally,
metrics, and report them consistently.
stress testing results may also expose previously unidentified or
emerging concentrations and risks that could threaten the viabil- Integrated data and systems within the bank are essential in
ity of the institution. providing liquidity managers with the capability to ensure that
reported metrics are (a) accurate, and (b) in sync with each
Spanning Various Time Horizons other. For example, deposit volumes feeding into liquidity stress
tests, and their resulting measures, should be derived from the
EWI coverage cannot be static and needs to reflect various time
same source system used to produce non-stressed measures,
horizons in order to match the institution’s unique balance sheet
such as week over week declines in deposit funding. This level
needs as well as the market and economic conditions under
of automation and integration is particularly important as EWI
which it operates.
frameworks increasingly supplement traditional market-based
Typical cycle time horizons that match banking forecasts and metrics with a larger array of internal indicators.
business operations tend to be daily, weekly, or monthly. An
indicator that is not updated for a period of more than a month Thresholds
is unlikely to satisfy the “early” aspect of the EWI. Certain EWIs Firms generally use a stoplight system in representing and commu-
may even be monitored on an intraday basis, as warranted by nicating their performance against the thresholds of their EWIs. A
business conditions or required by regulators. green indicator means that the measure is within normal bounds. A
measure that is classified as amber according to the threshold frame-
Escalation work should be investigated further while a red indicator should
Although escalation criteria are bespoke to a bank, an effective be a source for significant concern and may warrant an immediate
escalation policy should ensure that limit breaches are escalated response. The threshold boundaries for which an EWI moves from
to the appropriate level of management with the authority to green to amber should not be so wide that movements go unde-
undertake corrective actions. Modest responses such as increas- tected and the metric constantly indicates that the economic and
ing the liquid asset buffer may usually be done within the del- internal environments are healthy and unchanged. Institutions should
egation of the corporate treasurer; however, an EWI that signals also be careful not to set boundaries that are so narrow as to force
1

a potentially large cash outflow may require the asset-liability constant investigation of its movements, desensitizing management
5 60

to its impact and creating a “boy who cried wolf” circumstance.


ce.
e.
66

committee (ALCO) to authorize a check on future asset growth.


98 er
1- nt
20
66 Ce

The most extreme cases may require management to initiate the


Historical data analysis is commonly used to estimate the he volatil-
vvo
olatil
65 ks

bank’s contingency funding plan (CFP).


06 oo

ity of an EWI and to calibrate its thresholds. The length


gth of
o the
82 B

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

   


under stressed conditions. When available, a historical time series
OIS
of at least one year will be used for calibration. The threshold
should be subjected to back-testing to determine if recalibra- LIBOR/OIS Spread
tion is needed and a management override, based on historical Euribor vs. Eonia (bp)
judgment, is warranted (e.g., historical analysis of the volatility of 10 yr Benchmark Treasury
the Fed Fund rate is informative; however, triggers may be more 2Y/10Y U.S. Spread
appropriately set using the FOMC specified target range).
3M T-2yr T spread
Industry Practices 3M U.S. Tsy

Over the last few years, banking institutions have increased the 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

Table 3.3 Market Indicators I


Table 3.5 Market Indicators 3
EWI Type Actual Indicator
EWI Type Actual Indicator
Credit Rating Moody’s
Other Indicators USD/CAD foreign exchange rate
Standard & Poor’s
USD/CAD FX Spot Rate
Fitch Ratings
BKX Index (Banking Sector Health)
Changes in ratings
Unemployment Rate
Equity Markets DJ STOXX 600 Banks
GDP Growth Rate-QoQ Change
DJIA
Crude
S&P 500
Economic indicators forecasting
S&P TSX recession
NASDAQ Political interference in bank regula-
FTSE 100 tion/supervision, leading to reduced
capacity at FHLB or discount
NIKKEI 225
window
VIX (Stock market volatility)
Internal due diligence activity related
to a material acquisition
01
56

Table 3.4 Market Indicators 2 ABCP/LIBOR Spread


66
98 er
1- nt
20
66 Ce

EWI Type Actual Indicator State ISMs


65 ks
06 oo

Rates/MM 1M LIBOR Case-Shiller HPIs


82 B

trends
-9 ali

3M LIBOR NCREIF CRE Transaction


sacttion Price
P Index
58 ak
11 ah

6M LIBOR BBB Option-Adjusted


usted Spread
Adju
41 M

12M LIBOR Repo Spread


20
99

Chapter 3 Early Warning Indicators ■ 51

   


Table 3.6 Bank Specific Indicators 1

EWI Type Actual Indicator

Credit Risk Bank 5yr CDS(bp)


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

Table 3.7 Bank Specific Indicators 2

EWI Type Actual Indicator

Credit Performance Credit Card Net Losses


Credit Card Industry Avg Net Losses
1
60

Credit Card 30 + Day DQ


5
66
98 er
1- nt
20

Card Excess Spread


66 Ce
65 ks

Funding Need Total Deposits Variance to Plan (MM)


06 oo
82 B

Total Loans Outstanding Variance to Plan (MM)


-9 ali
58 ak
11 ah
41 M
20
99

52 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


Table 3.7 Bank Specific Indicators 2 (Continued)

EWI Type Actual Indicator

Liquidity Metrics RWAs


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

Table 3.8 Bank Specific Indicators 3

EWI Type Actual Indicator

Liquidity Metrics Disc Window Collateral


Due from % of 3rd Party Liabilities
Short term market cash
Total cash at FRB
Payments
Receipts
Closed Fed Balance
Collateral at Fed
Daylight OD Usage
Daily Highlight Comments
Other Immediate Potential Cash Outflows:
Anticipated Cash Inflows
More Liquid Assets
Total Gross Operational Risk Losses / 12 Month Revenue
1
605

Contingency Funding Plan Activation


66
98 er
1- nt
20

Bank Unsecured Capacity reduced by 10% or more MoM


66 Ce
65 ks

Bank Retail Loans greater than 30 days Delinquent


06 oo

Criticized Credits 7 7% of Total Commercial Loans


82 B
-9 ali

EPS Stress Test Ratio/EPS Branch Stress Test Ratio


58 ak
11 ah

Repo Haircut
41 M

Increased spread paid for uninsured debt issuance


20

Decline in earnings and or capital levels


99

Chapter 3 Early Warning Indicators ■ 53

   


Table 3.9 Bank Specific Indicators 4

EWI Type Actual Indicator

Market Sentiment Share Price


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

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

• Stakeholders—business lines/treasury/risk (second line of


5 60

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
99

54 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


The Investment
Function in
4
Financial-Services
Management
■ Learning Objectives
After completing this reading you should be able to:

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

● Identify and discuss various factors that affect the choice


of investment securities by a bank.

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

  


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

Assets Liabilities
Cash Deposits

Add to Sell When deposits are low Return investments pledged


investments investments use investments as as collateral to the investments
when cash is when cash is collateral for more portfolio when deposit growth
high low nondeposit borrowings is high

Investments Nondeposit
1

Borrowings
605
66
98 er
1- nt
20

Sell Add to
66 Ce

investments investments
65 ks

when loan when loan


06 oo

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

   


Table 4.1 Functions of the Investment Security Portfolio
Investment security portfolios help to
a. Stabilize income, so that revenues level out over the business cycle—when loan revenues fall, income from investment
securities may rise.
b. Offset credit risk exposure in the loan portfolio. High-quality securities can be purchased and held to balance out the risk
from loans.
c. Provide geographic diversification. Securities often come from different regions than the sources of loans, helping diversify
a financial firm’s sources of income.
d. Provide a backup source of liquidity, because securities can be sold to raise needed cash or used as collateral for borrowing
additional funds.
e. Reduce tax exposure, especially in offsetting taxable loan revenues.
f. Serve as collateral (pledged assets) to secure federal, state, and local government deposits held by a depository institution.
g. Help hedge against losses due to changing interest rates.
h. Provide flexibility in a financial firm’s asset portfolio because investment securities, unlike many loans, can be bought or sold
quickly to restructure assets.
i. Dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many
marketable securities,
Federal regulations stress the need for every regulated institution to develop a written investment policy giving specific
guidelines on:
a. The quality or degree of default risk exposure the institution is willing to accept.
b. The desired maturity range and degree of marketability sought for all securities purchased.
c. The goals sought for its investment portfolio.
d. The degree of portfolio diversification to reduce risk the institution wishes to achieve.

4.2 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

Chapter 4 The Investment Function in Financial-Services Management ■ 57

   



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

Money Market Instruments

 
Short-Term Federal International Short-Term
Treasury Notes Agency Certificates Eurocurrency Bankers’ 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.)

Federal Agency Securities


Bankers’ Acceptances
Marketable notes and bonds sold by agencies owned by or
Because they represent a bank’s promise to pay the holder
sponsored by the federal government are known as federal
a designated amount of money on a designated future date,
agency securities. Familiar examples include securities issued
bankers’ acceptances are considered to be among the safest of
by the Federal National Mortgage Association (Fannie Mae),
all money market instruments. Most arise from a financial firm’s
the Farm Credit System (FCS), the Federal Land Banks (FLBs),
decision to guarantee the credit of one of its customers who is
1

and the Federal Home Loan Mortgage Corporation (Freddie


60

exporting, importing, or storing goods or purchasing currency.


cur ency.
currency
5
66

Mac). Most of these instruments are not formally guaranteed


98 e
1- nt
20

In legal language, the financial firm issuing the credit


dit guarantee
gu
g
guara
guaran
66 Ce

by the federal government, though many believe Congress


agrees to be the primary obligor, committed to o paying
aying off a
pa
65 ks

would rescue an agency in trouble. This implied government


06 oo

customer’s debt in return for a fee. The issuing


ing institution
in
nstitu sup-
82 B

support keeps agency yields close to those on Treasury secu-


-9 ali

plies its name and credit standing so its customer


omer will be able to
custo
usto
rities and contributes to the high liquidity of many agency
58 ak
11 ah

obtain credit elsewhere at lower cost.


securities. Interest income on agency-issued notes is federally
41 M

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

Chapter 4 The Investment Function in Financial-Services Management ■ 59

   


If the current holder sells the acceptances, this does not erase problems in the wake of the Great Recession of 2007–2009 that
the issuer’s obligation to pay off its outstanding acceptances at weakened the credit quality of their notes, forcing investors to
maturity. However, by selling an acceptance, the holder adds take a closer look at the quality of the municipals they choose to
to its reserves and transfers interest rate risk to another inves- buy and their increasing volatility.
tor. The acceptance is a discount instrument and, therefore, is
sold at a price below par. The investor’s expected return comes
from the prospect that the acceptance will rise in price as it gets 4.4 POPULAR CAPITAL MARKET
closer to maturity. Rates of return on acceptances generally lie INVESTMENT INSTRUMENTS
close to the yields on Eurocurrency deposits and Treasury bills.
Another important advantage of acceptances is that they may Treasury Notes and Bonds
qualify for discounting (borrowing) at the Federal Reserve Banks,
provided they are eligible acceptances, which means they must Among the safest assets investing institutions can buy are U.S.
be denominated in U.S. dollars, normally cannot exceed six Treasury notes and bonds. T-notes are available in a wide variety
months to maturity, and must arise from the export or import of of maturities (ranging from 1 year to 10 years when issued) and
goods or from the storage of marketable commodities. in large volume. T-bonds (with original maturities of more than
10 years) are traded in a more limited market with wider price fluc-
tuations. Treasury bonds and notes carry higher expected returns
Commercial Paper than T-bills, but present an investing institution with greater price
Many smaller banks, money market funds, and other financial and liquidity risk. They are issued normally in denominations of
firms find commercial paper—short-term, unsecured IOUs $1,000, $5,000, $10,000, $100,000, and $1 million. Paralleling the
offered by major corporations—an attractive investment safer U.S. Treasury bond market in recent years has been the Eurozone
than many types of loans. Commercial paper sold in the United government bond market, valued below the U.S. government
States is of relatively short maturity—the bulk of it matures in security market with serious European budget problems.
90 days or less—and generally is issued by borrowers with the
highest credit ratings. In Europe and Japan the paper market
Municipal Notes and Bonds
has attracted participation by international banks, finance com-
panies, and other lending institutions. European paper gener- Long-term debt obligations issued by states, cities, and other
ally carries longer maturities and higher interest rates than U.S. local governmental units are known collectively as municipal
paper due to its greater perceived credit risk; however, there is bonds. Interest on the majority of these bonds is exempt from
a more active resale market for Europaper than for most U.S. U.S. federal income tax provided they are issued to fund pub-
paper issues. Most commercial paper is issued at a discount lic, not private, projects. Capital gains on municipals are fully
from par, though some bears a promised rate of return (coupon). taxable, however, except for bonds sold at a discounted price,
where the gain from purchase price to par value is considered a
portion of tax-exempt interest earnings.
Short-Term Municipal Obligations
Investing institutions often submit competitive bids for, or pur-
State and local governments—including counties, cities, and chase after private negotiation, the debt issued by local cities,
special districts—issue a variety of short-term debt instruments counties, and school districts as a way of demonstrating support
to cover temporary shortages. Two of the most common are for their communities and to attract other business. They also
tax-anticipation notes (TANs), issued in lieu of future tax rev- purchase municipals from security dealers if their credit ratings
enues, and revenue-anticipation notes (RANs), issued to cover are high. Unfortunately, municipals are often not very liquid—
expenses from special projects, such as the construction of a toll relatively few issues trade on any given day.
bridge or highway until revenues flow in. All interest earned on
1
60

municipal notes is exempt from U.S. federal income taxation,


5

Factoid
66
98 er

so they may be attractive to investors bearing relatively high


1- nt
20
66 Ce

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

banks in recent years, reducing their attractiveness relative to


-9 ali

Answer: T-notes (with an original maturity of 1 to


o 10 years),
y
58 ak

federal and privately issued securities. At the same time, some


11 ah

followed by T-bills. (See, for example, www.treas.gov.)


w.tre
w.trea
eas.go
41 M

state and local governments have encountered serious financial


20
99

60 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Many different types of municipal bonds are issued today, 4.5 INVESTMENT INSTRUMENTS
but the majority fall into one of two categories: (1) general
obligation (GO) bonds, backed by the full faith and credit
DEVELOPED MORE RECENTLY
of the issuing government, which means they may be paid
The range of investment opportunities for investing institutions
from any available source of revenue (including the levying of
has expanded in recent years. Some new securities have been
additional taxes); and (2) revenue bonds, which can be used
developed; some of these are variations on traditional notes
to fund long-term revenue-raising projects and are payable
and bonds, while others represent relatively young investment
only from certain stipulated sources of funds. U.S. banks have
vehicles. Examples include structured notes, securitized assets,
long possessed the authority to deal in and underwrite gen-
and stripped securities.
eral obligation (GO) municipal bonds, but for many years they
faced restrictions on directly underwriting revenue bonds until
this power was extended by the Gramm-Leach-Bliley Act in Structured Notes
1999. Unfortunately many municipalities (e.g., Harrisburg, PA) In their search to protect themselves against shifting interest
have recently been driven to the brink of failure in a troubled rates, many investing institutions added structured notes to
economy, falling back on credit insurers (such as Assured Guar- their portfolios during the 1990s. Most of these notes arose
anty Municipal) to pay off investors and reduce the supply of from security dealers who assembled pools of federal agency
municipals available. securities and offered investments officers a packaged invest-
ment whose interest yield could be reset periodically based
on what happened to a reference interest rate, such as a U.S.
Corporate Notes and Bonds Treasury bond rate. A guaranteed floor rate and cap rate may
Long-term debt securities issued by corporations are usu- be added in which the investment return could not drop below
ally called corporate notes when they mature within five a stated (floor) level or rise above some maximum (cap) level.
years or corporate bonds when they carry longer maturi- Some structured notes carry multiple coupon (promised) rates
ties. There are many different varieties, depending on the that periodically are given a boost (“step-up”) to give inves-
types of security pledged (e.g., mortgages on property tors a higher yield; others carry adjustable coupon (promised)
versus debentures), purpose and terms of issue. Corporate rates determined by formula. The complexity of these notes
notes and bonds generally are more attractive to insurance has resulted in substantial losses for some investing institutions,
companies and pension funds than to banks because of especially where interest rate risk is rising.
their higher credit risk relative to government securities and
their more limited resale market. However, they usually offer Securitized Assets
significantly higher yields than government securities and
their yield spread over governments widens when investors In recent years hybrid securities based upon pools of loans have
become more concerned about credit quality and economic been prominent forms of investment vehicles. These securitized
downturns. assets are backed by selected loans of uniform type and quality,
such as FHA- and VA-insured home loans and credit card
loans. The most common securitized assets that depository
institutions have employed as investments are based upon
home mortgages.
CONCEPT CHECK
There are at least three main types of mortgage-backed secu-
4.1. Why do banks and other institutions choose to ritized assets: (1) pass-through securities, (2) collateralized
devote a significant portion of their assets to invest- mortgage obligations (CMOs), and (3) mortgage-backed bonds. s.
1

ment securities?
60

Pass-through securities arise when a lender pools a group p off sim-


up sim
5
66
98 er

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

legal trustee, and issues securities using the mortga


mortgage
mortggage loans as
06 oo

4.3. What are the principal money market and capital


82 B

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

investors holding the mortgage-backed ssecurities. Repayment


ed secur
secu
41 M
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 61

  


of principal and interest on the calendar dates promised may be Pass-throughs, CMOs, and other securitized assets had been
guaranteed by the Government National Mortgage Association among the largest segments of the financial marketplace when
(Ginnie Mae), an agency of the U.S. government, in return for purchases of new homes reached record levels. Several factors
a small fee (for example: perhaps as much as 6 basis points, or accounted for the popularity of these asset-backed investment
0.06 percent of the total amount of loans placed in the pool). securities, including:

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.

Closely related to CMOs are REMICs—real estate mortgage Stripped Securities


investment conduits—that also partition the cash flow from a In the 1980s, security dealers developed a hybrid instrument
pool of mortgage loans or mortgage-backed securities into known as the stripped security—a claim against either the prin-
multiple maturity classes in order to help reduce the cash-flow cipal or interest payments associated with a debt security, such
uncertainty of investors. As we will see later in this chapter, the as a Treasury bond. Dealers create stripped securities by sepa-
principal risk to an investor buying these securities is prepay- rating the principal and interest payments from an underlying
ment risk because some borrowers pay off their home mort- debt security and selling separate claims to these two promised
gages early or default on their loans, meaning the holder may income streams. Claims against only the principal payments are
receive diminished income. called PO (principal-only) securities, while claims against only
the promised interest payments are referred to as IO (interest-
A third type of mortgage-related security is the mortgage-
only) securities.
backed bond. Unlike pass-throughs and CMOs, where
mortgage loans are removed from the balance sheet, mortgage- Stripped securities often display markedly different behavior
backed bonds (MBBs) and the mortgage loans backing them from the underlying securities from which they come. In particu-
1

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

  


Each stripped security is sold at a discount from par, so the 4.6 INVESTMENT SECURITIES
investor’s rate of return is based solely on price appreciation.
Because bonds normally pay interest twice a year, an investor
HELD BY BANKS
can lock in a fixed rate of return for a holding period as short as
We have examined the principal investment opportunities
six months or as long as several years up to the maturity of the
available to investing institutions, but which of these invest-
original bond. POs tend to be more price sensitive to interest-
ments are preferred? Table 4.3 provides an overview of
rate changes than regular bonds, whereas IOs tend to be less
investment securities held by U.S.-insured banks in 2010.
price sensitive.

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

All FDIC-Insured Banks Percent of Investments Held by

Smallest Banks Medium-Size


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

Total Investments $2,337,748 100.0% 100.0% 100.0% 100.0%


U.S. government obligations** $1,269,255 53.4% 64.3% 66.4% 52.9%
(including U.S. Treasury and
federal agency securities)
State and local government 165,729 7.1 28.5 25.2 5.0
obligations
Asset-backed securities 135,195 5.8 —*** 0.2 6.4
Other domestic debt securi- 458,965 19.6 3.6 5.0 21.3
ties (including corporate
bonds and commercial paper)
Foreign debt securities 241,843 10.3 —*** —*** 11.5
Equities (stock) 13,487 0.6 0.6 0.5 0.6
Total Investment securities as 19.3% 21.9% 19.6% 19.2%
a percent of total assets
Memo items:
Pledged securities $1,119,692 47.9% 36.2% 45.8% 48.3%
Mortgage-backed securities 1,252,730 53.6 28.3 39.9 55.3
Securities held to maturity 129,078 5.5 13.5 9.4 0.5
Securities available for sale 2,208,670 94.5 86.5 90.6 95.0
Total debt securities 2,323,635 99.4 99.3 99.4 99.4
1

Structured notes 33,526 1.4 7.6 6.5 0.8


60
5
66
98 er

Assets held in trading 764,426 32.7 —** 0.1 36.5


5
1 - nt
20
66 Ce

account
65 ks
06 oo

* Figures for 9/30/2010.


82 B

** Includes federally guaranteed mortgage-backed securities.


-9 ali
58 ak

*** Indicates figure is less than 0.05 percent.


11 ah

Source: Federal Deposit Insurance Corporation, December 31, 2007.


41 M
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 63

  


Clearly just a few types of securities dominate bank invest-
ment portfolios: CONCEPT CHECK
1. U.S. government (especially Treasury) securities. 4.4. What types of investment securities do banks seem
2. Obligations of various federal agencies such as the Federal to prefer the most? Can you explain why?
National Mortgage Association (FNMA), the Federal Home 4.5. What are securitized assets? Why have they grown
Loan Mortgage Corporation (FHLMC), and the Government so rapidly in recent years?
National Mortgage Association (GNMA), especially in the
4.6. What special risks do securitized assets present to
form of mortgage-backed securities.
institutions investing in them?
3. State and local government obligations (municipals).
4.7. What are structured notes and stripped securities?
4. Nonmortgage-related asset-backed securities (such as obli- What unusual features do they contain?
gations backed by credit card and automobile loans).
5. Equities (common and preferred stock).
As might be expected, the smallest banks tend to invest more
Federal-government-related IOUs account for just over half of heavily in government securities than do the largest. The smaller
banks’ investment total, counting various types of U.S. govern- institutions tend to be more heavily exposed to risk of loss from
ment and federal agency-guaranteed debt instruments. In par- economic problems in their local areas and, therefore, tend to use
ticular, mortgage-loan-backed securities also account for more the lowest-risk securities to offset the high risk often inherent in their
than half of all U.S. bank investment holdings (with the heaviest loans. In contrast, the largest banks tend to be more heavily invested
concentrations of these mortgage-related instruments held by in foreign securities and private debt and equity obligations (espe-
the largest banks in the industry) due to their comparatively cially corporate bonds and commercial paper), all of which tend to
high yields. Nongovernment-guaranteed asset-backed securities carry greater risk exposure than government securities.
(such as instruments backed by auto and credit card loans) fall In total, investment securities represent only about a fifth
just behind state and local government (municipal) and foreign of total bank assets. But this proportion of bank assets var-
debt securities. ies with size and location. Banks operating in areas with weak
As reflected in Table 4.3, we see that banks hold relatively fewer loan demand usually hold significantly greater percentages of
private-sector securities, such as corporate bonds, notes, and investment securities relative to their total assets. Moreover, as
commercial paper or corporate stock. They would usually prefer Table 4.3 suggests, size also plays a key role. The smallest size
to make direct loans to customers rather than to buy their secu- group of banks holds just over 20 percent of its assets in the
rities because the yield is often lower on investment securities form of investments, while the largest multi-billion-dollar banks
than on loans and because purchasing securities usually gener- hold a lesser proportion of their assets in investment securities,
ates no new deposits for a bank. reflecting the relatively heavy loan demand most large banks
face. In contrast, loans often represent over half of all bank
Table 4.3 also tells us that management targets most bank-
assets and a majority of revenues usually come from loans; no
held investments for eventual resale rather than planning
surprise, loans generally carry significantly higher average yields
to hold them until they reach maturity. These investments
than investments. But as we have already seen, the investment
will generally be sold when a financial firm needs cash to
portfolio is expected to do several jobs in addition to generat-
cover customer withdrawals of funds, to make loans, or to
ing income, such as tax sheltering and reducing risk exposure.
take advantage of more lucrative investment opportunities.
More than half of banks’ investment portfolios consists of
trading account securities, and the largest banks perform the 4.7 FACTORS AFFECTING CHOICE
role of dealers, purchasing investments and reselling them
OF INVESTMENT SECURITIES
1
60

to customers.
5
66
98 er
1- nt
20

The investments officer of a financial firm must consider several


seve eral
66 Ce
65 ks

factors in deciding which investment securities to buy,


y, sell,
se ll, or
ell, o
Factoid
06 oo

hold. The principal factors bearing on which investments


stm
tm ents are
men a
82 B
-9 ali

After loans, what is the greatest source of revenue for most chosen include:
58 ak
11 ah

banks around the world?


41 M

1. Expected rate of return


Answer: Interest and dividends on investment securities.
2. Tax exposure
20
99

64 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


3. Interest rate risk $80 $80 $80
$900 = + + c +
4. Credit or default risk (1 + YTM)1 (1 + YTM)2 (1 + YTM)5

5. Business risk $1,000


+ (4.1)
(1 + YTM)5
6. Liquidity risk
7. Call risk Solving using a financial calculator or software reveals that the
yield to maturity (YTM) is 10.74 percent. The calculated YTM
8. Prepayment risk
should be compared with the expected yields on other loans and
9. Inflation risk investments to determine where the best possible return lies.
10. Pledging requirements However, many financial firms frequently do not hold all their
We will briefly review each of these factors. investments to maturity. Some must be sold off early to accom-
modate new loan demand or to cover deposit withdrawals.
To deal with this situation, the investments officer needs to calcu-
Filmtoid late the holding period yield (HPY). The HPY is simply the rate of
return (discount factor) that equates a security’s purchase price
What 1987 film busted Michael Douglas’s and Charlie
with the stream of income expected until it is sold to another
Sheen’s characters for insider trading when the expected
investor. For example, suppose the 8 percent T-note described
rates of return in the market were not enough to satisfy
above and currently priced at $900 was sold at the end of two
their greed?
years for $950. Its holding period yield could be found from
Answer: Wall Street.
$80 $80 $950
$900 = + + (4.2)
(1 + HPY)1 (1 + HPY)2 (1 + HPY)2

Expected Rate of Return In this case, the note’s HPY would be 11.51 percent.1

The investments officer must determine the total rate of


return that can reasonably be expected from each security, Tax Exposure
including any interest payments promised and possible capi-
Interest and capital gains income from most investments are
tal gains or losses. For most investments this requires the
taxed as ordinary income for tax purposes, just as are wages and
portfolio manager to calculate the yield to maturity (YTM)
salaries earned by U.S. citizens. Because of their relatively high
if a security is to be held to maturity or the planned holding
tax exposure, banks are more interested in the after-tax rate of
period yield (HPY) between point of purchase and point
return on loans and securities than in their before-tax return.
of sale.
This situation contrasts with such institutions as credit unions
and mutual funds, which are generally tax-exempt.

Filmtoid The Tax Status of State and Local


What 2010 film follows the infamous Gordon Gekko’s Government Bonds
exploits (played by Michael Douglas) after he is released
For banks in the upper tax brackets, tax-exempt state and local
from prison for the crimes committed in Wall Street?
government (municipal) bonds and notes have been attractive
Answer: Wall Street: Money Never Sleeps from time to time, depending upon their status in tax law and
market conditions.
For example, suppose that Aaa-rated corporate bonds are car-
As we will see in Chapter 18, the yield to maturity formula
1
60

rying an average gross yield to maturity of 7 percent, thehe prime


rime
determines the rate of discount (or yield) on a loan or security
5
66
98 er

rate on top-quality corporate loans is 6 percent, and d Aaa-rated


Aaa
a-rate
1- nt

that equalizes the market price of the loan or security with its
20
66 Ce

municipal bonds have a 5.5 percent gross yield to o maturity.


maturity The
ma
expected stream of cash flows (interest and principal). To illus-
65 ks

investments officer for a financial firm subject to the


he corporate
th co
06 oo

trate how the YTM formula can be useful to an investments


82 B
-9 ali

officer, suppose the officer is considering purchasing a $1,000


58 ak

par-value Treasury note that promises an 8 percent coupon rate


11 ah

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

Chapter 4 The Investment Function in Financial-Services Management ■ 65

  


REAL BANKS, REAL DECISIONS

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.

Aaa@rated municipal bonds: 5.50 percent * (1 - 0)


The Impact of Changes in Tax Laws
= 5.50 percent before and after taxes
Tax reform in the United States has had a major impact on
1

Under the assumptions given, the municipal bond is the most


60

the relative attractiveness of state and local government


5
66

attractive investment in gross yield. However, other consider-


98 er

bonds as investments for banks. Prior to federal tax reform form


orm m
1- nt
20
66 Ce

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

customer accounts, management’s desire to keep good loan


06 oo

of all state and local government debt outstanding. ng. But


B their
t
82 B

customers, recent changes in tax laws, and changes in state and


share of the municipal market has fallen substantially
tantially
tanti ally since
-9 ali

local government credit quality.


58 ak

that time, due to (1) declining tax advantages,


ges,, (2) lower
ages, l
11 ah
41 M

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

  


Bank Qualified Bonds where the tax advantage of a qualified bond is determined like this:

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

ing new higher-yielding securities in order to boost future returns.


urns.
rns.
560
66
98 er

Tax considerations in choosing securities to buy or sell tend


te tot
1- nt
20
66 Ce

2 be more important for larger lending institutionss than


han for smaller
th
han
65 ks

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
-9 ali
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

Interest income from municipals has to be added in to determine each


41 M

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.
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 67

  


INSIGHTS AND ISSUES
Complex Investments on the Rise: Range Equity-linked CDs contain features of both debt and stock.
Notes, Bank Officer Life Insurance (Boli), They promise guaranteed interest income and provide an
embedded option, offering an additional bonus based on a
Equity-Linked CDs, Auction-Rate Securities, market index (most often Standard & Poor’s 500 stock index).
and Trust-Preferred Securities For example, a bull CD with an embedded call option scores
In recent years—especially prior to the Great Recession of additional returns if the market index rises above a designated
2007–2009—many financial firms have had the tendency to strike price, Alternatively, a bear CD contains a put option
accept greater risk and complexity in their investment port- only paying off if the market index falls below the strike price.
folios. New instruments have appeared intended to do more Auction-rate securities consist of bonds bearing short-term
than just provide liquidity and income. interest rates reset every few days. While many investors have
For example, range notes are callable securities that promise regarded auction-rate securities as relatively safe, recent experi-
relatively high coupon interest rates contingent on which way ence during the credit crisis of 2007–2009 suggests these instru-
the market moves. These notes pay out interest provided an ments can carry significant liquidity risk should their auctions fail.
agreed-upon market index stays within a specified range. Finally, trust-preferred securities are created with the help of
If the market index moves outside the designated range, an investment banker who sets up a special-purpose entity
there is no payoff. For example, a range note might call for (SPE) that issues preferred shares. In return, the participating
paying its holder interest only if the interest rate on Eurocur- institution issues long-term debentures to support the new
rency deposits stays between 2 and 4 percent stock. Multiple possible payoffs include that the debentures
Some financial firms have purchased life insurance on their are considered to be new capital, the interest paid out is tax
officers and directors (BOLI), with the purchasing firm des- deductible, and the risk of shareholder dilution is reduced.
ignated beneficiary. As long as the purchaser continues to Regulatory agencies have expressed concern in recent years
pay annual premiums, the BOLI is recorded as an asset on that many such investments carry considerable credit and
its books. If the officer or director dies during the policy’s liquidity risk. Regulators insist that purchasing institutions
term, the purchasing institution has several options, includ- do a careful prepurchase analysis of these investments and
ing donating the proceeds to charity and securing a tax employ stress testing to determine what their risk exposure
deduction. would be under different market conditions.

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

coupon rate to add to the


60

and higher returns in mind. Financial firms, for example, often income = $ 0.9 million
io
o
5

bank’s investment portfolio.


66
98 er
1- nt

sell off selected securities at a loss in order to offset large


20
66 Ce

amounts of loan income, thereby reducing their tax liability. Clearly, this bank takes an immediate $500,000 loss befor efore
beforee
65 ks
06 oo

They may also shift their portfolios simply to substitute new, taxes ($10 million - $9.5 million) on selling the 7 percent
perceent
82 B
-9 ali

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
11 ah
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
20
99

68 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


income for 10 years. This portfolio shift is probably worth the find themselves purchasing investment securities when interest
immediate loss the bank must absorb from its current earnings. rates and loan demand are declining and, therefore, the prices
Moreover, if the bank has high taxable income from loans, that investments officers must pay for desired investments are headed
near-term loss can be used to lower current taxable income and upward. A growing number of tools to hedge (counteract) inter-
perhaps increase this year’s after-tax profits. est rate risk have appeared in recent years, including financial
futures, options, interest-rate swaps, gap management, and dura-
tion, as we will see in Chapter 18.
Interest Rate Risk
Changing interest rates create real risk for investments officers
Credit or Default Risk
and their institutions. Rising interest rates lower the market value
of previously issued bonds and notes, with the longest-term The investments made by banks and their closest competitors
issues suffering the greatest losses. Moreover, periods of rising are closely regulated due to the credit risk displayed by many
interest rates are often marked by surging loan demand. Because securities, especially those issued by private corporations and
a lender’s first priority is usually to make loans, many investments some governments. The risk that the security issuer may default
must be sold off to generate cash for lending at the very time on the principal or interest owed has led to regulatory controls
their prices are headed downward. Such sales frequently result in that prohibit the acquisition of speculative securities—those
substantial capital losses, which the lender hopes to counteract rated below’ Baa by Moody’s or BBB on Standard & Poor’s
by a combination of tax benefits and the relatively higher yields bond-rating schedule and below BBB on Fitch’s Rating Service.
available on loans. On the other hand, investments officers often (See Table 4.4 for definitions of the various credit rating

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

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


Credit Quality of Securities Category Rating Category Category

Best quality/smallest investment risk Aaa AAA AAA Investment quality


or investment grade/
High grade or high quality Aa AA AA
considered acceptable
Upper medium grade A A A for most banks and
other closely regulated
Medium grade Baa BBB BBB
financial firms.
Medium grade with some Ba BB BB
speculative elements
Lower medium grade B B B Speculative quality
and junk bonds/not
Poor standing/may be in default Caa CCC CCC
considered suitable for
Speculative/often in default Ca CC CC banks and other closely
regulated financial firms.
s.
01

Lowest-grade speculative securities/ C C C


56
66

poor prospects
98 er
1- nt
20
66 Ce

Defaulted securities and securities Not rated DDD RD Includes security


ecuurity issuers
iss
65 ks

issued by bankrupt firms DD D in default


ult orr bankrupt.
ban
06 oo
82 B

D
-9 ali
58 ak

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
99

Chapter 4 The Investment Function in Financial-Services Management ■ 69

  


symbols used.) U.S. banks generally are allowed to buy only infrastructure needs (roads, bridges, etc.), higher energy costs,
investment-grade securities, rated at least Baa or BBB, in order and strong taxpayer resistance to higher taxes. Moreover, with
to protect depositors against excessive risk. Moreover, banks many local areas opposing new taxes and spending programs,
through their securities affiliates or through the formation of a a sizable portion of state and local governments have turned
financial holding company are permitted to underwrite govern- to more risky revenue bonds in an effort to supplement their
ment and privately issued securities (including corporate bonds, financing options.
notes, and stock).
Unfortunately the credit rating process has become far more
In 1997 Moody’s Investors Service announced significant modi- stressful as investors increasingly question the reliability of
fication of its credit rating system for bonds issued by state and the credit reports they are receiving. Financial reform in the
local (municipal) governments. Specifically, securities in selected wake of the Great Recession of 2007–2009 appears to have
categories (such as Aa, A, and Baa) were given 2 or 3 numerical exposed credit rating companies to greater risk of legal
modifiers added to their rating to differentiate securities slightly action when investors lose money. In some cases credit raters
different in quality that carry similar letter grades. In 1981 have refused to let bond issuers publish the ratings they are
Moody’s added the number 1 to the letter grades attached assigned.
to some A- and B-rated municipals. Now, with the numbers 2
As we saw in the preceding chapter, many lending institutions
and 3 also added to some letter grades, an investments officer
have developed new methods for dealing with credit risk in
is alerted that a 1 means the security in question ranks at the
their investments and loans in recent years. Credit options and
upper end of its letter rating category, while a 2 implies the
swaps can be used to protect the expected yield on invest-
issue lies in the middle range and a 3 suggests the security in
ment securities. For example, investments officers may be able
question lies at the low end of the letter grade category. These
to find another financial institution willing to swap an uncertain
1, 2, and 3 numerical modifiers were also added to corporate
return on securities held for a lower but more certain return
bond ratings from Aa to B. The table below provides a picture
based upon a standard reference rate, such as the market yield
of these more refined credit ratings:
on Treasury bonds. Credit options are also available in today’s
markets that help to hedge the value of a corporate bond,
Moody’s Investor Service’s Credit Rating Symbols for example. If the bond issuer defaults, the option holder
for State and Local Government Securities receives a payoff from the credit option that at least par-
tially offsets the loss. Investments officers can also use credit
Aaa Baa1 Caa
options to protect the market value of a bond in case its credit
Aa1 Baa2 Ca rating is lowered as happened to the declining credit rating
Aa2 Baa3 C attached to U.S. Treasury obligations by Standard & Poor’s
Aa3 Ba1 Corporation in 2011.

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
66
98 er

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
66 Ce

a record 258 municipal bond defaults occurred, involving usually means that many investment securities purchased hased
hase d will
wil
65 ks

about $5 billion in defaulted IOUs. Today many state and


06 oo

come from borrowers located outside the principal pal market


marke
m for
82 B

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
20
99

70 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


often encourage out-of-market security purchases to balance Prepayment Risk
risk exposure in the loan portfolio.
A form of risk specific to asset-backed securities is prepayment
risk. This form of risk arises because the realized interest and
Liquidity Risk principal payments (cash flow) from a pool of securitized loans,
such as GNMA or FNMA pass-throughs, collateralized mortgage
Financial institutions must be ever mindful of the possibility they
obligations (CMOs), or securitized packages of auto or credit
will be required to sell investment securities in advance of their
card loans, may be quite different from the cash flows expected
maturity due to liquidity needs and be subjected to liquidity
originally. Indeed, having to price the prepayment option asso-
risk. Thus, a key issue that a portfolio manager must face in
ciated with asset-backed securities distinguishes these invest-
selecting a security for investment portfolios is the breadth and
ments from any other investments.
depth of its resale market. Liquid securities are, by definition,
those investments that have a ready market, relatively stable For example, consider what can happen to the planned interest
price over time, and high probability of recovering the original and principal payments from a pool of home mortgage loans
amount invested (i.e., the risk to the principal value is low). that serve as collateral for the issuance of mortgage-backed
Treasury securities are generally the most liquid and have the securities. Variations in cash flow to holders of the securities
most active resale markets, followed by federal agency securi- backed by these loans can arise from
ties, municipals, and mortgage-backed securities. Unfortunately,
1. Loan refinancings, which tend to accelerate when market
the purchase of a large volume of liquid, readily marketable
interest rates fall (in this case, borrowers may realize they
securities tends to lower the average yield from a financial
will save on loan payments if they replace their existing
institution’s earning assets and reduce its profitability. Thus,
loans with new lower-rate loans).
management faces a trade-off between profitability and liquid-
ity that must be reevaluated daily as market interest rates and 2. Turnover of the assets behind the loans (in this case borrow-
exposure to liquidity risk change. ers may sell out and move away or some borrowers may not
be able to meet their required loan payments and default
on their loans).
Call Risk In either or both of these cases some loans will be terminated
Many corporations and some governments that issue securities or paid off ahead of schedule, generating smaller long-term
reserve the right to call in those instruments in advance of matu- cash flows than expected, which can lower the expected rate of
rity and pay them off. Because such calls usually take place when return from loan-backed securities.
market interest rates have declined (and the borrower can get The pace at which loans that underlie asset-backed securities
lower interest costs), the financial firm investing in callable secu- are terminated or paid off depends heavily upon the interest
rities runs the risk of an earnings loss because it must reinvest its rate spread between current interest rates on similar type loans
recovered funds at lower interest rates. Investments officers and the interest rates attached to loans in the securitized pool.
generally try to minimize this call risk by purchasing callable When market interest rates drop below the rates attached
instruments bearing longer call deferments (so that a call cannot to loans in the pool far enough to cover refinancing costs,
occur for several years) or simply by avoiding the purchase of more borrowers will call in their loans and pay them off early.
callable securities. Fortunately for investments officers, call privi- This means that the market value of a loan-backed security
leges attached to bonds have been declining in recent years depends not only upon the promised cash flows it will gener-
due to the availability of other tools to manage interest-rate risk ate, but also on the projected prepayments and loan defaults
(though call privileges are quite common today in the trillion- that occur—that is,
dollar market for municipal bonds).3
1
60

Expected cash flows Expected cash flows


lows
5

adjusted for any ted


ed for
adjusted fo
orr any
66
98 er

3
lnvestments officers dealing with callable bonds generally calculate
1- nt
20

prepayments or epaym ment or


ments
prepayments
66 Ce

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

able bond happens to be trading at a premium above its parvalue,


06 oo

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

loan@backed (1 + y/m)1 (1 + y/m)n * m


58 ak

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

maturity if it is trading at a discount. Its yield is relatively low compared


to current interest rates and, therefore, is less likely to be called. (4.8)
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 71

  


where n is the number of years required for the last of the loans Inflation Risk
in the pool to be paid off or retired, m represents the number
of times during the year interest and principal must be paid to Investing institutions must be alert to the possibility that the
holders of the loan-backed securities, and y is the expected purchasing power of interest income and repaid principal from
yield to maturity from these securities. a security or loan will be eroded by rising prices for goods and
services. Inflation can also erode the value of the stockholders’
In order to properly value an asset-backed security, the invest-
investment in a financial firm—its net worth. Some protection
ments officer needs to make some reasonable assumptions
against inflation risk is provided by short-term securities and
about what volume of loans might be prepaid or terminated
those with variable interest rates, which usually grant the invest-
while his or her institution is holding the security. In making esti-
ments officer greater flexibility in responding to any flare-up in
mates of loan prepayment behavior, the officer must consider
inflationary pressures.
such factors as expected market interest rates, future changes in
the shape of the yield curve, the impact of seasonal factors One recently developed inflation risk hedge that may aid some
(e.g., most homes are bought and sold in the spring of each financial firms is the United States Treasury Department’s TIPS—
year), the condition of the economy, and how old the loans in Treasury Inflation-Protected Securities. Beginning in 1997 the
the pool are (because new loans are less likely to be repaid). Treasury began issuing 5-, 10-, and 30-year inflation-adjusted
marketable notes and later announced the offering of inflation-
One commonly employed way of making loan prepayment
protected savings bonds for the small investor. Both the coupon
estimates is to use the prepayment model developed by
rate and the principal (face) value of a TIPS are adjusted annu-
the Public Securities Association (PSA), which calculates an
ally to match changes in the consumer price index (CPI). Thus,
average loan prepayment rate based upon past experience.
the spread between the market yield on noninflation-adjusted
The PSA model typically assumes, for example, that insured
Treasury notes or bonds and the yield on TIPS of the same matu-
home mortgages will prepay at an annual rate of 0.2 percent
rity provides an index of expected inflation as viewed by the
the first month and the prepayment rate will grow by 0.2 per-
average investor in the marketplace. If expected inflation rises,
cent each month for the first 30 months. Loan prepayments
TIPS tend to become more valuable to investors.
are then assumed to level off at a 6 percent annual rate for
the remainder of the loan pool’s life. When an investments Many financial institutions have not been particularly enthusi-
officer adopts the PSA model without any modifications, he or astic about TIPS recently for a variety of reasons. With inflation
she is said to be assuming a 100 percent PSA repayment rate. proceeding at a relatively moderate pace in the United States,
However, the investments officer may decide to alter the PSA the market yield on TIPS has been modest as well. Then, too,
model to 75 percent PSA or some other percentage multiplier other inflation hedges are available, such as real estate and
based upon his or her knowledge of the nature of loans in the selected stocks, with the potential for favorable returns. More-
pool, such as their geographic location, distribution of maturi- over, TIPS do not protect investors from all the effects of infla-
ties, or the average age of borrowers. tion, such as moving into higher tax brackets, and they carry
market risk like regular bonds, but tend to be less liquid.
It must be noted that while prepayment of securitized loans
tends to accelerate in periods of falling interest rates, this is not
always an adverse development for investors in asset-backed
Pledging Requirements
securities. For example, as prepayments accelerate, an investing
institution recovers its invested cash at a faster rate, which can Depository institutions in the United States cannot accept
be a favorable development if it has other profitable uses for deposits from federal, state, and local governments unless
those funds. Moreover, lower interest rates increase the present they post collateral acceptable to these governmental units in
value of all projected cash flows from a loan-backed security so order to safeguard public funds. At least the first $100,000 of
that its market value could rise. The investments officer must these public deposits is covered by federal deposit insurance;
1
60

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
66 Ce

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

paid loans. ment deposit pledging requirements differ er widely


wid from state to
20
99

72 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


CONCEPT CHECK
4.8. How is the expected yield on most bonds determined? 4.13. What is the net after-tax return on a qualified municipal
4.9. If a government bond is expected to mature in two security whose nominal gross return is 6 percent, the
years and has a current price of $950, what is the cost of borrowed funds is 5 percent, and the financial
bond’s YTM if it has a par value of $1,000 and a firm holding the bond is in the 35 percent tax bracket?
promised coupon rate of 10 percent? Suppose this What is the tax-equivalent yield (TEY) on this tax-
bond is sold one year after purchase for a price of $970. exempt security?
What would this investor’s holding period yield be? 4.14. Spiro Savings Bank currently holds a government bond
4.10. What forms of risk affect investments? valued on the day of its purchase at $5 million, with
a promised interest yield of 6 percent, whose current
4.11. How has the tax exposure of various U.S. bank security
market value is $3.9 million. Comparable quality bonds
investments changed in recent years?
are available today for a promised yield of 8 percent.
4.12. Suppose a corporate bond an investments officer What are the advantages to Spiro Savings from selling
would like to purchase for her bank has a before-tax the government bond bearing a 6 percent promised
yield of 8.98 percent and the bank is in the 35 percent yield and buying some 8 percent bonds?
federal income tax bracket. What is the bond’s after-
4.15. What is tax swapping? What is portfolio shifting? Give
tax gross yield? What after-tax rate of return must a
an example of each.
prospective loan generate to be competitive with the
corporate bond? Does a loan have some advantages 4.16. Why do depository institutions face pledging require-
for a lending institution that a corporate bond would ments when they accept government deposits?
not have? 4.17. What types of securities are used to meet collateraliza-
tion requirements?

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

years. It might then decide to invest 20 percent of the firm’sfirm’ss


firm
5
66
98 er

investment portfolio in securities one year or less from rom maturity,


m
matu
1- nt
20
66 Ce

4.8 INVESTMENT MATURITY another 20 percent in securities maturing within n two


two years
year but
yea
65 ks

STRATEGIES
06 oo

no less than one year, another 20 percent in the interval


nterv of two
in
interv
82 B

to three years, and so forth, until the five-year


yearr point
-year poin is reached.
poi
-9 ali
58 ak

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
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 73

  


The Ladder or Spaced-Maturity Policy

STRATEGY: Divide 30
investment portfolio

Percent of the value


of all securities held
equally among all
maturities acceptable
20
to the investing institution.
ADVANTAGES: Reduces
investment income 20% of 20% of 20% of 20% of 20% of
10 portfolio portfolio portfolio portfolio portfolio
fluctuations /requires
little management
expertise.
0
1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
Maturity in years and months

The Front-End Load Maturity Policy


STRATEGY: All
100
security investments
are short-term. 90
80 100% of portfolio
Percent of the value
of all securities held

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

The Back-End Load Maturity Policy

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.

approach tends to build in investment flexibility. Because some


1

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
66 Ce

securities than any other financial institution?


65 ks
06 oo

The Front-End Load Maturity Policy Answer: The Federal Reserve System with several al hundred
ral h
hu
undre
undre
82 B

billion in Treasuries in its portfolio; among private


vate financial
finan
f
Another popular strategy is to purchase only short-term securi-
-9

institutions pension funds, mutual funds, insurance


suraance companies,
58

ties and place all investments within a brief interval of time.


11

and depository institutions, hold large quantities


ntities of Treasuries.
For example, the investments officer may decide to invest
41
20
99

74 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The Barbell Investment Portfolio Strategy

STRATEGY: 50
Security holdings
Half or a substantial Half or a substantial

Percent of the value


of all securities held
are divided between 40
short-term and percentage of portfolio percentage of portfolio
long-term.
30
ADVANTAGES:
Helps to meet 20
liquidity needs with
short term securities 30% 30%
and to achieve earnings 10 20% 20%
goals due to higher
potential earnings from 0
the long term portion 1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.
of the portfolio.

The Rate-Expectations Approach


STRATEGY: 50
Change the mix of Shift toward long-term securities
investment maturities
Percent of the value
of all securities held 40 if interest rates are expected to fall
as the interest-rate
outlook changes.
30
ADVANTAGES: Shift toward short-term securities
Maximizes the if interest rates are expected to rise
potential for earnings 20
(and also for losses).
10

0
1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.
Exhibit 4.3 Additional 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
66 Ce

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
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 75

  


of directors that the loss will be more than made up by higher Forecasting Interest Rates and the Economy
expected returns on new assets acquired from the proceeds of
Yield curve shapes have critical implications for the decisions an
the security sale. In general, investing institutions are inclined
investments officer must make. For example, the yield curve con-
to trade securities if (a) their expected after-tax returns can be
tains an implicit forecast of future interest rate changes, Positively
raised through effective tax management strategies; (b) higher
sloped yield curves reflect the average expectation in the market
yields can be locked in at the long-term end of the yield curve
that future short-term interest rates will be higher than they are
when the forecast is for falling interest rates; (c) the trade would
today. In this case, investors expect to see an upward interest-rate
contribute to an overall improvement in asset quality that would
movement, and they often translate this expectation into action by
enable the institution to better weather an economic downturn;
shifting their investment holdings away from longer-term securities
or (d) the investment portfolio can be moved toward higher-
(which will incur greater capital losses when market interest rates
grade securities without an appreciable loss in expected return
do rise). Conversely, a downward-sloping yield curve points to
(especially if problems are developing in the loan portfolio).
investor expectations of declining short-term interest rates in the
period ahead. The investments officer will consider lengthening
portfolio maturity because falling interest rates offer the prospect
4.9 MATURITY MANAGEMENT TOOLS
of substantial capital gains income from longer-term investments.
In choosing among various maturities of investments to acquire, Yield curves also provide the investments officer with a clue
investments officers need to consider carefully the use of two about overpriced and underpriced securities, Because the pre-
key maturity management tools—the yield curve and duration. vailing yield curve indicates what the yield to maturity should
These tools help the investments officer understand more fully be for each maturity, a security whose yield lies above the curve
the consequences and potential impact upon earnings and risk represents a tempting buy situation; its yield is temporarily too
from any particular maturity mix of securities. high (and, therefore, its price is too low). On the other hand, a
security whose yield lies below the curve represents a possible
sell or “don’t buy” situation because its yield is too low for its
The Yield Curve maturity (and, thus, its price is too high).
As we will see in Chapter 18, the yield curve is simply a picture In the long run, yield curves send signals about what stage of
of how market interest rates differ across loans and securities the business cycle the economy presently occupies, They gener-
of varying term (time) to maturity. Each yield curve, such as ally rise in economic expansions and fall in recessions.
the one drawn in Exhibit 4.2, assumes that all interest rates (or
yields) included along the curve are measured at the same time
and that all other rate-determining forces are held fixed. While Risk-Return Trade-Offs
the curve in Exhibit 4.2 slopes upward as we move to the right, The yield curve is also useful because it tells the investments
yield curves may also slope downward or be horizontal, indicat- officer something important about the current trade-offs
ing that short- and long-term interest rates at that particular between greater returns and greater risks. The yield curve’s
moment are about the same. shape determines how much additional yield the investments
officer can earn by replacing shorter-term
securities with longer-term issues, or vice
versa. For example, a steeply sloped
positive yield curve that rises 100 basis
points between 2-year and 10-year matu-
rity bonds indicates that the investments
officer can pick up a full percentage point
1
60

in extra yield (less broker or dealer com- m-


5
66
98 er

missions and any tax liability incurred) ed) byy


1- nt
20
66 Ce

switching from 2-year to 10-yearr bonds.boon


nds.
65 ks
06 oo

However, 10-year bonds are generally


gene erally
82 B

more volatile in price than n 2-year


2-year bonds,
2-ye b
-9 ali
58 ak

so the investments officercer must


m be will-
11 ah
41 M

ing to accept greater risk


risskk of a capital loss
Exhibit 4.4 The yield curve. on the 10-year bonds ds if interest
iin rates
20
99

76 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


rise. Longer-term bonds often have a thinner market in case The need for this kind of information gave rise to the concept
cash must be raised quickly. The investments officer can mea- of duration—a present-value-weighted measure of maturity of
sure along the curve what gain in yield will result from maturity an individual security or portfolio of securities. As we will discuss
extension and compare that gain against the likelihood a finan- in Chapter 18, duration measures the average amount of time
cial firm will face a liquidity crisis (“cash out”) or suffer capital needed for all of the cash flows from a security to reach the
losses if interest rates go in an unexpected direction. investor who holds it.
We will see in Chapter 18 (especially from Equation [18.18]) that
Pursuing the Carry Trade there is a critical relationship between duration, market interest
Likewise, yield curves provide the investments officer with a rates, and investment security prices. Specifically, the percent-
measure of how much might be earned at the moment by pur- age change in the price of an investment security is equal to the
suing the carry trade, The officer can borrow funds at the short- negative of its duration times the change in interest rates
est end of the curve (such as borrowing short-term money using divided by one plus the initial interest rate or yield.4 Using this
the safest and most liquid investment securities in the financial relationship we can see how sensitive an investment security’s
firm’s portfolio as collateral) and then invest the borrowed funds market price will be to changes in market interest rates and we
in income-generating assets farther out along the curve. For can decide whether the security we are interested in is too price
example, the officer may borrow funds for 30 days at 4 percent sensitive, or perhaps not price sensitive enough, to meet our
and use that money to invest in five-year government bonds financial firm’s investment needs.
yielding 6 percent. The difference between these two rates of For example, suppose a Treasury note has a duration of
return is called carry income and tends to be greatest when the 4.26 years and market interest rates rise from 10.73 percent
yield curve has a steep upward slope. to 12 percent, or 1.27 percent. The duration relationship we
described above tells us that should interest rates rise just over
Riding the Yield Curve one percentage point, the security in question will experience
If the yield curve does have a sufficiently strong positive slope, almost a 5 percent decline in price. The investments officer must
an investing institution may also be able to score significant decide how much chance there is that market interest rates will
gains with a maneuver known as riding the yield curve, The rise, whether this degree of price sensitivity is acceptable, and
investments officer looks for a situation in which some securi- whether other investments would better suit the institution’s
ties are soon to approach maturity and their prices have risen current investment needs.
significantly while their yields to maturity have fallen. If the yield
curve’s slope is steep enough to more than cover transactions Immunization
costs, the investing institution can sell those securities, scoring Duration also suggests a way to minimize damage to an invest-
a capital gain due to the recent rise in their prices, and reinvest ing institution’s earnings that changes in market interest rates
the proceeds of that sale in longer-term securities carrying may cause. That is, duration gives the investments officer a tool
higher rates of return. If the riding maneuver works (i.e., the to reduce his or her institution’s exposure to interest rate risk. It
slope of the yield curve does not fall), the investing institution suggests a formula for minimizing interest rate risk:
will reap both higher current income and greater future returns.
Duration of Length of the investor’s
an individual planned holding period
Duration = (4.9)
security or a for a security or a
While the yield curve presents the investments officer with valu- security portfolio security portfolio
able information and occasionally the opportunity for substantial
gains, it has several limitations, such as uncertainty over exactly
1
60

how and why the curve appears the way it does at any particular
5
66
98 er

moment and the possibility of a change in the curve’s shape at 4


1- nt

The formula described in this sentence (and presented in n Cha


Chapter
apte 18)
apter
20
66 Ce

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

than once each year the appropriate formula is this:


06 oo

the timing of cash flows expected from a security. The most


82 B

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

Chapter 4 The Investment Function in Financial-Services Management ■ 77

  


CONCEPT CHECK
4.18. What factors affect a financial-service institution’s deci- you believe that each of these banks has adopted
sion regarding the different maturities of securities it the particular strategy it has as reflected in the
should hold? maturity structure of its portfolio?
4.19. What maturity strategies do financial firms employ in 4.21. How can the yield curve and duration help an invest-
managing their portfolios? ments officer choose which securities to acquire or sell?
4.20. Bacone National Bank has structured its investment 4.22. A bond currently sells for $950 based on a par value
portfolio, which extends out to four-year maturities, of $1,000 and promises $100 in interest for three
so that it holds about $11 million each in one-year, years before being retired. Yields to maturity on
two-year, three-year, and four-year securities. comparable-quality securities are currently at
In contrast, Dunham National Bank and Trust holds 12 percent. What is the bond’s duration? Suppose
$36 million in one- and two-year securities and interest rates in the market fall to 10 percent. What
about $30 million in 8- to 10-year maturities. What will be the approximate percent change in the
maturity strategy is each bank following? Why do bond’s price?

For example, suppose a bank is interested in buying Treasury SUMMARY


notes because loan demand currently is weak. However, the
investments officer is concerned that he or she may be This chapter has focused on investments in the banking and
required to sell those securities at this time next year in order financial-services field. What is involved in making investments
to make profitable loans. Faced with this prospect and deter- and why are they important?
mined to minimize interest rate risk, the officer could choose
• For most financial-service firms, investments refer to the buy-
those notes with a duration of one year. The effect of this step
ing and selling of marketable securities, such as government
is to engage in portfolio immunization—that is, protecting
bonds and notes.
securities purchased from loss of return, no matter which way
interest rates go.5 • Investments fulfill multiple roles in the management of a
financial firm. These roles include (a) supplementing income
Duration works to immunize a security or portfolio of securi-
from loans; (b) supplying extra liquidity when cash is low;
ties against interest rate changes because two key forms of
(c) serving as collateral for borrowings; (d) reducing tax expo-
risk—interest rate risk and reinvestment risk—offset each
sure; (e) offsetting risks inherent in other parts of the balance
other when duration is set equal to the investing institution’s
sheet, such as in the loan portfolio; (f) dressing up the bal-
planned holding period. If interest rates rise after the securi-
ance sheet; (g) helping to hedge against interest rate risk;
ties are purchased, their market price will decline, but the
and (h) providing greater flexibility in management of assets
investments officer can reinvest the cash flow those securities
and liabilities.
are generating at higher market rates. Similarly, if interest
rates fall, the institution will be forced to reinvest at lower • The investments officer must choose what kinds of invest-
interest rates but, correspondingly, the prices of those securi- ments best contribute to the goals established for each insti-
ties will have risen. The net result is to approximately freeze tution’s investment portfolio. In lending-type institutions, the
the total return from investment security holdings. Capital investment portfolio normally plays “second fiddle" and the
1
60

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
66 Ce

tion’s planned holding period. demand is weak and more cash when loan demand iss high. h
hig
gh.
65 ks
06 oo

• In choosing which investments to hold, investments ents officers


o
office
82 B

must weigh multiple factors: (a) the goal of thehe investment


in
nvestm
-9 ali
58 ak

portfolio; (b) expected rates of return; (c) tax exposure;


expo
e (d)
11 ah
41 M

risks associated with changing market interest


errest rates,
erest r with
5
See Chapter 18 for additional discussion of portfolio immunization. possible default by security issuers, with
h the possible need
20
99

78 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


for cash at any time, with the impact of inflation and business of the time distribution of expected cash flows from invest-
cycle upon the demand for financial services, and with the ments and can be used to help reduce interest rate risk.
prepayment of loans that can reduce expected returns. • Most financial firms appear to have a preferred range of
• An additional factor that investments officers must consider maturities and durations for the investments they make, with
is the maturity or duration of different investment securities, depository institutions tending to focus upon comparatively
represented by the yield curve. Yield curves convey informa- short and midrange maturities or durations, and many of
tion about the market’s outlook for interest rates and graphi- their competitors, such as insurance companies and pension
cally illustrate the trade-off between risk and return that funds, tending to reach heavily into the longest maturities or
confronts the investments officer. Duration provides a picture durations.

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
66 Ce
65 ks
06 oo
82 B
-9
58
11
41
20
99

Chapter 4 The Investment Function in Financial-Services Management ■ 79

  


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

PROBLEMS AND PROJECTS


1. A 20-year U.S. Treasury bond with a par value of $1,000 is c. Discuss the pros and cons of purchasing the nonquali-
currently selling for $1,025 from various securities dealers. fied rather than the bank-qualified municipal described
The bond carries a 6 percent coupon rate with payments in the previous problem.
made annually. If purchased today and held to maturity,
7. Lakeway Thrift Savings and Trust is interested in doing
what is its expected yield to maturity?
some investment portfolio shifting. This institution has had
2. A municipal bond has a $1,000 face (par) value. Its yield to a good year thus far, with strong loan demand; its loan
maturity is 5 percent, and the bond promises its holders revenue has increased by 16 percent over last year’s level.
$60 per year in interest (paid annually) for the next 10 years Lakeway is subject to the 35 percent corporate income
before it matures. What is the bond’s duration? tax rate. The investments officer has several options in the
3. Calculate the yield to maturity of a 20-year U.S. government form of bonds that have been held for some time in its
bond that is selling for $975 in today’s market and carries a portfolio:
5 percent coupon rate with interest paid semi-annually. a. Selling $4 million in 12-year City of Dallas bonds
4. A corporate bond being seriously considered for purchase with a coupon rate of 7.5 percent and purchasing
by Old Dominion Financial will mature 20 years from today $4 million in bonds from Bexar County (also with
and promises a 7 percent interest payment once a year. 12-year maturities) with a coupon of 8 percent and
Recent inflation in the economy has driven the yield to issued at par. The Dallas bonds have a current market
maturity on this bond to 10 percent, and it carries a face value of $3,750,000 but are listed at par on the institu-
value of $1,000. Calculate this bond’s duration. tion’s books.
b. Selling $4 million in 12-year U.S. Treasury bonds that
5. Forever Savings Bank regularly purchases municipal bonds
carry a coupon rate of 12 percent and are recorded
issued by small rural school districts in its region of the state.
at par, which was the price when the institution pur-
At the moment, the bank is considering purchasing an
chased them. The market value of these bonds has
$8 million general obligation issue from the York school district,
risen to $4,330,000.
the only bond issue that district plans this year. The bonds,
which mature in 15 years, carry a nominal annual rate of return Which of these two portfolio shifts would you recommend?
of 6.75 percent. Forever Savings, which is in the top corporate Is there a good reason for not selling these Treasury bonds?
tax bracket of 35 percent, must pay an average interest rate What other information is needed to make the best deci-
of 4.25 percent to borrow the funds needed to I purchase the sion? Please explain.
municipals. Would you recommend purchasing these bonds? 8. Current market yields on U.S. government securities are
Calculate the net after-tax return on this bank-qualified distributed by maturity as follows:
municipal security. What is the tax advantage for being a 3-month Treasury bills = 1.90 percent
qualified bond? 6-month Treasury bills = 2.10 percent
6. Forever Savings Bank also purchases municipal bonds issued 1-year Treasury notes = 2.25 percent
by the city of Richmond. Currently the bank is considering a 2-year Treasury notes = 2.51 percent
nonqualified general obligation municipal issue. The bonds, 3-year Treasury notes = 2.82 percent
which mature in 15 years, provide a nominal annual rate of 5-year Treasury notes = 3.28 percent
1

return of 9.75 percent. Forever Savings Bank has the same 7-year Treasury notes = 3.56 percent
560

10-year Treasury bonds = 3.98 percent


66
98 er

cost of funds and tax rate as stated in the previous problem.


1- nt
20

20-year Treasury bonds = 4.69 percent


66 Ce

a. Calculate the net after-tax return on this nonqualified


65 ks

30-year Treasury bonds = 5.25 percent


municipal security.
06 oo
82 B

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

fied municipal security? have for an investing institution with 75


5ppercent
perce
per ce of its
20
99

80 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

investment portfolio in 7-year to 30-year U.S. Treasury would you recommend as good additions to the portfolio
bonds and 25 percent in U.S. government bills and notes during the period covered by the recession forecast and
with maturities under one year? What would you recom- why? What other kinds of information would you like to
mend to management? have about the bank’s current balance sheet and earnings
9. A bond possesses a duration of 8.89 years. Suppose that report in order to help you make the best quality decisions
market interest rates on comparable bonds were 7.5 per- regarding the investment portfolio?
cent this morning, but have now shifted downward to 13. Arrington Hills Savings Bank, a $3.5 billion asset institution,
7.25 percent. What percentage change in the bond’s value holds the investment portfolio outlined in the following
occurred when interest rates decreased by 25 basis points? table. This savings bank serves a rapidly growing money
10. The investments officer for Sillistine Savings is concerned center into which substantial numbers of businesses are
about interest rate risk lowering the value of the institu- relocating their corporate headquarters. Suburban areas
tion’s bonds. A check of the bond portfolio reveals an aver- around the city are also growing rapidly as large numbers
age duration of 4.5 years. How could this bond portfolio of business owners and managers along with retired profes-
be altered in order to minimize interest rate risk within the sionals are purchasing new homes. Would you recommend
next year? any changes in the makeup of this investment portfolio?
Please explain why.
11. A bank’s economics department has just forecast acceler-
ated growth in the economy, with GDP expected to grow
at a 4.5 percent annual growth rate for at least the next two Percent Types of Percent
years. What are the implications of this economic forecast Types of of Total Securities of Total
for an investments officer? What types of securities should Securities Held Portfolio Held Portfolio
the officer think most seriously about adding to the invest-
U.S. Treasury 38.7% Securities 45.6%
ment portfolio? Why? Suppose the bank holds a security securities available for
portfolio similar to that described in Table 4.3 for all insured sale
Federal agency 35.2
U.S. banks. Which types of securities might the investments
securities
officer want to think seriously about selling if the projected
economic expansion takes place? What losses might occur State and local 15.5 Securities 11.3
government with
and how could these losses be minimized?
obligations maturities:
12. Contrary to the exuberant economic forecast described Under one
in Problem 11, suppose a bank’s economics department year
is forecasting a significant recession in economic activity. Domestic debt 5.1 One to five 37.9
Output and employment are projected to decline signifi- securities years
cantly over the next 18 months. What are the implications Foreign debt 4.9 Over five 50.8
of this forecast for an investment portfolio manager? What securities years
is the outlook for interest rates and inflation under the fore-
Equities 0.6
going assumptions? What types of investment securities

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Chapter 4 The Investment Function in Financial-Services Management ■ 81

  


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

Internet Exercises
1. As the investments officer for Bank of America, you have 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.

CASE ASSIGNMENT FOR CHAPTER 4

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

would appear as on the following page.


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A. Data Collection: For this part, you will access data at the
66 Ce

D. Utilizing the above information, write one or two paragraphs


arag
agra
grraphs
aphs
FDIC’s website located at www2.fdic.gov/sdi for your
65 ks

about your BHC’s securities portfolio and how it compares


commpare
mpar e
06 oo

BHC. Use SDI to create a four-column report of your bank’s


82 B

to its peers. Use your pie charts as graphics and incorporate


incorp
-9 ali

information and the peer group information across years. In


58 ak

them in the discussion. Provide inferencess concerning


con
ncern the fac-
11 ah

this part of the assignment for Report Selection use the pull-
41 M

tors (e.g., expected rate of return, tax exposure,


xpoosure interest rate
down menu to select Securities and view this in Percent of
risk) affecting the choice of investment securities.
secu
Assets. For the size of the securities portfolio relative to total
20
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82 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

Composition of Securities Portfolio for Composition of Securities Portfolio for


BB&T (12/31/2010) Peer Group (12/31/2010)
Other domestic Equity securities U.S. Treasury
debt securities 1% securities
Equity
10% securities 9%
Securities issued by 1%
states & political Foreign debt
subdivisions securities
9% 12 %

U.S. Government
obligations
80% Other domestic
debt securities
22 %

U.S. Government
obligations
Securities issued by 52%
states & political
subdivisions
4%

Part Two: Investment Maturity Strategies lien 1–4 residential mortgages, (2) CMOs, REMICs, and
stripped MBs, and (3) other debt securities. Groups 1 and 3
A. Data Collection: The chapter concludes with a discussion
are partitioned into six maturity periods, whereas Group 2,
of investment maturity strategies. The SDI at www2.fdic
given the prepayment risk, has its expected average life
.gov/sdi contains maturity data for debt securities for banks
partitioned into two more general categories. Our objective ve
and BHCs. You will follow the process used to collect data
1
60

is to aggregate the data for all the debt securities based


ba ed on
for Part One; however, this time you will focus on the dollar
5
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maturities and enter our dollar sums in the spreadsheet


eadsh
adshheet for
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year-end information for your BHC only. You will collect


66 Ce

year-to-year comparisons as illustrated for BB&T


B&&TT using 2010
information in the two-column format. For Report Selec-
65 ks

and 2009 data. For simplification we will include


inclu
includde CMOs,
ude C
06 oo

tion, use the pull-down menu to select Total Debt Securities


82 B

REMICs, and stripped MBs with expected ctedd average


aver lives of
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and view this in dollars. For maturity and repricing data for
58 ak

three years or less in the aggregation


ion for
or row
fo ro 82 and CMOs,
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debt securities (all securities but equities), you are inter-


REMICs, and stripped MBs with expected
exppecte average lives
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ested in items 3–16. This includes a breakdown by maturity


of more than three years in row 84. Enter
E the aggregated
of (1) mortgage pass-throughs backed by closed-end first
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Chapter 4 The Investment Function in Financial-Services Management ■ 83

  


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

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.

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

25,000,000

20,000,000

15,000,000

10,000,000 1
60

5,000,000
5
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0
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Total debt Three Over Over Over Over Over


-9 ali

securities months 3 months 1 year 3 years 5 years 15 years


58 ak

or less through through through through


11 ah
41 M

12 months 3 years 5 years 15 years


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84 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

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.

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Chapter 4 The Investment Function in Financial-Services Management ■ 85

  




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1


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.

● Estimate a bank’s liquidity needs through three methods


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(sources and uses of funds, structure of funds, and liquidity


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indicators).
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Excerpt is Chapter 11 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
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87

  


KEY TOPICS IN THIS CHAPTER The cash shortages that some financial-service providers
experience make clear that liquidity needs cannot be ignored.
• Sources of Demand for and Supply of Liquidity A financial firm can be closed if it cannot raise sufficient liquidity
even though, technically, it may still be solvent. For example,
• Why Financial Firms Have Liquidity Problems
during the 1990s, the Federal Reserve forced the closure of the
• Liquidity Management Strategies $10 billion Southeast Bank of Miami because it couldn’t come
• Estimating Liquidity Needs up with enough liquidity to repay the loans it had received from
• The Impact of Market Discipline the Fed. Moreover, the competence of liquidity managers is an
important barometer of management’s overall effectiveness in
• Legal Reserves and Money Management
achieving any institution’s goals. So, let’s begin our journey and
see how important quality liquidity management is to the suc-
5.1 INTRODUCTION cess of virtually any financial firm.

Not long ago, as noted in a recent article from the Federal


Reserve Bank of St. Louis [5], a savings bank headquartered
in the northeastern United States experienced a real liquidity 5.2 THE DEMAND FOR AND SUPPLY
crisis. Acting on rumors of a possible embezzlement of funds, OF LIQUIDITY
some worried depositors launched an old-fashioned “run” on
the bank. Flooding into the institution’s Philadelphia and New A financial institution’s need for liquidity—immediately spend-
York City branches, some frightened customers yanked out able funds—can be viewed within a demand–supply framework.
close to 13 percent of the savings bank’s deposits in less than What activities give rise to the demand for liquidity? And what
a week, sending management scrambling to find enough cash sources can be relied upon to supply liquidity?
to meet the demands of concerned depositors. While the bank
For most financial institutions, the most pressing demands
appeared to weather the storm in time, the event reminds us of
for spendable funds generally come from two sources:
at least two things: (1) how much financial institutions depend
(1) customers withdrawing money from their accounts, and
upon public confidence to survive and prosper and (2) how
(2) credit requests from customers the institution wishes to
quickly the essential item called “liquidity” can be eroded when
keep, either in the form of new loan requests or drawings
the public, even temporarily, loses its confidence in one or
upon existing credit lines. Other sources of liquidity demand
more institutions.
include paying off previous borrowings, such as loans the
One of the most important tasks the management of any finan- institution may have received from other financial firms or
cial institution faces is ensuring adequate liquidity at all times, from the central bank (e.g., the Federal Reserve System).
no matter what emergencies may appear. A financial firm is Similarly, payment of income taxes or cash dividends to
considered to be “liquid” if it has ready access to immediately stockholders periodically gives rise to a demand for immedi-
spendable funds at reasonable cost at precisely the time those ately spendable cash.
funds are needed. This suggests that a liquid financial firm either
To meet the foregoing demands for liquidity, financial firms can
has the right amount of immediately spendable funds on hand
draw upon several potential sources of supply. The most impor-
when they are required or can raise liquid funds in timely fashion
tant source for a depository institution normally is receipt of
by borrowing or selling assets.
new customer deposits. These deposit inflows tend to be heavy
Indeed, lack of adequate liquidity can be one of the first signs the first of each month as business payrolls are dispensed, and
that a financial institution is in trouble. For example, a troubled they may reach a secondary peak toward the middle of each
bank losing deposits will likely be forced to dispose of some month as bills are paid. Another important element in the sup-
1

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
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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
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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.
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88 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


These various sources of liquidity demand and supply come Timing is critical to liquidity management: Financial managers
together to determine each financial firm’s net liquidity position must plan carefully how, when, and where liquid funds can be
at any moment in time. That net liquidity position (L) at time t is: raised.

Supplies of Liquidity Flowing into the Financial Firm


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

- Demands on the Financial Firm for Liquidity


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

When the demand for liquidity exceeds its supply (i.e., Lt 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

borrowings of reserves from other financial firms. Of course,


5 60

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
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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.
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Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 89

  


2. There is a trade-off between liquidity and profitability. The institutions typically face an imbalance between the maturity
more resources are tied up in readiness to meet demands dates attached to their assets and the maturity dates of their
for liquidity, the lower is that financial firm’s expected prof- liabilities. Rarely will incoming cash flows from assets exactly
itability (other factors held constant). match the cash flowing out to cover liabilities.
Thus, ensuring adequate liquidity is a never-ending problem for
management that will always have significant implications for
the financial firm’s performance. Filmtoid
Moreover, resolving liquidity problems subjects a financial What Christmastime favorite finds George Bailey, played by
institution to costs, including the interest cost on borrowed Jimmy Stewart, suicidal when facing a liquidity crisis at his
funds, the transactions cost of time and money in finding small-town financial institution?
adequate liquid funds, and an opportunity cost in the form of Answer: It’s a Wonderful Life.
future earnings that must be forgone when earning assets are
sold in order to meet liquidity needs. Clearly, management
must weigh these costs against the immediacy of the institu- A problem related to the maturity mismatch situation is that
tion’s liquidity needs. If a financial firm winds up with excess most depository institutions hold an unusually high propor-
liquidity, its management must be prepared to invest those tion of liabilities subject to immediate payment, especially
excess funds immediately to avoid incurring an opportunity demand (checkable) deposits and money market borrowings.
cost from idle funds not generating earnings. They must stand ready to meet immediate cash demands that
can be substantial at times, especially near the end of a week,
From a slightly different vantage point, we could say that the
near the first of each month, and during certain seasons of
management of liquidity is subject to the risks that interest
the year.
rates will change (interest rate risk) and that liquid funds will
not be available in the volume needed (availability risk). If Another source of liquidity problems is sensitivity to changes
market interest rates rise, assets that the financial firm plans in market interest rates. When interest rates rise, for example,
to sell to raise liquid funds will decline in value, and some some customers will withdraw their funds in search of higher
must be sold at a loss. Not only will fewer liquid funds be returns elsewhere. Many loan customers may postpone new
raised from the sale of those assets, but the losses incurred loan requests or speed up their drawings on those credit lines
will reduce earnings as well. Then, too, raising liquid funds that carry lower interest rates. Thus, changing market interest
by borrowing will cost more as interest rates rise, and some rates affect both customer demand for deposits and customer
forms of borrowed liquidity may no longer be available. If demand for loans, each of which has a potent impact on a
lenders perceive a financial institution to be more risky than depository institution’s liquidity position. Moreover, movements
before, it will be forced to pay higher interest rates to borrow in market interest rates affect the market values of assets the
liquidity, and some lenders will simply refuse to make liquid financial firm may need to sell in order to raise additional funds,
funds available at all. and they directly affect the cost of borrowing in the money
market.
Beyond these factors, financial firms must give high priority to
5.3 WHY FINANCIAL FIRMS OFTEN meeting demands for liquidity. To fail in this area may severely
damage public confidence in the institution. We can imagine
FACE SIGNIFICANT LIQUIDITY the reaction of a bank’s customers, for example, if the teller
PROBLEMS windows and ATMs had to be closed one morning because the
bank was temporarily out of cash and could not cash checks or
It should be clear from the foregoing discussion that most finan-
meet deposit withdrawals (as happened to a bank in Montana
1
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cial institutions face major liquidity problems. This significant


5

several years ago, prompting a federal investigation). One of theth


hee
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exposure to liquidity pressures arises from several sources.


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20

most important tasks of a liquidity manager is to keep close


ose con-
c
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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
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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
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credit available to their borrowing customers. Thus, depository able when demand for funds occurs.
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90 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


CONCEPT CHECK
5.1. What are the principal sources of liquidity demand for a are projected to be $18 million, (f) new deposits should
financial firm? total $670 million, (g) borrowings from the money market
5.2. What are the principal sources from which the supply of are expected to be about $43 million, (h) nondeposit
liquidity comes? service fees should amount to $27 million, (i) previous
bank borrowings totaling $23 million are scheduled to be
5.3. Suppose that a bank faces the following cash inflows and
repaid, and (j) a dividend payment to back stockholders of
outflows during the coming week: (a) deposit withdrawals
$140 million is schduled. What is this bank’s projected net
are expected to total $33 million, (b) customer loan
liquidity position for the coming week?
repayments are expected to amount to $108 million,
(c) operating expenses demanding cash payment will 5.4. When is a financial institution adequately liquid?
probably approach $51 million, (d) acceptable new loan 5.5. Why do financial firms face significant liquidity manage-
requests should reach $294 million, (e) sales of bank assets ment problems?

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.

Asset Liquidity Management (or Asset Filmtoid


Conversion) Strategies What 1980s thriller, starring Kris Kristofferson and Jane
Fonda, aligned murder with the liquidity problems of
The oldest approach to meeting liquidity needs is known as
Borough National Bank created by Arab withdrawals of
asset conversion. In its purest form, this strategy calls for stor-
Eurodeposits?
ing liquidity in assets, predominantly in cash and marketable
securities. When liquidity is needed, selected assets are con- Answer: Rollover.
verted into cash until all demands for cash are met.

What is a liquid asset? It must have three characteristics:


Asset conversion strategy is used mainly by smaller financial
1. A liquid asset has a ready market so it can be converted institutions that find it a less risky approach to liquidity man-
into cash without delay. agement than relying on borrowings. But it is not a costless
2. It has a reasonably stable price so that, no matter how approach. First, selling assets means loss of future earnings
quickly the asset must be sold or how large the sale is, the those assets would have generated had they not been sold off.
market is deep enough to absorb the sale without a signifi- Thus, there is an opportunity cost to storing liquidity in assets
when those assets must be sold. Most asset sales also involve e
1

cant decline in price.


5 60

transactions costs (commissions) paid to security brokers. ers More-


kers. Mor
More
66
98 er

3. It is reversible, meaning the seller can recover his or her


1- nt
20

over, the assets in question may need to be sold in n a market


m
marke
66 Ce

original investment (principal) with little risk of loss.


experiencing declining prices and increasing risk. k. Management
sk. Mana
Manag
M
65 ks
06 oo

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
-9 ali

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
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 91

  


STORING LIQUIDITY IN ASSETS—THE PRINCIPAL OPTIONS
The principal options open to liquidity managers for holdings of 5. Municipal bonds and notes—debt securities issued by
liquid assets that can be sold when additional cash is needed are state and local governments that range in maturity from
a few days to several years.
1. Treasury bills—direct obligations of the United States gov-
ernment or of foreign governments issued at a discount 6. Federal agency securities—short- and long-term debt
and redeemed at par (face value) when they reach matu- instruments sold by federally sponsored agencies such as
rity; T-bills have original maturities of 3, 6, and 12 months, FNMA (Fannie Mae) or FHLMC (Freddie Mac).
with an active resale market through security dealers. 7. Negotiable certificates of deposit—investing in short-
2. Federal funds loans to other institutions—loans of term CDs until they mature and can be converted into
reserves held by depository institutions with short (often cash without penalty.
overnight) maturities. 8. Eurocurrency loans—the lending of deposits accepted
3. Purchase of liquid securities under a repurchase agree- by bank offices located outside a particular currency’s
ment (RP)—using high-quality securities as collateral to home country for periods stretching from a few days to a
raise new funds. few months.
4. Placing correspondent deposits with various depository
institutions—these interbank deposits can be borrowed
or loaned in minutes by telephone or by wire.

the appearance of the balance sheet because the assets sold 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.

Borrowing liquid funds has a number of advantages. A financial


Borrowed Liquidity (Liability) firm can choose to borrow only when it actually needs funds,
unlike storing liquidity in assets where a storehouse of liquid
Management Strategies
assets must be held at all times, lowering potential returns.
For several decades now the largest financial institutions Then, too, using borrowed funds permits a financial institu-
around the world have chosen to raise more of their liquid tion to leave the volume and composition of its asset portfolio

BORROWING LIQUIDITY—THE PRINCIPAL OPTIONS


When a liquidity deficit arises, the financial firm can borrow 4. Issuing Eurocurrency deposits to multinational banks and
funds from: other corporations at interest rates determined by the
demand and supply for these short-term international
1. Federal funds borrowings—reserves from other lenders
deposits.
that can be accessed immediately.
5. Securing advances from the Federal Home Loan Bank
2. Selling liquid, low-risk securities under a repurchase
1

(FHLB) system, which provides loans to institutions lend-


60

agreement (RP) to financial institutions having temporary


5

ing in the real-estate–backed loan market.


66
98 er

surpluses of funds. RPs generally carry a fixed rate of


1- nt
20

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
65 ks
06 oo

terminates the loan. of Japan)—usually available within a matter of minutes


minnutes
82 B

provided the borrowing institution has collateral


al on hand
atera
-9 ali

3. Issuing jumbo ($100,000+) negotiable CDs to major cor-


58 ak

and a signed borrowing authorization.


11 ah

porations, governmental units, and wealthy individuals


41 M

for periods ranging from a few days to several months.


20
99

92 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


unchanged if it is satisfied with the assets it currently holds. In
contrast, selling assets to provide liquidity for liability-derived CONCEPT CHECK
demands, such as deposit withdrawals, shrinks the size of a
5.6. What are the principal differences among asset
financial firm as its asset holdings decline. Finally, as we will see
liquidity management, liability management, and
in Chapter 18, liability management comes with its own control
balanced liquidity management?
lever—the interest rate offered to borrow funds. If the borrow-
ing institution needs more funds, it merely raises its offer rate 5.7. What guidelines should management keep in
until the requisite amount of funds flow in. If fewer funds are mind when it manages a financial firm’s liquidity
required, the financial firm’s offer rate may be lowered. position?

The principal sources of borrowed liquidity for a depository


institution include jumbo ($100,000+ ) negotiable CDs, federal
funds borrowings, repurchase agreements, Eurocurrency bor- Guidelines for Liquidity Managers
rowings, advances from the Federal Home Loan Banks, and
Over the years, liquidity managers have developed several rules
borrowings at the discount window of the central bank in each
that often guide their activities. First, the liquidity manager must
nation. (See the box above, “Borrowing Liquidity—The Princi-
keep track of the activities of all departments using and/or supply-
pal Options” for a description of these instruments.) Liability
ing funds. Whenever the loan department grants a new credit line
management techniques are used most extensively by the
to a customer, for example, the liquidity manager must prepare
largest banks, which often borrow close to 100 percent of their
for possible drawings against that line. If the savings account divi-
liquidity needs.
sion expects to receive several large deposits in the next few days,
Borrowing liquidity is the most risky approach to solving this information should be passed on to the liquidity manager.
liquidity problems (but also carries the highest expected
Second, those responsible for liquidity management should
return) because of the volatility of interest rates and the rapid-
know in advance when the biggest credit or funds-supplying
ity with which the availability of credit can change. Often
customers plan to withdraw their funds or add funds to their
financial-service providers must purchase liquidity when it is
accounts. This allows management to plan ahead to deal more
most difficult to do so, both in cost and availability. Borrow-
effectively with emerging liquidity surpluses and deficits.
ing cost is always uncertain, which adds greater uncertainty
to earnings. Moreover, a financial firm that gets into trouble Third, the liquidity manager must make sure the financial firm’s
is usually most in need of borrowed liquidity, particularly priorities for liquidity management are clear. For example, in
because knowledge of its difficulties spreads and customers the past, a depository institution’s liquidity position was often
begin to withdraw their funds. At the same time, other finan- assigned top priority when it came to allocating funds. A typi-
cial firms become less willing to lend to the troubled institu- cal assumption was that a depository institution had little or no
tion due to the risk involved. control over its sources of funds—those were determined by
the public—but the institution could control its uses of funds.
In addition, because the law may require depository institutions
Balanced Liquidity Management to set aside liquid funds at the central bank to cover reserve
Strategies requirements and because the depository must be ready at all
times to handle deposit withdrawals, liquidity management and
Due to the risks inherent in relying on borrowed liquidity and
the diverting of sufficient funds into liquid assets were given
the costs of storing liquidity in assets, most financial firms
the highest priority. Today, liquidity management has generally
compromise by using both asset and liability management.
been relegated to a supporting role compared to most financial
Under a balanced liquidity management strategy, some
firms’ number one priority—making loans and supplying fee-
of the expected demands for liquidity are stored in assets
1

generating services to all qualified customers in order to maxi-


axi-
xi-
60

(principally holdings of marketable securities), while other


5
66

mize returns.
98 er

anticipated liquidity needs are backstopped by advance


1- nt
20
66 Ce

arrangements for lines of credit from potential suppliers of Fourth, liquidity needs must be analyzed on a continuinginuing basis
ontiinu
65 ks
06 oo

funds. Unexpected cash needs are typically met from near- to avoid both excess and deficit liquidity positions.
itionns. Excess
itions Ex
82 B

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
41 M

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.
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 93

  


5.5 ESTIMATING LIQUIDITY NEEDS The Sources and Uses of Funds Approach
The sources and uses of funds method for estimating liquidity
Several methods have been developed in recent years for esti-
needs begins with two simple facts:
mating a financial institution’s liquidity requirements. These
methods include the sources and uses of funds approach, the 1. In the case of a bank, for example, liquidity rises as deposits
structure of funds approach, the liquidity indicator approach, increase and loans decrease.
and the market signals (or discipline) approach. Each method 2. Alternatively, liquidity declines when deposits decrease and
rests on specific assumptions and yields only an approximation loans increase.
of actual liquidity requirements. This is why a liquidity manager
Whenever sources and uses of liquidity do not match, there is a
must always be ready to fine-tune estimates of liquidity require-
liquidity gap, measured by the size of the difference between
ments as new information becomes available. In fact, most
sources and uses of funds. When sources of liquidity (e.g.,
financial firms make sure their liquidity reserves include both a
increasing deposits or decreasing loans) exceed uses of liquidity
planned component, consisting of the reserves called for by the
(e.g., decreasing deposits or increasing loans), the financial firm
latest forecast, and a protective component, consisting of an
will have a positive liquidity gap (surplus). Its surplus liquid funds
extra margin of liquid reserves over those dictated by the most
must be quickly invested in earning assets until they are needed
recent forecast. The protective liquidity component may be
to cover future cash needs. On the other hand, when uses
large or small, depending on management’s philosophy and atti-
exceed sources, a financial institution faces a negative liquid-
tude toward risk—that is, how much chance of running a “cash-
ity gap (deficit). It now must raise funds from the cheapest and
out” management wishes to accept.
most timely sources available.
The key steps in the sources and uses of funds approach, using a
Factoid bank as an example, are:
Among the most rapidly growing sources of borrowed liquid-
1. Loans and deposits must be forecast for a given planning
ity among U.S. financial institutions are advances of funds by
period.
the Federal Home Loan Banks, which are relatively low in cost
and more stable with longer maturities than most deposits. 2. The estimated change in loans and deposits must be calcu-
By the 21st century close to half of all U.S. banks had FHLB lated for that same period.
advances outstanding, but some of these federal banks faced 3. The liquidity manager must estimate the net liquid funds’
serious financial problems. surplus or deficit for the planning period by comparing the
estimated change in loans (or other uses of funds) to the
estimated change in deposits (or other funds sources).
Let us turn now to a few of the most popular methods for estimat-
ing a financial institution’s liquidity needs. For illustrative purposes, Banks, for example, use a wide variety of statistical techniques,
we will focus on the problem of estimating a bank’s liquidity needs supplemented by management’s judgment and experience, to
because banks typically face the greatest liquidity management prepare forecasts of deposits and loans. For example, a bank’s
challenges of any financial firm. However, the principles we will economics department or its liquidity managers might develop
explore apply to other financial-service providers as well. the following forecasting models:

projected growth in the


Estimated economy projected
change in total is a (for example, the quarterly
F¶ ∂, § ¥,
loans for the function growth of gross domestic corporate
1

coming period of product [GDP] or earnings


5 60

business sales)
66
98 er
1- nt
20
66 Ce

projected prime
65 ks
06 oo

current rate of loan rate


82 B

estimated
growth in the minus the
-9 ali

§ ¥, ¶ ∂, and £ rate of ≥ V (5.2)


58 ak

money commercial
11 ah

inflation
41 M

supply paper rate


or CD rate
20
99

94 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Estimated
change in total is a projected growth estimated
deposits for function C £ in personal income ≥, £ increase in ≥ S ,
the coming of in the economy retail sales
period
current rate of
projected yield on
growth of the estimated rate
§ ¥, £ money market ≥, and ¢ ≤R (5.3)
money of inflation
deposits
supply

bank’s total deposits stood at $1,200 million and total loans


Factoid outstanding reached $800 million at the most recent year-end.
Did you know that robberies of cash from banks have been Table 5.1 presents a forecast of weekly deposit and loan totals
on the rise again in recent years due, in part, to banking for the first six weeks of the new year. Each weekly loan and
offices that stress customer convenience and easy access deposit trend figure shown in column 1 accounts for a one-week
rather than security? Does this seem to make sense as a busi- portion of the projected 10 percent annual increase in deposits
ness decision? Why? and the expected 8 percent annual increase in loans. To derive
the appropriate seasonal element shown in column 2, we com-
pare the ratio for the average (trend) deposit and loan figure
Using the forecasts of loans and deposits generated by the for each week of the year to the average deposit and loan level
foregoing relationships, management could then estimate the during the final week of the year for each of the past 10 years.
bank’s need for liquidity by calculating We assume the seasonal ratio of the current week’s level to the
Estimated liquidity Estimated preceding year-end level applies in the current year in the same
deficit (-) or surplus (+) = Estimated change in - change in (5.4) way as it did for all past years, so we simply add or subtract the
for the coming period deposits loans calculated seasonal element to the trend element.
The cyclical element, given in column 3, compares the sum of
A somewhat simpler approach for estimating future deposits (or
the estimated trend and seasonal elements with the actual level
other funds sources) and loans (or other funds uses) is to divide the
of deposits and loans the previous year. The dollar gap between
forecast of future deposit and loan growth into three components:
these two numbers is presumed to result from cyclical forces,
1. A trend component, estimated by constructing a trend and we assume that roughly the same cyclical pressures that
(constant-growth) line using as reference points year-end, prevailed last year apply to the current year. Finally, column 4
quarterly, or monthly deposit and loan totals established reports estimated total deposits and loans, consisting of the
over at least the last 10 years (or some other base period sum of trend (column 1), seasonal (column 2), and cyclical com-
sufficiently long to define a trend growth rate). ponents (column 3).
2. A seasonal component, measuring how deposits (or other Table 5.2 shows how we can take estimated deposit and loan fig-
funds sources) and loans (or other funds uses) are expected ures, such as those given in column 4 of Table 5.1, and use them
to behave in any given week or month due to seasonal fac- to estimate expected liquidity deficits and surpluses in the period
tors, as compared to the most recent year-end deposit or ahead. In this instance, the liquidity manager has estimated liquid-
loan level. ity needs for the next six weeks. Columns 1 and 2 in Table 5.2
3. A cyclical component, representing positive or negative merely repeat the estimated total deposit and total loan figures
1

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
1- nt
20
66 Ce

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
82 B

a liquidity deficit is more likely to occur. Whenen d deposits


epos grow and
de
For example, suppose we are managing liquidity for a bank
-9 al

loans decline, a liquidity surplus is more likely


likely.
ikelyy.
58 ak

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
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 95

  


Table 5.1 Forecasting Deposits and Loans with the Sources and Uses of Funds Approach (figures in millions
of dollars)
Trend Estimate Seasonal Cyclical Estimated
Deposit Forecast for for Deposits Element* Element** Total Deposits
January, Week 1 $1,210 -4 -6 $1,200
January, Week 2 1,212 - 54 -58 1,100
January, Week 3 1,214 -121 - 93 1,000
January, Week 4 1,216 -165 -101 950
February, Week 1 1,218 +70 - 38 1,250
February, Week 2 1,220 +32 -52 1,200
Trend Estimate Seasonal Cyclical Estimated
Loan Forecast for for Loans Element* Element** Total Loans
January, Week 1 $799 +6 -5 $800
January, Week 2 800 +59 -9 850
January, Week 3 801 +174 - 25 950
January, Week 4 802 + 166 + 32 1,000
February, Week 1 803 +27 - 80 750
February, Week 2 804 +98 -2 900
*The seasonal element compares the average level of deposits and loans for each week over the past 10 years to the average level of deposits and
loans for the final week of December over the preceding 10 years.
**The cyclical element reflects the difference between expected deposit and loan levels in each week during the preceding year (measured by the
trend and seasonal elements) and the actual volume of total deposits and total loans the bank posted that week.

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

Estimated Estimated Estimated Estimated Estimated Liquidity


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

January, Week 1 $1,200 $ 800 $ $ $


January, Week 2 1,100 850 -100 +50 -150
January, Week 3 1,000 950 -100 +100 - 200
January, Week 4 950 1,000 -50 +50 -100
February, Week 1 1,250 750 + 300 - 250 +550
February, Week 2 1,200 900 -50 +150 - 200

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
98 er

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
1- nt
20
66 Ce

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
-9 ali
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
11 ah
41 M

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.
20
99

96 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The Structure of Funds Approach liquid reserves on hand because, once a loan is made, the bor-
rowing customer will spend the proceeds immediately and those
Another approach to estimating a financial firm’s liquidity require- funds will flow out to other institutions. However, this lending
ments is the structure of funds method. Once again we will institution does not want to turn down any good loan, because
illustrate this liquidity estimation procedure using some figures pro- loan customers bring in new deposits and normally are the prin-
vided by a bank that frequently faces substantial liquidity demands. cipal source of earnings from interest and fees.
In the first step in the structure of funds approach, deposits and
Indeed, a substantial body of current thinking suggests that any
other funds sources are divided into categories based upon their
lending institution should make all good loans, counting on its
estimated probability of being withdrawn and, therefore, lost
ability to borrow liquid funds, if necessary, to cover any pressing
to the financial firm. As an illustration, we might divide a bank’s
cash needs. Under today’s concept of relationship banking, once
deposit and nondeposit liabilities into three categories:
the customer is sold a loan, the lender can then proceed to sell
1. “Hot money” liabilities (often called volatile liabilities)— that customer other services, establishing a multidimensional
deposits and other borrowed funds (such as federal funds relationship that will bring in additional fee income and increase
borrowings) that are very interest sensitive or that manage- the customer’s dependence on (and, therefore, loyalty to) the
ment is sure will be withdrawn during the current period. lending institution. This reasoning suggests that management
2. Vulnerable funds—customer deposits of which a substantial must try to estimate the maximum possible figure for total loans
portion, perhaps 25 to 30 percent, will probably be with- and hold in liquid reserves or borrowing capacity the full amount
drawn sometime during the current time period. (100 percent) of the difference between the actual amount of
loans outstanding and the maximum potential for total loans.
3. Stable funds (often called core deposits or core liabilities)—
funds that management considers unlikely to be removed Combining both loan and deposit liquidity requirements, this
(except for a minor percentage of the total). institution’s total liquidity requirement would be:

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
98 er

* (Stable deposits and nondeposit funds annual rate. Thus, within the coming year, total loans might
ns migght rreach
1- nt
20
66 Ce

- 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
41 M

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.
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 97

  


Table 5.3 Estimating Liquidity Needs with the Structure of Funds Method
A. First National Bank finds that its current deposits and nondeposit liabilities break down as follows:
Hot money $ 25 million
Vulnerable funds (including the largest
deposit and nondeposit liability accounts) $ 24 million
Stable (core) funds $100 million
First National’s management wants to keep a 95% reserve behind its hot money deposits (less the 3% legal reserve require-
ment imposed by the central bank behind many of these deposits) and nondeposit liabilities, a 30% liquidity reserve in back of
its vulnerable deposits and other borrowings (less required reserves), and a 15% liquidity reserve behind its core deposit and
nondeposit funds (less required reserves).
B. First National Bank’s loans total $135 million but recently have been as high as $140 million, with a trend growth rate of about
10 percent a year. This financial firm wishes to be ready at all times to honor customer demands for all loans that meet its
quality standards.
C. The bank’s total liquidity requirement is:

Deposit/Nondeposit Funds plus Loans


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

REAL BANKS, REAL DECISIONS

Liquidity Shortages in the Wake of the 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

own promises to pay. Within hours many financial institutions


60

pour new funds into the money market. Discount window


5

faced a fullblown liquidity crisis.


66
98 er

loans jumped from a daily average of about $100 million to


1- nt
20
66 Ce

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
82 B

the attacks stopped transferring reserves to other institu-


-9 al

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
11 ah
41 M

receive the incoming funds they expected. Several banks that links to their customers soon quelled this liquidity
idity crisis.
20
99

98 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Many financial firms like to use probabilities in deciding how situation next week as likely to fall into one of three possible
much liquidity to hold. Under this refinement of the structure of situations:
funds approach, the liquidity manager will
want to define the best and the worst pos-
Estimated Estimated Estimated Probability
sible liquidity positions his or her financial
Average Average Liquidity Assigned by
institution might find itself in and assign
Possible Volume of Volume Surplus or Management
probabilities to each. For example,
Liquidity Deposits of Loans Deficit Position to Each
1. The worst possible liquidity position. Outcomes for Next Week Next Week Next Week Possible
Suppose deposit growth at the finan- Next Week (millions) (millions) (millions) Outcome
cial firm we have been following falls
Best possible $170 $110 + $60 15%
below management’s expectations, so
liquidity
that actual deposit totals sometimes go position
below the lowest points on the firm’s (maximum
historical minimum deposit growth deposits,
track. Further, suppose loan demand minimum loans)
rises significantly above management’s Liquidity $150 $140 + $10 60%
expectations, so that loan demand position
sometimes goes beyond the high points bearing
the highest
of the firm’s loan growth track. In this
probability
instance, the financial firm would face
maximum pressure on its available liq- Worst possible $130 $150 - $20 25%
liquidity
uid reserves because deposit growth
position
would not likely be able to fund all the (minimum
loans customers were demanding. In deposits,
this worst situation the liquidity man- maximum loans)
ager would have to prepare for a sizable
liquidity deficit and develop a plan for raising substantial Thus, management sees the worst possible situation next week
amounts of new funds. as one characterized by a $20 million liquidity deficit, but this
2. The best possible liquidity position. Suppose deposit growth least desirable outcome is assigned a probability of only 25 per-
turns out to be above management’s expectations, so that cent. Similarly, the best possible outcome would be a $60 mil-
it touches the highest points in the financial institution’s lion liquidity surplus. However, this is judged to have only a
deposit growth record. Moreover, suppose loan demand 15 percent probability of occurring. More likely is the middle
turns out to be below management’s expectations, so that ground—a $10 million liquidity surplus—with a management-
loan demand grows along a minimum path that touches low estimated probability of 60 percent.
points in the financial firm’s loan growth track. In this case What, then, is the institution’s expected liquidity requirement?
the firm would face minimum pressure on its liquid reserves We can find the answer from:
because deposit growth probably could fund nearly all the
quality loans that walk in the door. In this “best” situation, Estimated
it is likely that a liquidity surplus will develop. The liquidity Expected liquidity
Probability of
manager must have a plan for investing these surplus funds liquidity = Outcome A * • surplus or μ
in order to maximize the institution’s return. requirement deficit in
Outcome A
1
0

Of course, neither the worst nor the best possible outcome is (5.7)
(5.
(5.7
56
66
98 er

likely for both deposit and loan growth. The most likely out- Estimated
1- nt
20
66 Ce

come lies somewhere between these extremes. Many financial liquidity


65 ks

firms like to calculate their expected liquidity requirement, + Probability of * • surplus or μ


06 oo
B

based on the probabilities they assign to different possible Outcome B cit iin
deficit n
82

outcomes. For example, suppose the liquidity manager of the Outcome


utcomme B
-9
58

institution we have been following considers the firm’s liquidity +g+g


11
41
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 99

  


for all possible outcomes, subject to the restriction that the sum 6. Hot money ratio: Money market (short-term) assets ,
of all probabilities assigned by management must be 1. volatile liabilities = (Cash and due from deposits held at
other depository institutions + holdings of short@term
Using this formula, this financial firm’s expected liquidity require-
securities + Federal funds loans + reverse repurchase
ment must be:
agreements) , (large CDs + Eurocurrency deposits
Expected + Federal funds borrowings + repurchase agreements), a
liquidity = 0.15 * (+ $60 million) + 0.60 * (+ $10 million) ratio that reflects whether the institution has roughly bal-
requirement +0.25 * (- $20 million) anced the volatile liabilities it has issued with the money
= + $10 million market assets it holds that could be sold quickly to cover
those liabilities.
On average, management should plan for a $10 million liquid-
ity surplus next week and begin now to review the options for 7. Deposit brokerage index: Brokered deposits , total
investing this expected surplus. Of course, management would deposits, where brokered deposits consist of packages of
do well to have a contingency plan in case the worst possible funds (usually $100,000 or less to gain the advantage of
outcome occurs. deposit insurance) placed by securities brokers for their cus-
tomers with institutions paying the highest yields. Brokered
deposits are interest sensitive and may be quickly with-
Liquidity Indicator Approach
drawn; the more a depository institution holds, the greater
Many financial-service institutions estimate their liquidity needs the chance of a liquidity crisis.
based upon experience and industry averages. This often means
8. Core deposit ratio: Core deposits , total assets, where
using certain liquidity indicators. For example, for depository
core deposits include total deposits less all deposits over
institutions the following liquidity indicator ratios are often useful:
$100,000. Core deposits are primarily small-denomination
1. Cash position indicator: Cash and deposits due from depos- checking and savings accounts that are considered unlikely
itory institutions , total assets, where a greater proportion to be withdrawn on short notice and so carry lower liquidity
of cash implies the institution is in a stronger position to requirements.
handle immediate cash needs.
9. Deposit composition ratio: Demand deposits , time
2. Liquid securities indicator: U.S. government securities , deposits, where demand deposits are subject to immedi-
total assets, which compares the most marketable securities ate withdrawal via check writing, while time deposits have
an institution can hold with the overall size of its asset port- fixed maturities with penalties for early withdrawal. This
folio; the greater the proportion of government securities, ratio measures how stable a funding base each institution
the more liquid the depository institution’s position tends possesses; a decline suggests greater deposit stability and
to be. a lesser need for liquidity.
3. Net federal funds and repurchase agreements position: 10. Loan commitments ratio: Unused loan commitments ,
(Federal funds sold and reverse repurchase agreements – total assets, which measures the volume of promises a
Federal funds purchased and repurchase agreements) lender has made to its customers to provide credit up to a
, total assets, which measures the comparative impor- prespecified amount over a given time period. These com-
tance of overnight loans relative to overnight borrowings of mitments will not appear on the lender’s balance sheet until
reserves; liquidity tends to increase when this ratio rises. a loan is actually “taken down” (i.e., drawn upon) by the
4. Capacity ratio: Net loans and leases , total assets, which is borrower. Thus, with loan commitments there is risk as to
really a negative liquidity indicator because loans and leases the exact amount and timing when some portion of loan
are often the most illiquid of assets. commitments become actual loans. The lender must be
1

prepared with sufficient liquidity to accommodate a variety


5. Pledged securities ratio: Pledged securities , total security
5 60

of “takedown” scenarios that borrowers may demand.. A


66
98 er

holdings, also a negative liquidity indicator because the


1- nt
20

rise in this ratio implies greater future liquidity needs.


s.
66 Ce

greater the proportion of securities pledged to back gov-


65 ks

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
-9 ali
58 ak

during the first decade of the 21st century as depository


depossitory institutions
11 ah
41 M

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
99

100 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 5.4 Recent Trends in Liquidity Indicators for FDIC-Insured U.S. Banks

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

occasionally lower legal reserve requirements during a reces-


60

Liquidity Needs: Signals from the


5

sion so that less cash is demanded by law. On the other hand, if


66
98 er
1- nt

Marketplace
20

reserve requirements are raised, usually out of fear of inflation,


66 Ce
65 ks

more cash usually is needed. Then, too, clever financial manag-


Many analysts believe there is one ultimately sound oundd method
me
06 oo

ers have occasionally discovered new and improved ways to


82 B

for assessing a financial institution’s liquiditytyy needs


needs and
a how
-9 ali

forecast liquidity demands and to meet those demands.


58 ak

well it is fulfilling them. This method centers


nterss on the
t discipline of
11 ah
41 M

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

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 101

  


CONCEPT CHECK
5.8. How does the sources and uses of funds approach help will hold a 5 percent liquidity reserve. The thrift expects
a manager estimate a financial institution’s need for its loans to grow 8 percent annually; its loans currently
liquidity? total $117 million but have recently reached $132
5.9. Suppose that a bank estimates its total deposits for the million. If reserve requirements on liabilities currently
next six months in millions of dollars to be, respectively, stand at 3 percent, what is this depository institution’s
$112, $132, $121, $147, $151, and $139, while its loans total liquidity requirement?
(also in millions of dollars) will total an estimated $87, 5.12. What is the liquidity indicator approach to liquidity
$95, $102, $113, $101, and $124, respectively, over the management?
same six months. Under the sources and uses of funds 5.13. First National Bank posts the following balance sheet
approach, when does this bank face liquidity deficits, entries on today’s date: Net loans and leases, $3,502
if any? million; cash and deposits held at other banks, $633
5.10. What steps are needed to carry out the structure of million; Federal funds sold, $48 million; U.S. govern-
funds approach to liquidity management? ment securities, $185 million; Federal funds pur-
5.11. Suppose that a thrift institution’s liquidity division esti- chased, $62 million; demand deposits, $988 million;
mates that it holds $19 million in hot money deposits time deposits, $2,627 million; and total assets, $4,446
and other lOUs against which it will hold an 80 percent million. How many liquidity indicators can you calculate
liquidity reserve, $54 million in vulnerable funds against from these figures?
which it plans to hold a 25 percent liquidity reserve, 5.14. How can the discipline of the marketplace be used as a
and $112 million in stable or core funds against which it guide for making liquidity management decisions?

REAL BANKS, REAL DECISIONS

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
66 Ce

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
20
99

102 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


For example, liquidity managers should closely monitor the fol- Most large depository institutions have designated an officer of
lowing market signals: the firm as money position manager. Smaller banks and thrifts
often hand this job over to larger depositories with whom they
1. Public confidence. Is there evidence the institution is losing
have a correspondent relationship (that is, that hold deposits to
money because individuals and institutions believe there
help clear checks and meet other liquidity needs).
is some danger it will be unable to meet its obligations on
time?
Legal Reserves
2. Stock price behavior. Is the corporation’s stock price falling
because investors perceive the institution has an actual or The manager of the money position is responsible for ensur-
pending liquidity crisis? ing that his or her institution maintains an adequate level of
legal reserves—that is, those assets that law and central bank
3. Risk premiums on CDs and other borrowings. Is there evi-
regulation say must be held during a particular time period.
dence the institution is paying higher interest rates on its
For example, in the United States a qualified depository institu-
offerings of time and savings deposits (especially on large
tion must hold the required level of legal reserves in the form
negotiable CDs) and money market borrowings than other
of vault cash and, if this is not sufficient, in the form of deposits
institutions of similar size and location? In other words, is
held in a reserve account at the Federal Reserve bank in the
the market imposing a risk premium in the form of higher
region. Smaller depository institutions and banks, who are not
borrowing costs because it believes the institution is
members of the Federal Reserve system, may be granted per-
headed for a liquidity crisis?
mission to hold their legal reserve deposits with a Fed-approved
4. Loss sales of assets. Has the institution recently been forced institution. Among the financial firms subject to U.S. legal
to sell assets in a hurry, with significant losses, in order to reserve requirements are commercial and savings banks, savings
meet demands for liquidity? Is this a rare event or has it and loan associations, credit unions, agencies and branches of
become a frequent occurrence? foreign banks offering qualified deposits and other liabilities in
5. Meeting commitments to credit customers. Has the institu- the United States.
tion been able to honor all potentially profitable requests The very smallest U.S. depository institutions (holding about
for loans from its valued customers? Or have liquidity pres- $10.7 million of reservable deposits in 2010) are exempt from
sures compelled management to turn down some otherwise any legal reserve requirements at all. This zero exemption is
acceptable credit applications? adjusted each year to help reduce the impact of inflation on
6. Borrowings from the central bank. Has the institution been deposit growth and lighten the regulatory burden on the small-
forced to borrow in larger volume and more frequently from est depository institutions.
the central bank in its home territory (such as the Federal
Reserve or Bank of Japan) lately? Have central bank officials
begun to question the institution’s borrowings?
Regulations on Calculating Legal Reserve
If the answer to any of the foregoing questions is yes, Requirements
management needs to take a close look at its liquidity
management policies and practices to determine whether Reserve Computation
changes are needed. Exhibit 5.1 illustrates the timing associated with calculating
reserve requirements and maintaining reserves that the Fed-
eral Reserve has set up for institutions holding deposits and
5.6 LEGAL RESERVES AND MONEY other liabilities subject to legal reserve requirements. As the
POSITION MANAGEMENT exhibit shows, under the current system of accounting for
legal reserves—called lagged reserve accounting (LRA)—
1
60

the daily average amount of deposits and other reservableervable lia-


lli
5
66
98 er

The Money Position Manager


1- nt
20

bilities are computed using information gathered d over


er a two-
ove t
66 Ce

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
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 103

  


Exhibit 5.1 that this period begins
30 days after the beginning of the
reserve computation period for depos-
its and other reservable liabilities. Using
LRA, the money position manager has
a 16-day lag following the computation
period and preceding the maintenance
period. This period provides time for
money position managers to plan.

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

Calculating Required Reserves


60

latter group of institutions have their daily average deposit balances


5
66
98 er

figured over a seven-day computation period beginning on the third


The largest depository institutions must hold the largest per-
1- nt
20

Tuesday in the months of March, June, September, and December,


66 Ce

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

required legal reserves of each depository institution


nstituution are figured
stitu
11 ah

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

  


Table 5.5 Sample Calculation of Legal Reserve Requirements in the United States
The first $10.7 million of net transaction deposits are subject to a 0 percent legal reserve requirement (known as the “exemption
amount”). The volume of net transaction deposits over $10.7 million up to $58.8 million carries a 3 percent reserve requirement
(known as the “low reserve tranche”), while the amount over $58.8 million is subject to a 10 percent reserve requirement (the
“high reserve tranche”). Nontransaction reservable liabilities (including nonpersonal time deposits and Eurocurrency liabilities)
are subject to a 0 percent reserve requirement.*
First National’s net transaction deposits averaged $100 million over the 14-day reserve computation period, while its nontransac-
tion reservable liabilities had a daily average of $200 million over the same period. Then First National’s daily average required
legal reserve level = 0.0 * $10.7 million + 0.03 * ($58.8 million - $10.7 million) + 0.10 ($100 million - $58.8 million)
= $5.563 million.**
First National held a daily average of $5 million in vault cash over the required two-week reserve computation period. Therefore,
it must hold an additional amount of legal reserves over its two-week reserve maintenance period as follows:
Daily average level of additional = Total required - Daily average vault = $5.563 million - $5.000 million = $0.563 million
legal reserves First National legal reserves cash holdings
Bank must raise
Federal Reserve officials today differentiate between so-called bound and nonbound depository institutions. Bound institutions’
required reserves are larger than their vault cash holdings, meaning that they must hold additional reserves beyond the amount
of their vault cash at the Federal Reserve Bank in their district. Nonbound institutions hold more vault cash than their required
reserves and therefore are not required to hold legal reserves at the Fed. As reserve requirements have been lowered in recent
years, the number of nonbound depositories has increased.
* As of 2010.
** Net transaction deposits are gross demand deposits less cash items in process of collection and deposits due from other banks. The percentage
reserve requirement on nonpersonal time deposits with an original maturity of less than 18 months and on Eurocurrency liabilities was reduced to zero
in 1991. Nonpersonal time deposits 18 months or longer to maturity were assigned a zero reserve requirement in 1983.
Source: Board of Governors of the Federal Reserve System.

by the stipulated reserve requirement percentage to derive each 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

natural person (i.e., not an individual, family, or sole proprietorship). Eurocur-


60

ditions have struggled to improve, even if only slowly.


5

rency liabilities are mainly the sum of net borrowings from foreign offices.
66
98 er

On the other hand, if the calculated required reserve rve figure


fiigure
1- nt
20

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

Eurocurrency deposits whose reserve requirement is zero. However,


58 ak

deficit by acquiring additional legal reserves.


servves. And
eserv A there may be
11 ah

transaction accounts usually pay little or no interest, which helps offset a


41 M

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

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 105

  


Rate depending upon the circumstances that led to the reserve Assuming a 360-day year for ease of computation, this bank could
deficit. Actually, regulations may allow a depository institution apply up to $2,138.89 to offset any fees charged the bank for its use
to run a small deficit in its required daily average reserve posi- of Federal Reserve services. In October 2008, the Fed began paying
tion, provided this shortfall is balanced out by a corresponding interest on legal reserve balances held by depository institutions.
excess during the next reserve maintenance period.4
Factors Influencing the Money Position
Clearing Balances
A depository institution’s money position is influenced by a long
In addition to holding a legal reserve account at the central bank, list of factors, some of which are included in the following table.
many depository institutions also hold a clearing balance with Among the most important are the volume of checks and other
the Fed to cover any checks or other debit items drawn against drafts cleared each day, the amount of currency and coin ship-
them. In the United States any depository institution using ments back and forth between each depository and the central
the Federal Reserve’s check-clearing facilities must maintain a bank’s vault, purchases and sales of government securities, and
minimum-sized clearing balance—an amount set by agreement borrowing and lending in the Federal funds (interbank) market.
between each institution and its district Federal Reserve bank. Some of these factors are largely controllable by management,
Clearing balance rules work much like legal reserve require- while others are essentially noncontrollable, and management
ments, with depository institutions required to maintain a needs to anticipate and react quickly to them.
minimum daily average amount in their clearing account over Controllable Factors Controllable Factors
the same two-week maintenance period as applies to legal Increasing Legal Reserves Decreasing Legal Reserves
reserves. When they fall below the minimum balance required,
• Selling securities. • Purchasing securities.
they must provide additional funds to bring the balance up to
• Receiving interest pay- • Making interest payments
the promised level. If a clearing balance has an excess amount
ments on securities. to investors holding the
in it, this can act as an extra cushion of reserves to help a
bank’s securities.
depository institution avoid a deficit in its legal reserve account.
• Borrowing reserves from • Repaying a loan from the
A depository institution earns credit from holding a clearing the Federal Reserve bank. Federal Reserve bank.
balance that it can apply to help cover the cost of using Fed • Purchasing Federal funds • Selling Federal funds to
services (such as the collection of checks or making: use of Fed from other banks. other institutions in need
Wire, the Federal Reserve’s electronic wire transfer service). The of reserves.
amount of credit earned from holding a Fed clearing balance • Selling securities under a • Security purchases under a
depends on the size of the average account balance and the repurchase agreement (RP). repurchase agreement (RP).
level of the Federal funds interest rate over the relevant period, • Selling new CDs, Eurocur- • Receiving currency and
For example, suppose a bank had a clearing balance averaging rency deposits, or other coin shipments from the
$1 million during a particular two-week maintenance period and deposits to customers. Federal Reserve bank.
the Federal funds interest rate over this same period averaged Noncontrollable Factors Noncontrollable Factors
5.50 percent. Then it would earn a Federal Reserve credit of Increasing Legal Reserves Decreasing Legal Reserves
Average clearing balance * Annualized Fed funds rate • Surplus position at the • Deficit position at the local
* 14 days>360 days = $1,000,000 * .055 * .0389 local clearinghouse due to clearinghouse due to more
= $2,138.89 (5.9) receiving more deposited checks drawn against the
checks in its favor than bank than in its favor.
checks drawn against it.
4 • Credit from cash letters • Calls of funds from the
In September 2006 the U.S. Congress granted the Federal Reserve per-
mission to pay interest quarterly on reserve balances held by depository
1

sent to the Fed, listing bank’s tax and loan account


60

institutions at a Federal Reserve bank. However, the new law called for a
5

drafts received by the bank. by the U.S. Treasury.


66
98 er

delay in paying interest on reserve balances until 2011 because the Fed
1- nt
20

• Deposits made by the U.S. • Debits received from m thee


66 Ce

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

• Credit received from the Fed- bank’s reserve


rve account.
acc
58 ak

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

ances at the Fed soared to more than a trillion dollars by 2010.


99

106 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


bankers can compete for corporate deposits and more easily
Factoid attract capital, which was going abroad more often than not,
The oldest kind of sweep account offered by deposi- and bring cash accounts back to their home offices inside the
tory institutions is business-oriented sweep programs that United States.
convert business checking accounts, usually overnight, The key goal of money position management is to keep legal
into interestbearing savings deposits or off-balance-sheet reserves at the required level, with no excess reserves and no
interest-bearing investments. Recently the U.S. federal reserve deficit large enough to incur a penalty. If a depository
government lifted restrictions against corporate deposi- institution has an excess reserve position, it will sell Federal
tors earning interest income on bank deposits as part of the funds to other depositories short of legal reserves, or if the
Dodd-Frank Regulatory Reform legislation. excess appears to be longer lasting, purchase securities or
make new loans. If the depository institution has a legal reserve
In recent years the volume of legal reserves held at the Fed- deficit, it will usually purchase Federal funds or borrow from the
eral Reserve by depository institutions operating in the United Federal Reserve bank in its district. If the deficit appears to be
States has declined sharply. Today, for example, legal reserves especially large or long lasting, the institution may sell some of
held by depository institutions at all 12 Federal Reserve banks its marketable securities and cut back on its lending.
are well below their volume during the 1990s. The decline in
legal reserves is largely due to the development of sweep An Example
accounts—a customer service that results in bankers shifting
their customers’ deposited funds out of low-yielding accounts Table 5.6 illustrates how a bank, for example, can keep track of
that carry reserve requirements (currently checkable or transac- its reserve position on a daily basis. This example also illustrates
tion accounts), usually overnight, into repurchase agreements, the money desk manager’s principal problem—trying to keep
shares in money market funds, and savings accounts (not cur- track of the many transactions each day that will affect this partic-
rently bearing reserve requirements). Such sweeps yield an ular bank’s legal reserves. In this example, the money desk man-
advantage to the offering depository institution because they ager had estimated that his bank needed to average $500 million
lower its overall cost of funds, while still preserving depositor per day in its reserve account. However, at the end of the first
access to his or her checking account and the ability to make day (Thursday) of the new reserve maintenance period, it had a
payments or execute withdrawals. $550 million reserve position. The money manager tried to take
advantage of this excess reserve position the next day (Friday) by
These sweep arrangements have ballooned in size to cover purchasing $100 million in Treasury securities. The result was a
well over $500 billion in deposit balances, substantially lower- reserve deficit of $130 million, much deeper than expected, due
ing total required reserves of depository institutions. Sweep in part to an $80 million adverse clearing balance (that is, this
activities have been aided by access to online sites made avail- bank had more checks presented for deduction from its custom-
able from the Federal Reserve banks that track on a real-time ers’ deposits than it received from other depository institutions
basis any large dollar payments flowing into or out of reserve for crediting to its own customers’ accounts).
accounts, allowing money managers to better plan what hap-
pens to their legal reserve positions on a daily basis. Today To help offset this steep decline in its reserve account, the
the sweep accounts depository institutions offer include retail money manager borrowed $50 million from the Federal Reserve
sweeps, involving checking and savings accounts of individuals bank’s discount window on Friday afternoon. This helped a little
and families, and business sweeps, where commercial checkable because Friday’s reserve position counts for Saturday and Sunday
deposit balances are changed overnight into commercial savings as well, when most depository institutions are closed, so the
deposits or moved off depository institutions’ balance sheets $130 million reserve deficit on Friday resulted in a $390 million
into interest-bearing investments and then quickly returned.
1
60

The sweeps market is likely to change in form and importance Factoid


5
66
98 er

due to the recent passage of FINREG—the Dodd-Frank Wall


1- nt
20

Two of the most important regulations focusing on the th


he man-
ma
66 Ce

Street Reform and Consumer Protection Act of 2009. Among


agement of reserves and liquidity for depository
ory institutions
iin
nstitu
65 ks

many provisos this extensive legislation knocked down the


06 oo

are Regulations Q and D of the Federal Reserveervve Board.


eserve
ese Bo Q
82 B

long-standing prohibition against banks paying interest on com-


-9 ali

impacts the interest rates that depository


ry institutions
ory in
nstitu are
58 ak

mercial checking accounts which had stood for about 75 years.


11 ah

allowed to pay on deposits, while D setss out the rules for


The U.S. Congress of the 1930s believed that many banks got
41 M

calculating and meeting legal reserve


e requirements
req in the
into trouble because they granted interest on business depos-
United States.
20

its. Recent research has suggested quite the opposite. Now


99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 107

  



108
Table 5.6 An Example: Daily Schedule for Evaluating a Bank’s Money Position (all figures in millions of dollars)

Required Daily Adjustments to the Bank’s Legal Reserve Balance Closing


Daily Daily Excess Cumulative Cumulative
Federal Funds Fed’s Discount Check
Days in the Average Average or Deficit Excess Closing
Transactions Window Treasury Securities Clearing
Reserve Legal Legal in Legal or Deficit Balance
Maintenance Reserve Purchases Sales Borrow Repay Redeem Purchase Credit Debit Reserve Reserve in Legal in Legal
Period Balance (+) (−) (+) (−) (+) (−) (+) (−) Balance Position Reserves Reserves

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


0
Thursday $500 + 50 - 25 - 25 +50 $550 + 50 + 50 $550
Friday 500 +50 -100 - 80 370 -130 - 80 920
Saturday 500 +50 -100 - 80 370 -130 - 210 1,290
Sunday 500 +50 -100 - 80 370 -130 - 340 1,660
Monday 500 -25 -50 +40 465 - 35 - 375 2,125
Tuesday 500 +50 - 25 525 + 25 - 350 2,650
Wednesday 500 +50 -60 490 - 10 - 360 3,140
Thursday 500 +10 510 + 10 - 350 3,650
Friday 500 +100 -50 -70 480 - 20 - 370 4,130
Saturday 500 +100 -50 -70 480 - 20 - 390 4,610
Sunday 500 +100 -50 -70 480 - 20 - 410 5,090
Monday 500 +250 -25 +15 740 + 240 - 170 5,830
Tuesday 500 +100 600 + 100 -70 6,430
Wednesday 500 +70 570 + 70 0 7,000
mul
Cumulative
99 $7,000
20
Daily 4
11 Ma $ 500
average 15 ha
8- ak
98 li B
20 o
66 ok
56 s C
61 en
-9 te
82 r
06
65
60
1


(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

the level and upward or downward movements in the effec-


60

manager’s job is to find the best options in terms of cost,


st risk,
ost,
5

tive daily Fed funds rate. One factor that aids the manager in
66
98 er

and other factors.


1- nt
20

anticipating changes in the funds market is the fact that the


66 Ce
65 ks

Federal Reserve sets a target range for the Fed funds rate and
Bank Size and Borrowing and Lending
ing
g Reserves
Res
06 oo

intervenes periodically to move the current funds rate closer to


82 B

for the Money Position


-9 ali

its target. As Exhibit 5.2 indicates, the effective daily funds rate
58 ak
11 ah

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
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 109

  


surpluses, particularly when loan demand is low in their market Liquidity managers must restrict their range of choices to
areas, and, therefore, are interested in lending these surpluses those their institution can access quickly.
out to larger institutions. If smaller depositories do have reserve 4. Relative costs and risks of alternative sources of funds. The
deficits, these normally occur late in the reserve maintenance cost of each source of reserves changes daily, and the avail-
period. In contrast, the largest depository institutions tend to ability of surplus liquidity is also highly uncertain. Other
have reserve needs day after day and find themselves on the things being equal, the liquidity manager will draw on the
borrowing side of the money market most of the time. cheapest source of reliable funds, maintaining constant con-
tact with the money and capital markets to be aware of how
Overdraft Penalties interest rates and credit conditions are changing.
Depository institutions operating inside the U.S. financial system 5. The interest rate outlook. When planning to deal with a
run the risk of modest penalties if they run an intraday overdraft future liquidity deficit, the liquidity manager wants to draw
and possibly a stiffer penalty if overnight overdrafts occur in upon those funds sources whose interest rates are expected
their reserves. Avoiding intraday and overnight overdrafts is to be the lowest. New futures and options contracts, espe-
not easy for most institutions because they have only partial cially the Fed funds futures and options contracts and the
control over the amount and timing of inflows and outflows of Eurodollar futures contracts traded on the Chicago Mer-
funds from their reserves. Because of possible overdraft penal- cantile Exchange and Chicago Board of Trade (now part of
ties, many financial institutions hold “precautionary balances” the CME Group), have greatly assisted liquidity managers
(extra supplies of reserves) to help prevent overdrafting of their in forecasting the most likely scenario for future borrowing
reserve account. costs. These contracts provide estimates of the probability
that market interest rates will be higher or lower in the days
and weeks ahead.
5.7 FACTORS IN CHOOSING AMONG
6. Outlook for central bank monetary policy. Closely con-
THE DIFFERENT SOURCES OF nected to the outlook for interest rates is the outlook for
RESERVES changes in central bank monetary policy which shapes
the direction and intensity of credit conditions in the
In choosing which source of reserves to draw upon to cover a money market. For example, a more restrictive monetary
legal reserve deficit, money position managers must carefully policy implies higher borrowing costs and reduced credit
consider several aspects of their institution’s need for liquid availability for liquidity managers. The Federal funds
funds: and Eurodollar futures and options contracts mentioned
1. Immediacy of need. If a reserve deficit comes due within above have proven to be especially useful to liquid-
minutes or hours, the money position manager will normally ity managers in gauging what changes in central bank
tap the Federal funds market for an overnight loan or con- policies affecting interest rates are most likely down
tact the central bank for a loan from its discount window. In the road.
contrast, a depository institution can meet its nonimmedi- 7. Rules and regulations applicable to a liquidity source. Most
ate reserve needs by selling deposits or assets, which may sources of liquidity cannot be used indiscriminately; the
require more time to arrange than immediately available user must conform to the rules. For example, borrowing
borrowings normally do. reserves from a central bank frequently requires the borrow-
2. Duration of need. If the liquidity deficit is expected to last ing institution to provide collateral behind the loan. In the
for only a few hours, the Federal funds market or the central United States and Europe two key liquidity sources—the
bank’s discount window is normally the preferred source of Federal funds and Eurocurrency markets—close down near
funds. Liquidity shortages lasting days, weeks, or months, the end of the trading day, forcing borrowing institutions
1
60

on the other hand, are often covered with sales of longer- that are in danger of overdrafting their accounts to quickly
ckly
kly
5
66
98 e

arrange for their funding needs before the door closesses orr
1- nt
20

term assets or longer-term borrowings.


66 Ce

look for cash elsewhere.


65 ks

3. Access to the market for liquid funds. Not all depository


06 oo
82 B

institutions have access to all funds markets. For example, The liquidity manager must carefully weigh each of these
hese factors
tth f
-9 al

smaller depositories cannot, as a practical matter, draw in order to make a rational choice among alternative
ve sources
ernativ
rnativ
ive so of
58 ak
11 ah

upon the Eurocurrency market or sell commercial paper. reserves.


41 M
20
99

110 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


CONCEPT CHECK
5.15. What is money position management? you recommend that its management respond to the
current situation?
5.16. What is the principal goal of money position
management? 5.20. What factors should a money position manager con-
sider in meeting a deficit in a depository institution’s
5.17. Exactly how is a depository institution’s legal reserve
legal reserve account?
requirement determined?
5.21. What are clearing balances? Of what benefit can clear-
5.18. First National Bank finds that its net transaction
ing balances be to a depository that uses the Federal
deposits average $140 million over the latest reserve
Reserve System’s check-clearing network?
computation period. Using the reserve requirement
ratios imposed by the Federal Reserve as given in 5.22. Suppose a bank maintains an average clearing balance
the textbook, what is the bank’s total required legal of $5 million during a period in which the Federal funds
reserve? rate averages 6 percent. How much would this bank
have available in credits at the Federal Reserve Bank in
5.19. A U.S. savings bank has a daily average reserve bal-
its district to help offset the charges assessed against
ance at the Federal Reserve bank in its district of
the bank for using Federal Reserve services?
$25 million during the latest reserve maintenance
period. Its vault cash holdings averaged $1 million 5.23. What are sweep accounts? Why have they led to a sig-
and the savings bank’s total transaction deposits (net nificant decline in the total legal reserves held at the
of interbank deposits and cash items in collection) Federal Reserve banks by depository institutions oper-
averaged $200 million daily over the latest reserve ating in the United States?
maintenance period. Does this depository institution 5.24. What impact has recent financial reform legislation had
currently have a legal reserve deficiency? How would on raising short-term cash?

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

• Managers of financial firms have developed several differ- r


60

liquid funds.
5

ent methods to estimate what their institution’s true ue liquidity


rue liq
liquidi
quid
66
98 er
1- nt
20
66 Ce

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
65 ks

imposed no reserve requirements at all, the managers of deposi- the sources and uses of funds method in which ich total
hich ttota sources
06 oo
82 B

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-
-9 al

depository institutions at one time or another need immediately zon and liquidity deficits and surpluses
es are
arre calculated
cal from
58 ak
11 ah

available funds to handle customer withdrawals, meet new loan the difference between funds sourcesces and funds uses.
41 M
20
99

Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 111

  


• Another popular liquidity estimation technique is the struc- repurchase agreements (RPs), and issuing CDs or Eurocur-
ture of funds method. This requires each financial firm to clas- rency deposits.
sify its funds uses and sources according to their probability • One of the most challenging areas of funds management among
of withdrawal or loss. depository institutions centers upon the money position man-
• Still another liquidity estimation approach focuses on liquid- ager who oversees the institution’s legal reserve account. These
ity indicators, in which selected financial ratios measuring a legal reserves include vault cash held on a depository institu-
financial firm’s liquidity position with the liquidity manager tion’s premises and may also encompass deposits kept with the
looking for evidence of adverse trends in liquidity. central bank, which must be managed to achieve a target level
• Financial institutions today can draw upon multiple sources of legal reserves over each reserve maintenance period.
of liquid assets and borrowed liquidity. Key sources of liquid- • Liquidity and money position managers choose their sources
ity on the asset side of the balance sheet include correspon- of liquidity based on several key factors, including (1) imme-
dent balances held with depository institutions and sales of diacy of need; (2) duration of need; (3) market access; (4) rel-
highly liquid money market instruments. Important borrowed ative costs and risks; (5) the outlook for market interest rates;
liquidity sources include borrowing from the central bank’s (6) the outlook for central bank monetary policy; and (7) gov-
discount window, purchasing Federal funds, employing ernment regulations.

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

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
20
99

112 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

PROBLEMS AND PROJECTS


1. Ocean View State Bank estimates that over the next
April 90 485 700 175
24 hours the following cash inflows and outflows will occur
(all figures in millions of dollars): May 105 465 710 160
June 80 490 700 200
Deposit withdrawals $100 Sales of bank assets 40
July 90 525 700 175
Deposit inflows 95 Stockholder dividend 150
payments August 100 515 675 150

Scheduled loan 90 Revenues from sale of 95 4. Queen Savings is attempting to determine its liquidity require-
repayments nondeposit services ments today (the last day in August) for the month of Septem-
Acceptable loan 60 Repayments of bank 60 ber. September is usually a month of heavy loan demand due
requests borrowings to the beginning of the school term and the buildup of busi-
Borrowings from the 80 Operating expenses 50 ness inventories of goods and services for the fall season and
money market winter. This thrift institution has analyzed its deposit accounts
thoroughly and classified them as explained below.
What is this bank’s projected net liquidity position in the
next 24 hours? From what sources can the bank cover its Management has elected to hold a 85 percent reserve in
liquidity needs? liquid assets or borrowing capacity for each dollar of hot
money deposits, a 25 percent reserve behind vulnerable
2. Mountain Top Savings is projecting a net liquidity deficit
deposits, and a 5 percent reserve for its holdings of core
of $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.
1
60

detect any significant liquidity trends? Which trends


d should
ould
5
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management investigate?
1- nt
20

Time and
66 Ce

Checkable Savings Commercial Consumer


65 ks

Most Previous
P
06 oo

Deposits Deposits Loans Loans Recent


nt Year
Ye
ear Year
82 B
-9 ali

January $120 $550 $650 $160


58 ak

Assets:
11 ah
41 M

February 115 500 650 230


Cash and due from depository $345,000
$34 $358,000
March 100 500 700 210 institutions
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Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 113

  


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

the simplified balance sheet provided in the previous prob-


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

Loans and leases net 2,148,000 1,948,000 8. Suppose Abigail Savings Bank’s liquidity manager estimates
that the bank will experience a $375 million liquidity deficit
Total assets 3,500,000 3,250,000
next month with a probability of 15 percent, a $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
1
60

Federal funds 1.98%


5

the size of Bank of Your Dreams?


66
98 er

Borrowing from the central bank’s discount 2.25


1 - nt
20
66 Ce

b. If liability management is used to cover the deposit window


65 ks

drain, what happens to the size of Bank of Your Dreams?


06 oo

Commercial paper (one-month maturity) 2.33


2.33
82 B

7. The liquidity manager for the Bank of Your Dreams needs


-9 ali

Bankers’ acceptances (three-month maturity)) 2.30


2
58 a k

cash to meet some unanticipated loan demand. The loan


11 ah

Certificates of deposit (one-month maturity)


ty) 2.52
41 M

officer has $600 million in loans that he wants to make. Use


20
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114 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

Check-clearing estimates over the next 14 days are as


Current
follows:
Money Market Instruments Market Yield

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


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

U.S. Treasury notes and bonds (5-year maturity) 3.65 2 -60

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


maturity) 4 Closed
One week ago, the bank borrowed $20 million from the 5 -40
Federal Reserve’s discount window, which it paid back
6 - 25
yesterday. The bank had a $5 million reserve deficit during
the previous reserve maintenance period. From the bank’s 7 +30
standpoint, which sources of reserves appear to be the 8 -45
most promising? Which source would you recommend to 9 -5
cover the bank’s reserve deficit? Why?
10 Closed
11. Gwynn’s Island Building and Loan Association estimates the
11 Closed
following information regarding this institution’s reserve
position at the Federal Reserve for the reserve mainte- 12 + 20
nance period that begins today (Thursday): 13 -70

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


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

the Federal Reserve’s discount window as tools to manage


56
66

More than $58.8 million 10%


10%
98 er

its reserve position, carefully construct a pro forma daily


1- nt
20
66 Ce

worksheet for this association’s money position over the Nonpersonal time deposits:
65 ks
06 oo

next two weeks. Insert your planned adjustments in discount Less than 18 months 3%
82 B

window borrowing and Federal funds purchases and sales


-9 ali

18 months or more 0%
58 ak

over the period to show how you plan to manage Gwynn’s


11 ah

Eurocurrency liabilities—all types 3%


41 M

Island’s reserve position and hit your desired reserve target.


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Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 115

  


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

What is this bank’s daily average required level of legal 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.

CASE ASSIGNMENT FOR CHAPTER 5

YOUR BANK’S LIQUIDITY REQUIREMENT: Application of the Liquidity Indicator Approach:


AN EXAMINATION OF ITS LIQUIDITY Trend and Comparative Analysis
INDICATORS A. Data Collection: To calculate these liquidity ratios, we will
Chapter 5 describes liquidity and reserve management. use some data collected in prior assignments and visit the
Within the chapter we explore how liquidity managers evalu- Statistics for Depository Institutions website (www2.fdic
ate their institution’s liquidity needs. Four methodologies
.gov/sdi/) to gather more information for your BHC and its
are described: (1) the sources and uses of funds approach,
(2) the structure of funds approach, (3) the liquidity indica- peer group. Use SDI to create a four-column report of your
1
60

tor approach, and (4) signals from the marketplace. In this bank’s information and the peer group information across ss
5
66
98 er

assignment we will calculate and interpret several of the ratios years. In this part of the assignment, for Report Selection
ction
1- nt
20
66 Ce

associated with the liquidity indicators approach. By compar- you will access a number of different reports. We suggest
sug
gggest
65 ks

ing these ratios across time and with a group of contemporary


06 oo

that you continue to collect percentage informationatio


ation
onn to
banks, we will examine the liquidity needs of your BHC. In
82 B

calculate your liquidity indicators. The additionalal informa-


tiona info
-9 ali

doing so, you will familiarize yourself with some new terms and
58 ak

tion you need to collect before calculatingng the


he indicators
th in
11 ah

tools associated with real data. This assignment involves some


41 M

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
20
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116 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

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

B. Having collected the additional data needed, use the newly All bank holding companies need to maintain adequate liquid-
collected and previously collected data to calculate the 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
56
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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Chapter 5 Liquidity and Reserves Management: Strategies and Policies ■ 117

  


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

Selected References
The following studies discuss the instruments often used to 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:

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


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

1
60
5
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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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118 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Intraday Liquidity
Risk Management
6
■ Learning Objectives
After completing this reading you should be able to:

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

● Discuss the governance structure of intraday liquidity risk


management.

1
605
66
98 er
1- nt
20
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65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M

Excerpt is Chapter 4 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen
tephe Baird.
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119

  


6.1 INTRODUCTION were significantly expanding the effective money supply,
causing central bankers to worry that their policy actions could
The banking industry’s interest in intraday liquidity risk in the be blunted or accentuated by this “shadow” money supply.
United States can be traced back to the early 1980s. This was Table 6.1 compares the annual average peak intraday overdraft
an era of extremely high interest rates and tight money, engi- (calculated system-wide) and the M1 money supply in five-year
neered by Paul Volcker, who was appointed chairman of the snapshots beginning in 1986, when the Federal Reserve began
Board of Governors of the Federal Reserve System (Federal measurements. As Table 6.1 indicates, peak overdrafts routinely
Reserve) in August of 1979. Chairman Volcker is widely cred- approached 10% or more of the money supply in those early
ited with ending the “stagflation” crisis in the United States by years. Conversely, in today’s environment, which is character-
dramatically raising the Federal Funds rate upon taking office ized by low interest rates and accommodative monetary policy,
(from an average of 11.2% in 1979 to a peak of 20% in June of intraday overdrafts are much smaller, both in nominal terms and
1981), and ushering in an extended period of high real interest in proportion to the M1 money supply.
rates. Regulators and major industry players became aware of The trend in aggregate intraday overdrafts illustrated in
the large overdrafts that were endemic in the banking systems Table 6.1 demonstrates the success of the Federal Reserve’s
in the middle of the business day during this period, as the dis- efforts to more effectively manage payment systems risk. As
incentives for banks to leave idle cash reserves at the Federal mentioned earlier, in 1985, the Federal Reserve issued its first
Reserve and correspondent banks began to grow. policy addressing intraday credit, which focused on daylight
With the opportunity cost of cash so high, major banks employed overdrafts incurred as a result of Fedwire funds transactions.
aggressive cash management techniques to minimize their cash This policy sought to limit intraday overdrafts by requiring all
balances on deposit. At the time, the Federal Reserve did not institutions that incurred intraday overdrafts in their Federal
pay interest on bank deposits and correspondent banks could Reserve Bank accounts to establish a maximum limit, called
not pay interest on operating balances in demand deposit a net debit cap, which was determined by a self-assessment
accounts (both of which are now permitted). As a result, banks process, and required approval by the institution’s board of
actively managed their balances down to the minimums called directors. Since then, the Board of Governors has continued
for by: (a) reserve requirement regulations (at their Federal to expand and modify its payment systems risk policies by
Reserve accounts); and (b) compensation arrangements for ser- introducing new tools and refining existing ones to reduce the
vices provided by correspondent banks. This often meant their aggregate level of intraday overdrafts. Subsequent significant
accounts were in a negative position during the day (hence the revisions include:
terms intraday daylight and overdraft). Against this backdrop, the • Extension of payment types beyond wire transfers to include
Federal Reserve released a policy in 1985 that began the process Automated Clearing House (ACH), Fedwire Securities Service
of containing, and eventually shrinking, daylight overdrafts in the transfers, and off-shore dollar clearing (1985–1992).
banking system.
• Assessment of a 24 basis point fee for intraday overdrafts in
There were two reasons why central banks were concerned excess of a deductible equal to 10% of the institution’s risk
about daylight overdrafts. First, central banks wished to avoid based capital (1994).
inadvertently extending credit to their member banks. If one • Increase in the fee for intraday overdrafts to 36 basis points
of the banks were to fail during the day when its account was (1995).
in a large deficit position, the central bank (and potentially
• Expansion and enhancement of the Federal Reserve’s Net
the taxpayers) would be on the hook for any losses. Second,
Settlement Services for private clearing and settlement
when viewed across the whole system, intraday overdrafts
1
60

Table 6.1 Relationship of U.S. Banks’ Average Peak Intraday Overdrafts to M1 Money Supply
5
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98 er
1 - nt
20
66 Ce

1986 1991 1996 2001 2006 2011 2013


3
65 ks
06 oo

Peak Intraday Overdraft ($billions) 62.9 106.2 67.4 99.4 140.0 29.4 16.6
82 B
-9 ali

M1 Money Supply ($billions) 666.3 859.0 1106.9 1140.2 1374.8 2009.6


6 2511.3
2
5 8 ak
11 ah

OD as % of M1 9.4% 12.4% 6.1% 8.7% 10.2% 1.5%


1.5% 0.7%
41 M

Data Source: Federal Reserve Board of Governors website (www.federalreserve.gov), money supply data.
20
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120 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


systems, provided initially to Clearing House Interbank Risk (PSR) policy to adopt the CPSS-published Core Principles
Payments System (CHIPS) in 1981 (1999). for Systemically Important Payment Systems (the Core Princi-
• Acceptance of collateral to secure intraday overdrafts for a ples),3 and the Recommendations for Securities Settlement
select few institutions, enabling them to exceed their net Systems (RSSS),4 as the minimum standards for systemically
debit caps (the so-called “max cap”) (2001). important payment and securities settlement systems, respec-
tively. To this day, the Federal Reserve, Commodity Futures
• Increase in the fee for unsecured intraday overdrafts to
Trading Commission (CFTC), and the Securities and Exchange
50 basis points, along with the introduction of a zero fee
Commission (SEC) continue to incorporate the work of CPSS
for fully collateralized overdrafts. The Federal Reserve also
into their rulemaking and regulatory guidance.
adjusted net debit cap multiples, eliminated the deductible
amount, and increased the penalty fee to 150 basis points for CPMI has worked in conjunction with the Basel Committee on
institutions that do not have discount window access (e.g., Banking Supervision (BCBS), another committee of central bank
a government sponsored entity or Banker’s Bank) and incur a experts that is part of BIS. BCBS began publishing guidance on
daylight overdraft (2008). managing liquidity risk in banking organizations in 1992 and has
been updating it periodically since. In response to the 2007–08
International interest in intraday liquidity risk began to acceler-
financial crisis, BCBS significantly expanded its work in liquidity
ate during the mid-1980s as well. In 1980, the central banks of
risk and began incorporating intraday liquidity risk into its
the Group of Ten (G10) countries established a working group
framework. In April 2013, BCBS published Monitoring Tools for
called the Group, of Experts on Payment Systems, which in 1990
Intraday Liquidity Management, a paper designed to help
became the Committee on Payment and Settlement Systems
regulators and banks track intraday risk more empirically.5 The
(CPSS) and is now the Committee on Payments and Market
reader is encouraged to reference the various papers on
Infrastructures (CPMI), a committee of the Bank for International
liquidity risk management available on the BIS website. This
Settlements (BIS). The Group of Experts on Payments Systems
continuum of work demonstrates how the industry focus has
began compiling data on payments systems in the G10 coun-
evolved from identifying and understanding intraday liquidity
tries, which was first published by the BIS in 1985, and has con-
risk to measuring and managing it.
tinued as a series that has become known as “red books.” In
1989, the Group of Experts on Payments Systems published the
Report on Netting Schemes, which focused on the efficiency of
financial markets and payment systems, and the effects of net-
6.2 USES AND SOURCES
ting on counterparty credit and liquidity risks.1 It is in this early OF INTRADAY LIQUIDITY
work that the Group of Experts on Payments Systems identified
This section provides an overview of the challenges faced
reduction of daylight overdrafts as an objective and driver of
by a bank treasurer in managing intraday liquidity risk and
netting arrangements.
enumerates the sources and uses of intraday funds for a typical
Most recently, the CPMI (which now consists of representation large bank.
from twenty-five central banks) has been focused on develop-
To understand how to better manage intraday liquidity risk,
ing, promulgating, and monitoring implementation of its
it is useful to start with an analysis of how daylight overdrafts
Principles for Financial Market Infrastructure, a set of standards
are created in the first place. The U.S. banking system starts
and policies designed to guide credit, liquidity, and systemic risk
and ends the day with plenty of cash on deposit at the Federal
management at payments, clearing, and settlement systems.2
Reserve (nearly $1.5 trillion as of December 31, 2012, per the
Reflecting the influence of CPMI, the central banks of most
Federal Reserve’s balance sheet). In fact, some level of depos-
developed countries around the world are striving to align their
its at the Federal Reserve is mandated by reserve requirement
regulations with the risk management principles espoused by
regulations. So, why do banks face a shortage of liquidity during ng
CPMI (formerly CPSS). In the United States, this first began in
1
60

the day? The answer is twofold.


2004, when the Federal Reserve modified its Payment System
5
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1- nt
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3
CPSS. “Core Principles for Systemically Important Payme
Payment
65 ks

ayment S
Sy
Systems.”
06 oo

1 p
pdf.
January 2001. http://www.bis.org/cpmi/publ/d43.pdf.
82 B

Group of Experts on Payment Systems of the Central Banks of


-9 ali

4
the Group of Ten Countries. February 1989. http://www.bis.org/cpmi/ CPSS. “Recommendations for Securities Settlement
tleme
emeent S
Sy
Systems.”
58 ak

publ/d02.pdf. /publ/
publ//d46.
November 2001. http://www.bis.org/cpmi/publ/d46.pdf.
11 ah
41 M

2 5
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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Chapter 6 Intraday Liquidity Risk Management ■ 121

  


First, certain market conventions and behaviors that have been accounts real-time (and often correspondent accounts) through
engrained over decades serve to institutionalize intraday over- online account reporting tools, while other data resides in
drafts. For instance, a bank can borrow fed funds in the inter- systems managed by lines of business and operations. Table 6.2
bank market any time during the business day with delivery of contains the common uses of intraday liquidity. The list that
funds occurring almost immediately, but the return of borrowed follows provides further explanation:
funds typically takes place as a first order item the following Outgoing wire transfers. Outgoing wire payments, on
morning. Even though the transaction is priced as a one-day behalf of clients or the bank’s own account, are typically
loan, in reality, the borrower has use of the funds for less than the largest use of intraday liquidity. Payment activity runs
twenty-four hours. The typical pattern is to borrow to cover the entire length of the business day and typically follows a
funding shortfalls in the afternoon, and return the funds at open- fairly predictable pattern. Some large banks have to care-
ing of business the next day. Thus, a bank that is a net borrower fully manage the volume of outgoing payments when their
of fed funds may overdraft ifs Federal Reserve account during daylight overdraft approaches the level of their debit cap.
the middle of the day after returning borrowed funds from the This is accomplished by “throttling” outgoing payments and
previous day. closely monitoring incoming credits to ensure the cap is not
Another example is the settlement of positions at financial exceeded, Most large value payment systems (LVPSs) and
market utilities (FMUs). Many (but not all) FMUs have one some other payment, clearing, and settlement systems (PCSs)
settlement window, typically at the end of day, during which have hard controls that prevent participants from exceeding
bank participants settle their accounts with the clearinghouse their intraday credit limits.
by transferring (or receiving) funds to (from) the clearing- Settlements, at PCS systems. Most PCS systems have one
house accounts, which may be held at another bank or the settlement per day, with many occurring in the late after-
central bank. Let’s assume that a bank participant is expect- noon timeframe. This may serve as either a source or use of
ing a large credit in its account from a clearinghouse at end funds depending on the net position of a participant on any
of day in conjunction with having sold a large block of securi- given day.
ties. The bank likely would not be able to sell off or invest
those funds upon receipt at end of day. Rather than maintain Funding of nostro accounts. Banks manage the cash they
a large, un-invested balance overnight, it will prefer to have its place in correspondent bank accounts to a target average
account in a deficit position until the credit is received from the monthly balance as part of the compensation provided to the
clearinghouse. correspondent for its banking services. On any given day, the
account funding position may act as a source or use of funds
The second type of behavior that generates daylight overdrafts to the bank’s overall liquidity profile, depending on the net
is the provision of intraday credit to clients. Many banks allow position of the activity flowing through the account that day.
their corporate and institutional clients to deploy cash intraday Nostro account balances are replenished or drawn down on a
without sufficient funds in their accounts. For instance, a com- daily basis.
mercial client may expect a large wire transfer to be received in
the afternoon but still wish to fund its payroll in the morning. In Collateral pledging. Some banking activities, such as
another example, a bank that provides securities-related cus- over-the-counter capital markets trading and deposits of
tody services may extend intraday credit by allowing its client to certain public funds, require a bank to earmark and set
purchase an asset prior to receiving credit for a maturing asset aside collateral. Acquiring additional collateral to support an
or selling an investment later in the day. Banks establish daylight increasing liability (or as a result of a mark-to-market induced
overdraft lines of credit to help facilitate these transactions for margin call) is a frequent use of intraday funding. Collateral
their clients and typically do not receive direct compensation for positions are adjusted on a daily basis.
doing so. Asset purchases/funding. Funding other balance sheet
1
60

With all of this occurring, the funds management group of a assets, such as securities purchases for the investment
5
66
98 er

large bank’s treasury has a difficult task in managing intraday portfolio, client loans, and fixed asset purchases, is another
other
ther
1- nt
20
66 Ce

liquidity. A bank’s cash position is impacted by literally thou- common use of intraday liquidity.
65 ks
06 oo

sands of transactions per hour, both client- and bank-related Fortunately for the bank treasurer, there are multiple le sources
ource of
so
82 B

activity, much of it not known in advance by the treasury group. intraday funding available. Each source varies inn its contribution
ccontr
-9 ali
58 ak

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
11 ah
41 M

ing data in one system. They can monitor their central bank overall funding landscape. Table 6.3 lists the
e common
ccomm sources
20
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122 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  




Table 6.2 Uses of Intraday Credit

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

Outgoing Wire Transfers Payments on LVPS Yes, clients provide bank Yes, Bank Treasury and lines Bank activity can usually be
such as Fedwire and instructions of business have payment forecasted with 1 to 2 days’ notice;
CHIPS needs client payment activity is more
difficult to predict
Settlements at Payment, Net cash settlements Not directly initiated by Yes, position monitored by Can be forecast for securities that
Clearing and Settlement at payments systems, clients, but includes client operations groups have multi-day settlements (e.g.,
(PCS) Systems clearinghouses activity T + 3); more difficult for same day
settlement activity
Funding of Nostro Cash transfer to a Not directly initiated by Yes, position monitored by Securities settlements are generally
Accounts correspondent bank clients, but includes client operations groups predictable; client payment activity
for services provided activity flowing through correspondents is
less predictable
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
99
20
41 M
11 ah
58 ak
-9 ali
82 B
06 oo
65 ks

Chapter 6 Intraday Liquidity Risk Management


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1- nt
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■ 123
1



Table 6.3 Sources of Intraday Credit

Funding Requirement Description Client Activity Bank Activity Ability to Forecast

Cash Balances Deposits at the No, clients do not directly Yes, Bank Treasury Bank activity can usually be


central bank and at impact closing/start of day determines level of closing/ forecasted with 1 to 2 days’ notice;
correspondent bank cash balances start of day cash balances client payment activity is more
nostro accounts difficult to predict
Incoming Funds Flow Incoming cash payments Yes, incoming client Yes, activities conducted Bank activity can usually be
and cash credits from payments are credited for the bank’s business can forecasted with 1 to 2 days’ notice;
FMU to the bank’s accounts impact cash balances client payment activity is more
at the central bank and difficult to predict. FMU credit
correspondents can be forecast for securities that
have multi-day settlements (e.g.,
T + 3); more difficult for same day
settlement activity
Intraday Credit Credit line or overdraft No, client activity does not Yes, counterparties will Some intraday credit facilities are
permitted during directly impact the amount often adjust intraday disclosed and well known to a bank
business hours and of intraday credit extended credit extensions to reflect (e.g., FRB net debit cap). Others
covered by close of to a bank business activity from other are not disclosed but can often be
business. Lines are areas of the bank (e.g., OTC inferred from historical data
often uncommitted trading)
and provided without
interest charges.
Liquid Assets Cash, money market Yes, client may be sources of Yes, bank trading and Liquid assets held in the investment
deposits, and short- liquidity in converting liquid investment portfolio activity portfolio and in other money market
term government debt assets to cash (e.g,, repo can impact the amount of investments tend to have low volatil-
(e.g., T-Bills) which can transaction) liquid assets available. ity and as a result are predictable
be quickly converted to
cash
Overnight Borrowings Fed Funds, Eurodollar Yes, clients may be direct No, other Bank lines of Client supply of overnight borrowing
borrowing, overnight sources of liquidity for business do not regularly tends to be fairly predictable, but
deposits overnight borrowing (e.g.,. supply overnight funding with moderate volatility
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
11 ah
58 ak repos from FHLB, money sources of liquidity for term business do not regularly to be fairly predictable, with low
-9 ali market funds, etc. funding supply term funding volatility
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124 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
56
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

cost of having excess liquidity at the end of the day against


20
66 Ce

the risk of not being able to complete the current day’s busi-
65 ks

Governance of Intraday LRM


06 oo

ness (or facing reputational risk exposure from delayed trans-


82 B
-9 ali

actions) due to breaching a daylight overdraft limit.


All risk management frameworks start with a governance
gov struc-
58 ak
11 ah

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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Chapter 6 Intraday Liquidity Risk Management ■ 125

  


The following list provides characteristics of an effective gover- line of business and risk management review the effective-
nance structure for overseeing intraday liquidity risk: ness of controls in mitigating settlement risk.

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

the institution’s intraday flows. The second set of measures


66
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tion from the critical areas (e.g., treasury, operations, IT,


1- nt
20

provides ratios for monitoring risk levels. Institutions mayy wis


wish
sh
66 Ce

lines of business).
65 ks

to set risk limits/thresholds, and perform ongoing monitoring


onito
oring
Risk assessment. At leading institutions, intraday liquidity risk
06 oo

against these measures.


82 B

is incorporated into the risk taxonomy and is a component of


-9 ali
58 ak

risk self-assessments. Through this analysis, settlement risks


11 ah
41 M

related to existing and potential new products and opera- 6


BCBS. “Monitoring Tools for Intraday Liquidity Manag
Management.”
anag April
tional processes are identified, measured, and evaluated. The 2013. http://www.bis.org/publ/bcbs248.pdf.
20
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126 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Measures for Understanding Intraday correlate them with external market factors to improve its ability
to predict upcoming liquidity requirements earlier in the day
Flows
Total Payments Time Sensitive Obligations
A bank and its intraday risk management teams should maintain Similar to settlement positions, these transactions require
statistics concerning the amount of payments it makes on all completion at a specific time during the day. Examples include
electronic payments systems in which it participates. For every transactions concerning market activities (such as the return
payment, a bank would store in a data warehouse the criti- of borrowings), margin payments, and other payments criti-
cal information needed for analysis, such as payment amount, cal to a bank’s business or reputation (e.g., client closing on a
time received or originated, times for each processing step in corporate acquisition). Failure to settle certain time sensitive
the payment workflow, routing information, payer and payee, obligations could result in a financial penalty or other negative
payment system used, any suspensions of the payment, and consequences. A bank should monitor the volume and settle-
so on. Compiling this information would allow a risk manager ment patterns of these time specific obligations by recording
to summarize the data for a variety of purposes, including, for the amounts and deadline times.
example, the following:

• 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

Measures for Quantifying and Monitoring


toring
60
5

Settlement Positions
66
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Risk Levels
1- nt
20
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If complete data to reconstruct account positions at any time


65 ks

Daily Maximum Intraday Liquidity Usage


Usag
ge
06 oo

of day is not available, at a minimum a bank should maintain


82 B

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
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Chapter 6 Intraday Liquidity Risk Management ■ 127

  


of a day’s positions ex-post) to capture all of the negative posi- policies regarding the provision and size of intraday credit lines
tions. The measure is the ratio of the day’s largest net negative relative to industry cohorts and client risk levels.
balance relative to the size of the committed or uncommitted
credit line. Typically, the peak and average of this metric is Payment Throughput
tracked over a period of time (e.g., monthly).
These measures track the percentage of outgoing payment
At a minimum, this measure should be tracked for every cash activity relative to time of day. For banks that are direct
account held at the central bank, FMUs, and correspondent participants in FMUs, it is useful to actively-measure and moni-
banks. Ideally, a bank should also monitor its consolidated posi- tor the flow of outgoing payment transactions relative to total
tion across all accounts between which liquidity can be readily payments or time markers for several reasons: (1) to track its vol-
transferred intraday without restrictions in order to get a true ume patterns and help ensure that all of the day’s payments are
picture of its intraday liquidity usage. This is logically done for processed in time; (2) in some cases, to meet FMU requirements
accounts denominated in the same currency and connected to for submitting a target percentage of payments by a deadline;
a common payment system but can be done for multiple cur- and (3) to help the bank identify and monitor its peak periods
rencies and in different jurisdictions if cash and collateral can be over time and the correlation of this activity with its intraday
freely transferred between the jurisdictions intraday. liquidity on hand and intraday credit usage.
In addition, a bank can track its peak intraday credit usage rela-
Intraday Credit Relative to Tier 1 Capital
tive to total volumes with an FMU to provide an indicator of the
This measure is a broad representation of the intraday settle- efficiency of the FMU’s usage of daylight credit. FMUs employ
ment risk posed by a bank. The measure should be tracked for different system rules and operating models resulting in varia-
total intraday credit and unsecured intraday credit, available tions in how efficiently they use intraday liquidity. Understanding
and used, under the theory that posting high-quality collateral these differences can enable a bank to redirect payment flows
mitigates intraday settlement risk. Available, unsecured intraday as a tool to manage intraday liquidity needs, assuming it has the
credit relative to an institution’s tier 1 capital is a rough measure requisite operational capabilities.
of the inadvertent systemic risk that the institution poses to the
financial system. Such measures, when viewed as, a time series,
as well as horizontally in comparisons to other institutions, pro- Role of Stress Testing
vide bank risk managers with an understanding of the relative
The previous indicators are important in understanding and
systemic risk of their business model as well as changes in their
monitoring a bank’s need for and use of intraday credit under
risk profile over time.
business-as-usual (conditions. However, intraday liquidity
requirements and usage patterns can change substantially dur-
Client Intraday Credit Usage ing periods of market stress. As a result, a bank that regularly
This measure is derived by comparing a client’s peak daily intra- relies on intraday credit should have the ability to model the
day overdraft to the established (committed or uncommitted) impact of different events on its requirements and the avail-
credit line. Tracking aggregate intraday credit exposures pro- ability of intraday liquidity (i.e., modeling the impact of differ-
vides a bank with an indicator of required liquidity needed to ent scenarios on the indicators mentioned). While the banking
support its clients’ business activities. Monitoring the averages, industry has historically developed effective stress tests of over-
volatility, and correlation of these measures to other money all liquidity management that have been instrumental in devel-
market indicators provides useful insights for understanding oping liquidity contingency plans, the industry as a whole needs
how client activity impacts the bank’s ability to manage its own to extend these capabilities to intraday position modeling.
intraday liquidity. (Regulators may push the industry to develop these capabilities
as the focus on intraday liquidity risk increases over time.
1

Tracking client usage of intraday credit lines at the individual


560

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

  


liquidity, risk management, client management, correspondent BCBS guidance also encourages banks to develop reverse stress
banking, operations, and technology to think through the sce- testing capabilities, and testing other scenarios such as the
narios can be beneficial in yielding new insights and ideas. impact of natural disasters, currency crises, and so on.
Understanding how a proposed stress event might impact a
bank’s positions and the behavior of other market participants
helps it to identify key vulnerabilities and their sensitivity to 6.4 RISK MANAGEMENT,
external factors. Developing and modeling potential responses MEASUREMENT, MONITORING
to a stress event helps in formulating contingency plans and TOOLS FOR FMUS
playbooks for how a bank might respond to an event. Finally,
developing the technology infrastructure to support robust This subsection provides a high level overview of risk manage-
modeling provides the institution with an extremely useful ment practices at FMUs. FMUs comprise payments systems,
capability for working through an actual crisis. This implies the securities settlement networks, exchanges, and central securities
need for a data aggregation capability (either a data warehouse depositories. There are a number of characteristics that render
or tools that can assimilate and transform data “on the fly”) each entity unique, including: clearing and settlement services
with data updated frequently, ideally daily. In addition, the bank provided, ownership structure, membership and operating rules,
would need tools that enable it to pull historical data, modify degree and nature of central bank involvement and support,
the data with different sets of assumptions, and simulate a pro- and risk management practices. As a result of this diversity, a
cessing day under those assumptions. comprehensive discussion of FMU risk management practices
Banks should continuously build and expand the types of sce- is beyond the scope of this book. However, a discussion of
narios they can model in stress testing. In its April 2013 guid- intraday liquidity would be incomplete without a discussion
ance, the BCBS suggests that a bank have at least the following FMUs due to their importance in intraday funds manage-
four scenarios:7 ment. This subsection will provide a brief overview of FMU risk
management, and focus on selective risk practices observed in
• Own financial stress. A bank suffers or is perceived to be the industry that are relevant to the discussion of intraday liquid-
suffering from, a stress event. ity risk.
• Counterparty stress. A major financial institution
counterparty suffers an intraday stress event which prevents
it from making payments. Overview of FMU Risk Management
• Customer stress. The customer bank of a correspondent FMUs have long focused on how they would handle the failure
bank suffers a stress event. of one of their participants to complete its settlement obliga-
• Market-wide credit or liquidity stress. tions. FMUs have evolved to have several lines of defense in
managing participant risk.
These four items can be thought of as stress categories as within
each one of these, a bank could develop multiple scenarios The first line of defense is membership criteria. FMUs often
with different characteristics. For example, in the “own finan- have size and creditworthiness criteria that constrain the pro-
cial stress” category, there could be different scenarios for a files of direct members. In addition, some FMUs permit indirect
deteriorating credit portfolio and an idiosyncratic operational members which do not participate in the interbank payment
risk event that results in a large loss. Counterparty stress could system itself, but rely on direct or “corresponding” members
involve a trading partner, an FMU, or a correspondent bank to send their payments to the clearing system. In those cases,
through which the bank routes payment and/or securities trans- the direct members are underwriting the risk of the indirect
actions. Finally, a market-wide category could, for instance, have participants.
scenarios for extremely tight honey market conditions, multiple
1

While this approach allows FMUs to more easily apply credit risk
60

bank failures, widespread decrease in the market value of securi-


5

analysis to their counterparties, membership “tiering” ” poten-


po
oten-
ten-
66
98 er
1- nt

ties held as collateral, a very large corporate action, of opera-


20

tially introduces intraday settlement risks to the system. m. This


ystem Th
66 Ce

tional failures.
65 ks

risk is particularly acute because of exposures between


betw ween first-and
06 oo

second-tier banks and the concentration of allll payment


p
payme
aym activ-
82 B
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ity at a smaller number of settlement banks. nks. The


T particular risks
58 ak
11 ah

7
BCBS. “Monitoring Tools for Intraday Liquidity Management.” April of tiering are: (1) the failure of a directt member
meembe affecting the
41 M

2013. http://www.bis.org/publ/bcbs248.pdf. indirect members that are relying on itt to handle


h their payments;
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Chapter 6 Intraday Liquidity Risk Management ■ 129

  


(2) other members may be hesitant to send payments to the The third line of defense for many FMUs is a mechanism to
member clearing bank of a large, failing institution; and facilitate settlement in the event of a participant failure. This is
(3) increased operational interdependence. accomplished by mutualizing the default risk, thereby dispers-
ing credit risk and potential losses, across a broad number of
Recognizing these concerns, some FMUs have tried to reduce
entities. FMUs commonly build risk mutualization provisions
their tiering. In 2010, the Bank of England made the reduction
into their operating rules to ensure than any realized losses do
of tiering in the Clearing House Automated Payment System
not result in an interruption of service. The operating rules are
(CHAPS) one of its key risk reduction objectives. At the time,
intended to establish a process by which a failed participant’s
CHAPS had only eighteen banks as direct members of the pay-
positions can be quickly, covered and settled so that the FMU
ment system. By comparison, Target2 had 866 direct members,
can re-open for normal activity.
Fedwire had more than 7,000 direct members, and direct mem-
bership of the Hong Kong interbank payment system is compul- Risk mutualization can take several forms. Many FMUs (particularly
sory for all licensed banks in the territory. Since then, CHAPS those employing a CCP model) utilize a “guarantee” fund (also
has taken steps to encourage more members to join as direct commonly; referred to as a default or settlement fund). Guaran-
members by waiving new member fees and replacing its propri- tee funds are prefunded pools of cash and highly liquid assets
etary messaging system with Swift, as most banks already have a reserved for the potential failure of one or more participants. This
Swift connection. typically requires participants to contribute cash to an asset pool,
with the amounts based on their volumes or risk levels. If a partici-
Monitoring the risks of their participants is the second line
pant fails with a debit that cannot be fully covered by its margin
of defense used by most FMUs. This can take several forms,
collateral, then the FMU would draw on the guarantee fund to
depending on the FMU and the risk level. Most EMUs have peri-
settle the failed participant’s positions and then allocate the losses
odic (annually or quarterly) reviews of their participants’ financial
back to the remaining participants. Each participant would then
statements to ensure maintenance of minimum capital levels
need to replenish its contribution to the guarantee in order to
and other financial guidelines that are stipulated in the member-
resume a normal level of trading the next day.
ship rules. Some FMUs require submission of monthly financial
statements for the direct member legal entity (e.g,, the broker- Similarly, the involvement of a central bank in underwriting
dealer sub of a large bank). PCS activities could be considered risk mutualization due to
the central bank’s ability to pass on losses to governments and
In addition to the financial conditions of the participants, FMUs
ultimately taxpayers. This model is frequently observed with
also monitor their participants’ settlement positions and mar-
LVPSs that are operated by the central bank. In order to achieve
gin collateral. Securities settlement networks have monitoring
immediate finality of payment (meaning the payment is final
programs that, during their overnight cycle (some are more fre-
when the amount is credited to the participant’s account), many
quently), recalculate the risk potential and the collateral values
central banks underwrite all of the participant credit risk on their
of each participant’s account to ensure the bank has sufficient
national LVPS. This is the model used by the Federal Reserve for
margin posted.
Fedwire.
When an FMU is concerned about the default risk of one of its
members, there are several risk mitigation actions it may con-
sider to reduce intraday settlement risk. For example: FMU Tools to Manage Intraday
• Securities settlement networks that run risk margining may
Settlement Risk
decide to run cycles several times per day for higher risk par- As mentioned above, the second line of defense for an FMU is
ticipants. This means the FMU may make an intraday margin monitoring the risk exposures of its participants. For its highest
call, requiring additional collateral from the participant pursu- risk exposures, an FMU typically monitors the participant’s set-
ant to changes in its risk and collateral positions. tlement requirements on a real-time, intraday basis. FMUs use
1
60

• A payment system may reduce a member’s net debit cap several tools to monitor and manage these intraday exposures ess
5
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(which is essentially an intraday credit line), or require a par- and to assist their participants with their own intraday liquidity
uidity
idityy
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ticipant to pre-fund its account and not permit it to run intra- risk management.
65 ks
06 oo

day overdrafts.
B

• An FMU may require a participant to post additional collat-


Net Debit Caps
82

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
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130 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


negative position in a cash account, typically suspending further situation. These lines are not used under business-as-usual
transactions until additional liquidity is added to the account. conditions and are only maintained for emergencies.
Net debit caps are standard at large value payment systems,
and used at other types of FMUs as well. In managing a deterio-
rating credit risk situation, an FMU may reduce or even eliminate CONCLUSION
a participant’s net debit cap, requiring the participant to provide
more liquidity to settle its positions. While initial management efforts concerning intraday liquidity
risk date back to the 1980s, the 2007–08 financial crisis high-
Collateral lighted a number of deficiencies in industry practices and led to
Cash or securities collateral is a key component for FMU risk more rigorous research efforts and industry focus on this area.
management. As with net debit caps, in a deteriorating credit It is fair to say that, across the financial services industry, under-
situation, an FMU may begin to monitor a participant’s risk posi- standing intraday liquidity risk and developing tools to man-
tion and its initial and variation margin collateral values in real- age it remain works in progress. While some banks and FMUs
time to ensure sufficient coverage. Depending on a number of exhibit leading-edge capabilities, in general, industry partici-
factors, the FMU may require a participant to adjust its collateral pants need to make significant investments to enhance their risk
position by modifying the acceptable composition of collateral, management frameworks, systems, and data management to
advance rates on certain securities, and concentration limits. truly understand their intraday liquidity risk profile and be able
to manage that risk during periods of market stress. With the
Liquidity Savings Mechanism implementation of Basel III, regulators are increasingly focused
on liquidity risk in general and have signaled their intent to
FMUs have to balance their risk management considerations
ensure that banks include intraday liquidity risk in their liquidity
with their business objectives of minimizing cost and maximiz-
risk programs. As a result, this will be an exciting area of bank-
ing value to participants. Many FMUs have developed inno-
ing to watch over the next few years.
vative ways to clear and settle transactions that reduce the
overall operating liquidity required by the system (i.e., liquidity
savings mechanism). These tactics essentially increase transac-
tion throughput for a given amount of liquidity. This achieves GLOSSARY
both objectives by reducing the size of settlement positions
This section provides definitions for key terms that are frequently
(and settlement risk) and minimizing the cost of idle liquid-
used in discussions of intraday liquidity risk management.
ity for a participant. Examples of liquidity savings mechanisms
include transaction netting (bilateral and multilateral), net credit D
caps (which may suspend transactions to a participant until
Daylight Overdraft (DOD)
they provide more outgoing liquidity), transaction throughput
Daylight overdraft, also referred to as intraday overdraft (IOD),
requirements (e.g., requiring a certain percentage of outgoing
refers to a cash account with a negative cash position during
transactions to be submitted by a mid-day deadline), transac-
the business day. This results when the cumulative amount of
tion prioritization capabilities, and intra-system lending (e.g.,
debit transactions posted to the account exceeds the sum of the
securities lending).
opening balance plus posted credit transactions

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

referred to as Financial Market Infrastructure (FMI) or Value


60

FMUs have staggered multiple settlement windows throughout


5
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the day. This can be achieved by having individual settlement Transfer Networks (VTNs). This includes:
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times for specific asset classes or currencies. • Wholesale payments systems, such as wire transfer
ansfe
ansf
fer networks,
ne
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also referred to as Large Value Payment Systems


y ms (LVPSs)
ystem (L
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Contingent Liquidity
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• Retail payment systems, typically low value


e transfer
tran networks
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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
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Chapter 6 Intraday Liquidity Risk Management ■ 131

  


• Trade execution facilities, such as exchanges P
• Securities settlement networks (SSNs), including clearing and Payment Finality
settlement networks Refers to the point at which the value (payment) received by a
• Central securities depositories (CSDs) that hold book-entry beneficiary becomes final and cannot be reversed for any rea-
issued assets son. This is the point which the beneficiary has full, irrevocable
Some FMUs are referred to as central counterparties (CCP). In ownership of the value transferred.
this model, which is used frequently for securities settlements, Payments, Clearing, and Settlement Services (PCSs)
an FMU inserts itself as a legal intermediary in the transaction, PCS is used to describe a broad range of services that support
centralizing the counterparty credit exposure of settling funds transfers, securities transfers, foreign exchange transac-
transactions in a single entity. CCPs net and clear exchange and tiohs, trade execution, and derivative transactions.
OTC-based trading securities transactions, often handing off to
S
a CSD for final settlement.
Systemically Important Financial Institutions (SIFIs)
I Financial institutions of significant size that provide market-
Intraday Liquidity critical services are generally defined as systemically important.
Cash funding which can be accessed at any point during the In general, the label if implies that the failure of a SIFI has the
business day to enable banks to continue processing transac- potential to spread loss and market distress to other institutions
tions; this can include the interbank funds markets, wholesale by nature of the SIFI’s size and interconnectedness.
money markets, and intraday credit lines provided by central Systemic Risk
banks or FMUs. The risk of simultaneous failure of multiple participants in a
Intraday Liquidity Risk financial system or market; systemic risk generally refers to a
The risk that a bank or FMU is unable to meet a payment or “contagion effect” in which the failure of a single entity has a
settlement obligation at the expected time due to inadequate cascading effect, causing multiple subsequent failures because
liquid funds (cash); also known as settlement risk of the amounts owed by the first failed entity to other partici-
pants. Exposures to the failed entity can be either deliberate
N credit extensions made in the ordinary course of business (such
Net Debit Cap as loans, trading activity, balances related to correspondent
A risk management tool utilized by providers of intraday liquid- banking) or inadvertent or unforeseen credit exposures.
ity to limit their risk exposure; a debit cap constrains the size Inadvertent exposures could arise, for example, as a result of
of a negative position in a cash account, typically suspending the allocation to a solvent bank of credit losses pursuant to the
further transactions until additional liquidity is added to the loss sharing arrangement of an FMU. In fact, one could argue
account. that all intraday settlement risks exposures are inadvertent in the
sense that they are viewed as a cost of doing business and not
Netting/Net Settlement
a risk exposure for which a bank is being directly compensated.
The process of offsetting obligations between two or more
One of the objectives of managing intraday liquidity risk is to
banks, which reduces the size of final settlements and intraday
minimize or eliminate inadvertent credit exposures.
liquidity risk; “bilateral” netting occurs between two banks;
“multilateral” netting occurs on a payments or securities settle- T
ment system.
Time Critical Payment
Nostro Account A payment obligation that is due at a specific time during the
A cash account maintained by a bank outside of its home mar- day such as a clearinghouse settlement deadline or a client
1
60

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

securities transactions in that market. mortgage loan or an acquisition of a company).


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65 ks
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58 ak
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132 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Monitoring
Liquidity
7
■ Learning Objectives
After completing this reading you should be able to:

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

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

● Describe and apply the concepts of liquidity risk, funding


cost risk, liquidity generation capacity, expected liquidity,
and cash flow at risk.

1
605
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65 ks
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Excerpt is Chapter 6 of Measuring and Managing Liquidity Risk, by Antonio Castagna and Francesco Fede.
e.
20
99

133

  


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

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

Deterministic Stochastic Let us begin with deterministic amount/deter-


ministic time cash flows: they are typically related
to financial contracts, such as fixed rate bonds or
Deterministic

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

([HUFLVH cash flows belong to the fixed amount/deter-


5 60

ministic time category can only be ensured d if the


th
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ō:LWKGUDZDOVIURPGHSRVLWV
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ō:LWKGUDZDOVRIFUHGLWOLQHVWR
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%HKDYLRXUDO FOLHQW obligor, or the bond’s issuer, is risk free,, so


s that
tth
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ō3UHSD\PHQWVRIPRUWJDJHV
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ō3UHSD\PHQWRIGHSRVLWV credit events cannot affect the cash flowlow sched-


sche
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ule provided for in the contract.


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1HZ ō1HZ'HEW,VVXDQFHE\WKH%DQN ō1HZGHSRVLWV


ō1HZORDQV
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%XVLQHVV ō5HQHZDORI([SLULQJ&RQWUDFWV ō1HZDVVHWV Deterministic amount cash flowss can also occur
11 ah
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at stochastic times, either because


ecaus the con-
be
Figure 7.1 Taxonomy of the cash flows. tract can provide for a given
ven sum
s to be paid
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134 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


or received by the bank, or because the amount depends on a schedule can be determined once prepayment occurs. If the
choice made by the bank. An example of the first kind of cash prepaid mortgage, as before, is fixed rate amortizing, then we
flow can be represented by the payout of one-touch options: in have a modified cash flow schedule on the contract interest rate
fact, the buyer of this type of option receives a given amount and capital repayment times.
of money when the underlying asset breaches some barrier
Other behavioural cash flows, befalling at stochastic times, are
level, from below or from above. The time is unknown from the
those originated by credit lines that are open to clients: with-
reference instant, but the amount can easily be deducted from
drawals may occur at any time until the expiry of the contract
the contract’s terms. An example of cash flows that depend on
and in an uncertain amount, although within the limits of the
the bank’s decisions can be represented by the positive cash
line. Withdrawals from sight or saving deposits belong to this
flows originated by the withdrawals of credit lines received by
category too.
the bank. In this case, the amount can safely be assumed to be
some level between 0 and the limit of the credit line chosen by Finally, we have stochastic amount cash flows related to the
the bank depending on its needs, but it can occur at any time replacement of expiring contracts and to new business activity.
until the expiry of the contract, since liquidity needs may arise at For example, the bank may plan to deal new loans to replace
some stochastic time. exactly the amount of loans expiring in the next two years,
and this will produce a stochastic amount of cash flows since it
Shifting the analysis to the stochastic amount category, we first
is unsure whether new clients will want or need to close such
identify credit-related cash flows that are due to the default of
contracts. Old contracts expire at a known maturity so that cash
one or more clients, so that once the default time is fixed, their
flows linked to their replacement are known as well. Moreover,
amount can be implied. The default time is obviously not known
the new issuance of bonds by the bank can be well defined
at the reference time, so that the time when these cash flows
under a time perspective, but the amount may not be com-
occur is stochastic. An example can be represented by the miss-
pletely in line with the plans.
ing cash flows, after the default, of the contract stream of fixed
interests and of capital repayment of the loan. A missing cash By the same reasoning, the evolution of completely new con-
flow may be considered a negative cash flow that alters a given tracts may not follow the pattern predicted in business develop-
cash flow schedule: if a loan, for example, is fixed rate amortiz- ment documents, so that related cash flows are both amount
ing, then we have a modified cash flow schedule on the contract and time stochastic. For example, new retail deposits, new, mort-
interest rate and capital repayment times. Moreover, the recovery gages and new assets in general may be only partially predicted.
value after default can be inserted in this category of cash flows. In general, cash flows due to new business, or to the rollover of
existing business, are quite difficult to model and to manage.
Stochastic amount cash flows we can also be indexed/contin-
gent (i.e., linked to market variables). Examples of such cash
flows are, amongst others, floating rate coupons that are linked
to market fixings (e.g., Libor) and the payout of European 7.2 LIQUIDITY OPTIONS
options, which also depend on the level of the underlying asset
Some of the categories of cash flows described above are con-
at the expiry of the contract. In these the time of the occurrence
nected with the exercise of so-called liquidity options. These
of cash flows is known (the coupon payment, the exercise date),
kinds of options are conceptually no different from other
but there may also be indexed/contingent cash flows that can
options, yet the decision to exercise them depends on their
manifest at stochastic times. Examples are the payout of Ameri-
particular nature.
can options, both when the bank is long or short them, because
the exercise time is stochastic and depends on future market More specifically, a liquidity option can be defined as the right
conditions that determine the optimality of early exercise. of a holder to receive cash from, or to give cash to, the bank at
Again, here we have to stress that we are referring to contracts predefined times and terms. Exercising a liquidity option does
1

whose counterparty to the bank is default risk free. not directly entail a profit or a loss in financial terms, rather it is
560
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as a result of a need for or a surplus of liquidity of the hee holder.


ho
older.
Anther type of stochastic amount cash flow is behavioural; for
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This does not necessarily exclude linking the exercising ng of a


rciisin
example, when a bank’s clients decide to prepay the outstand-
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liquidity option to financial effects; on the contrary,


ntraryy, such
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ing amount of their loans or mortgages. In this case the bank


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is sometimes quite strong: this is clear from m the


th
hee examples
exa of
may compute the prepaid amount received on prepayment:
-9 a
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liquidity options we provide below.


the prepayment time cannot be predicted with certainty by the
11 ah
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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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Chapter 7 Monitoring Liquidity ■ 135

  


exercised when there is a profit, independently of the cash contract ends. Although the bank would benefit in this case
flows following exercise, although typically they are positive. from the greater amount of liquidity available, economic effects
For example, a European option on a stock is a financial option are usually negative and thus cause a loss. An example is given
that is exercised at expiry if the strike price of the underlying by the prepayment of fixed rate mortgages or loans: they can
asset is lower than the market price. The profit can immediately be paid back before the expiry for exogenous reasons, often
be monetized by selling the stock in the market so that the linked to events in the life of the client such as divorces or
holder receives a positive net cash flow equal to the difference retirements; more often prepayment is triggered by a financial
between the strike price (paid) and the sell price (received). incentive to close the contract and reopen it under current mar-
Alternatively, options may be exercised and the stock not ket conditions if the interest rate falls. In the first case the bank
immediately sold in the market, so that only a negative cash would not suffer any loss if market rates rose or stayed constant,
flow occurs: this is because the holder wants to keep the stock on the contrary it could even reinvest at better market condi-
in her portfolio, for example, and it is more convenient to buy tions those funds received earlier than expected. In the second
it at the strike price instead of the prevailing market price. The case, prepayment would cause a loss since replacement of the
convenience to exercise is then independent of the cash flows mortgage or closure of the loan before maturity would be at
after exercise. rates lower than those provided for by old contracts.

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

due to the need of liquidity for transaction purposes. So, even in


60

imply costs that have to be properly accounted for when pric- c


c-
5
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this case there may exist some financial rationale behind exercis-
ing contracts to deal with clients, so that models to price long g
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ing a liquidity option, but it can also be triggered by many other


and short liquidity options have also to be designed. Since, e, as
Sincce
different reasons that are hardly predictable, or can be forecast
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shown above, liquidity options also produce financial ial p


pr
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rofits
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on a statistical basis.
or losses when exercised, so that they can also be seen een under
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Exercising a liquidity option can also work the other way round: some respects as financial options, models must jointly
jjoint consider
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the bank’s client has the right to repay the funds before the liquidity and financial aspects.
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136 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


7.3 LIQUIDITY RISK at Figure 7.2, which shows the rolling series of the CDS Itraxx
Financial spread. We use this as a proxy for funding spread over
Risk is always related to uncertainty about the future: this may the risk-free curve for top European banks on a 5-year maturity.
turn out to be more favourable than initially expected or, on As is manifest, the spread was almost constant and low until
the contrary, more adverse than forecast. Although positive 2007 (the outbreak of the subprime crises in the US). This means
and negative outcomes should be balanced, in practice it is the that banks were considered virtually default risk free and fund-
adverse unexpected states of the world that is of interest. Bear- ing costs, meant as the spread over the risk-free curve, had a
ing this in mind, a very general definition of liquidity risk for a very limited effect on the profitability of banks.
financial institution is the following. Moreover, it should be stressed that in such a constant low-
Definition 7.3.1 (Liquidity risk). The event that in the future spread environment, the rollover of the bank’s liabilities that
the bank receives smaller than expected amounts of cash flows expire entails negligible risk in terms of unexpected spread
to meet its payment obligations. levels. This combined with abundant liquidity such that the
quantity of funding available was in practice without relevant
We have analysed the different kinds of liquidity concepts and
limits, banks were able to decide how to finance their assets as
related risks. Definition 7.3.1 encompasses both funding liquid-
they preferred; the rollover of maturity was an almost risk-free
ity risk and market liquidity risk. In fact, if a bank is not able to
activity. For these reasons, trying to predict funding costs was
fund its future payment obligations because it is receiving less
a futile exercise and their inclusion in the pricing of contracts
funds than expected from clients, from the sale of assets, from
was straightforward.
the interbank market or from the central bank, this risk may
produce an insolvency situation if the bank is absolutely unable Since the middle of 2007, financial institutions have no longer
to settle its obligations, even by resorting to very costly alter- been able to always raise funds at low spreads: the volatility
natives. Market liquidity risk according to the definition above of spreads even over interbank market rates (e.g., Libor) dra-
is the result of the inability to sell assets, such as bonds, at fair matically increased, and the amount of funding available in the
price and with immediacy, and leads to a situation in which capital market declined, at least for the banking sector. As a
the bank receives smaller than expected amounts of positive consequence of these two reasons, the funding policy of banks
cash flows. is now subject to constraints so as to abate the average funding

The risk dimension considered in Defini-


tion 7.3.1 refers to the quantity of flows,
so we call this quantitative liquidity risk.
Nonetheless, we claim that another
risk dimension for liquidity should be
considered: the cost of liquidity, or cost
of funding, and the related risk can be
defined as follows.
Definition 7.3.2 (Funding cost risk).
The event that in the future the bank
has to pay greater than expected cost
(spread) above the risk-free rate to
receive funds from sources of liquidity
that are available.
This can be defined as cost of liquid-
01
56

ity risk or cost of funding risk. Not too


66
98 er

much attention has been paid to the


1- nt
20
66 Ce

modelling of funding cost risk, although


65 ks
06 oo

in the past it was always recognized as


82 B

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

on banking activity. The reason for this is September 2011.


11 ah
41 M

quite simple to understand if one looks Source: Market quotes from major brokers.
20
99

Chapter 7 Monitoring Liquidity ■ 137

  


cost, reduce rollover risk (regarding both the quantitative and Definition 7.4.2 (Sources of liquidity). All factors capable of
risk dimension) and hence make credit intermediation activity generating positive cash flows to manage and hedge liquidity
still a profitable business. risk and can be disposed of promptly by the bank determine
the liquidity generation capacity (defined in the following) of the
The conclusion we can draw from this is that modern liquidity
financial institution.
risk management must consider both the quantitative dimen-
sion and the cost dimension as equally important and robust First we set the notation. Let us indicate with cfe+(t0, ti) = E[cf+(t0, ti)]
modelling must be developed for the two dimensions. We can the sum of expected positive cash flows occurring at time
synthesize both dimensions of liquidity risk in the following com- ti from the reference time t0. Similarly, we indicate by
prehensive definition. cfe-(t0, ti) = E[cf-(t0, ti)] the sum of expected negative cash flows
occurring on the same date.
Definition 7.3.3 (Liquidity risk). The amount of economic
losses due to the fact that on a given date the algebraic sum We analysed above the different categories of cash flows and
of positive and negative cash flows and of existing cash avail- saw that many are stochastic in terms of the amount or time
able at that date, is different from some (desired) expected of occurrence or both. This is the reason we have stressed the
level. fact that the sum of cash flows, either positive or negative, is
just expected. On the other hand, if cash flows are expected,
This definition includes a manifestation of liquidity risk as:
this also means that their distribution at each time should be
1. Inability to raise enough funds to meet payment obliga- determined so as to recover measures other than the expected
tions, so that the bank is forced to sell its assets, thus caus- (average) amount, to increase the effectiveness of liquidity man-
ing costs related to the non-fair level at which they are sold agement. We will come back to this later on, but for the moment
or to suboptimal asset allocation. The complete inability to we can formally define the positive and negative cash flows for
raise funds would eventually produce an insolvency state for the set of contracts and/or securities {d1, d2, c , dN} as:
the bank. These costs refer to the quantitative dimension of N
liquidity risk. cfe+(t0, ti) = EJ a cf+(t0, ti; dj) R (7.1)
j=1
2. Ability to raise funds only at costs above those expected.
These costs refer to the cost dimension of liquidity risk. and similarly
N
3. Ability to invest excess liquidity only at rates below those cfe-(t0, ti) = EJ a cf-(t0, ti; dj) R (7.2)
expected. We are in the opposite situation to point 2, j=1

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

The term structure of expected cash flows (TSECF) can be


66
98 er
1- nt
20
66 Ce

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

the causes of liquidity risk. Cash flows generated by the causes


58 ak

TSECCF(t0, tb) = {cfe+(t0, t0), cfe-(t0, t0), cfe+(t0, t1), ccfe-((tt0, t1), c ,
11 ah

of liquidity can be both positive and negative.


cfe+(t0, tb), cfe-(t0, tb)}
41 M

(7.4)
The other class of factors is given by Definition 7.4.2.
20
99

138 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


At the end of the TSECF, with an indefinite expiry correspond- Table 7.1 Assets and Liabilities Reclassified
ing to the end of business activity, there is reimbursement of According to Maturity
the equity to stockholders. TSECF is often referred to as the
Expiry Assets Liabilities
maturity ladder: we reserve this name for the initial part, up
to one-year maturity, of the TSECF. It is also standard practice 1 20
to identify short-term liquidity, up to one year, and structural 2 10
liquidity, beyond one year.
5 50
The term structure of cumulated expected cash flows (TSECCF)
7 70
is similar to the TSECF: it is the collection of expected cumu-
lated cash flows, starting at t0 and ending at tb, ordered by date: 10 30

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.
20
99

Chapter 7 Monitoring Liquidity ■ 139

  


Table 7.2 Interest Yield of the Assets and Liabilities Example 7.4.1 shows a very simple balance sheet producing a
of the Simplified Balance Sheet Reclassified in Table 7.1 very simple TSECF and related TSECCF. In a real balance sheet
the number and type of contracts entering into the analysis is
Interest Yield
much greater and is not just limited to those existent at the
Expiry Assets (%) Liabilities (%) reference time, but also all new activities that can be reasonably
expected to be operated and in most of cases belonging to the
1 5.00%
category of new business of Figure 7.1.
2 4.00%
In greater detail, the cash flows of the TSECF are those pro-
5 6.00% duced by all the causes of cash flows, as defined above. This
7 4.50% means that the TSECF
10 6.50% • includes the cash flows from all existing contracts that com-
710 prise the assets and liabilities: in many cases cash flows are
stochastic because they can be linked to market indices, such
as Libor or Euribor fixings (interest rate models are needed to
each date, cash flows from the initial date t0 up to each date ti
compute expected cash flows);
are cumulated according to formula (7.3) and entered in the
TSECCF: the result is also shown in Figure 7.4. • cash flows are adjusted to consider credit risks: credit mod-
els have to be used to take into account defaults on an
This overly simplified example can be made a bit more realistic if
aggregated basis by also considering the correlation existing
we also consider the interest payments that assets and liabilities
amongst the bank’s counterparties;
yield. Assume a yearly period for coupon payments and an aver-
• cash flows are adjusted to account for liquidity options:
age yield common to all contracts expiring on a given date: the
behavioural models are used for typical banking products
interest yielded by each contract is shown in Table 7.2.
such as sight deposits, credit link usage and prepayment of
When interest payments are added, the TSECF is built as in mortgages;
Table 7.3, where there is also the TSECCF. In Figure 7.5 the
• cash flows originated, by new business increasing the assets
TSECF is represented for each date, decomposed in positive
should be included: they are typically stochastic in both the
and negative cash flows, and in the bottom diagram cumulated
amount and time dimensions, so they are treated by means
cash flows are also shown.
of models that consider all related risks;
• the rollover of maturing liabilities, by similar or different
Table 7.3 The Term Structure of Cash Flows contracts, and new bond issuances (which could also be
and of Cumulated Cash Flows included in the new business category) to fund the increase
cf+ cf− in assets, have to be taken into account. The risks related
to the stochastic nature of these flows have to be properly
Notional Interest Notional Interest TSECCF measured as well resulting in a need to set up proper liquid-
1 20 5.95 0 -3.55 22.40 ity buffers.

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

and the TSECCF. The perfect condition is reached if the TSECCF


60

6 0 1.95 0 -3.15 68.00


5

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

able to cover negative cash flows, both of which are generated


enerat
eraated
ted
65 ks

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

cannot be verified for two reasons:


9 0 1.69 0 0 0.18
-9 ali
58 ak

1. Many of the cash flows belong to categories


oriess that are sto-
11 ah

10 30 1.69 0 0 31.87
41 M

chastic in the amount and/or the time dimension,


dim
mens such that
710 0 0 - 20 0 11.87 the TSECF always forecasts just the expected
xpec
xpect value of a
20
99

140 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


80 Interest Neg CFs the future TSECCF is always positive. But since we have
Notional Neg. CFs seen that this ideal situation cannot always be fulfilled, we
60 Interest Pos CFs need to discover which tools can be used to cope with
Notional Pos. CFs the case when the TSECCF has negative values.
40

20 7.4.2 Liquidity Generation Capacity


0 Liquidity generation capacity (LGC) is the main tool
a bank can use to handle the negative entries of the
–20
TSECCF. It can be defined as follows.
1 2 3 4 5 6 7 8 9 10 >10
–40 Definition 7.4.3 (Liquidity generation capacity). The
ability of a bank to generate positive cash flows,
–60
beyond contractual ones, from the sources of liquid-
ity available in the balance sheet and off the balance
–80
sheet at a given date.

80 The LGC manifests itself in two ways:


Cumulated
70 1. Balance sheet expansion with secured or unse-
cured funding.
60
2. Balance sheet shrinkage by selling assets.
50
Balance sheet expansion can be achieved via
40
• borrowing through an increase of deposits, typically
30 in the interbank market (retail or wholesale unse-
cured funding);
20
• withdrawal of credit lines the financial institution
10
has been granted by other financial counterparties
0 (wholesale unsecured funding);
1 2 3 4 5 6 7 8 9 10 >10
–10 • issuance of new bonds (wholesale and retail unse-
cured funding).
Figure 7.5 Term structure of expected cash flows for
the simplified balance sheet reclassified in Table 7.1 It is worth noting that new debt is not the same as that planned
including interest payments (top) and term structure of to roll over existing contracts or to fund new business: in this
expected cumulated cash flows (bottom). case the related cash flows would be included in the TSECF and
in the TSECCF, as seen above.

distribution of flows. As a result the TSECCF contains only 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

2. The temporal distribution of the maturities of the assets


60
5
66

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

are short and can be managed effectively with the tools we


06 oo

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

Chapter 7 Monitoring Liquidity ■ 141

  


neutral” repo transactions, are not. So it is possible to present an We can now define the term structure of LGC as the collection,
alternative distinction within LGC; namely, we can identify at reference time t0, of liquidity that can be generated at a given
• balance sheet liquidity (BSL), or liquidity that can be gener- time ti, by the sources of liquidity, up to a terminal time tb:
ated by the assets existing in the balance sheet. BSL is tightly TSLGC(t0, tb) = {AS(t0, t1), RP(t0, t1), USF(t0, t1), c , AS(t0, tb),
linked to balance sheet reduction LGC and it is also the RP(t0, tb), USF(t0, tb)} (7.6)
ground on which to build liquidity buffers.
where AS(t0, t1) is the liquidity that can be generated by the sale
• remaining liquidity, originated by the other possible ways of assets at time ti, computed at the reference time t0; RP(t0, t1)
mentioned above, which relates to balance sheet expansion. and USF(t0, t1) are defined similarly.
A similar classification within LGC is based on the link between Analogously, the term structure of cumulated LGC is the collec-
the generation of liquidity and the assets in the balance sheet, tion, at the reference time t0, of the cumulated liquidity that can
so that we have: be generated at a given time ti, by the sources of liquidity, up to
• Security-linked liquidity including a terminal time tb:
– secured withdrawals of credit fines received from other 1 2
TSCLGC(t0, tb) = b a TSLGC(t0, ti), a TSLGC(t0, ti), c ,
financial institutions; i=0 i=0
b
– secured debt issuance;
a TSLGC(t0, ti) r (7.7)
– selling of assets and repo. i=0

• 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

3 is not the same as the unsecured funding we inserted in the


5

As mentioned above, assets in the banking book can be also so


o
66
98 er

TSECF and TSECCF, but is mainly related to the rollover of


1- nt
20

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

ness expansion. In fact, while in the latter case we referred to


82 B

existing and planned activity funding usual banking activity, the


-9 ali

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

mplyy refer to assets


definition used for accountancy purposes. We simply
41 M

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

  


seen as a collateralized loan that the bank may receive: as such to experience systemic liquidity crises (e.g., as in 2008) that
it can be safely assumed that liquidity can be obtained more strongly limit the availability of funds via this channel. The other
easily than unsecured funding, since the credit risk of the bank important factor is the costs related to the funding spread.
is considerably abated. For the same reason the funding cost,
Building the TSLGC can be very difficult, since the assumptions
meant as the spread over the risk-free rate, is also dramatically
made for a given period affect other periods. For example,
reduced for the bank.
if the bank wants to compute the liquidity-generating capac-
Besides the factors that affect liquidity that AFS bonds can gen- ity provided by a given bond held in the assets, assuming it is
erate, there is another factor determining the actual liquidity pledged as collateral for a loan starting in t1 and expiring in t2 to
that can be obtained by a repo or a collateralized loan transac- cover negative cumulated cash flows occurring during the same
tion: the haircut, or the cut in the market value of the bond indi- period, then the same bond has to be excluded for the same
cating how much the counterparty is willing to lend to the bank, period and other overlapping periods from the TSLGC. This
given an amount of bonds transferred as collateral. The haircut means that the process to build the actual TSLGC should be
will depend on the volatility of the price of the collateral bond carried out in a greater number of steps.
and on the probability of default of the issuer of the bond.
It should also be stressed that the TSLGC is intertwined with the
Haircuts have to be modelled not only for unencumbered assets TSECF (and thus the TSECCF): there are feedback effects when
to assert their liquidity potential, but also for encumbered defining the TSLGC that affect expected cash flows, which makes
assets, involved in collateralized loans, to forecast possible the building process a recursive procedure to be repeated until
margin calls and reintegration of the collateral when their prices an equilibrium point is reached. For example, if we still consider
decline by an appreciable amount. that the TSLGC for a given period can be fed by a bond that can
be pledged as collateral or repoed, then the cash flows of this
Finally, received committed credit lines, which are not exactly
bond should be excluded from the TSECF for the period of the
in the balance sheet until they are used (in which case they
loan or repo contract.3 Missing cash-flows for the corresponding
become liabilities) have to be included in the TSLGC and their
period worsen the cash flow term structure (although marginally),
amount and future actual existence taken into account. In fact,
but this means that they must also be included in the analysis.
although it is also quite reasonable to receive committed credit
lines from other financial institutions after the expiry of the lines In the end, most of the problems in building the TSLGC are
currently received, their amount could be constrained by pos- caused by unencumbered assets (most of which are what we
sible systemic liquidity issues. Moreover, the costs in terms of earlier referred to as AFS bonds), both because the bank must
funding spreads and other fees to be paid have to be consid- keep track of how many are either sold or repoed out, and
ered as well. because the liquidity amount that can be extracted from these
assets depends on several risk factors. It is useful then to intro-
If we move to the trading book, we can identify bonds and other
duce a tool that helps monitoring this part of the LGC more
assets similar to those included in the banldng book as sources
thoroughly: it is the term structure of available assets (TSAA)
of liquidity. Amongst the other assets that can be used to gener-
and will be described in the next section.
ate liquidity we may add stocks and also some structured prod-
ucts, such as eligible ABSs or even more complex structures.2
These assets, provided they are unencumbered, can be sold or
they can be pledged in collateralized loans or repoed. In these 7.4.3 The Term Structure
cases the same considerations we have made above can be of Available Assets
repeated here and the same factors have to be included in the
In the previous section we stressed that BSL is originated by
assessment of the liquidity potential to include in the TSLGC.
selling assets and/or by the repo transactions made on them.
Unsecured funding on the interbank market via deposit transac- When building the TSLGC, it is important to ascertain whether
1
60

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

source of liquidity should be carefully weighted by the possibility terms of liquidity.


65 ks
06 oo
82 B
-9 ali

2
58 ak

The liquidity of structured products can be strongly dependent on the


11 ah

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

Chapter 7 Monitoring Liquidity ■ 143

  


When an asset, such as a bond, is purchased by a bank a cor- the asset is increased by an amount equal to the notional of
responding outflow equal to the (dirty) price is recorded in the the repo agreement. The TSLGC is not affected but the asset
cash position of the bank. During the life of the bond coupon can be repoed until the end, so that it can be altered until
flows are received by the bank and finally, at expiry, the face this date. Reverse repo transactions are treated as assets in
value of the bond is reimbursed by the issuer. All these cash the balance sheet, since they can be seen as collataralized
flows should be considered contract related, so that they are loans to the counterparty.
included in the TSECF and the TSECCF. The likelihood of the • Sell/buyback transactions: similar to repo transactions in
issuer defaulting should also be taken into account. terms of the exchange of cash and of the asset, with the dif-
The TSAA is affected by purchases, since it records increases in ference that ownership passes to the buyer (the counter-
the security for the amount bought. When the asset expires, the party) at the start of the contract together with the
TSAA records a reduction to zero of its availability, since it no lon- possession. All payments received for the asset before the
ger exists. During the life of the asset, the availability is affected buyback belong to the counterparty.4 The cash flows
by total or partial selling of the position, and by repo transactions. between the start and end of the contract will be taken from
the TSECF and the TSECCF. The TSAA of the asset decreases
The TSAA is also affected by other kinds of transactions that
by an amount equal to the notional of the sell/buyback con-
can be loosely likened to repo agreements, but have different
tract. The TSLGC is affected in the same way as in the repo
impacts. Namely, we also have to analyse buy/sellback (and sell/
agreement, since sell/buyback transactions are a way to gen-
buyback) transactions and security lending (and borrowing).
erate BSL. Sell/buyback transactions represent a commitment
What matters in terms of availability for liquidity purposes is the
for the bank at the end of the contract.
possession of the asset rather than its ownership. We summarize
all possible cases in the following: • Buy/sellback transactions: similar to reverse repo transactions
in terms of the exchange of cash and of the asset, with the
• Repo transactions: at the start of the agreement the bank
difference that ownership passes to the buyer (the bank) at
receives cash for an amount equal to the price of the asset
the start of the agreement together with the possession. This
reduced by the haircut; at the same time it delivers the asset
implies that the payments received for the asset before the
to the counterparty. Although the asset is still owned by
sellback belong to the bank, so that they enter the TSECF
the bank, its possession passes to the counterparty, so that
and the TSECCF, along with the cash flows at the start and
the bank no longer has availability of the security. This will
end that relate to the purchase and sale, since they are con-
become encumbered and cannot either be sold or used as
tract flows. The TSAA of the asset is increased by an amount
collateral until the end of the repo agreement, when it is
equal to the notional of the buy/sellback agreement. The
returned. Payments by the asset during the repo agreement
TSLGC is not affected but the asset can be repoed until the
belong to the bank since it is the owner, so that the TSECF
end, so that it can be altered until this date. Buy/sellback
and in the TSECCF are not affected in any way. The TSAA
transactions represent an asset for the period of the contract.
of the asset is reduced by an amount equal to the notional
of the repo agreement, whereas the cash flow received by • Security lending: similar to sell/buyback transactions in terms
the bank at the start and the negative cash flow at the end of exchange of the asset, but no cash is paid by the counter-
are both entered in the TSLGC. Repo transactions produce a party to the bank (except a periodic fee as service remunera-
liability in the balance sheet, since they can be seen as collat- tion). Only possession passes to the counterparty, so that
eralized debts of the bank. the payments received for the asset before the end of the
contract belong to the bank and they enter the TSECF and
• Reverse repo transactions: at the start of the agreement the
the TSECCF, as does the interest paid by the countertparty at
bank pays cash for an amount equal to the price of the asset
expiry when returning the asset to the bank. The TSAA of the
reduced by the haircut and receives the asset. The asset is
asset decreases by an amount equal to the notional of the
owned by the counterparty, but it is now in the possession of
1
60

the bank, so that it can be used as collateral by the bank for


5
66
98 er

other transactions until the end of the repo agreement, when


1- nt
20

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

tions). Currently sell/buyback (and buy/sellback that we will a ad


ddres in
address
82 B

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

they do not enter the TSECF or the TSECCF, but we include gh


that all payments are returned to the seller, although h onnlyy at tthe end of
only
11 ah

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

  


lending, since the bank cannot use it as collateral or sell it. The TSAA can now be built keeping these results in mind, since
The TSLGC is not affected and the asset cannot produce any for a given asset it is defined as the collection, for each date
liquidity until the end of the contract. Security lending repre- from an initial time t0 to a terminal date tb, of the quantity in
sents an asset of the bank for the period of the contract. possession of the bank, regardless of its ownership. In fact, the
• Security borrowing: similar to buy/sellback transactions in main purpose of the TSAA is to indicate how much of the asset
terms of exchange of the asset, but no cash is paid by the can be used to extract liquidity and thus its contribution to
bank to the counterparty (except a periodic fee as service global LGC. In more formal terms, for an asset A1 we have:
remuneration). Possession passes to the bank, so that the TSAAA1(t0, tb) = {AP1(t0), AP1(t1), c , AP1(tb)} (7.8)
payments received for the asset before the end of the con-
where AP1(ti)is the quantity of the asset in possession of the
tract belong to the counterparty. The TSECF and the TSECCF
bank at time ti. On an aggregated basis, regarding a set of M
are not affected apart from the interest paid by the bank at
securities in possession of the bank, the total TSAA including all
expiry of the borrowing. The TSAA of the asset increases by
the assets is:
an amount equal to the notional of the borrowing, since the
M M M
bank can use it as collateral provided it returns it to the coun-
TSAA(t0, tb) = b a APm(t0), a APm(t1), c , a APm(tb) r (7.9)
terparty at expiry. The TSLGC is not affected but the asset m=1 m=1 m=1
can produce liquidity until the end of the contract. Security The TSAA only shows how many single securities, or all of them,
borrowing represents a liability of the bank. are available for inclusion in LGC. Obviously, this does not imply
Other assets, such as stocks, do not have a specific expiry that the notional amount can be fully converted into liquidity.
date. In this case contract cash flows entering the TSECF According to the type of operation (selling or repo) the price
and the TSECCF are just the initial outflow representing the and/or the haircut are factors that need to be considered to
price paid to purchase the asset and the periodic dividend determine the actual amount of liquidity that can be generated.
received. Moreover, non-maturing assets can be the underly- Hence, we need proper models that allow the bank to forecast
ing of repo transactions, buy/sellback (sell/buyback) contracts expected (or stressed) values for the price and the haircut, both
and security lending (and borrowing): the analysis is the same at the single and aggregated assets level.
as above. In Example 7.4.2 we show how the interrelations amongst the
In Table 7.4 we recapitulate the results for all types of con- different term structures operate in practice.
tracts that can be written on assets. It is worth noting that
TSLGC is always affected either because the contract is dealt
to generate BSL or because LGC is potentially increased Example 7.4.2
over its lifetime. The only contract that does not increase The bank buys a bond at time 0 for a notional amount of
the TSLGC is security lending, which actually decreases LGC 1,000,000 at a price of 98.50; the payment is settled after
related to BSL. 3 days, when the bond’s possession also passes to the bank.

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

Changes to

Type Ownership Possession TSECF/TSECCF TSAA TSLGC

Buy Bank Bank Yes Yes No/Possible


Sell Counterparty Counterparty Yes Yes Yes
1
60

Repo Bank Counterparty No Yes Yes


5
66
98 er
1- nt
20

Reverse repo Counterparty Bank Yes Yes No/Possible


ossib
ble
66 Ce
65 ks

Sell/buyback Counterparty Counterparty Yes Yes Yes


06 oo
82 B

Buy/sellback Bank Bank Yes Yes No/Possible


N
No/P
-9 a
58 a k
11 h

Security lending Bank Counterparty Yes Yes No


N
41 M

Security borrowing Counterparty Bank Yes Yes No/Possible


20
99

Chapter 7 Monitoring Liquidity ■ 145

  


Table 7.5 Purchase of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0.01 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

Table 7.6 Selling of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0.01 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
98 er

1 Coupon 25,000 512,000 99.90 15


1- nt
20
66 Ce

1.25 512,000 99.90 5


15
65 ks
06 oo

1.5 Coupon 25,000 -885,000 512,250 99.95 15


82 B
-9 ali

1.75 — 512,250 99.95 15


58 a k
11 ah

Coupon + - 360,000
41 M

2 525,000 — 512,500 100.00 15


Reimbursement
20
99

146 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 7.7 Repo and Reverse Repo of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0.01 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

In Table 7.8 we also show the effects of a sell/buyback of


sequence; what is more, the TSAA increases up to 1,500,000
5
66
98 er

the bond starting after 1 year and 3 months (1.25 years)


ars)) and
ears)
1- nt
20

since the bond is in possession of the bank. All this is shown in


66 Ce

Table 7.7. The TSCLGC is left unchanged.


65 ks
06 oo
82 B

At the end of the reverse repo contract, assuming the interest


-9 ali

rate paid by the counterparty is 11%, the inflow received by the 5


58 ak

We assume the bank closed a buy/sellback k trans


tran
transaction
sactio that was not
11 ah

bank is: following more recent conventions, wherebyby th


he eff
the effects would be the
41 M

F is cconcerned. The effects


same as in the repo case as far as the TSECF
424,681 * (1 + 11% * 0.5) = 471,396 hose we describe here.
on the TSAA would remain the same as those
20
99

Chapter 7 Monitoring Liquidity ■ 147

  


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

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0.01 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.

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

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0.01 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
66
98 er

1 Coupon 50,000 1,000,000 99.90 15


1- nt
20
66 Ce

1.25 Start borrowing -877,500 1,000,000 99.90 15


5
65 ks
06 oo

1.5 Coupon 50,000 -827,500 1,000,000 99.95 15


82 B
-9 ali

1.75 End borrowing -4,500 - 832,000 1,000,000 99.95 15


58 a k
11 ah

Coupon +
41 M

2 1,050,000 218,000 — 100.00 15


Reimbursement
20
99

148 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The bank borrows a quantity of 300,000 of the same bond at If the Treasury Department aims at preserving a positive sign for
1.25 years for a period of 6 Months. The TSAA is only affected the TSECCF for all maturities, and this cannot always be guaran-
at the start and end of the contract. The TSECF only records the teed, as soon as we add it to our analysis of the TSCLGC we end
borrowing fee paid by the bank: up with a total picture for projected expected liquidity and the
means the financial institution has at its disposal to cover nega-
300,000 * (3% * 0.5) = 4,500
tive cumulated cash flows (i.e., the TSL). The TSL must always be
positive if the financial institution has to be solvent all the time.
The TSLe includes all possible expected cash flows generated
by ordinary business activity, new business, the liquidity policy
7.5 THE TERM STRUCTURE operated and the measures taken to cope with negative cumu-
OF EXPECTED LIQUIDITY lated cash flows. If in the end it is impossible to exclude nega-
tive expected cumulated cash flows, then it is also impossible to
The term structure of expected liquidity (TSLe) is basically a prevent the financial institution from becoming insolvent.
combination of the TSECCF and the TSLGC. Formally, it can be
written as:
Example 7.5.1
TSLe(t0, tb) = {TSECCF(t0, t0), TSECCF(t0, t1) + TSCLGC(t0, t1),
Let us revert back to Example 7.4.1 and expand it to take
TSECCF(t0, t2) + TSCLGC(t0, t2), c ,
account of the TSAA and the TSCLGC with the objective of
TSECCF(t0, tb) + TSCLGC(t0, tb)} (7.10) finally building a TSLe. The main results are shown in Table 7.10.

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

Years TSECF TSECCF TSCLGC TSLe TSAA Price

0 0 0 0 0 30 97.00
1 22.4 22.4 0 22.4 30 97.20
2 -8.6 13.8 0 13.8 30 97.45

3 1.8 15.6 0 15.6 30 97.60


4 1.8 17.4 0 17.4 30 98.00
5 51.8 69.2 0 69.2 30 98.20
6 -1.2 68 0 68 30 98.60
1
60

7 -71.2 - 3.2 3.96 0.76 26 99.00


.0
5
66
98 er
1- nt
20

8 1.69 -1.51 3.96 2.45 26 99.50


99
9.50
66 Ce
65 ks

9 1.69 0.18 3.96 4.14 26 99.75


9
06 oo
82 B

10 27.69 27.87 3.96 31.83 —


-9 ali
5 8 ak
11 ah

100.00
41 M

710 - 20 7.87 0 7.8


20
99

Chapter 7 Monitoring Liquidity ■ 149

  


80 Nonetheless, the fact that cash flows are sto-
TSECCF
chastic suggests that not only one synthetic
70 TSCLGC
metric of the distribution (i.e., the expected
TSLe
value) should be taken into account, but also
60
some other measure related to its volatility.
50 In this way it is possible to build the same
term structure we analysed above from a
40 different perspective showing the extreme
values that both positive and negative cash
30
flows may assume during the time of their
20 occurrence.

In order to achieve this result, we need to link


10
the single cash flows originated by contracts
0 on and off the balance sheet to risk factors
0 1 2 3 4 5 6 7 8 9 10 >10 related to market, credit and behavioural
–10 variables. Here we show the general prin-
Figure 7.6 Term structure of expected cumulated cash flows, of ciples to build term structures that we define
cumulated liquidity generation capacity and of expected liquidity. as unexpected with respect to the expected
ones we looked at earlier.
The first concept to introduce is the positive
It should be noted that selling the bonds affects the TSECF,
cash-flow-at-risk, defined as
and hence the TSECCF, in the two ways shown in the previous
section: there are fewer inflows for interest paid by the bond cfaRa+(t0, ti) = cfa+(t0, ti; x) - E[cf(t0, ti; x)]
and the final reimbursement is lower as well. In this example = cfa+(t0, ti; x) - cfe(t0, ti; x)
the change in the TSECF does not produce other negative On a given date ti, determined by the reference date t0, the
cumulated cash flows, so the LGC can be limited to selling maximum positive cash flow, computed at a given confidence
the bond. level a(cfa+(t0, ti; x)), is reduced by an amount equal to the
The TSLe is the sum of the TSECCF and the TSCLGC at each expected amount of the (sum of positive and negative) cash
period as shown in Table 7.10: it is always greater than or flows on the same date (cfe(t0, ti; x)). It is worthy of note that
equal to zero, so the bank is in (expected) liquidity equilib- we have added a dependency of the cash flows on x: this is an
rium. Figure 7.6 shows how the TSECCF, the TSCLGC and the array x = [x1, x2, c , xR] of R risk factors, which include market,
TSLe have evolved: the first and the last term structure clash credit and behavioural variables.
on the same line until the seventh year, when the TSECCF Analogously, a negative cash-flow-at-risk is defined as:
becomes negative and it has to be counterbalanced by
cfaR1- - a(t0, ti) = cf1- - a(t0, ti; x) - E[cf(t0, ti; x)]
the TSCLGC.
= cf1- - a(t0, ti; x) - cfe(t0, ti; x)

where in this case on a given date ti, determined by the ref-


erence date t0, the minimum negative cash flow, computed
7.6 CASH FLOWS AT RISK at a given confidence level a(cfa+(t0, ti; x)), is netted with the
AND THE TERM STRUCTURE expected cash flow occurring on the same date (cfe(t0, ti; x)).

OF LIQUIDITY AT RISK Note that the distribution of cash flows ranges from the small-
1
60

est, possibly but not necessarily, negative ones to the largest,,


5
66
98 er

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
66 Ce

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

bigger than cfa+(t0, ti; x), whose total probability of occurrence


06 oo

chastic in either or both dimensions. This is the resaon we intro- ccurrrenc is


82 B

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

   


Table 7.11 Notional Amount Indexed to Different Libor Fixings and Fixed Cash Flows, for Cash Flows Occurring
in a Period of 20 Days

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

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


Example 7.6.1
duce the term structure of unexpected positive cash flows, given
a confidence level of a. This is the collection of positive cfaR We present a simplified TSCF and TSECF for a set offixed and
for all the dates included between the start and the end of the floating cash flows for a period covering 14 days. The notional
observation period: amount for each date and for each type of index is shown in
Table 7.11. For example, on the first day a contract of 1,000,000
TSCFa+(t0, tb) = {cfaRa+(t0, t0), cfaRa+(t0, t1), c , cfaRa+(t0, tb) (7.11) produces an outflow indexed to 1-month Libor: it could be a
bond the bank issued. There are also some dates when cash
Similarly, the term structure of unexpected negative cash flows,
flows are not indexed to a floating rate, such as Libor, but have
given a confidence level of 1 - a, is:
a fixed rate.
- - - -
TSCF1-a (t0, tb) = {cfaR1-a (t0, t0), cfaR1-a (t0, t1), c , cfaR1-a (t0, tb)
We simulate 10,000 scenarios with a stochastic model for the evo-
(7.12)
lution of the interest rate: the Cox, Ingersoll and Ross model (CIR,
The TSCFa+ and TSCF1-a -
can be described as the upper and [54]).6 Each simulation allows different fixing levels for each date to
lower bound of the term structure of cash flows, centred be computed, then correspondingly we can determine the TSCF.
around the expected level that is given by the TSECF. It For each date we will have 10,000 possible cash flows that are
does not make much sense to build a cumulated TSCFa+ and ordered from the lowest to the highest. We choose a confidence
1

level a = 99%, which lets us identify the minimum cash flow


60

- flo as the
TSCF1-a , since they will rapidly diverge upward or downward
5
66
98 er

at unreasonable levels without providing accurate informa-


1- nt
20
66 Ce

tion for liquidity risk management. It is much more useful to


65 ks
06 oo

build a term structure of unexpected liquidity that includes


82 B

both the term structure of cash flows and liquidity generation


-9 ali

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

lowing CIR parameters r0 = 2%, k = 0.5%, %, u = 4.5


4.5% and s = 7.90%.
dwell on that below; but first we give an example of TSCFa+
41 M

We do not consider any spread between the e fixin


fixing (Libor) rates and the
-
and TSCF1-a . risk-free rate.
20
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Chapter 7 Monitoring Liquidity ■ 151

   


250,000.00 Min the last two dates (as shown in Table 7.12). In this
200,000.00 Max case, if the index rate to which the cash flows are
150,000.00 Average linked fixes higher than the cap’s strike level the
100,000.00 level is always considered equal to the strike.
50,000.00 The results are shown in Figure 7.8: they are derived
in the same way as above but they take the caps
–50,000.00 1 6 11 16 into account as well. Compared with the results in
–100,000.00 Figure 7.7, it is easy to see that caps have the effect
–150,000.00 of lowering the maximum cash flow and reducing the
–200,000.00 expected (average) level as well. The effects are not
unequivocally predictable, they depend on the strike
–250,000.00
level, the notional amount and the buying or selling
–300,000.00
of the optionality. In any case a simulation is needed
Figure 7.7 Maximum, minimum (at the A = 99% c.l.) and to verify the distribution of cash flows for a given
expected (average) cash flows for a period of 20 days. period.

100th and the maximum cash flow as the 9,900th in the ordered
As anticipated before setting out Example 7.6.1, it makes little
set of cash flows for the 14 days. Moreover, we compute the
sense to construct a TSL-at-risk simply as the sum of the TSCCF
expected level on each date, which is simply the average of the
and the TSCLGC computed separately at a given confidence
10,000 possible cash flows. The result is shown in Figure 7.7. It is
level. In fact, if we try to build a maximum or a minimum TSCCF
worthy of note that the minimum cash flow is not necessarily an
by Slimming the items that comprise the TSCFa or the 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

9 2,500,000 2,500,000 2,000,000


56
66
98 er

10 2,000,000 3,000,000 2,500,000 500,000 25,000


000
0
20
1- n
66 Ce

11
65 ks
06 oo

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


82 B
-9 ali

13
58 ak
11 ah

14 2,000,000 3,000,000 2,500,000 500,000 4.50% 4.75% 5.00% 5.25%


25%
% 25,000
41
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152 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


300,000.00 Min respectively, are identified. We denote
Max them as cfa(t0, tm) and cf1 - a(t0, tm),
Average respectively.
200,000.00
Let us now define the TSL at the maximum
100,000.00 and minimum extremes. In fact, the TSL with
maximum cash flows at confidence level a is
simply the collection of maximum cash flows
derived using Procedure 7.6.1:
1 6 11 16
TSLa(t0, tb) = {cfa(t0, t1), c , cfa(t0, tb)} (7.13)
–100,000.00
with the initial condition that TSLa(t0, t0) = Cash
(t0). Similarly, the TSL with minimum cash flows
–200,000.00
at confidence level 1 - a is:

TSL1-a(t0, tb) = {cf1-a(t0, t1), c , cf1 - a(t0, tb)}


–300,000.00
(7.14)
Figure 7.8 Maximum, minimum (at the A = 99% c.l.) and expected
(average) cash flows for a period of 20 days, with some cash flows capped. The two term structures of liquidity that we
have just defined, together with the term
structure of expected liquidity TSLe, allow us
although calculated at their minimum at the chosen confidence
to define a term structure of liquidity-at-risk (TSLaR): this is a col-
level, are actually netted by the LGC that is forecast at its maxi-
lection of unexpected cash flows at each date in a given period
mum at the same confidence level. So, negative cash flows do
[t0, tb], calculated as the difference between the minimum and
not really cumulate at extreme values, when considered at the
the average level of cash flows. Although it is possible to com-
all-encompassing balance sheet level. While it is possible from
pute the TSLaR for both the unexpected maximum and mini-
a mathematical point of view, and meaningful from a risk man-
mum levels, for risk management purposes it is more sensible
agement point of view, to build the TSECCF and the expected
to refer to the minimum unexpected levels, since unexpected
TSCLGC separately and then sum them together in the TSLe, it is
levels, since unexpected inflows should not bring about prob-
mathematically wrong and managerially misleading to sum two
lems. Then we formally define the TSLaR, at a confidence level
term structures computed separately at extreme levels.
of 1 - a, as:
From these considerations, we need to calculate at an aggre-
gated level the net cash flows included in both the TSCF and TSLaR1-a(t0, tb) = {cf1-a(t0, t1) - TSECCF(t0, t1) - TSCLGC(t0, t1),
the TSLGC. To this end we can use the following procedure. c , cf1-a(t0, tb) - TSECCF(t0, tb) - TSCLGC(t0, tb)} (7.15)
Procedure 7.6.1. The steps to compute aggregated cash flows
It is easy to check, by inspecting formulae (7.15) and (7.10), that
and their maxima and minima are:
each element of the TSLaR1-a is the difference between corre-
1. Simulate a number N of possible paths for all the R risk fac- sponding elements of the TSL1-a and the TSLe.
tors of the array x = [x1, x2, c , xR]; each path contains M
We have already mentioned that the curves presented in this
steps referring to as many calendar dates.
section have to be computed by simulating the risk factors
2. For each scenario n ∈ {1, c , N}, the cash flows included in
affecting all the cash flows at a balance sheet level. Although
the TSCF and the TSLGC are algebraically summed for each
their use is generally restricted to simulation engines to gener-
of M steps: we obtain a matrix N * M of aggregated cash
ate the TSLe and the TSL1-a, they can be used at a less general
flows:
level to:
1
60

D
5

cf(t0, tm; n) = a cf(t0, tm; dj, n)


66
98 er

• calculate single metrics of interest, such as the TSAASAA


AA of
o
1- nt
20

j=1
66 Ce

a single bond or of a portfolio of bonds, the TSLTSLGC


SLLGC
GCC of
65 ks

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
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Chapter 7 Monitoring Liquidity ■ 153

   


• measure single phenomena such as prepayments, usage of way should never form the basis for aggregation into a compre-
credit lines or the evolution of non-maturing liabilities (e.g., hensive measure of liquidity risk.
sight deposits);
We present models that allow the bank to simulate the cash
• price the liquidity risk embedded in banking and trading flows of the main items on its balance sheet and to build
book products. all the metrics we have described. But before doing so, we
When used independently the information derived by the mod- have to spend more time considering the liquidity buffer
els is useful for pricing and risk management, with the caveat and term structure of funding liquidity and the interrelations
that we are getting away from the more general picture where existing between them when the bank plans an equilibrium
correlation effects play a big role. Thus, results obtained in this liquidity policy.

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
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154 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


The Failure
Mechanics
8
of Dealer Banks
■ Learning Objectives
After completing this reading you should be able to:

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

● Identify situations that can cause a liquidity crisis at a


dealer bank and explain responses that can mitigate
these risks.

1
60
5
66
98 er
1- nt
20
66 Ce
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
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155

  


A bank is conventionally viewed as an intermediary between such services as information technology, trade execution,
depositors, who desire short-term liquidity, and borrowers, who accounting reports, and—more important to our story—holding
seek project financing. Occasionally, perhaps from an unex- the hedge funds’ cash and securities. These hedge funds have
pected surge in the cash withdrawals of depositors or from a heard the rumors and have been watching the market prices of
shock to the ability of borrowers to repay their loans, depositors Alpha’s equity and debt in order to gauge Alpha’s prospects.
may become concerned over the bank’s solvency. Depositors They begin to shift their cash and securities to better capital-
may then “run,” accelerating or worsening the bank’s failure. ized prime brokers or, safer yet, custodian banks. Because Alpha
The standard policy tools for treating the social costs of bank had relied in part on its clients’ cash and securities to finance
failures include regulatory supervision and risk-based capital its own business, these departures reduce Alpha’s financial
requirements to reduce the chance of a solvency threatening flexibility.
loss of capital; deposit insurance to reduce the incentives of
Alpha notices that some of its derivatives counterparties
individual depositors to trigger cash insolvency by racing each
(entities with whom Alpha has entered derivative contracts)
other to withdraw their deposits; and regulatory resolution
have begun to lower their exposures to Alpha. Their transac-
mechanisms, which give authorities the power to efficiently
tions are more and more slanted toward trades that drain
restructure or liquidate a bank.
cash toward the counterparties and away from Alpha. In addi-
During the recent financial crisis, major dealer banks—that is, tion, other dealer banks are increasingly being asked to enter
banks that intermediate markets for securities and derivatives— derivatives trades, called “novations,” that have the effect
suffered from new forms of bank runs. The most vivid examples of inserting the other dealers between Alpha and its original
are the 2008 failures of Bear Stearns and Lehman Brothers. derivatives counterparties, insulating those counterparties from
Dealer banks are often parts of large complex financial organi- Alpha’s default risk. As those dealers notice this trend, they
zations whose failures can damage the economy significantly. begin to refuse novations that would expose them to Alpha’s
As a result, they are sometimes considered “too big to fail.” default. This damages Alpha’s reputation. Further, the cash
The mechanics by which dealer banks can fail and the policies collateral placed with Alpha by its derivatives counterparties,
available to treat the systemic risk of their failures differ mark- which had been an extra source of financing to Alpha, is rapidly
edly from the case of conventional commercial bank runs. These dwindling.
failure mechanics are the focus of this article.
Alpha’s short-term secured creditors see no good reason to
As an illustration, consider a protagonist dealer bank, whom renew their loans to Alpha. Potentially, they could get caught
we shall call Alpha Bank, whose capital position has just been up in the administrative mess that would accompany Alpha’s
severely weakened by trading losses. The cause need not be default. Most of them fail to renew their loans to Alpha. A large
a general financial crisis, although that would further reduce fraction of these short-term secured loans are in the form of
Alpha’s chances for recovery. repurchase agreements, or “repos.” The majority of these repos
Alpha seeks new equity capital to shore up the value of its have a term of one day. Thus, on short notice, Alpha needs to
business, but potential providers of new equity question find significant new financing or to conduct costly fire sales of its
whether their capital infusions would do much more than securities.
improve the position of Alpha’s creditors. They also feel too Alpha’s liquidity position is now grave. In the normal course of
uninformed about the value of Alpha’s assets and future busi- business, Alpha’s clearing bank allows Alpha and other dealers
ness opportunities to offer a price for new shares that Alpha, the flexibility of “daylight overdrafts” of cash for the intraday
given its own information, is willing to accept. financing of trades. The clearing bank routinely holds Alpha’s
In a rational gamble to signal its strength and to protect its long- securities in amounts sufficient to cover these overdrafts.
run brand reputation and customer network, Alpha uses some of Finally, however, Alpha receives word that its clearing bank has
its scarce capital to bail out important clients from the significant exercised its right to stop processing Alpha’s cash and securities
1
60

losses that they have suffered through investments arranged by transactions given the exposure of the clearing bank to Alpha’s ha
as
5
66
98 er

Alpha. Alpha’s managers understand their bank’s vulnerability overall position. Unable to execute trades or to send cash h to
1- nt
20
66 Ce

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
20
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156 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


addition to their securities and derivatives businesses, may oper- Table 8.1 Dealers Invited to an April 1, 2009,
ate traditional commercial banks or have significant activities in Meeting on Over-the-Counter Derivatives, Hosted
investment banking, asset management, and prime brokerage. by the New York Federal Reserve Bank
Most of these are among the dealer banks listed in Table 8.1
that were invited by the New York Federal Reserve to a meeting Bank of America, N.A.
concerning over-the-counter derivatives on April 1, 2009. This Barclays Capital
list overlaps substantially with the list of primary dealers in U.S. BNP Paribas
government securities.1 As Table 8.1 suggests, large dealer
Citigroup
banks typically operate under the corporate umbrellas of
holding companies. Credit Suisse

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
98 er
1- nt
20

institutional and wealthy individual investors. Dealer er banks


baanks also
66 Ce
65 ks

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

primary dealers in U.S. government securities are the Royal Bank of


11 ah

Scotland Group, Société Générale, and Wachovia Bank (now owned by partnerships, of which the bank acts effectively
effecctivel as a general
41 M

Wells Fargo). partner with limited-partner clients.


20
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Chapter 8 The Failure Mechanics of Dealer Banks ■ 157

   


Dealer banks are typically parts of large financial organizations investing, often called proprietary trading, which can be aided
that operate other financial businesses, although these will not in part by the ability to observe flows of capital into and out of
be our focus here. For example, many large dealer-banks have certain classes of securities.
conventional commercial banking operations, including deposit
Securities dealers also intermediate in the market for repur-
taking as well as lending to corporations and consumers. They
chase agreements, or “repos.” A repo is in essence a short-
may also act as investment banks, which can involve managing
term cash loan collateralized by securities. One counterparty
and underwriting securities issuances and advising corporate
borrows cash from the other, and as collateral against per-
clients on mergers and acquisitions. Investment banking some-
formance on the loan, that counterparty posts government
times includes “merchant banking” activities, such as buying
bonds, corporate bonds, securities from government-sponsored
and selling oil, forests, foodstuffs, metals, or other raw
enterprises, or other securities such as collateralized debt obli-
materials.2
gations. For example, a hedge fund that specializes in fixed-
One suspects that some of the risk-management failures discov- income securities can finance the purchase of a large quantity
ered during the financial crisis are associated with diseconomies of securities with a small amount of capital by placing purchased
of scope in risk management and corporate governance. In securities into repurchase agreements with a dealer, using the
other words, some senior executives and boards simply found it cash proceeds of the repo to purchase additional securities. The
too difficult to comprehend or control some of the risk-taking majority of repurchase agreements are for short terms, typi-
activities inside their own firms.3 cally overnight. These repurchase agreements are commonly
renewed with the same dealer or replaced by new repos with
other dealers. The performance risk on a repo is typically miti-
Securities Dealing, Underwriting, gated by a “haircut” that reflects the risk or liquidity of the secu-
and Trading rities. For instance, a haircut of 10 percent allows a cash loan of
Dealer banks intermediate in the primary market between $90 million to be obtained by posting securities with a market
issuers and investors of securities, and in the secondary mar- value of $100 million.
ket among investors. In the primary market, the dealer bank, For settlement of their repo and securities trades, dealers typi-
sometimes acting as an underwriter, effectively buys equities cally maintain “clearing accounts” with other banks. JPMorgan
or bonds from an issuer and then sells them over time to inves- Chase and the Bank of New York Mellon handle most dealer
tors. In secondary markets, a dealer stands ready to have its clearing. Access to clearing bank services is crucial to a dealer’s
bid prices hit by sellers and its ask prices hit by buyers. Dealer daily operations. Transactions cannot otherwise be executed.
banks dominate the intermediation of over-the-counter securi-
In order to mitigate counterparty risk, some repurchase agree-
ties markets, covering bonds issued by corporations, munici-
ments are “tri-party.” The third party is usually a clearing bank
palities, certain national governments, and securitized credit
that holds the collateral and is responsible for returning the cash
products. Over-the-counter trades are privately negotiated.
to the creditor. In principle, this facilitates trade and insulates
Trade between dealers in some securities, particularly govern-
the lender somewhat from the risk of a borrower’s default. In
ment bonds, can also be intermediated by interdealer brokers
2007, tri-party repos totaled $2.5 trillion (Geithner, 2008). The
and electronic trading platforms (which are essentially “bulletin
same two clearing banks, JPMorgan Chase and the Bank of New
boards” on which bids or offers can be commonly observed
York Mellon, are also dominant in tri-party repos. In Europe, tri-
by other dealers). Although public equities are easily traded
party repos are also arranged through specialized repo clearing
on exchanges, dealers are also active in secondary markets for
services: Clearstream and Euroclear.
equities—for example, dealers often intermediate large block
trades. Banks with dealer subsidiaries also engage in speculative
Over-the-Counter Derivatives
1
60

Derivatives are contracts that transfer financial risk from one


5

2
The relevant research, for example Boot, Milbourn, and Thakor (1999),
66
98 er

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

scope in information technology, marketing, and financial innovation.


06 oo

shielding the investor from the risk that the cost of acquiring
acquuiring the
82 B

For potential synergies between commercial and investment banking,


asset could rise. Derivatives are traded on exchanges
angees and over
-9 ali

see Kanatas and Qi (2003).


58 ak

the counter. Because over-the-counter derivatives es are negoti-


atives
11 ah

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
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158 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


counterparties is a dealer. The dealer usually lays off much or all Normally, various over-the-counter derivatives trades between
of the risk of its client-initiated derivatives positions by running a a given pair of counterparties are legally combined under a
“matched book,” that is, by aiming for offsetting trades, profit- “master swap agreement” between those two counterparties,
ing on the differences between bid and offer terms. As in their conforming to standards set by the International Swaps and
securities businesses, dealer banks also conduct proprietary Derivatives Association (ISDA). Among other provisions, master
trading in over-the-counter derivatives markets. swap agreements spell out collateral requirements as well as
The notional amount of an over-the-counter derivative contract the obligations of the two counterparties in the event that one
is typically measured as the market value—or, in the case of of them cannot perform. As the market values of the derivatives
bond derivatives, the face value—of the asset whose risk is contracts between two counterparties fluctuate, the collateral
transferred by the derivative. For example, a call option to buy required is recalculated, normally on a daily basis, and is netted
one million shares of an equity whose price is $50 per share across the various derivatives held between the two counter-
represents a notional position of $50 million dollars. The total parties. For example, suppose that A has an exposure to B of
notional amount of over-the-counter derivatives outstand- $100 million on an oil derivative, while B has an exposure to A
ing is roughly $600 trillion dollars, according to the Bank of of $80 million on an interest-rate derivative. If the master-swap
International Settlements. In notional terms, exchange-traded agreement specifies full collateralization of the net exposure,
derivatives positions total to approximately $400 trillion. The then B posts $20 million of collateral with A. Thus, netting under
majority of over-the-counter derivatives are interest-rate swaps, a master swap agreement lowers exposures and lowers collat-
which are commitments to make periodic exchanges of one eral requirements.
interest rate, such as the variable London Interbank Offered As the financial crisis that began in 2007 deepened, the range
Rate (LIBOR), for another interest rate, such as a fixed rate, on of acceptable forms of collateral taken by dealers from their
a stated notional principal until a stipulated maturity date. The over-the-counter derivatives counterparties was narrowed. By
largest over-the-counter derivatives dealer by volume is 2008, over 80 percent of collateral for these agreements was in
JPMorgan, with a total notional position of approximately the form of cash, according to a survey conducted by the Inter-
$80 trillion, according to the U.S. Office of the Comptroller of national Swaps and Derivatives Association (2009). The total
the Currency (2009). amount of collateral demanded also nearly doubled in 2008,
from about $2 trillion in 2007 to about $4 trillion in 2008.
It is an accounting identity that the total market value of all
derivatives contracts must be zero—that is, the total amount Table 8.2 shows the total exposures represented by the over-
of positive (purchased) positions is equal to the total amount the-counter derivatives portfolios of major dealers, in each of
of negative (sold) positions. Contingent on events that may the major asset classes, as estimated from dealer surveys by the
occur over time, derivatives transfer wealth from counterparty Bank for International Settlements (2009a). At least one of the
to counterparty, but do not directly add to or subtract from the two counterparties of most over-the-counter derivatives is typi-
total stock of wealth. Indirectly, however, derivatives can cause cally a dealer. Frequently, both parties are dealers. The final row
net losses through the frictional costs of bankruptcies, such as of Table 8.2 shows a substantial reduction in exposure due to
legal fees, and other costs associated with financial distress. netting.
Derivatives markets also serve a social purpose of transfer-
Dealers are especially likely to be counterparties to other deal-
ring risk from those less equipped to bear it to others more
ers in the case of credit default swaps, which are in essence
equipped to bear it.
insurance against the default of a named borrower. When a
In addition to the risk associated with the contingent payments hedge fund decides to reduce a credit default swap position,
promised by a derivatives contract, there is also the risk that the a typical step is to have its original credit default swap position
counterparty could fail to meet its promised payments. A use- “novated” to another dealer, which then stands between the
ful gauge of counterparty risk in the over-the-counter market is hedge fund and the original dealer by entering new back-to-
1
60

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
66 Ce

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

$40 million. positions. Since mid-2008, when the e total


tota notional size of the
41
20
99

Chapter 8 The Failure Mechanics of Dealer Banks ■ 159

   


Table 8.2 Exposures of Dealers in Over-the-Counter wrap the client’s limited-partner position within the scope of
Derivatives Markets by Asset Class, as of June 2009 general asset-management services for that client.
(net exposures do not include non-U.S. credit default A limited partner in an internal hedge fund may perceive that
swaps) a large dealer bank is more stable than a stand-alone hedge
Asset Class Exposure ($ billions) fund and that the dealer bank might even voluntarily support
an internal hedge fund at a time of extreme need. For example,
Credit default swap 2,987 near the end of June 2007, Bear Stearns offered to lend
Interest rate 15,478 $3.2 billion to one of its failing internal hedge funds, the High-
Equity linked 879 Grade Structured Credit Fund (Barr, 2007b). In August 2007, at
a time of extreme market stress and losses to some of its inter-
Foreign exchange 2,470
nal hedge funds, Goldman Sachs (2007) injected a significant
Commodity 689 amount of capital into one of them, the Global Equity Opportu-
Unallocated 2,868 nities Fund. In February 2008, Citigroup provided $500 million
in funding to an internal hedge fund known as Falcon (CNBC,
Total 25,372
2008). Such actions can be viewed as a rational attempt by
Total after netting 3,744 dealer banks to protect their reputation and to reassure impor-
Source: Bank for International Settlements, November, 2009. tant clients that their financial position is secure.

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

ance sheets. For example, at June 2008, Citigroup, Inc. reported


60

Dealer banks often have large asset-management divisions


5
66

over $800 billion in off-balance-sheet assets held in such “quali-


quali-
quali
98 er

that cater to the investment needs of institutional and wealthy


1- nt
20
66 Ce

fied special purpose entities.”


individual clients. The services provided include the holding of
65 ks
06 oo

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

  


dramatically in the United States and subprime residential mort- over recent years, they have financed the purchase of their secu-
gage defaults rose, the solvency of many structured investment rities inventories with short-term repurchase agreements. The
vehicles was threatened—especially as some short-term credi- counterparties of these repos are often money-market funds,
tors to these funds recognized the solvency concerns and failed securities borrowers, and other dealers. Repos with a term of
to renew their loans. one day, called “overnight repo,” are common. Under normal
pre-crisis conditions, a dealer bank might have been able to
Some large dealer banks bailed out investors in some of their
finance most of its holdings of agency securities, Treasuries, cor-
structured investment vehicles. For example, in late 2007, HSBC
porate bonds, mortgages, and collateralized debt obligations
voluntarily committed about $35 billion to bring elements of its
by daily renewal of overnight repos with an average haircut of
structured investment vehicles onto its balance sheet (Goldstein,
under 2 percent. The dealer could therefore hold these securi-
2007). Citigroup followed in December 2007 by bringing
ties with little incremental capital.
$49 billion in assets and liabilities of structured investment
vehicles onto its own balance sheet (Moyer, 2007). As with Before their failures, Bear Stearns and Lehman had leverage
the support provided to distressed internal hedge funds, the ratios (the ratio of assets to equity capital) of over 30, with sig-
equity owners and managers of these banks may have feared nificant dependence on short-term repo financing. Although the
that the alternative of providing no recourse to their effective repo creditors providing cash to a dealer bank have recourse to
clients would have resulted in a loss of market value through collateralizing assets, with haircuts that protect them to some
a reduction in reputation and market share. Some of these degree from fluctuations in the market value of the collateral,
banks, had they been able to foresee the extent of their later they may have little or no incentive to renew repos in the face of
losses during the financial crisis, might have preferred to allow concerns over the dealer bank’s solvency. Additionally, the repo
their off-balance clients to fend for themselves. creditors could be legally required to sell the collateral immedi-
ately4 or could potentially face litigation over allegations of
improper disposal of the collateral. The repo creditors can avoid
8.2 FAILURE MECHANISMS these risks and other unforeseen difficulties simply by reinvest-
FOR DEALER BANKS ing their cash in new repos with other dealers.
If a dealer bank’s repo creditors fail to renew their positions en
The relationships between a dealer bank and its derivatives
masse, the ability of the dealer to finance its assets with suf-
counterparties, prime-brokerage clients, potential debt and
ficient amounts of new private-sector cash on short notice is
equity investors, clearing bank, and other clients can change
doubtful. The dealer may therefore be forced to sell its assets
rapidly if the solvency of the dealer bank is threatened. The
in a hurry to buyers that know it needs to sell quickly. This
concepts at play are similar to those of a depositor run at a com-
scenario, called a “fire sale,” can easily result in much lower
mercial bank. That is, fears over the solvency of the bank lead
prices for the assets than might be expected in a more orderly
others to act so as to reduce their potential losses in the event
sale. The proceeds of an asset fire sale could be insufficient to
of the bank’s default. Unlike insured depositors at a commercial
meet the dealer’s cash needs, especially if the dealer’s original
bank, many of those with exposures to dealer banks have no
solvency concerns were prompted by declines in the market
default insurance, or do not wish to bear the frictional costs of
values of the collateral assets themselves. A fire sale could
involvement in the bank’s failure procedures even if they do
also lead to fatal inferences by other market participants of
have insurance. The key mechanisms that lead to the failure of a
the weakened condition of the dealer. Further, the low prices
dealer bank are the flight of short-term creditors, the departures
recorded in a fire sale could lower the market valuation of the
of prime-brokerage clients, various cash-draining actions by
securities not sold, and thus reduce the amount of cash that
derivatives counterparties that are designed to lower their expo-
could be raised through repurchase agreements collateralized
sures to the dealer bank, and finally and most decisively, the
by those securities, prompting a “death spiral” of further fire
loss of clearing-bank privileges. We will describe each of these
1

sales. For the same reason, fire sales by one large bank could ld
60

types of “run-on-the-bank” behavior in turn and then discuss


5
66
98 er

set off fire sales by other banks, causing a systemic risk.


sk.
implications for potential improvements in market infrastructure
1- nt
20
66 Ce

or regulation.
65 ks
06 oo
82 B

4
In the United States, money market funds, typically
pically ope
pically operating under
-9 ali

The Flight of Short-Term Creditors


58 ak

Rule 2a-7 of the Securities and Exchange Commission,


ommis ssion have restrictions
mmisssion,
11 ah

on the types of assets they are permitted to hoold an


hold and would be required
41 M

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

Chapter 8 The Failure Mechanics of Dealer Banks ■ 161

  


A dealer bank’s financing problems could be exacerbated dur- stigmatize banks that are so weak as to need to use it. Dealers
ing a general financial crisis. For example, haircuts of even that are not regulated as banks do not have access to the dis-
investment-grade corporate bonds rose from under 5 percent count window. During the financial crisis, special credit facilities
before the financial crisis to around 20 percent in the weeks fol- were established by Federal Reserve banks, allowing even deal-
lowing the failure of Lehman Brothers, while repo financing of ers that did not have access to the discount window to arrange
many forms of collateralized debt obligations and speculatively the financing of a wide range of assets or to temporarily
rated corporate bonds became essentially impossible.5 Peter exchange relatively less liquid securities for Treasuries.6 Almost
Fisher (2008) of BlackRock, an investment management firm, immediately after the failure of Lehman, the last two large deal-
wrote: “I would also suggest that the prevalence of repo-based ers that had not been regulated as banks, Morgan Stanley and
financing helps explain the abruptness and persistence with Goldman Sachs, became regulated bank holding companies,
which the de-levering has been translated into illiquidity and giving them access to the discount window, among other
sharp asset price declines.” Abate (2009) reported that corpo- sources of government support like government debt
rate bond repo transactions (which include certain mortgage- guarantees.
backed securities not backed by government-sponsored
Other central banks have taken similar steps. The European
enterprises) fell approximately 60 percent between March 2008
Central Bank (ECB) provides repo financing to Eurozone banks
and March 2009. During the week leading up to the failure of
through regular auctions, by which the ECB accepts a wide
Bear Stearns, Cohan (2009) reports on the increasing set of Bear
range of collateral at moderate haircuts. Cassola, Hortacsu, and
Stearns’ normal repo counterparties who told Bear Stearns that
Kastl (2008) show that from August 2007, when the range of col-
they would not be renewing their repo financing to Bear or were
lateral that was acceptable in the over-the-counter repo market
applying more onerous haircuts and disputing collateral
narrowed after a rash of sub-prime mortgage defaults, banks in
valuations.
the Eurozone bid significantly more aggressively for financing
A dealer bank can mitigate the risk of a loss of liquidity from a in these repo auctions. Tucker (2009) describes a range of new
run by short-term creditors in various ways: by establishing lines secured financing facilities of the Bank of England.
of bank credit; by dedicating a buffer stock of cash and liquid
The extent to which a dealer bank is financed by traditional
securities for emergency liquidity needs; and by “laddering” the
insured bank deposits may lessen its need during a solvency
maturities of its liabilities so that only a small fraction of its debt
crisis to replace cash that is lost from the exits of repo counter-
must be refinanced within a short period of time. Major dealer
parties and other less-stable funding sources. Insured deposits
banks have teams of professionals that manage liquidity risk by
are less likely to run than are many other forms of short-term
controlling the distribution of liability maturities and by manag-
liabilities. However, under Rule 23A of the Federal Reserve
ing the availability of pools of cash and of noncash collateral
Act, U.S.-regulated banks may not use deposits to fund broker-
that is acceptable to secured creditors.
dealer affiliates of the bank.
A common central-bank response to the systemic risk created
by the potential for fire sales is broad and flexible lender-of-last-
resort financing to large banks (Tucker, 2009). Such financing
The Flight of Prime Brokerage Clients
buys the time needed to liquidate financial claims in an orderly Prime brokerage, as described earlier, is an important source
manner. of fee revenue to some dealer banks. Under normal conditions,
The U.S. Federal Reserve has always provided secured financing prime brokers can also finance themselves in part with the
to regulated commercial banks through its discount window. cash and securities that clients leave in their prime brokerage
Discount-window financing, however, is available only for a accounts.
restricted range of high-quality collateral and is also believed to Here’s how it works. In the United Kingdom, securities and cash
in prime brokerage accounts are generally commingled with the
1
60

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
66 Ce

behavior of repo markets during the financial crisis. Gorton (April, 2009)
65 ks

provides estimates of the haircuts applied to various classes of securities


06 oo

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

ton’s source to have no financing in the repo market. Facility.


20
99

162 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


broker for its business purposes, including secured borrowing. failure to run, as Lehman’s London-based clients learned, could
Cash in London-based prime brokerage accounts is, for practical leave a client unable to claim ownership of assets that had not
purposes, equivalent to uninsured deposits. Prime brokers oper- been segregated in the client’s account and had been
ating under United States rules may or may not fully segregate re-hypothecated to third parties (for discussions, see Farrell,
their client’s cash, depending on the situation, according to Rule 2008; Mackintosh, 2008a; Singh and Aitken, 2009).
15c3-2 of the Securities and Exchange Act of 1934. This SEC
In the United States, ironically, a prime broker’s cash liquidity
rule governs the treatment of “free credit balances,” the cash
problems can be exacerbated by its prime brokerage business
that a client has a right to demand on short notice. Under Rule
whether or not clients run. Under its contract with its prime
15c3-3, a U.S.-regulated prime broker must aggregate its
broker, a hedge fund could continue to demand cash margin
clients’ free credit balances “in safe areas of the broker or
loans from the dealer backed by securities that the hedge
dealer’s business related to servicing its customers” or otherwise
fund has left in its prime brokerage account. A prime broker
deposit the funds in a reserve bank account to prevent commin-
whose solvency is known to be questionable may not itself be
gling of customer and firm funds.7
able to obtain cash by using those same securities as collateral
The ability to aggregate cash associated with clients’ free credit with other lenders. The dealer’s potential secured lenders, as
balances into a single pool, although separate from the prime explained earlier, could find it preferable to lend elsewhere.
broker’s own funds, provides flexibility to a prime broker in Thus, even the absence of a run by prime brokerage clients
managing the cash needs of its clients. For example, the prime could temporarily exacerbate a dealer’s liquidity crisis. A dealer
broker can use one client’s cash balances to meet the immediate could therefore even have an incentive to “fire” a prime broker-
cash demands of another. Suppose that a dealer has two prime age client to avoid providing cash margin financing to the client!
brokerage clients. It holds cash belonging to Hedge Fund A
If prime brokerage clients do run, however, the cash that they
of $150 million and has given a cash loan to Hedge Fund B for
pull from their free credit balances is no longer available to meet
$100 million. The excess cash of $50 million must be held in a
the demands of other clients on short notice, so the prime bro-
reserve account. But if Hedge Fund A moves its prime broker-
ker may be forced to use its own cash to meet these demands.8
age account to another dealer, then the original prime broker
The exit of prime brokerage clients whose assets had been used
must come up with $100 million of cash from new sources.
by the prime broker as collateral for securities lending can elimi-
Prime brokers provide financing to their clients, typically hedge nate a valuable source of liquidity to the prime broker. Even cli-
funds, secured by assets of those clients. For U.S. prime bro- ents that do not move to another prime broker may, in the face
kers, the amounts of such margin loans are limited by regulated of concerns over their broker’s solvency, move some of their
“advance rates” that are set according to asset classes. For securities into accounts that restrict the access of the prime bro-
example, the maximum amount of cash that can be advanced ker to the securities.
for equities is 50 percent of the market value of the equities.
Sorkin (2009) discusses the extreme stress on Morgan Stanley’s
Margin loans for a dealer bank can also be financed using the
cash liquidity that was caused by the departure of prime bro-
client’s own assets as collateral, through “re-hypothecation.”
kerage clients during the week of the bankruptcy of Lehman
Specifically, the prime broker can obtain the cash that it lends
Brothers. Singh and Aitken (2009) calculate that between
a client, as well as additional cash for its own purposes, by
August 2008 and November 2008, the securities that Morgan
using the client’s securities as collateral on a secured loan
Stanley had received from its clients that were available for
for itself from a third-party lender. For each $100 of margin
Morgan Stanley to pledge to others declined by 69 percent,
cash that it lends to a prime-brokerage client, the dealer is
from $832 billion to $294 billion. For Merrill Lynch and Goldman
permitted by regulation to finance itself by using up to $140
Sachs, the corresponding declines in re-pledgeable client collat-
worth of the client’s assets as collateral on new secured loans.
eral over this short period spanning the default of Lehman were
Re-hypothecation of securities received from prime brokerage
51 and 30 percent, respectively.
1

clients is, under normal conditions, a significant source of financ-


5 60

The flight of prime-brokerage clients in the face of a deal


dealer
dea er
66
98 er

ing for the prime broker.


1- nt
20

bank’s financial weakness could also raise concernss ove


over the
er th
66 Ce

When a dealer bank’s financial position is weakened, hedge


65 ks

dealer’s long-run profitability among potential prov


providers
vider of
viders
06 oo

funds may move their prime brokerage accounts elsewhere. A


emergency capital.
82 B
-9

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

cinnati College of Law. Protection Corporation (SIPC).


20
99

Chapter 8 The Failure Mechanics of Dealer Banks ■ 163

  


In the days immediately following Lehman’s default, credit collateral, fell from $126 billion in March 2008 to $81 billion in
default swap rates for Morgan Stanley exceeded 1000 basis March 2009, suggesting that counterparties significantly reduced
points, meaning that the cost of insuring $100 million of senior their exposures to a dealer whose solvency was in question. Over
unsecured Morgan Stanley debt against default losses was the same period, by comparison, over-the-counter derivatives
above $10 million per year. Some analysts believe that hedge exposures to comparatively healthy JPMorgan Chase grew from
funds are likely to diversify their sources of prime brokerage fur- $68 billion to $86 billion.
ther and in the future place more of their assets with custodian
As discussed earlier, over-the-counter derivatives agreements
banks rather than with traditional prime brokers (Hintz, Mont-
often call for posting collateral. Further, they call for increases
gomery, and Curotto, 2009).
in collateral from a counterparty whose credit rating is down-
graded below a stipulated level. For example, in its 10K filing
When Derivatives Counterparties with the Securities and Exchange Commission dated January
Duck for Cover 1, 2009 (p. 82), Morgan Stanley disclosed: “In connection with
certain OTC trading agreements and certain other agreements
If a dealer bank is perceived to have some risk of a solvency
associated with the Institutional Securities business segment,
crisis, an over-the-counter derivatives counterparty would look
the Company may be required to provide additional collateral
for opportunities to reduce its exposure to that dealer bank. A
to certain counterparties in the event of a credit ratings down-
variety of mechanisms are possible here. A counterparty could
grade. As of November 30, 2008, the amount of additional col-
reduce its exposure by borrowing from the dealer. Another
lateral that could be called by counterparties under the terms
strategy is to reduce the exposure by entering new trades with
of collateral agreements in the event of a one-notch downgrade
the dealer that cause that dealer to pay out cash for a deriva-
of the Company’s long-term credit rating was approximately
tives position. A counterparty could also seek to harvest cash
$498.3 million. An additional amount of approximately
from any derivatives positions that have swung in its favor over
$1,456.2 million could be called in the event of a two-notch
time, and thereby reduce exposure to the dealer. All of these
downgrade.” Collateral-on-downgrade triggers were the most
actions reduce the dealer’s cash position. If the dealer wants
proximate cause of the need by the insurance company AIG for
to avoid an adverse signal of its weakness, the dealer cannot
a massive U.S. government bailout.
afford to refuse its counterparties the opportunity to make these
trades at terms prevailing elsewhere in the market. Master swap agreements include terms for the early termina-
tion of derivatives in a selection of contingencies, including the
As we have explained, a counterparty to the dealer could also
default of one of the counterparties. The actual procedures
reduce its exposure through novation to another dealer (Inter-
to be followed can be complicated, as appears to be case in
national Swaps and Derivatives Association, 2004). For instance,
the Lehman bankruptcy (Lehman Bankruptcy Docket, 2008a;
a hedge fund that had purchased protection from a dealer on
2008b). The general thrust of the settlement terms in the event
a named borrower, using a credit default swap contract, could
of a default is that the nondefaulting counterparty is entitled
ask a different dealer for a “novation.” The new dealer would
to the replacement cost of the contracts it holds. For any con-
thereby offer protection to the hedge fund and buy protection
tingent claim, including a derivative contract, other dealers
itself from the original dealer, thus insulating the hedge fund
offer one price to buy and a higher price to sell. This bid–offer
from the default of the original dealer. When Bear Stearns’
spread implies an effective transaction cost that increases the
solvency was threatened in mid 2008, some of Bear Stearns’
replacement cost of the derivatives portfolio and thus raises the
counterparties asked other dealers for novations, by which
claim against the defaulting dealer. For example, Citibank had
those dealers would effectively absorb the risk of a failure by
an over-the-counter derivatives portfolio with a total notional
Bear Stearns (Burroughs, 2008; Kelly, 2008; Cohan, 2009, p. 27).
size of roughly $30 trillion in the summer of 2009 (according
Although dealers routinely grant such novations because they
to data from the Office of the Comptroller of the Currency). If
facilitate normal trading strategies, in this case other dealers
1

the effective average bid–offer spread on this portfolio is, for


60

began to refuse these Bear Stearns novations. This in turn is


5
66
98 er

example, 0.2 percent of the notional position amount, then n the


e
1- nt
20

likely to have spread alarm over Bear Stearns’s difficulties, lead-


66 Ce

effective increase in liability to Citibank associated with h a default


de
efault
ing to actions that are likely to have worsened Bear Stearns’s
65 ks

termination of its derivatives portfolio would be on the order


o
06 oo

cash position (for further discussion, see Yavorsky, 2008a; Leis-


82 B

of $60 billion. This termination loss on the derivativesess portfolio


ative
tive port
ing, 2009).
-9 a
58 ak

would be above and beyond any loss associated ed with


ted w the t fair
11 ah

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
99

164 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Further, most over-the-counter derivatives contracts are wired to the dealer’s counterparty (or that counterparty’s own
exempted by law as “qualifying financial contracts” from the clearing bank) before the necessary cash actually appears in the
automatic stay at bankruptcy that holds up other creditors of a dealer’s clearing account on that day, under the premise that
dealer. The effect of unwinding the dealer’s derivatives portfolio the dealer will receive sufficient cash from other counterparties
is a large post-bankruptcy drain on the defaulting dealer, with during the day in the course of settling other transactions.
priority to derivatives counterparties. This raises the incentive Meanwhile, the dealer holds securities in its clearing account
of other creditors to run from their exposures before default or with a market value that is likely to be more than sufficient to
to fail to finance a dealer threatened by a cash liquidity crisis, cover any potential shortfall.10 Abate (2009) estimates that the
further accelerating the default. intraday peak level of overdrafts typically occurs at about
10 a.m. and “easily exceeds several hundred billion dollars.”
One way to reduce the incentive of counterparties to flee from
an apparently weak dealer bank is to have the derivatives con- When a dealer’s cash liquidity comes into doubt, however, a
tracts guaranteed by a “central clearing counterparty,” a clearing bank has a “right of offset,” a contractual right to dis-
special-purpose financial institution whose only business is to continue making cash payments that would reduce the account
stand in between the original buyers and sellers of over-the- holder’s cash balance below zero during the day, after account-
counter derivatives (Bank for International Settlements, 2007; ing for the value of any potential exposures that the clearing
Bliss and Steigerwald, 2006; Duffie and Zhu, 2009, Hills, Rule, bank has to the account holder. In the case of Lehman’s default,
Parkinson, and Young, 1999; Ledrut and Upper, 2007). A central for instance, it has been reported that Lehman’s clearing bank,
clearing counterparty collects capital from all members and col- JPMorgan Chase, invoked this right, refusing to process Lehm-
lateral against derivatives exposures to its members in order to an’s instructions to wire cash needed to settle Lehman’s trades
cover any losses associated with defaults. Assuming that the with its counterparties (Dey and Fortson, 2008; Teather, 2008;
central clearing counterparty has sufficient resources, the origi- Craig and Sidel, 2008). Lehman was unable to meet its obliga-
nal counterparties to the dealer are insulated from the default of tions on that day and entered bankruptcy.
the dealer. As one example, Global Association of Central Coun-
terparties (2009) describes the performance of central clearing
counterparties in processing some of Lehman’s derivatives posi- 8.3 POLICY RESPONSES
tions when it defaulted.9
Policies for the prudential supervision, capital requirements,
Central clearing counterparties can handle only derivatives
and failure resolution of traditional commercial banks have
with relatively standard terms, however, and therefore would
been developed over many years and are relatively settled. The
not have been in a position to mitigate the counterparty risks
financial crisis, however, has brought significant new attention to
associated with the infamous credit derivatives of AIG Financial
policies for reducing the risks posed by large systemically impor-
Products unit, which were highly customized.
tant financial institutions, particularly dealer banks.

The regulatory changes currently envisioned for systemically


Loss of Cash Settlement Privileges important financial institutions in both the United States and
The final step in the collapse of a dealer bank’s ability to meet Europe include higher capital requirements, new supervi-
its daily obligations is likely to be the refusal of its clearing bank sory councils, and special powers to resolve these financial
to process transactions. In the normal course of business, a institutions as they approach insolvency or illiquidity. Banks
clearing bank would extend “daylight overdraft privileges” to its sponsoring securitization deals will also be required to hold at
creditworthy clearing customers. For example, the cash required least a minimum level of exposure to the securitized cash flows,
to settle a securities trade on behalf of a dealer client could be in an attempt to give them the incentive to lower the risk of 1

10
60

In the U.S. interbank market, cash payments are settled by Fe FedWire


Wire
5

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

Chapter 8 The Failure Mechanics of Dealer Banks ■ 165

  


these securitization structures. Capital requirements are likely backing. Currently, the majority of over-the-counter derivatives
to be higher for derivatives that are not guaranteed by a central positions are not centrally cleared. There has been modest prog-
clearing counterparty. Information about derivatives positions ress toward clearing significant quantities of over-the-counter
will be placed into repositories available to regulators. To this derivatives that are based on equities, commodities, and for-
point, however, proposed regulations are unlikely to result eign exchange. Although a large quantity of interest-rate swaps
in the safe resolution of dealer banks that depend on large are cleared, the majority are not. Even the recently established
amounts of overnight repo financing and have large over-the- central clearing counterparties for credit default swaps will not
counter derivatives portfolios. Most repos and over-the-counter easily treat a large quantity of positions in credit default swaps
derivatives are qualifying financial contracts that are exempt that are not standard enough to be cleared. The challenge of
from automatic stays at bankruptcy (Bliss, 2003; Edwards and how to clear a greater share of derivatives and how to deal
Morrison, 2005). Runs by short-term secured lenders and with the fact that many derivatives are not standard has only
over-the-counter derivatives counterparties may continue to been partially addressed through legislative proposals that
contribute to the failure mechanics of large dealer banks and to include higher regulatory capital requirements for uncleared
systemic risk. derivatives.

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
60
5

King, Matthew Leising, Paul Klemperer, Joseph Langsam,


66
98 er

The threat posed by the flight of over-the-counter derivatives


1- nt
20

Raghu Rajan, Manmohan Singh, Glen Taksler, Rick Thielke, lke,


ke,
66 Ce

counterparties can be lowered by central clearing. Sufficiently


65 ks

cker,
ker,
Till Schuermann, Hyun Shin, Jeremy Stein, Paul Tucker,
06 oo

extensive and unified clearing can reduce the total exposure of


Andrew White, Alex Wolf, Alex Yavorsky, Haoxiang angg Zhu,
Z and
82 B

market participants to any given dealer through the multilateral


-9 ali

had Jones,
Tatjana Zidulina. I also thank David Autor, Chad Jones
J Ann
58 ak

netting of positive against negative exposures (Duffie and Zhu,


11 ah

Norman, and especially Timothy Taylor forr guidance


gui
uidanc from the
41 M

2009). Obviously, the financial strength of large central clear-


Journal of Economic Perspectives.
ing counterparties is crucial, as is their implicit government
20
99

166 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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Boot, Arnoud, Todd Milbourn, and Anjun Thakor. 1999. “Mega-


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Standards.” Policy Statement, October, 2009.


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.gov.uk/pubs/policy/ps09_16.pdf.
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System and Monetary Policy: Implementation,” Bank of Japan, University of Cincinnati College of Law. 2009. “Securities Law-
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1
605
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Chapter 8 The Failure Mechanics of Dealer Banks ■ 169

  




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560
1


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.

● Estimate contingent liquidity via the liquid asset buffer.

1
60
5
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58
11

Excerpt is Chapter 3 of Liquidity Risk Management: A Practitioner’s Perspective, by Shyam Venkat and Stephen
ephe Baird.
41
20
99

171

  


The global liquidity crisis, which lasted from approximately the amount of liquidity that must be held in order to ensure the
August 2007 to the end of 2008, ushered in the broader finan- institution can meet financial obligations under stressed condi-
cial crisis and highlighted the importance of prudent manage- tions. A robust liquidity stress test is based on a projection of
ment of liquidity risk. Prior to the crisis, liquidity was readily cash flows arising from assets, liabilities, and other off-balance
available at low cost, and many banks, though apparently well sheet items under a variety of systemic and idiosyncratic sce-
capitalized, did not have an adequate framework for ensuring narios that can occur over varying time horizons. The results
ample liquidity to see them through a prolonged dislocation in of the liquidity stress test provide the foundation for setting
the financial markets. Believing that the funding of contingent the bank’s liquidity risk appetite, establishing appropriate
obligations and the inability to roll over existing contractual limits and targets, and developing an effective contingency
obligations were highly unlikely, these institutions did not funding plan.
conduct stress tests that adequately reflected the severity and
In this chapter we will define what is meant by “contingent
duration of the liquidity crisis that actually occurred during
liquidity” within the context of liquidity risk management and
this period.
the liquidity stress test in particular. We will review the key
The liquidity stress test provides the critical underpinning to components of a liquidity stress test, including (a) the appropri-
a bank’s liquidity risk management framework by determining ate scope and structure of the liquidity stress test across the

IMAGE IS EVERYTHING: THE COLLAPSE OF WASHINGTON MUTUAL


Ignited by a sudden $17 billion run on bank deposits reserves to $50 billion, and shuttered underperforming busi-
lasting approximately nine days, WaMu, the thrift divi- ness units. In short, although the bank held a significant
sion of Washington Mutual, Inc., was seized by the Office sub-prime exposure, it was well positioned to fund opera-
of Thrift Supervision on September 25, 2008—to date, tions through a competitive buyout process and possibly
the largest such seizure in U.S. history. Once considered achieve long-term recovery albeit with a smaller scale thrift
the banking industry’s version of Walmart, WaMu filed for division. Nonetheless, the crushing blow to WaMu’s reputa-
bankruptcy protection under Chapter 11 one day after the tion resulting from dismal outlook reports left the bank with a
Office of Thrift Supervision placed its thrift operations into widespread public perception of illiquidity and scant options
FDIC receivership, thus becoming the second largest such outside of bankruptcy.
bankruptcy filing in U.S. history—surpassed only by that of
Lehman Brothers a week earlier. In a deal brokered chiefly References:
by the FDIC, JP Morgan Chase & Co. purchased WaMu,
preventing a potentially devastating insurance payout to “WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure
WaMu’s depositors. in U.S. Banking History” Robin Sidel, David Enrich, Dan
The root of the deluge of retail deposits flowing out of Fitzpatrick. The Wall Street Journal; published September
WaMu’s branches can be traced to market perceptions of the 26, 2008
bank’s solvency. Two of WaMu’s major sources of unsecured
funding—commercial paper and federal funds purchased— “Saying Yes, WaMu Built Empire on Shaky Loans” Peter S.
dried up almost completely. This was interpreted by the Goodman and Gretchen Morgenson. The New York Times;
rest of the bank’s lenders to mean the bank was no longer a published December 28, 2008
viable counterparty and led to the bank’s collapse. Yet, rep-
resentatives of WaMu were quick to note that its operations “WaMu Slumps as Gimme Credit Cites Liquidity
did not depend on the availability of short-term financing. In Concern” Ari Levy. Bloomberg Financial News; published
fact, this position was likely correct. At the time of its demise, July 24, 2008
1

WaMu still had one of the country’s largest retail branch


60

“WaMu: We have $50 billion in liquidity” Aaron Smith. CNN


5

networks, and only a few months before had received an


66
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Money.com; published July 25, 2008.


1- nt
20

investment from a private-equity firm, increased its liquidity


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172 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


enterprise, (b) scenario development, and (c) the development objective of the liquidity stress test, must also be carefully con-
of key assumptions. We will also discuss the broader governance sidered in the liquidity stress test since it can also impact the
context of the liquidity stress test, including the governance amount of funding that can be made available from the sale
around the liquidity stress testing process, how outputs sup- of assets.
port the liquidity risk management regime of the organization,
As a source of funding liquidity, businesses, including finan-
and the controls required within and around the process. Intra-
cial institutions, utilize liquidity for four purposes: operational,
day liquidity considerations, however, are separately discussed
restricted, contingent, and strategic.
in Chapter 6.
Operational liquidity represents the cash that is needed to fund
While the industry has made significant strides in enhanc-
the business on a daily basis, and it is required to ensure orderly
ing liquidity stress testing capabilities since the dark days of
clearing of payment transactions. Depending on the nature of
2007–08, banks and their regulators will be working hard to
the institution’s business, operating cash needs might be quite
meet a number of challenges over the next several years in
volatile and, as a result, a cushion is added to account for the
order to realize the goal of establishing a fully robust liquid-
unpredictability of daily settlements and the excessive system
ity stress testing program. In this chapter we will focus on two
and management effort that would be required to manage
of these emerging trends. First, the industry should improve
cash to its theoretical minimum. Operational liquidity must be
the level of integration and consistency between the liquid-
maintained to ensure the institution’s operations and is therefore
ity stress test, the capital stress test, and, more broadly,
unavailable to meet financial obligations under a liquidity stress
risk measurement and monitoring, performance measure-
test.
ment, and regulatory reporting. Second, banks should invest
in achieving a sustainable technology infrastructure that Restricted liquidity represents liquid assets that are available to
ensures liquidity stress testing is performed in an efficient and be used only for specifically defined purposes. For example, a
controlled manner. bank may be required to collateralize certain wholesale borrow-
ings. Restricted liquidity is unavailable to meet general financial
As was seen during the financial crisis, the perception of a
obligations under a liquidity stress test, but should be applied to
liquidity problem that may arise through an insufficient liquidity
any assumed outflows which they support.
risk management framework can be just as problematic for a
financial institution as an actual inability to meet financial obliga- Contingent liquidity represents the liquidity that is available to
tions. The fall of Washington Mutual Bank (WaMu) provides an meet general financial obligations under a stress scenario. This
instructive example. liquidity is available in the form of the institution’s liquid asset
buffer, which comprises access to financial assets that are of very
high quality and can be easily converted into cash without any
real loss of market value. Measuring required contingent liquid-
9.1 MEASURING CONTINGENT ity to cover stressed cash outflows is the principal objective of
LIQUIDITY REQUIREMENTS the liquidity stress test.

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
1
60

fund its obligations without incurring unacceptable economic feasible only if such liquidity is present via holdings of
o highly
ighly
5
66
98 er

liquid assets.
1- nt

losses. Assessing asset liquidity—the risk of incurring losses


20
66 Ce

due to difficulty converting assets into cash—while not the This liquidity taxonomy is illustrated in Figure 9.1.
.1.
1.
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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Chapter 9 Liquidity Stress Testing ■ 173

  


Figure 9.1 Liquidity taxonomy.

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.
1
560

able market, and low concentration of buyers and sellers. The Stressed liquid asset buffer. The liquid asset buffer, nett of
66
98 er
1- nt
20

liquid asset buffer should also meet operational requirements stress outflows and stress inflows, indicates the adequacy
uacyy
66 Ce

that ensure the liquidity is under the control of the central of the current liquid asset buffer given the stress scenario
scena
cena
ario
65 ks
06 oo

treasury area of the entity undergoing the stress test. assumptions.


82 B
-9 ali
58 ak

Stressed outflows. Stressed outflows are those assumed The components of the liquidity stress test model
odell are depicted
11 ah

to occur under stress scenarios. Stressed outflows may in Figure 9.2.


41 M
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174 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Figure 9.2 Components of the liquidity stress testing model.

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-
1
60

vice centers. Each of these cases may be addressed through a essarily give rise to the need for an additional stress test t
5
66
98 er

separate liquidity stress test, where necessary. For less material where it can be demonstrated that a subsidiary would ouldd not
1- nt
20
66 Ce

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
06 oo
82 B

be sufficient. As a general rule, the institution should consider company but choose not to test individual ual banking
b
banki subsidiar-
-9 ali
58 ak

the organizational level at which (a) liquidity is commingled, ies under the assumption that movementmentt of cash
c from the
11 ah

and (b) liquidity oversight has management accountability. parent to the subsidiary would be unrestricted.
unrrestri
estr
41 M
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Chapter 9 Liquidity Stress Testing ■ 175

  


Figure 9.3 Liquidity stress testing design components.

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
1
60

least twelve months. The bank may choose to project cash


5

There are three general approaches to performing a liquidity dity


ty
66
98 er

flows beyond twelve months; however, longer-term projec-


1- nt
20
66 Ce

stress test—historical statistical techniques, deterministic


ticc
tions may be subject to significant forecast error depend-
65 ks

models, and Monte Carlo simulation:


06 oo

ing on the time horizon of the baseline balance sheet and


82 B

income statement budgeting performed as part of the Historical statistical techniques, such as cash h flow
flow at risk
-9 ali
58 ak

strategic planning process. Moreover, the likelihood of the (CFaR), model a historical pro forma cash flow w based
base on the
bas
11 ah
41 M

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

  


Deterministic models, such as the development of hypothet- stimulus, and customer delevering led to a liquidity buildup
ical liquidity stress scenarios, model the liquidity impact of a that quickly stuffed the cash coffers of all but the shakiest
forward-looking or historical-based scenario that has been banks.
developed by the institution.
As a result of these limitations and the highly complex, intercon-
Monte Carlo simulation is a statistical technique that relies nected nature of liquidity behavior, the industry approach to
on simulation modeling and can be used to assess liquidity performing a liquidity stress test is to develop a set of discrete,
risk by stress testing specified variables over a future time deterministic scenarios. While the menu of liquidity stress test
frame. scenarios has become somewhat standardized across the bank-
ing industry since the financial crisis, it is important that each
Stochastic techniques that rely on observations of historical vola-
financial institution carefully consider its unique or idiosyncratic
tility of cash flow variables, whether using historical statistical
material risks when building out its scenario framework.
models such as CFaR or Monte Carlo simulation techniques that
rely on historical observations of volatility, are viewed less favor- There are two general types of liquidity stress scenarios—historical
ably in the wake of the financial crisis. By its nature, liquidity scenarios and forward-looking (hypothetical) scenarios.
stress is an extreme “tail event,” and deterministic scenarios,
despite their reliance on many assumptions that are derived
through expert judgment, are viewed by regulators and most Historical Scenarios
financial institutions as the most effective tool for assessing Historical scenarios are based on actual liquidity failures and
liquidity risk. An additional challenge of stochastic approaches attempt to translate those events to the financial institution
is their limited ability to accurately predict the management performing the stress test. The failures of WaMu and Northern
countermeasures that would occur during a liquidity crisis event. Rock in 2008 are common reference events. The advantage of
The remainder of this chapter will focus on the development of historical scenarios is that they are empirically based. The disad-
a deterministic liquidity stress test framework. vantage of this approach is that few such failures have actually
occurred; and for the ones that have taken place, very limited
data are available. Additionally, future business conditions may
9.5 BASELINE SCENARIO
cause new and unanticipated liquidity events, creating a poten-
tial blind spot for management.
The starting point for building the liquidity stress test is the
baseline balance sheet funding and liquidity plan. As a banking
organization builds out its liquidity stress test framework, it is Hypothetical Scenarios
sometimes necessary to enhance the structure of the baseline
plan as well to ensure that the base case is consistently struc- Hypothetical scenarios are based on a forward-looking view in
tured and at the same level of detail as the stress scenarios. which the financial institution experiences severe liquidity stress.
It is also advisable to house the baseline analysis in the same Banks typically develop multiple scenarios. Liquidity stress sce-
reporting and analysis platform as the liquidity stress test. The narios should exhibit the following characteristics:
objective is to ensure that the institution can gauge the sever- Distinguish between systemic and idiosyncratic risk. Some
ity of each stress scenario by making a valid comparison to the liquidity stress impacts are the result of systemic stress, such
baseline forecast. as a reduction in the market liquidity of securities, while
other impacts are the result of bank-only stress, such as a
deposit run. See Figure 9.3 for a detailed description of
9.6 SCENARIO DEVELOPMENT these impacts. Banks should develop at least one scenario for
each of the cases of systemic, idiosyncratic, and combined
By its very nature, liquidity failure is a high-impact, low-
1

idiosyncratic and systemic in order to capture these varying ng


60

frequency event. Fortunately, only a handful of large financial


5

impacts.
66
98 er

institutions have collapsed due to insufficient liquidity. Unfor-


1- nt
20
66 Ce

tunately for this very reason, there is little data upon which to Distinguish between levels of severity. Assuming g graduat-
umiing
uminng gra
65 ks
06 oo

build reliable, predictive models that can accurately estimate ing levels of severity, for example, by developing
eloping adverse
elopi a
82 B

the minimum level of liquidity an institution can expect to and severely adverse variations of the idiosyncratic
idios yncra scenario,
diossyncra
-9 ali
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
11 ah
41 M

cial crisis, a combination of government intervention, monetary applicable limits.


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Chapter 9 Liquidity Stress Testing ■ 177

  


Clearly define the scenarios. The bank must establish a spe- objective of a reverse liquidity stress test is to determine
cific, detailed description of the business and market events which conditions would need to exist, given the bank’s current
associated with each scenario in order to provide the foun- liquidity level, to cause its current business plan to become
dation for assumption development as well as linking stress unviable. To construct such a scenario will require determina-
testing to early warning indicators in contingency funding tion of which factors will have the most significant impact on
plans. In developing and documenting each stress scenario, liquidity and stressing these assumptions to the institution’s
the bank should ensure the level of detail is sufficient to pro- destruction. Developing such a reverse stress test scenario,
vide a comprehensive view into the specific conditions the while simple in theory, presents a number of problems as there
institution is experiencing. Scenario descriptions typically are a large number of factors which could combine to destroy
include, at a minimum: the institution. It can also be difficult to develop a destruction
• The general level of stress (e.g., high) of market, eco- scenario if the bank is highly liquid without making fantastic,
nomic, and credit conditions apocalyptic assumptions. As a result, reverse stress testing is
not a universally performed exercise among financial institu-
• Conditions of wholesale secured and unsecured funding
tions; however, the FRB’s SR Letter 12-7 does provide guidance
markets
on reverse stress testing, which is applicable to institutions
• Changes in counterparty haircut requirements by collateral above $10 billion in consolidated assets. In this context, the
type failure considerations (which most banks qualify as a liquidity
• Liquidity impacts on securities in the liquidity buffer and driven event) under recovery and resolution planning might be
other assets in the event of sale viewed as constituting a reverse stress test. Nevertheless, it is
• Details of credit grade downgrades advisable to at least think through a reverse stress test in devel-
oping traditional stress test scenarios as a way of facilitating
• Deposit runoff assumptions by product and customer
an understanding of the priority risks the institution should be
type, and with consideration to other factors such as insur-
testing (Table 9.1).
ance coverage
• Description of impacts on specific counterparty
relationships
• Rating trigger impacts on derivative margin and collateral 9.7 DEVELOPMENT OF ASSUMPTIONS
calls
Liquidity stress testing is built on hypothetical and historical
• Impact of regulatory actions or limit breaches in foreign
scenarios, and as a result is highly dependent on the validity
jurisdictions
of assumptions in generating meaningful results. For many key
• Assumed drawdowns on unfunded credit and liquidity
assumptions there is limited historical or market data to draw
facilities
upon in building a fact base. Nevertheless, applying segmen-
• Assumed debt calls and buybacks tation frameworks that enable differentiation of assumptions
Consider more holistic approaches to scenario across varying levels of cash flow risk enhances the rigor of the
development. Standard industry liquidity stress test liquidity stress test.
scenarios, including those required by regulators under the In addition to developing internal views of stressed liquidity
Basel III liquidity coverage ratio (LCR), are highly prescrip- behavior, the institution should reference the Basel III (including
tive. This philosophy is in sharp contrast to the approach as implemented in local jurisdictions) liquidity coverage ratio
taken for capital stress testing, where a set of high-level cash flow rates.
macroeconomic developments are assumed and then care-
fully assessed to link their impacts to the bank’s financial Generally, in developing liquidity stress testing assumptions the
institution should do the following:
1

performance and capital position. In addition to the liquidity-


5 60

specific scenarios described here, the institution should also


66
98 er

1. Qualitatively assess the expected liquidity behavior fororr each


eacch
1- nt
20
66 Ce

consider scenarios based on broader economic and business ificcan


type of cash flow to determine where there is significant nt
65 ks

impacts. Doing so will ensure the bank is considering sys- liquidity risk.
06 oo
82 B

temic, interdependent risk behavior rather than simply devel-


2. Determine the appropriate level of segmentation
ntatio
tatio
on for
fo each
-9 ali

oping isolated liquidity assumptions.


58 ak

type of risk based on an assessment of behavioral


behavaviora differ-
11 ah
41 M

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

  


Table 9.1 Key Liquidity Stress Impact Factors

Category Key Liquidity Stress Impacts

Deposit runoff Depositors accelerate demand deposit withdrawals


Deposit runoff Term depositors exercise early withdrawal rights
Loss of wholesale funding Inability to roll over short-term, maturing unsecured wholesale funding
Loss of wholesale funding Early termination of unsecured wholesale funding credit lines and/or early redemption
of wholesale fundings
Loss of secured funding Loss of willing counterparties for secured funding
Loss of secured funding Limitation of security types available for secured funding and/or increased collateral
haircuts
Loss of secured funding Loss of access to asset-backed funding facilities due to lack of funding, embedded
options, or lack of eligible assets
Reduced investment portfolio liquidity Increased liquidity haircuts and/or reduced valuations of liquidity portfolio securities
Derivative cash flows Increased derivative margin/collateral calls due to increased market volatility of under-
lying position
Derivative cash flows Increased collateral calls due to reduction in collateral value
Ratings downgrades Collateral or other liquidity impacts due to ratings triggers
Credit/liquidity facilities Accelerated drawdown of credit and liquidity facilities by customers/counterparties

3. Qualitatively assess and order by rank varying levels of 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

funded bank, liquidity stress test models built on simplistictic


ic
60

ity through pledging, funding through a repo transaction,


5

assumptions concerning deposit behavior will most st likely


ost likkely
66
98 er

or outright sale of investment portfolio securities will have


1- nt
20
66 Ce

yield meaningless results, even if other aspectss of


o the
the model
m
a critical impact on available liquidity under stress. For sys-
65 ks

have been calibrated rigorously.


06 oo

temic stress scenarios, it is assumed that haircuts will widen


82 B

on securities as was observed during the crisis. The model Unfortunately, there is a scarcity of historical
orical data
torica da to rely
-9 ali
58 ak

should include varying haircut assumptions for each security upon in developing deposit runoff assumptions.
assum mptio While
11 ah
41 M

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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Chapter 9 Liquidity Stress Testing ■ 179

  


Table 9.2 Deposit Behavioral Characteristics

Typical Behavioral Assessment Factors

Consumer Small Business Commercial and Institutional

• Relationship tenure • Relationship tenure • Relationship tenure


• Checking product usage • Value-added product usage • Credit usage
• ATM usage frequency • Credit usage • Treasury and trade usage
• Rate paid • Branch usage frequency • Balance level
• Internet usage • FDIC coverage • Net borrowing position
• FDIC coverage • Rate paid • Industry segment
• Direct control vs. escrow • Company size
• Rate paid

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
1
60

increased collateral levels required as a result of changes in


5
66
98 er

derivative positions. How the institution develops assump- 9.8 OUTPUTS OF THE MODEL
1- nt
20
66 Ce

tions for collateral call levels (as opposed to collateral valu-


65 ks
06 oo

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
-9
58

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
41
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180 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


forms an integral part of an institution’s liquidity risk escalation assessing the economic impact of the investment portfolio
process. The bank’s liquidity limit structure, and in particular the by measuring yield net of a regulatory or economic capital
contingency funding plan, should be tied directly to the results charge enables the institution to assess the tradeoff between
of the liquidity stress test. These linkages may exist through, for low-yielding, low-haircut instruments and higher performance,
example, survival horizon metric minimums, minimum available less liquid ones. Monitoring key capital metrics for each entity
liquidity limits, and stressed liquidity metric limits. ensures that the model captures the impact of any capital
actions required to support liquidity during the stress period.
The liquidity stress test should enable the production of a regu-
lar reporting package that contains the following for each of the The frequency with which the liquidity stress test is performed
entities being tested: will vary and typically depends upon the cadence of manage-
ment oversight and operational and technological capabilities
Stress testing assumptions. Key assumptions include
of the institution. At a minimum, the liquidity stress test should
(1) overall stress level represented by the scenario; (2) indica-
be performed quarterly in order to support review by the asset
tion of whether the scenario is systemic, idiosyncratic, or both
liability management committee. More advanced banking
systemic and idiosyncratic; (3) documentation of the overall
organizations have made significant investments in building the
macroeconomic, market, and company-specific events lead-
ability to perform liquidity stress tests more frequently, in some
ing to the stress scenario; and (4) description of the cash flow
cases even daily.
impacts of the scenario.

Liquidity position metrics. The principal measurement out-


come of the liquidity stress test is the level of available liquid-
9.9 GOVERNANCE AND CONTROLS
ity relative to net cash outflows under each scenario. The
As an integral part of the institution’s liquidity risk governance
exact form of this metric varies across institutions but may
framework, the liquidity stress test should be the subject of, while
be expressed as a percentage of net outflows or as a dollar
at the same time supporting, effective oversight in order to help
value relative to a policy minimum. Some institutions distin-
ensure the liquidity risk profile is aligned to the bank’s risk appe-
guish between tactical and structural liquidity in measuring
tite and capacity. The specific roles should consist of the following:
the results of the liquidity stress test. The Basel III LCR, for
example, provides a thirty day view into available liquidity Asset-liability committee (ALCO). The ALCO, consistent
under stress. To measure the longer-term or structural liquid- with its board, management risk committee, and executive
ity position, the institution may calculate a survival horizon management delegated oversight of managing liquidity risk,
relative to a limit. For example, the bank’s policy may be to typically has overall responsibility for the liquidity stress test-
maintain available liquidity to support twelve months of net ing framework. Specifically, the ALCO should be responsible
outflow under a specific stress scenario. for the following:

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

ances, intercompany funding transactions, or capital actions.


66
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• Suggesting and approving liquidity risk scenarios,


rios,
ios,
1- nt
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The institution may choose to establish limits for prospective including major changes to liquidity scenarios
oss and/or
rios a
and/o
65 ks

liquidity in addition to current liquidity, for example, maintain- assumptions.


06 oo
82 B

ing a certain survival horizon throughout the stress test.


• Setting liquidity risk policy limits dependent
epend
pendent on stress
-9 ali
58 ak

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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Chapter 9 Liquidity Stress Testing ■ 181

  


Treasury. The treasury unit, as the first line of defense, Where multiple risk units within the institution are oversee-
typically has ownership of the liquidity stress test modeling ing liquidity stress testing, the independent risk management
process. Treasury should be responsible for the following: function should be responsible for coordinating globally with
• Maintenance of liquidity stress testing procedures. regional and business unit risk management teams to ensure
enterprise-wide consistency.
• Recommending stress test scenarios.
Internal audit. Internal audit, as the third line of defense,
• Reviewing and monitoring the liquidity characteristics
should periodically review the liquidity stress testing frame-
of the institution’s assets and liabilities and making rec-
work, procedures, and controls to ensure compliance with
ommendations to the ALCO concerning stress testing
policy, regulatory, and control requirements.
assumptions. Treasury should work with other functions
within the organization, in particular business line manage- Model risk management: Model risk management is respon-
ment, in developing assumptions for customer assets and sible for providing independent validation and changing
liabilities. A formal requirement should be established in management governance of the liquidity stress testing model
the liquidity stress testing policy that management reviews in line with the institution’s model risk management policy.
the key analytical assumptions of the liquidity stress test at Practices vary among institutions in defining and evaluat-
least quarterly. ing models for oversight. It is assumed, however, that the
• Producing stress test-based liquidity risk reporting. liquidity stress testing model will be assessed as highly criti-
cal given its foundational role in monitoring the bank’s risk
It is recommended that the liquidity stress test baseline
profile.
balance sheet data (i.e., the current positions and contractual
maturities) be fed from, or at least reconciled to, reporting
prepared by a group independent of treasury, such as
financial control, independent risk management, or middle
9.10 LIQUIDITY OPTIMIZATION
office.
The primary goal of the liquidity stress test is to determine the
Within large, complex banking organizations, it is expected appropriate size of the liquidity buffer. However, the liquidity
that multiple treasury units will perform liquidity stress tests stress test should also be referenced in developing the composi-
for their respective entities. In such cases the corporate trea- tion of the buffer, with the objective of maximizing the efficiency
sury group should ensure that the global liquidity stress test- of the liquidity portfolio. Given a target level of contingent
ing policy establishes a consistent framework of scenarios, liquidity required to support risk limits and regulatory require-
assumptions, and model design across the enterprise. ments, Treasury will be able to choose between portfolio alter-
Risk management. The independent risk management func- natives that vary in terms of both yield and capital requirements.
tion, as the second line of defense, is responsible for provid- This choice gives rise to an optimization opportunity:
ing independent oversight of liquidity stress testing along Liquidity versus yield: Typically, higher yielding instruments
with the other components of the liquidity risk management will have less favorable liquidity characteristics and/or add
program. Specifically, risk management is responsible for the duration to the investment portfolio. Maximizing the yield
following: and/or duration of the portfolio (even under the usual strict
• Administering the liquidity risk stress testing policy investment policy constraints) is likely to be suboptimal for
the institution’s return on asset performance as a whole. This
• Reviewing and providing effective challenge of the sce-
yield maximizing portfolio will be inefficient due to the addi-
nario design and assumptions
tional balance level required to offset stress test haircuts and
• Ensuring the institution’s approach to liquidity stress test- the mismatch between the portfolio’s inflows and the stress
ing is in line with acceptable industry practices and regula- test outflows. For example, taking the simplified stress test-
1
60

tory rules and guidance ing example represented by the Basel III LCR, maximizing g
5
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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
1- nt
20
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limits mortgage-backed securities) that require a 15% haircut,ircu


rcu t may
utt, ma
65 ks
06 oo

• Monitoring of liquidity stress test-based limits reduce overall return on assets relative to investing
ing slightly
sslight
82 B

lower yielding treasury securities that requiree no haircut.


hairc
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• Ensuring the institution’s ALCO, executive management,


58 ak
11 ah

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

  


with a robust liquidity stress testing model, treasury should complex financial institutions has been that developing such
avoid constructing a needlessly conservative liquidity an infrastructure for liquidity stress data has required signifi-
portfolio when the pattern of stressed net outflows dem- cant modifications to existing data warehouse capabilities built
onstrates that the institution can comfortably stretch the largely on general ledger and transactional customer data. In
duration and risk profile of its investments. building an infrastructure that supports liquidity stress testing,
the institution should ensure that several critical requirements
Liquidity vs. capital. Depending upon the institution’s eco-
are met. These include:
nomic and regulatory capital framework, a similar trade-off
exists for incorporating the capital impact of various port- Position data collection and aggregation. A data manage-
folio alternatives. Continuing with the example of Level 2A ment model must be established to ensure that required
agency mortgage-backed securities, maximizing the invest- liquidity position data are captured in an automated fashion.
ment allocation of these instruments may be suboptimal The specific architecture employed by an institution will vary,
given the additional regulatory and potentially economic but could include the use of standardized templates or data
capital requirements associated with these instruments. For hub structures. Required liquidity attributes may need to be
banks whose capital position is such that any additional asset associated to each position to enable automated develop-
amount gives rise to an additional equity capital requirement ment of model inputs. The position data will also need to
under leverage ratio limits, the additional haircut required for conform to the required organizational granularity. For large,
higher-risk instruments will also be problematic. internationally active banking organizations, this is likely
to require data across numerous legal entity, business line,
and jurisdictional dimensions. In addition to capture current
9.11 FUNDING OPTIMIZATION positions, the institution should retain historic data in the
data hub for historical analysis-based model calibration. The
An important insight provided by the liquidity stress test model objective is to ensure that liquidity data is housed in a single
is the impact of varying funding sources with differing liquidity location and forms a single source of truth.
characteristics. In fact, a key objective of the focus on enhancing
Regulatory report generation. Building on this automated
liquidity stress testing since the financial crisis has been to cre-
position capture should be the ability to generate regulatory
ate an incentive for financial institutions to favor “sticky” funding
reports (e.g., the Basel III LCR) with a minimum of manual
sources such as retail branch deposits at the expense of “hot”
intervention. Solutions may include functional replicas of offi-
money sourced from wholesale channels. By explicitly model-
cial regulatory reports—or customized proprietary versions if
ing the liquidity impact of these funding alternatives, treasury
official templates are not available—that are populated with
can and should develop a target funding profile that balances
associated validations and regulatory adjustments, requiring
liquidity and cost. For example, the superior liquidity profile of
minimal user manipulation. Such solutions may be developed
commercial deposits linked to treasury management services
as proprietary applications or included within the reporting
should serve to bolster the business case for investing in target
functionality of third party treasury platforms.
industry segments with more intensive working capital require-
ments. Building this linkage requires a funds transfer pricing Analytics. The liquidity stress test model should contain the
(FTP) framework that accurately incorporates the stressed liquid- features and functions that management would expect in
ity profile of various business segments across the enterprise. any robust analysis tool. These would include, for example,
the ability to perform sensitivity analysis on stress test
assumptions, the ability to save scenarios, and the ability
9.12 ESTABLISHING A SUSTAINABLE to easily generate various legal entity views. In addition to
such flexible forecasting functionality, leading practice is
INFRASTRUCTURE to include analytic functionality that, for example, assesses
1
60

rtfo
tfo o
the economic capital impact of various liquidity portfolio
5

The strongest liquidity stress testing analytical framework will


66
98 er

allocations.
1- nt
20

have little value without a data management infrastructure to


66 Ce
65 ks

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
-9 ali

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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Chapter 9 Liquidity Stress Testing ■ 183

  


9.13 INTEGRATION OF LIQUIDITY with performing the capital stress test, the institution should
perform a liquidity impact analysis to determine whether
STRESS TESTING WITH RELATED RISK additional capital impacts may occur through investment
MODELS portfolio and required funding actions that would cause fur-
ther deterioration in capital adequacy.
Liquidity stress testing should not be performed in a silo with-
Liquidity stress testing and asset liability management.
out consideration of other related risk frameworks, such as
Interest rate risk models are designed to assess the interest
asset liability management (for interest rate risk), capital stress
expense and economic value of equity impacts of severe
testing, and recovery and resolution planning. These models
movements in interest rates. Such a stress event could have
may employ related assumptions concerning the balance sheet
a significant impact on capital but is less likely to have a
behavior of certain accounts, and developing these assump-
direct impact on the bank’s short-term liquidity profile. As a
tions independently is likely to lead to an inconsistent overall
result, a liquidity impact analysis is typically not run concur-
risk management framework. More importantly, it is imperative
rently with interest rate risk stress testing analogous to what
that a banking organization consider the correlations between
must be performed for capital stress testing. Nevertheless,
risk types that are likely to surface in a systemic or idiosyncratic
a consistent behavioral framework should be applied to
stress scenario. For example, in a capital-stressed environment,
both the interest rate and liquidity stress testing models.
an institution may be required to take a capital action requiring
For example, if the liquidity stress test model assumes that
the raising of liquidity at the holding company level. If raising
certain operational deposits do not run off in a stress event,
such liquidity requires incurring losses on investment portfolio
the interest rate risk model should segment these deposits
liquidation (all the more likely in a stressed environment), addi-
and assume that they would have duration at least as long as
tional capital pressures may occur.
non-operational deposits.
In theory, the institution should maintain a holistic risk model
When it comes to the liquidity stress model, however, it is
that assesses the impact on liquidity, capital, and balance
important to consider interest rate impacts. In particular, the
sheet structure under a common set of scenarios. In prac-
liquidity stress test scenario framework, liquidity risk dash-
tice, such an approach can be problematic due not only to
boards, and liquidity risk early warning indicators should not
the modeling complexity involved, but also as a result of the
neglect to include the possibility of an interest rate shock
need to develop unique stress scenarios for each risk type.
and the potential impact such an event would have on inde-
For example, a bank may stress capital based on a recession-
terminate liabilities. For example, in an environment where
ary scenario that adversely affects credit performance but is
rates are historically low and there is significant risk of a yield
also associated with falling interest rates (as expected during
curve steepening (i.e., the current environment), the institu-
a recession) and a less severe impact on liquidity than what
tion must carefully consider the impact of deposit disinter-
would be typically assumed under an idiosyncratic “run on the
mediation due to interest rate increases. A significant yield
bank” liquidity stress test scenario. Nevertheless, the bank
curve steepening could present significant liquidity risk to the
should carefully consider the interdependencies and connec-
institution, even in the absence of any safety and soundness
tion points between the liquidity stress model and other risk
concerns, as depositors seek the higher yields available in
models:
longer-duration investments.
Liquidity stress testing and capital stress testing. Linking
Liquidity stress testing and funds transfer pricing. The FTP
capital and liquidity stress testing requires, first, ensuring that
framework, while not a risk model, is a strategically impor-
the liquidity stress test incorporates any required capital infu-
tant tool for driving business decision making. One of the
sions of subsidiary entities. For each liquidity stress test sce-
key objectives of any FTP framework is proper pricing of
nario, capital impact assumptions must be developed based
liquidity, whether provided by the treasury center for lend-
1

on the overall market and idiosyncratic conditions assumed


60

ing purposes or credited to liability-generating activities.


5

to occur under the scenario. The level of detail in developing


66
98 er

The FTP framework should leverage and be consistentt with h


1- nt
20

these assumptions may vary from a high-level capital infusion


66 Ce

the contingent liquidity requirement for assets and liabilities


liab
biilities
bil
65 ks

assumption for affected subsidiaries to detailed credit loss


measured by the liquidity stress test model. For example,
exammple if
06 oo

and pre-provision net revenue modeling.


82 B

it is determined that a 25% cash buffer is required


uired to support
quired s
-9 ali
58 ak

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

  


CONCLUSION nevertheless make a diligent attempt to build the most
robust set of assumptions possible. Increasing the level of
The liquidity stress test is a core component of the bank’s granularity—such as by enhancing the level of segmentation
liquidity risk framework, and following the financial crisis has for deposit behavioural analysis—typically yields beneficial
become an increased area of scrutiny and expectation among results.
regulators and other stakeholders. While nearly all financial • Improving integration with related risk and performance
institutions of significant size have a basic liquidity stress models. Longer term, the industry will continue to evolve
testing process in place, there are typically a number of areas toward unifying what is currently a set of relatively isolated
of potential improvement. As banks continue to refine and frameworks in addressing liquidity risk, capital, asset liability
improve their liquidity stress capabilities, they should focus on management, and performance measurement. Developing
four areas: better linkage between stress testing and performance man-
agement and across risk categories will create the necessity
• Ensuring the appropriate scope and structure of the liquid-
to holistically assess risk-based performance results in busi-
ity stress test. While stress testing the consolidated entity is
ness and treasury banking activities.
a common practice, it is important to carefully review juris-
diction, legal entity, charter, and foreign exchange liquidity • Automating the process. Creating a sustainable liquidity risk
restrictions to ensure testing is performed with each appro- infrastructure is a necessary foundation for improved analyt-
priate view. ics and more frequent monitoring. For most institutions, this
will require establishing and maintaining a tailored data hub,
• Building the model on robust assumptions. While there
an automated data model, and robust analytics and reporting
is unlikely to be a perfect historical experiment upon which
capabilities.
to base stress scenario assumptions, the bank should

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Chapter 9 Liquidity Stress Testing ■ 185

  




99
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11 ah
58 ak
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82 B
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
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1


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.

● Compare and interpret different types of liquidity


risk reports.

1
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Excerpt is Chapter 14 of The Principles of Banking, by Moorad Choudhry.


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187

  


Elsewhere I have highlighted the nature of liquidity risk We see that this bank is required to meet a Board-approved LTD
exposure measurement. We press on further with a look at ratio limit of 85%, which it is just exceeding as at the date of this
benchmark liquidity risk reporting, and stress testing report- report, but the forecast for year-end is within this.
ing output. We look at a range of quantitative and qualitative
Table 10.1B is the second part of the deposit tracker, it shows
liquidity reports, as part of our approach to a general under-
how much liabilities will need to increase, or assets reduce, all
standing of liquidity risk management at the aggregate over-
else being equal, for the bank to meet a particular LTD ratio.
view level.
Figure 10.1 is a graphical presentation of the deposit tracker
We begin with an illustration using examples of baseline liquidity report.
reports. This is followed with a description of additional liquid-
Figure 10.2A from the report shows the customer deposits
ity reports, together with a summary of the reporting frequency
by account type and tenor, while Figure 10.2B shows the
required by UK regulated banks. This regulatory reporting
deposits’ maturity profile. This illustration assists the Treasury
requirement is similar in most other jurisdictions. The second
department to gauge the trend of the deposit balances over
part of the chapter looks at the presentation of liquidity stress
time. For example, from Figure 10.2A it is clear that a large
testing results.
percentage of the retail bank deposits are current accounts
A number of the reports shown here are available as template and rolling deposits, with very little fixed-term deposits. For
spreadsheets on the Wiley website supplementary material. regulatory purposes, these funds will be treated as short-term
liabilities and will not assist the bank’s regulatory liquidity
metrics (which emphasises long-term funds), even though the
10.1 LIQUIDITY RISK REPORTING local regulator may allow the bank to treat overnight balances
as longer term if they can be shown to be acting as such in
A bank will produce a number of liquidity reports in the normal “behavioural” terms. In this case, it is worthwhile for the bank
course of business, on a daily, weekly, monthly and quarterly to undertake a marketing exercise to determine if customers
basis. It is important that the format of liquidity MI is both trans- may be interested in moving their deposits into fixed-term
parent and accessible. We illustrate a sample of reports that or notice accounts. Any increase in the size of the latter will
provide a benchmark framework for reporting. improve the firm’s liquidity metrics.

The forecast element of this report is based essentially on


Deposit Tracker Report objective judgement. The historical trend up to the current
The deposit tracker is a simple report of the current size of date will assist in making the forecast; otherwise, it is a case
deposits, together with a forecast of what the level of deposits of making as best an estimate as possible, with inputs from
are expected to be going forward. This report is tracked weekly the relationship managers who look after the various cus-
and monthly because it provides an idea of the LTD ratio in the tomer accounts.
immediate short term. The LTD is a key management liquidity
ratio.
Daily Liquidity Report
Table 10.1A shows the first part of a typical deposit
tracker report for a medium-sized commercial bank, as at The daily liquidity report is a straightforward spreadsheet
month-end May 2009. We see that the report provides the detailing the bank’s liquid and marketable assets, together
following: with liabilities, up to 1-year maturity and beyond. It provides an
end-of-day of the bank’s liquidity position for the Treasury and
• the month-end actuals for deposits by customer type; Finance departments. Each branch and subsidiary will complete
• the change from each month-end one, although a bank that has only a branch structure (and no
1

• 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
1- nt
20
66 Ce

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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82 B
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58 ak
11 ah
41 M
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188 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  



Table 10.1A Deposit Tracker Report, Month-End Actuals and Year-End Forecast


Deposit Tracker Month End Actuals Forecasts

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

Eligible Correspon- 482,236 431,166 485,302 507,193 536,907 493,930 515,753 520,753 520,753 520,753 525,753 530,753 535,753
dent Banks

Corporate Client 449,871 375,849 248,677 263,267 243,710 280,248 273,893 273,893 273,893 273,893 273,893 273,893 273,893
Deposits

Private Bank Client 14,168 23,334 18,990 102,174 102,582 99,119 99,123 99,123 99,123 124,123 124,123 124,123 124,123
Deposits

Local Authority 196,624 195,814 192,100 226,622 267,001 325,016 333,287 343,287 348,287 373,287 393,287 413,287 433,287
Deposits

Retail Bank 1,234,799 1,318,219 1,323,738 1,264,323 1,293,918 1,258,133 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025
Deposits

Eligible Private 24,864 37,456 38,358 37,196 37,388 35,512 35,529 35,529 35,529 35,529 35,529 35,529 35,529
Bank Correspon-
dent Banks

Treasury Sales 5,775 5,198 4,477 3,846 822 770 763 763 763 763 763 763 763

Total Customer 2,408,337 2,387,036 2,311,642 2,404,621 2,482,328 2,492,728 2,522,373 2,537,373 2,542,373 2,592,373 2,617,373 2,642,373 2,667,373
Deposits:

M/M +/- -21,301 -75,394 92,979 77,707 10,400 29,645 15,000 5,000 50,000 25,000 25,000 25,000

W>W + > -

Mend +/-

Drawdown–Month 76,374 8,526 4,479 5,298 2,911 3,136 5,570


ahead

Repayment–From 37,888 11,920 4,429 2,326 25,800 7,965 20,863


loans schedules

Forecast
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



190


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
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06 oo
65 ks
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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

Customer deposits / Accounts by maturity


300 1200

250 1000
Corporate banking EUR MM

Retail banking EUR MM


200 800

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

accounts deposits week +


5
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Correspondent banks 22.74 0 44.13 273.68 183.40 26.00 0.00 0.00


1- nt
20
66 Ce

Corporate banking 78.89 51.94 55.78 25.32 61.08 7.27 0.17 0.00
65 ks
06 oo

Local authority deposits 0 0 29.60 74.24 127.63 71.64 29.18 1.00


82 B
-9 ali

Private banking 13.76 95.35 0.00 0.00 0.00 0.00 0.00 00


0
0.00
58 ak
11 ah

Retail banking 112.98 1036.85 0.59 7.49 28.73 69.35 9.65 2.1
14
4
2.14
41 M

Figure 10.2A Deposit tracker, deposit type and tenor.


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Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 191

  


Customer deposits / Accounts maturity profile
600.00 1,400.00

1200.00
Corporate banking EUR MM 500.00

1000.00

Retail banking EUR MM


400.00

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 +

Retail banking 1,267.78 117.36 109.87 81.14 11.79 2.14


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

Figure 10.2B Deposits maturity profile.

risk factor calculation. The “counterbalancing capacity” in 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

the cumulative liquidity cash flow of the previous report just


5
66
98 er

described, and indeed the two reports can be combined. An


Funding source concentration reports are key MI for senior eniorr
1- nt
20
66 Ce

extract is shown at Table 10.3. Figure 10.4 shows the maturity


Treasury and relationship managers. A central principle ple of
ciple
65 ks

mismatch in graphical form. The key indicates the cash flow for
06 oo

liquidity management is funding diversity, and itss empha-


em
mpha
82 B

each type of product.


-9 ali

sis that a bank should not become over-reliant ntt on


n a single
sin
si
58 ak

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

  


SECURITIES AND CDs

00s
Input data
Classification
Marketable Securities CDs

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


(breakdown below)
Bank CDs: ECB eligible, liquid same day 0
ECB eligible securities, liquid in 1 week tender 649,967
Non-ECB eligible securities, can be sold over 4 weeks 277,589
Government securities 9,640
TOTAL MARKETABLE SECURITIES AND CDs 937,196 231,645
Non-marketable
Non-ECB eligible CD summary
Average remaining tenor Amount
1 day
2 days
1 week
2 weeks 6,645
1 month 25,000
2 months 50,000
3 months 35,000
6 months 115,000
12 months

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

Table 10.4 is an example of a Large Depositor Concentration 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

Undrawn Commitment Report Liability Profile


58 ak
11 ah
41 M

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

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 193

  



Table 10.2A Asset and Liability Cash Flows
Input Data

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 call a/c 6,754 0 0 0 0 0 0 0 0 0 6,754


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

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


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

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


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

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


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

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

Average remaining 44.59 Months


duration of assets

Input Data

Liabilities 000s 1 Day 2 Days 1 Week 2 Weeks 1 Month 2 Months 3 Months 6 Months *1 Year +1 Year Total

Without any stickiness


assumptions

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


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

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

Inter-Group time 72,276 136,744 351,130 233,319 60,987 161,120 43,881 101,896 24,294 0 1,185,647
Other bank call 235,097 0 0 0 0 0 0 0 0 0 235,097
Other bank time 16,088 116,319 135,796 21,210 121,181 85,287 192,512 64,901 0 0 753,294
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

Liquidity Risk Factor Months

Average remaining term of assets 44.5900 Excluding marketable securities


Adjusted for marketable securities 34.8776
99
20 Average remaining term of liabilities 7.7200 With no call stickiness
41 M
Excluding
Excl 8.0046
ah
11 ludin
58 ak call deposits
Average
erage
-9 ealte
en of call deposits 37.55
B
82 tenor
06 oo
Combineded6 average
a s remaining term of liabilities 9.0593
5avera
66 Ce
LRF 1- nt 3.8499
9 8 er
20
66
56

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 195


01



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

No behavioural or stress adjustments applied

Inflows Sight Two – Eight Nine One – Three Three – Six Six One – Three Three – Five Five Years and Total
Days Days – One Months Months Months – One Years Years on
Month Year

TOTAL INFLOWS (908,203,354) (188,005,661) (705,398,674) (376,131,077) (86,328,844) (97,212,696) (481,473,198) (444,603,252) (734,632,172) (4,021,988,928)

Outflows Sight Two – Eight Nine Days – One – Three Three – Six Six Months – One – Three Three – Five Five Years and Total
Days One Month Months Months One Year Years Years on

TOTAL OUTFLOWS 893,940,981 397,283,377 1,379,620,964 1,251,323,695 328,027,956 105,751,557 3,219,569 0 0 4,359,168,099

Behavioural OK
Adjustments/Stress

Net Mismatch per (14,262,374) 209,277,716 674,222,290 875,192,618 241,699,112 8,538,861 (478,253,629) (444,603,252) (734,632,172) 337,179,171
Bucket

Adjustments Sight Sight – 8 Days Sight – 1 Month Sight – Three Sight – Six Sight – One Sight – Three Sight – Five Sight – Five Total
Months Months Year Years Years Years

TOTAL ADJUSTMENTS (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (11,311,886,530)

Cumulative Mismatch Sight Sight – 8 Days Sight – 1 Month Sight – Three Sight – Six Sight – One Sight – Three Sight – Five Sight – Five
Months Months Year Years Years Years

(1,271,138,655) (1,061,860,938) (387,638,649) 487,553,969 729,253,082 737,791,943 259,538,314 (185,064,938) (919,697,110)

Liquidity Ratio 29.16% 24.36% 8.89% -11.18% -16.73% -16.93% -5.95% 4.25% 21.10%

Behavioural 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Adjustments/Stress
Variance

Internal Limit 0.00% 3.00% -3.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

FSA Limit 0.00% -5.00%


99
Notes:s:204
M
“Outflow” w” are
11ar LIABILITIES.
e aLIA
“Inflow” are
1 ASSETS.
re 5AS
ha
8 SETSk
-9 ali
82 B
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
560
1


Figure 10.4 Graphical representation, maturity gap report.

2,000,000,000 Cash flow survival horizon

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

categories: • Asset-backed securities;


82 B
-9 ali

• Customers: individuals; • Unsecured: other wholesale;


58 ak
11 ah

• Customers: large enterprises; • Repo (other assets);


41 M

• Repo (highly liquid securities); • Conditional liabilities;


20
99

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 197

  



Table 10.4 Funding Concentration Report

LARGE DEPOSITOR CONCENTRATION REPORT SUMMARY – 31 AUG 10

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

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

A 1,652,551 44.3% 5.0%


B 1,193,328 27.0% 3.6%


C 1,061,180 33.6% 3.2%
D 818,658 10.4% 2.5%
E 119,664 4.7% 0.4%
F 50,195 3.7% 0.2%
G 40,000 4.0% 0.1%
Total 4,935,577 15.0%
* Large depositors lend Bank plc more than $50m.

Large Depositors as a Percentage of Country and Total Funding

Deposit Percentage of Group


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

Bank plc A B C D E F G

CBS 844,101 16.5% 1.4% 0.8% 2.5%


CBL 588,777 7.4% 3.3% 1.8%
Customer 2 448,000 14.2% 1.4%
ACO 341,150 9.1% 1.0%
Bank Med 307,609 0.1% 7.1% 0.5% 0.9%
Sovereign 300,000 8.0% 0.9%
Monetary
Agency 1
99
20 CBJ 227,730 1.9% 2.8% 12.8% 0.7%
41 M
CBA
11 A h 190,706 3.2% 0.9% 0.6%
58 ak
Sovereign
verei
-9 gn
82 B 171,195 1.1% 0.9% 3.7% 0.5%

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

Deposit Percentage of Group


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

Bank plc A B C D E F G

Customer 1 142,516 4.5% 0.4%


Customer 3 133,080 1.7% 0.4%
AMF 122,850 3.3% 0.4%
Customer 4 102,600 1.3% 0.3%
R Bank 100,000 2.7% 0.3%
Petro Company 94,421 3.0% 0.3%
ABC 92,819 2.3% 0.1% 0.3%
ALF 88,311 2.8% 0.3%
Retail depositor 80,000 2.5% 0.2%
Customer 5 68,116 0.9% 0.2%
Principal Bank 62,933 2.0% 0.2%
Sicon Construction 60,139 2.4% 0.2%
The Public Ware- 59,526 2.3% 0.2%
housing Co
GIB 54,000 1.4% 0.2%
SCB 50,000 0.3% 4.0% 0.2%
99 SIB 50,000 1.3% 0.2%
20
41C M
CBUAE 50,000 1.3% 0.2%
ah
11BUA
Total 4,975,577 27.0% 33.6% 44.3% 10.4% 4.0% 12.8% 3.7% 4.7% 15.0%
58 ak
otal- a
98 li B
CBS is Bank
ank
20 plc’s
p oo bbiggest depositor (16.5% of funding). This exceeds the Group’s 10% max. depositor funding limit.
66 k
56 s C
61 en
-9 te
82 r
06
65
60

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 199


1


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.

Wholesale Pricing and Volume


A bank’s liquidity position is not illustrated solely
by its cash flow liquidity metrics. An indica-
tion of liquidity strength can also be gleaned
from looking at a bank’s funding costs, and the
composition of its funding by product. The first,
especially, is valuable market intelligence and
the bank regulator will also be compiling this
Figure 10.6B Undrawn commitment report, head office. information. The regulatory authority can obtain

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

Figure 10.7 Liability profile.


20
99

200 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Figure 10.8 Firm-specific funding yield curve.

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

Figure 10.9 Wholesale funding breakdown by product and tenor bucket.


06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
99

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 201

  


MONTHLY LIQUIDITY SNAPSHOT
CUMULATIVE LIQUIDITY REPORT ($’000)

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 80 80 –1,260 –1,260 –1,180 –1,408 –1,150 –850 –850
Other Forecast Inflows
Other Forecast Outflows
Cumulative Cash Gap 80 80 –1,260 –1,260 –1,180 –1,408 –1,150 –850 –850
Counterbalancing Capacity 180 180 635 640 748 748 1,238 1,238 1,238
Liquidity Gap 260 260 –625 –620 –432 –660 88 388 388
Limit

Variance 260 260 –625 –620 –432 –660 88 388 388

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


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

LIQUIDITY RATIOS – THREE MONTH VIEW

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

Current month Previous month Change

LIQUIDITY RISK FACTOR 22.2 25.1

LOAN-TO-DEPOSIT RATIO 96% 93%

NET INTER-GROUP LENDING (1,228) (1,552)

Figure 10.10 Monthly liquidity snapshot for senior management.

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

and where reporting requirements are waived or modified, ed,


d,
98 er
1- nt
20
66 Ce

the regulatory authority will agree the format and frequency


eq
quen
quen ncy
Frequency of Reporting
65 ks

of iliquidity reporting on a case-by-case basis. Table 10.5


ble 10
0.5
0. 5 iis a
06 oo
82 B

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

  


GROUP TREASURY QUALITATIVE REPORTING
Monthly Liquidity Highlights
Template for Branches and Subsidiaries to Summarise Main Liquidity Changes for the Last Month
To be Provided a Fixed Specified Date Each Week
Points to consider:
1. Explain significant changes in your 1-week and 1-month liquidity ratios
2. Explain any changes to your cash and liquidity gap in your Cumulative Liquidity model
3. Explain significant changes to the Liquidity Risk Factor
4. Explain growth or shrinkage of asset books
5. Detail any changes to inter-group borrowing/lending position; detail the counterparties for any
large-size deals
6. Any increase/decrease in corporate deposits, detail large dated transactions with an estimated
confidence level of roll-over
7. Any increase/decrease in retail deposits
8. Average daily opening cash position
This list is not exhaustive and any other relevant points are welcome.

Figure 10.11 Group treasury qualitative reporting, regular liquidity highlights.

Table 10.5 UK Liquidity Reporting Requirements: Standard ILAS Firms

Report Description Frequency Submission Deadlines

FSA047: Daily Flows 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

large enterprises corporate ing profile and the stickiness of month-end


6
82 r
-9 te
06
61 en

funding retail deposits


56 s C

FSA054: Currency analysis Analysis of foreign exchange (FX) Quarterly 15 business


ss days
66 ok

dayys after
aft
20 o

exposures on firm’s balance sheet month-end


nd
d
98 B
8- ka

Off-balance sheet report Aggregate undrawn committed Monthly 15 business


ness days
busin d after
facilities month-end
onth
h-en
5
11
41

Source: FSA.
20
99

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 203

  


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

01
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Figure 10.12A and B Stress test results: cash flow survival horizon.
41
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204 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


LIQUIDITY RISK (STRESS TESTING) WEEKLY SUMMARY 23 February 2010

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

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

 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

     


      Z [">@@$M    '*@M=   '     $ W+    
    Z $  !   $ ' >@       \) $ W  ! W   '+   
 $€150mm to €1.13bn
         
OBF applied
 

       ! "#$"%&%  ] ^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 $ >

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

money for regulatory purposes, although certain regulatory Bank liquidity models commonly apply the following treatment:
authorities will allow a “behavioural” adjustment of retail depos-
• 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

In general, a conservative approach to treatment of expected


p ed d
5 60

• Derivatives values/notionals are not included in the liquidity


66

cash outflows, whether as derivative collateral or undrawn


rawn com-
drawn com
co
98 er
1- nt
20

ratio calculation; however, coupons receivable or payable will


66 Ce

mitments, is recommended business bestpractice. e.


be included on their pay dates.
65 ks
06 oo
82 B

• Commitments: 10% (specified by FSA) committed but


-9 ali

undrawn lending is included as an outflow of cash (at sight)


58 ak
11 ah

and included in the ratio calculations.


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Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 205

  



Table 10.6 Liquidity Management: Individual Stress Test Results Report

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

Reduction in Liquid Assets


Change in repo criteria Light Rating category 1 notch downgrade 8.46% 1.35% 50% 30


Moderate Rating category 2 notch downgrade 2.34% 0.12% 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
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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
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Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 207


01




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41 M
11 ah
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06 oo
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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
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Excerpt is Chapter 7 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen
tephe Baird.
41
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209

  


11.1 ACTIONS IN A LIQUIDITY CRISIS set out the company’s strategies for addressing liquidity needs
during liquidity stress events.
A contingency funding plan (CFP) serves as a logical connection As part of this guidance, supervisors have indicated that CFPs
to its companion, the liquidity stress testing framework, by link- should have defined policies and procedures that address the
ing the stress test results and other related information as inputs governance, roles and responsibilities, liquidity measures and
to the CFP governance, menu of contingent liquidity actions, triggers, menu of contingent actions, and communication pro-
and decision framework. tocols. Further, an institution’s CFP, or collective set of CFPs,
Contingent liquidity events can be categorized by their level should be tailored to the specific business and risk profiles of
of estimated adverse impact and probability. Institutions man- the institution, covering the different set of businesses, subsid-
age one end of the spectrum—the low-impact, high-probability iaries, legal entities, products/asset classes, and geographic and
events—as part of their business-as-usual (BAU) funding and foreign exchange (FX) coverage in which the institution oper-
liquidity risk management activities but use CFPs to address ates. Finally, institutions should also regularly test their CFPs to
the other end of the spectrum associated with high-impact ensure operational effectiveness.
low-probability events. CFPs provide a structured approach for In addition to the specific guidance on CFPs, other supervisory
developing and implementing the institution’s financial and oper- guidance on capital management, liquidity risk management,
ational strategies for effectively managing such contingent liquid- and recovery and resolution planning have impacted how insti-
ity events during periods of severe market and financial stress. tutions design their CFPs. In particular, the Federal Reserve’s
This chapter provides a brief overview of the CFP’s evolution Comprehensive Liquidity Assessment and Review (CLAR) and
and recent changes, design framework and key considerations, the daily liquidity regulatory reporting requirements have link-
and implementation considerations. ages to the CFPs’ governance and liquidity measures. Addi-
tionally, CFPs are often referenced as part of and aligned to
an institution’s recovery and resolution planning activities, as
11.2 EVOLVING CAPABILITIES liquidity risk is often one of the key drivers of the potential
AND ENHANCEMENTS institution’s failure and a critical resource needed to effectively
support the execution of the institutions’ resolution strategies’.
Formalized CFPs have gained greater traction and importance In this capacity, the CFP serves as an important bridge between
over the past decade as market disruptions have become more the institution’s BAU liquidity risk management practices and the
common and concerns for the survival of institutions in crisis recovery and resolution planning activities, where specific parts
have drawn sharpened attention. Progress has been made in of the institution must be resolved.
formalizing and standardizing CFPs; however, there remain
notable differences among institutions with respect to the level
of coverage and detail. In general, smaller institutions have 11.3 DESIGN CONSIDERATIONS
typically included their CFPs as part of their broader business
continuity plans, while larger institutions have established more While no universal CFP exists that can cover all types of institu-
formalized CFPs. Larger, more complex firms may also have tions and situations, there are several CFP key design consider-
several CFPs to address the specific challenges and options for ations that firms should be mindful of in designing or refreshing
different subsidiaries and legal entities. their CFPs. These considerations include the following:

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
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have released additional guidance pertaining to CFP design


65 ks
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and implementation requirements. More recently, the Federal


I. Align to Business and Risk Profiles
ofil
filles
es
82 B

Reserve, in its “Enhanced Prudential Standards for Bank Hold-


-9 al
58 ak

ing Companies and Foreign Banking Organizations” guidance, CFPs should be considered in the context of the institu-
insti
instit
11 ah
41 M

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
20
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210 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


FX coverage, and legal entity structures. Institutions should associated management actions that can be calibrated for differ-
ensure consistency by aligning their risk appetite statement to ent stages of the liquidity crisis.
the CFP framework, through quantifiable early warning indica-
By virtue of the fact that the CFP cannot anticipate all possible
tors, limits, and escalation levels.
situations that may lead to a liquidity crisis, effective CFPs strike a
A CFP should be refreshed accordingly as the institution’s balance between specifying recommended contingency actions
business and risk profile changes over time; both internally as while enabling management sufficient flexibility and discretion to
corporate and business strategies change, new products and make informed decisions as the crisis evolves over time.
services are introduced, as well as externally, as the macro-
economic and market environments evolve. In addition to the
periodic updates to the CFP, leading institutions are taking a
IV. Inclusive of Appropriate
more proactive stance on the development of the CFP by incor- Stakeholder Groups
porating it as part of, or in parallel with, their strategic planning Developing operational readiness in a CFP requires a thorough
exercises, thereby positioning the CFP to be more forward- understanding of both strategic and tactical aspects of the
looking and flexible. institution. This assessment begins with scenario design, contin-
gency planning, and communication strategies, and continues
II. Integrate with Broader Risk through execution, where timely coordination and communica-
tion are critical to ensuring that internal and external stakehold-
Management Frameworks
ers remain confident in the institution’s financial strength.
The CFP is not a stand-alone tool, but rather, an integrated part
For these reasons, the involvement of appropriate stakeholder
of the institution’s liquidity risk management and firm-wide risk
groups, including various management committees (e.g., asset-
management frame-works, including enterprise risk manage-
liability committee (ALCO), risk and capital committee, invest-
ment (ERM), capital management, and business continuity and
ment committee), business units, finance, corporate treasury,
crisis management. This integration of the CFP to other compo-
risk, operations and technology, is needed to capture the
nents of the ERM disciplines increases the CFP’s effectiveness
appropriate elements of the CFP as part of the design and to
and consistency by enabling it to leverage and reference estab-
ensure successful coordination from an execution standpoint.
lished controls and processes.
In practice, involvement of the various stakeholder groups pro-
The CFP should be explicitly linked to the liquidity risk mea- vides a strong forum in which potential issues or challenges can
surement framework and the liquidity stress test, in particular be openly discussed and addressed.
through its limit structure and escalation levels. For example, the
liquidity risk measures used in the institution’s BAU risk manage-
ment activities serve as a foundation from which the CFP defines
V. Supported by a Communication Plan
its early warning indicators (EWIs). Additionally, linkages to As in any crisis, the coordinated and timely communication of
the business continuity and crisis management frameworks will information to stakeholders is critical—a key lesson that resur-
reinforce key operational and communication protocols during faced in the recent financial crisis. In addition to the need for the
times of crisis. institution to be internally coordinated, external communication
to clients, analysts, counterparties, and regulators with timely and
III. Operational, Actionable, accurate information is critical as it helps to reinforce confidence
in the institution and mitigate potential risk that rumors and fears
but Flexible Playbook
do not further precipitate and adversely impact the institution.
As a playbook, the effectiveness of the CFP lies in its opera-
tional readiness. In a crisis, the ability to convene management
1

11.4 FRAMEWORK AND BUILDING


N
60

and start to develop contingent strategies and a plan of action


5
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would likely prove highly challenging without prior planning. As BLOCKS


1- nt
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such, it is important for the CFP to include a menu of possible


65 ks
06 oo

contingency actions that management can undertake in differ- With these key design considerations in mind, d, institutions
inst
ins
stitut
82 B

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
11 ah
41 M

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
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Chapter 11 Contingency Funding Planning ■ 211

  


business activities, products/asset classes, geographic and FX Liquidity crisis team. The LCT serves as the central point
coverage, subsidiaries, and/or legal entities. of contact and is responsible for the continuous monitoring
of the institution’s liquidity profile. The LCT will also provide
Key components of a CFP framework include the following:
recommendations on CFP actions, working closely with cor-
1. Governance and oversight porate treasury and the management committee. In perform-
2. Scenarios and liquidity gap analysis ing this function, the LCT helps ensure effective coordination
and communication across the organization as well as with
3. Contingent actions
external stakeholders. The LCT should be composed of
4. Monitoring and escalation senior members of the institution’s business and supporting
5. Data and reporting functions, including C-level executives, and heads of business
segments, geographies, and legal entities. Generally, the LCT
is responsible for designing the CFP and submitting it to the
Governance and Oversight
senior management group for review and approval.
An effective CFP requires both well-defined roles and responsi-
Management committee. During a crisis, the senior manage-
bilities and a strong communication strategy that ensures timely
ment of an institution provides oversight of the LCT and con-
coordination and communication among internal and external
sults with the board of directors, monitoring the institution’s
stakeholders. Both the organizational roles and communications
liquidity risk profile and reviewing specific recommendations
plan need to be supported by well-defined policies and proce-
for and coordination of CFP actions.
dures, and reinforced through CFP periodic testing and simula-
tion exercises. Board of directors. The board of directors should be
actively engaged, in coordination with the management
Stakeholder Involvement, Roles, committee and LCT teams, during the crisis and serve as
and Responsibilities an advisor and counsel to them. A strong understanding
of the contents of the CFP will enable board members
A well-designed CFP requires representation from a variety of
to be actively engaged with the management committee
stakeholder groups across the institution. Front office and busi-
in evaluating CFP actions being considered, particularly
ness groups can provide insights into how their businesses per-
if the institution’s liquidity position continues to worsen,
form under different business environments and stress scenarios;
and strategic actions, such as large asset and/or subsidiary
corporate finance, treasury and risk management groups can
sales, need to be taken.
provide perspectives on how funding and liquidity risk profiles
are managed, both in BAU and in crisis situations, and the tools For institutions that have complex business models that
afforded as the liquidity crisis escalates; and operations can include multiple business segments, geographies, and/or
describe the collateral and cash management processes and legal entities, it is important that the overall organizational
how they manage the inflows and outflows of liquidity. structure be well defined at the parent level and the operat-
ing subsidiaries. This helps ensure a proper chain of com-
While the specific CFP roles and responsibilities of different groups
mand where decisions are well coordinated and aligned
may vary across different institutions, there are several groups that
across the institution as a whole.
play a pivotal role in the CFP design and implementation, including
corporate treasury, the liquidity crisis team, management com-
mittee, and board of directors. The following descriptions should
Communication and Coordination
serve as a starting point for institutions in defining specific CFP CFPs should include a communications strategy and plan to
roles and responsibilities. Institutions should be mindful that these ensure proper notification, coordination, issue reporting and
roles should be tailored to address institution-specific organiza- escalation. The different groups across the institution must work
1

tional structure, capabilities, and coverage/responsibilities: in concert, relying on each other to ensure information is avail-
560

able on a timely basis to support management decision-making. aking


g.
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Corporate treasury. As part of its BAU activities, corporate


1- nt
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Additionally, an effective communication strategy and plan p an pro-


pla p
treasury monitors the ongoing business, risk, funding, and
65 ks

motes confidence. Confidence is critical, as demonstrated ed time


trate
rate tim
06 oo

liquidity profile of the institution. The treasurer, in consulta-


82 B

and again in financial services industry, most recently


ntllyy during
entl duri the
durin
tion with the CFO and others, may invoke the CFP and con-
-9 al

financial crisis of 2007-08.


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vene the liquidity crisis team (LCT) based on a review of the


11 ah
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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
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212 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


management understands the challenges ahead and has a plan of • Inputs, outputs, and calculations
action. This is important to both internal and external stakehold- • Key assumptions
ers, including employees, clients, counterparties, shareholders, rat-
• Data control
ings agencies, and regulators, as the loss of confidence can quickly
spiral downward when rumors start to take over news headlines— • Model validation
whether such headlines are grounded on reality or not. • Monitoring and escalation
Communications with respect to messaging and content should • Regular monitoring and risk management
be centrally managed. Everyone should be working off the same • Liquidity gap analysis
page. However, the bidirectional communication and coordina-
• Contingent actions
tion with the stakeholders should reside with those executive
and management teams that have existing working relation- • Reporting
ships. For example: • Reporting frequency
• Business units—clients, counterparties • Briefing decks and reports
• Corporate treasury—regulators and supervisors, rating The CFP policy should be consistently applied, whether it is a sin-
agencies, clearing banks gle CFP or multiple CFPs, and should be reviewed and updated
• Investor relations—investors, analyst community, public media periodically to ensure continued alignment to the institutions
current and forecasted business activities and risks exposures.
• Legal and compliance—regulators and supervisors
These coordination points may differ across institutions, Testing and Readiness Assessment
depending on their size, complexity, and organization structure.
On a periodic basis, institutions should evaluate their CFP oper-
Additionally, institutions may already have existing communi-
ational readiness and test targeted elements of their CFPs to
cation plans, as part of their BAU and/or business continuity
ensure relevance and execution effectiveness in times of stress,
activities. As such, institutions should look to leverage existing
particularly given changing market dynamics and the institution’s
practices as part of their CFP design and make appropriate
business and risk profiles. While certain contingent activities,
enhancements, where appropriate.
such as business divestitures, large asset sales, and use of Fed-
eral Reserve borrowing, may be impractical or unavailable for
Policies and Procedures
testing, there are some market activities such as debt issuances,
Institutions should document their CFPs and ensure alignment brokered deposits issuances, and limited securities sale of the
with other risk management, business continuity, and recov- investment portfolio to generate additional liquidity that may be
ery planning-related policies and procedures. Documentation appropriate to test.
should include all aspects of the CFP, including the governance
Additionally, institutions should evaluate the CFP’s opera-
structure, processes, data, and reporting activities. An illustra-
tional effectiveness: Such activities should include the CFP’s
tive example of a CFP policy outline is as follows:
governance, escalation process, communication, coordi-
• Introduction nation, and reporting. Leading institutions that perform
• Overview and purpose of the CFP frequent exercises that best simulate the potential liquidity
• Related policies including CFPs across business segments, crisis environment will improve the CFP’s operational effec-
geographies and legal entities, resolution and recovery tiveness and response times, aspects that are critical during a
planning, and business continuity policies crisis. Further, the test simulations may also identify potential
gaps and/or improvement opportunities that would otherwise
• Governance be undetected if the CFP were left purely as a theoretical
1

• Roles and responsibilities


60

design exercise.
5
66
98 er

• Review and approval


1- nt
20
66 Ce

• Periodic review Scenarios and Liquidity Gap Analysis


naly
ysis
65 ks
06 oo

• Stress testing and scenarios overview (likely covered in detail


82 B

Institutions should align their CFP stress scenarios


cenaarios to those in its
-9 ali

in separate document)
58 ak

liquidity stress testing framework, as well as to other


o frameworks
11 ah

• Methodology
41 M

such as the recovery and resolution plans.


ns. The
an Th liquidity stress
• Scenario design testing scenarios will cover both systemic
temi (general market) and
temic
20
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Chapter 11 Contingency Funding Planning ■ 213

  


idiosyncratic (institution-specific) risks and address both mar- • Securitizing retail assets (e.g., mortgages, credit card receiv-
ket (asset) liquidity and funding liquidity, over short-term and ables, loans, auto leases)
prolonged stress periods. The liquidity stress testing framework • Pledging of assets through the Federal Reserve discount
should ensure that effects of these stresses on the institution’s window
liquidity profile is appropriately measured and monitored. The
• Selling liquid assets/investments
CFP in turn should provide a tactical mechanism for escalating
a developing crisis to management’s attention and ensuring • Drawing down on securitization conduits
actionable responses are available. • Issuing subordinated debt

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
98 er
1- nt
20

• Changing investment strategy to roll off reinvestment of concentration


66 Ce
65 ks

securities at maturity • Counterparties not willing to roll over funding


06 oo
82 B

• Shifting allocation from short-term funding to longer-term Management should try to anticipate these challenges ges as well as
lleng
leng
-9 ali
58 ak

funding sources the implications they may have on its liquidity


tyy responses.
resspons
spon Where
11 ah
41 M

• 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

  


Market Signals and Reputational Impact These measures can be organized as market and business mea-
sures (external and internal) and liquidity health measures (inter-
In the early stages when an institution experiences liquidity
nal), and represent factors that affect—directly or indirectly—the
stress, it may elect to curtail certain businesses activities, tighten
institution’s liquidity position. Collectively, these measures form
its credit and lending standards, and/or limit its exposure to
a set of key risk indicators or Early Warning Indicators (EWIs)
higher risk counterparties to strengthen its liquidity profile and
that provide advance signaling of potential liquidity problems
resources. While these responses will provide some measure of
on the horizon, enabling management to evaluate and take
improved liquidity, such actions may send inadvertent signals to
measured steps as the crisis escalates.
the market and thereby impact the external perception of the
institution’s financial strength and reputation, adversely limiting
the availability and/or effectiveness of future contingent actions
Early Warning Indicators
as the crisis evolves. Market and business measures reflect the market environment
and institution-specific business strategy and activities. These
For example, borrowers who believe that the institution has
indicators, such as significant changes in levels and volatility
spurned their business will likely look to other lenders. Coun-
of the equity markets, severe drop in institution’s stock price,
terparties, such as hedge funds, which rely on credit from prime
and dramatic changes in the business’ revenues from a certain
brokers or trading counterparties, could cease their relation-
geographic area, can prompt management to evaluate how
ship with the institution and seek other trading partners or
changing market conditions and institution’s business strat-
intermediaries. Certain debt holders that have strong business
egy may be adversely impacted and thereby proactively take
relationships with the institution could “force” a debt buyback,
actions in advance of oncoming market disruptions.
and the institution in agreeing to such buyback will likely reduce
its liquidity; however, refusing to do so could raise questions Liquidity health measures serve as indicators of the institution’s
regarding the institution’s viability. liquidity base and strength. While the market and business
risk measures should be evaluated within a broader context,
A change in the market’s perception of an institution’s viability
the liquidity health measures, such as short-term funding as
could have rapid and severe impacts on its liquidity. For this
a proportion of total funding, deposits-to-loan for depository
reason, certain actions could cause more harm than benefit
businesses, and the firm’s credit rating, are more targeted in
depending on the severity of the stress and the institution’s
that deterioration in these metrics reflect a direct and adverse
financial strength, as already noted.
impact on the institution’s current and/or projected liquidity
At various stages of liquidity stress, management must consider profile and strength.
the signals that its actions convey to the markets, its lenders,
Both types of measures are important for informing manage-
clients, and counterparties. Depending on the specific timing,
ment of the potential effects of different liquidity stress sce-
certain contingent actions, while they may provide short-term
narios. Internal and external EWIs should be selected in concert
liquidity, may ultimately leave the institution worse off, depend-
so that the institution can identify emerging liquidity risks and
ing on the reactions of its external stakeholders. For example,
the nature of these risks as idiosyncratic, systemic, or some
attempts to access a sovereign lending facility or other emer-
combination of the two. The combination of EWIs and escala-
gency source of funds may lead counterparties and lenders to
tion levels enable the institution to anticipate and manage the
immediately withdraw existing credit out of concern that the
liquidity crisis as it unfolds over time.
institution will fail. The sale of certain businesses or a suspen-
sion of activities, such as reverse repo or other customer funding
operations, could be perceived as signs of distress. These con- Market and Business Factors
tingent actions may be necessary during the later stages of the Institutions will need to define EWIs using external and internal
crisis; however, at earlier stages, perceived signals of weakness information in order to monitor trends in the market as well
1

may actually precipitate a liquidity crunch for the institution. as among the institution’s peer group. Such information can
60
5
66

include a combination of macroeconomic measures, industry


indu
ndu
ustry
98 er
1- nt
20
66 Ce

measures, and institution-specific measures.


Monitoring and Escalation
65 ks
06 oo

Macro-environment factors may not directly correspondespon to indi-


corre
82 B

The CFP should leverage the institution’s liquidity risk monitor- vidual liquidity challenges that an institution
on may
m face;
fa however,
-9 ali
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
41 M

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
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Chapter 11 Contingency Funding Planning ■ 215

  


should focus on risks that are specific to the financial system Such EWIs are generally most useful before or at the onset
and its general liquidity. Examples may include repo spreads, of the liquidity crisis, and during the early stages of the CFP
asset haircut trends, and movements in credit default swap escalation levels; however, their usefulness and applicability are
(CDS) spreads. aligned to the specific stress scenario and the institution’s spe-
cific business and risk profiles.
Industry factors include trends in the profitability of the financial
sector, recent rating agency action, banking industry capital
adequacy, S&P financial institution sector movement, and other Liquidity Health Measures
factors. Competitor analysis can also be applied to evaluate the
While the review of macro-economic and industry measures
trends in the industry to detect potential performance problems
provide advance signaling of a potential pending liquidity crisis,
in an institution’s peer group.
institutions should also monitor a suite of liquidity health ratios
Institution-specific measures help management to assess the to help quantify the impact of the liquidity risks and to support
market’s perception of the institution’s financial strength and the decision making on CFP actions being considered. These met-
likelihood of a liquidity crisis through external information. Inter- rics will typically be detailed in the institution’s liquidity risk man-
nal measures provide greater insight into the operations of the agement policy and referenced by the CFP. Key liquidity health
institution and their potential impact on its liquidity position. measures include, but are not limited to, the following:

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

ers that comprise a substantial proportion of an institution’s ns


5

• Requests from depositors for early withdrawal of their funds,


66
98 er

funding needs could cause serious harm to liquidity during uring


g
1- nt
20

or the bank has to repurchase its paper in the market


66 Ce

times of stress, should they decide that their exposure e to


sure
ure t the
65 ks

• Calls by debt holders for the institution to buy back its debt
06 oo

institution is too large and decrease that exposure.ure. Managing


M
Mana
82 B

or CD issuance concentration and establishing a variety of liquidity


quidity providers
pr
-9 ali
58 ak

• 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.
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216 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


• Funding maturity profile. In addition to managing the con- escalation levels required in CFPs, three to five escalation levels
centration of funding sources, institutions should also evalu- are common industry practice. For illustrative purposes, here are
ate the concentration of maturities for their funding. Large descriptions of the different escalation levels, using three levels:
concentrations in funding maturities can threaten an institu-
• Level 1. This is the initial escalation level and represents ele-
tion’s liquidity position, particularly when a concentration in
vated monitoring over market conditions and the impact to
maturity is accompanied by a reliance on short-term fund-
the institution’s business segments and performance. Level 1
ing. Institutions should assess the maturity horizon of their
could be triggered by stress test results indicating a greater
funding sources in tandem with the concentration of funding
decline in liquidity than the institution’s risk appetite targets
sources and with significant consideration to the institution’s
and/or a shift in the market’s perception of the institution.
reliance on short-term funding.
The convening of the LCT prompts closer coordination and
• Used capacity to total borrowing capacity. Measures the
communications among the various stakeholders internally
borrowing capacity available to the institution, based on the
and a communication plan is executed to keep external stake-
used capacity relative to the total borrowing capacity, where
holder properly informed and aware of the institution-specific
the used capacity represents the amount of funding currently
issues and challenges, and actions being contemplated.
being utilized across all funding channels (core funding, inter-
Monitoring should remain focused on forward-looking mea-
bank markets, and funds generated by institutional sales).
sures of the institution’s liquidity health and the general market
• Liquid assets to volatile liabilities. Measures the basic perception. Business activities that are expected to impact the
surplus or cushion that liquid assets provide over required business and risk profile of the institution will likely be closely
funding needs and can be used to monitor the level of liquid monitored with increased frequency and scrutiny.
assets available to offset volatile funding.
• Level 2. At this escalation level, the institution has experi-
• Unpledged eligible collateral to total assets. Measures the enced noticeable markets and/or idiosyncratic events that are
institution’s ability to sell assets or use assets as collateral adversely impacting its business and liquidity risk profile. The
to obtain funding to meet future requirements. The ability institution should monitor indicators of its current liquidity
to quickly identify and understand the liquidity of unencum- position and any causes of deterioration more closely, with a
bered assets will help it optimize its management of the focus on how the institution’s peers and counterparties react
collateral, particularly during periods of market stress. to the changing market dynamics.
• Loans to commitments. Measures the exposure to credit As the crisis continues to worsen, management’s attention
facilities that may be required at some point in the future. As is on recovery while sustaining business and financial perfor-
these commitments are drawn down, utilization increases, mance; however, the focus is more attuned to the immediate
prompting further need for funding to meet the obligations. and short-term horizon. The LCT and management commit-
For institutions with more advanced liquidity risk management tee activities are taken to actively enhance the institution’s
capabilities, these liquidity health measures will also include liquidity position, likely curtailing business activities, and lim-
daily liquidity position reporting, the Basel III Liquidity Coverage iting the extension of additional and new credit facilities.
Ratio (LCR) and the Net Stable Funding Ratio (NSFR) measures. In addition, the institution may take steps to improve its
These liquidity health measures should be monitored continu- liquidity through strategic sales of less liquid portfolio invest-
ously over the course of the crisis; however, their importance ments and assets, in addition to evaluating the feasibility of
is related to their associated limits. As these liquidity health significant CFP contingent actions, such as larger asset sales,
measures start to reach predefined limits, management should business divestitures, and discontinuing certain business
start to evaluate what contingent actions are appropriate. Simi- activities, given the evolving market conditions.
lar to the market and business measures, the usefulness and • Level 3. At the later stages of the crisis, the institution would d
1

applicability of liquidity health measures are dependent on the


60

have taken dramatic steps to stabilize its liquidity position,on,


n,
5

institution’s scope and complexity of business activities.


66
98 er

potentially including significant curtailing of liquidity


ity intensive
dity in
intens
ntens
1- nt
20
66 Ce

business activities or disposition/sales of businesses.


nessse
es.
65 ks

Escalation Levels At this point, the institution’s focus is primarily


arily on
prima o
06 oo
82 B

In designing their CFPs, institutions establish a series of esca- survival. In this situation, the market environment,
vironmen state of
nviron
-9 ali
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
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Chapter 11 Contingency Funding Planning ■ 217

  


Events that trigger the status of the escalation level should be Consideration should be given to the dissemination of liquidity
analyzed to understand the cause of the trigger event(s) and risk reports within the institutions, how these reports are used
the association to capital adequacy; findings should be summa- by management and the board in making decisions, and the
rized and communicated, along with specific recommendations. appropriateness of the information contained within the reports,
The movement from one escalation level to another—whether given their audience.
up or down—should be explicitly considered and approved by
the LCT. While the CFP provides a structured outline for the
expected levels and trend of EWIs and liquidity risk measures, 11.5 ADDITIONAL CONSIDERATIONS
the importance of management’s expert judgment and ability to
put together the mosaic of the different challenges and decide
Different Types of Institutions
on a proper course of action should not be understated.
As noted earlier, the scope and depth of the CFP will be
At each escalation level, notification, review and approval
dependent on the type of institution. Depository institutions
requirements should be defined to ensure appropriate com-
will primarily focus on their deposit base and potential runoff,
munications and reporting, in alignment and concert with the
while institutions that rely more on wholesale funding will look
defined CFP governance structure, roles and responsibilities. For
to lines of credit and funding markets. Insurance companies
example, the Level 1 escalation level, which represents height-
primarily derive their funding from the liabilities of their poli-
ened management monitoring, may require only notification
cies and have historically focused on cash flow matching more
and periodic update to senior management, CFO, CRO, etc.;
than banking institutions. These unique characteristics should
contingent actions taken at this level may require ALCO and/or
be reflected in the CFP’s design, monitoring tools, and menu of
the Treasurer. At the Level 2 or 3 escalation levels, where contin-
contingent actions.
gency actions typically involve more severe actions, notification
as well as approvals for certain contingent actions will inevitably Institutions must also recognize the risks inherent in their busi-
involve senior management and/or the Board. ness practices. Lending institutions that specialize in revolv-
ers and other open commitment loans should incorporate
Additional information on EWIs can be found in Chapter 3—
the potential liquidity drain from obligors drawing down on
Early Warning Indicators.
unfunded commitments. Prime brokers and broker dealers can
experience a decline in the funding coverage of their assets as
Data and Reporting clients withdraw their accounts from the institution. Counterpar-
ties may also make collateral calls, where they previously did
When ensuring that the institution’s liquidity risk monitoring
not, on positions that have moved in their favor or refuse to post
and measuring framework adequately supports the objec-
collateral. Institutions that rely on wholesale funding may also
tives of the CFP, one should consider the frequency with which
experience higher margin requirements and collateral haircuts
various measurements utilized to monitor and manage liquid-
as their creditworthiness comes under question.
ity risk are generated, assessed, and reported. While daily
reporting of the liquidity profile to the treasury function and
the funding desks is prevalent at many institutions, there are
Organizational Structure of the CFPs
a number of institutions that could benefit from increasing
the frequency of liquidity management reporting, especially An effective CFP properly addresses the institution’s suite
to other areas of the institution (such as senior management of businesses, geographies, and legal entities. However, it is
group, ALCO and other risk committees, and the board). This unlikely that a single CFP document can properly cover all
broader reporting of liquidity management should have the these elements in a clear and concise manner. More practically,
contextual information and qualitative guidance to support institutions have developed a portfolio of CFPs. This portfolio
1

senior management in its approach to understanding the insti- of CFPs consists of individual CFPs that address business-
60
5
66

specific segment, products/asset classes, geographic and FX


98 er

tution’s liquidity profile.


1- nt
20
66 Ce

coverage, and legal entities. In aggregate, the portfolio


o of
o CFPs
C
Reports should convey the methods used to determine liquidity
65 ks

provides a comprehensive view and coverage of the institution’s


e insti
titutio
06 oo

coverage for upcoming liabilities and funding needs and elabo-


82 B

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
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218 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


regulator than that of the institution’s regulator at the holding review their CFPs to ensure that the key elements that consti-
company have separate CFPs. Some industry participants have tute an effective CFP include the following attributes:
taken the opportunity to align CFP coverage to also include
• Strong management involvement and participation from the
legal entities classifications associated with their recovery and
enterprise
resolution planning strategies. Other institutions that have large
• Alignment to other capital and risk management frameworks
FX business and coverage may develop a currency CFP that ana-
lyzes the currency exposures across its legal entities. • Evaluation of a wide range of possible scenarios
• Clearly documented management action plan

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

Basel Committee on Banking Supervision, 2008. “Principles


CONCLUSION for Sound Liquidity Risk Management and Supervision, Bank
for International Settlement—Basel Committee on Banking
While institutions have made measureable progress in their Supervision”
CFPs, there are nevertheless opportunities for improvement.
Office of the Comptroller of the Currency. 2012. Comptroller’s
Regulatory focus will likely remain elevated in the area of liquid-
Handbook, “Safety and Soundness—Liquidity,” June 2012,
ity risk management, and expectations will likely only increase.
Office of the Comptroller of the Currency
Consequently, institutions need to demonstrate their CFPs are
well designed, aligned with the institution’s target business and R. Bryant. “Contingency Funding Plan: Banking Busywork or
risk profiles, and are actionable. As such, institutions should Essential Management Tool?” Federal Reserve Bank of Atlanta

1
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41 M
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Chapter 11 Contingency Funding Planning ■ 219

  




99
20
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11 ah
58 ak
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06 oo
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1- nt
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1


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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Excerpt is Chapter 12 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
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221

  


KEY TOPICS IN THIS CHAPTER and competitive maneuverings of other financial institutions
offering similar services, such as share accounts in money
• Types of Deposit Accounts Offered market mutual funds and credit unions, cash management
accounts offered by brokerage firms and insurance companies,
• The Changing Mix of Deposits and Deposit Costs
and interest-bearing investment accounts offered by many
• Pricing Deposit Services securities firms.
• Conditional Deposit Pricing
So challenging has it become today to attract significant new
• Rules for Deposit Insurance Coverage deposits that many financial firms have created a new executive
• Disclosure of Deposit Terms position—chief deposit officer. Innovation in the form of new
• Lifeline Banking types of deposits, new service delivery methods (increasingly
electronic in design), and new pricing schemes is accelerating
today. Financial-service managers who fail to stay abreast of
changes in their competitors’ deposit pricing and marketing
12.1 INTRODUCTION
programs stand to lose both customers and profits. In this chap-
Barney Kilgore, one of the most famous presidents in the history ter we explore the types of deposits that depository institutions
of Dow Jones & Company and publisher of The Wall Street sell to the public. We also examine how deposits are priced,
Journal, once cautioned his staff: “Don’t write banking stories the methods for determining their cost to the offering institu-
for bankers. Write for the bank’s customers. There are a hell of tion, and the impact of government regulation on the deposit
a lot more depositors than bankers.” Kilgore was a wise man, function.
indeed. For every banker in this world there are thousands upon
thousands of depositors. Deposit accounts are the number one
source of funds at most banks. 12.2 TYPES OF DEPOSITS OFFERED
Deposits are a key element in defining what a banking firm BY DEPOSITORY INSTITUTIONS
really does and what critical roles it really plays in the economy.
The ability of management and staff to attract transaction The number and range of deposit services offered by deposi-
(checkable) and savings deposits from businesses and consum- tory institutions are impressive indeed and often confusing for
ers is an important measure of a depository institution’s accep- customers. Like a Baskin-Robbins ice cream store, deposit plans
tance by the public. Moreover, deposits provide much of the designed to attract customer funds today come in 31 flavors
raw material for making loans and, thus, may represent the ulti- and more, each plan having features intended to closely match
mate source of profits and growth for a depository institution. business and household needs for saving money and making
Important indicators of management’s effectiveness are whether payments for goods and services.
or not funds deposited by the public have been raised at the
lowest possible cost and whether sufficient deposits are avail-
able to fund all those loans and projects management wishes to
Transaction (Payments or Demand)
pursue.1 Deposits
This last point highlights two key issues every depository One of the oldest services offered by depository institutions
institution must deal with in managing the public’s deposits: has centered on making payments on behalf of customers. This
(1) Where can funds be raised at lowest possible cost? and transaction, or demand, deposit service requires financial-
(2) How can management ensure that the institution always service providers to honor immediately any withdrawals made
has enough deposits to support lending and other services either in person by the customer or by a third party designated
the public demands? Neither question is easy to answer, by the customer to be the recipient of funds withdrawn. Trans-
1
560

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
-9 ali

card, or via an electronic network, and interest-bearing


t-bea
bea ring demand
aring
58 ak
11 ah

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

  


Two other important interest-bearing transaction accounts were
Factoid created in the United States in 1982 with passage of the Garn–St
In 2003 for the first time in the history of the United States Germain Depository Institutions Act. Banks and thrift institutions
payments made by checks written against transaction could offer deposits competitive with the share accounts offered
deposit accounts were smaller in number than electronic by money market funds that carried higher, unregulated interest
payments, due principally to the explosive growth of debit rates and are normally backed by a pool of high-quality securi-
cards and computer terminals which promise to expand ties. The result was the appearance of money market deposit
sharply in the new century. accounts (MMDAs) and Super NOWs (SNOWs), offering flexible
money market interest rates but accessible via check or preau-
thorized draft to pay for goods and services.
MMDAs are short-maturity deposits that may have a term of
Noninterest-Bearing Transaction (Demand)
only a few days, weeks, or months, and the offering institution
Deposits
can pay any interest rate competitive enough to attract and
Interest payments have been prohibited on regular check- hold the customer’s deposit. Up to six preauthorized drafts per
ing accounts in the United States since passage of the Glass- month are allowed, but only three withdrawals may be made by
Steagall Act of 1933. Congress feared at the time that paying writing checks. There is no limit to the personal withdrawals the
interest on immediately withdrawable deposits endangered customer may make (though service providers reserve the right
bank safety—a proposition that researchers have subsequently to set maximum amounts and frequencies for personal with-
found to have little support. However, demand (transaction) drawals). Unlike NOWs, MMDAs can be held by businesses as
deposits are among the most volatile and least predictable of well as individuals.
a depository institution’s sources of funds, with the shortest
Super NOWs were authorized at about the same time as
potential maturity, because they can be withdrawn without prior
MMDAs, but could be held only by individuals and nonprofit
notice. Most noninterest-bearing demand deposits are held by
institutions. The number of checks the depositor may write is
business firms. In 2009 the U.S. Congress passed the Wall Street
not limited by regulation. However, offering institutions post
Reform and Consumer Protection Act, allowing banks offering
lower yields on SNOWs than on MMDAs because the former
demand deposits to corporations to pay interest on these
can be drafted more frequently by customers. Incidentally, fed-
accounts.
eral regulatory authorities classify MMDAs today not as trans-
action (payments) deposits, but as savings deposits. They are
Interest-Bearing Transaction Deposits
included in this section on transaction accounts because they
Many consumers today have moved their funds into other carry limited check-writing privileges.
types of transaction deposits that pay at least some interest
return. Beginning in New England during the 1970s, hybrid Mobile Apps—Impact on Transaction Deposits
checking–savings deposits began to appear in the form of and Potential Customers
negotiable order of withdrawal (NOW) accounts. NOWs are
Finally, the hottest item in the transaction deposit field today
interest-bearing savings deposits that give the offering deposi-
appears to be the mobile check deposit. Designed principally
tory institution the right to insist on prior notice before the cus-
for customers on the move, carrying camera-equipped smart
tomer withdraws funds. Because this notice requirement is rarely
phones (such as iPhone or BlackBerry), users take pictures of the
exercised, the NOW can be used just like a checking (transac-
front and back of endorsed checks, upload this information into
tion) account to pay for purchases of goods and services. NOWs
their deposit account, regardless of their location, and receive
were permitted nationwide beginning in 1981 as a result of pas-
instant confirmation of the posted deposit. Protection can be
sage of the Depository Institutions Deregulation Act of 1980.
provided by such security measures as two-factor login authen- n
n-
1

However, they could be held only by individuals and nonprofit


60

tication; recent deposits may be visible where the participating


ticip
ci ating
5

institutions. When NOWs became legal nationwide, the U.S.


66
98 er

depository institution allows this visibility, and photo


to clarity
arity may
cla m
1- nt
20

Congress also sanctioned the offering of automatic transfers


66 Ce

be corrected and improved.


(ATS), which permit the customer to preauthorize a depository
65 ks
06 oo

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

earned on a savings account. a host of smaller depository institutions,


ns, both
bo banks and credit
20
99

Chapter 12 Managing and Pricing Deposit Services ■ 223

  


unions, advertising the capability to make deposits from homes, or electronic statements, showing deposits, withdrawals, interest
businesses, shopping centers, and thousands of other, more earned, and the balance in the account. Many depository institu-
convenient locations. Key questions for the future: tions, however, still offer the more traditional passbook savings
deposit, where the customer is given a booklet or electronic
• With mobile-phone digital services who will want to write
message, showing the account’s balance, interest earnings,
checks?
deposits, and withdrawals, as well as the many rules that bind
• What will be the use of building or operating branch offices depository institution and depositor.
and automated teller machines (ATMs)?
For many years, wealthier individuals and businesses have been
• With phone delivery what is the compelling reason to actually
offered time deposits, which carry fixed maturity dates (often
visit a depository institution?
covering 30, 60, 90,180 or 360 days and 1 through 5 years or
• What opportunities for attracting new deposits and new more) with fixed and sometimes fluctuating interest rates. More
sources of revenue does mobile-phone banking present to recently, time deposits have been issued with interest rates
the industry? adjusted periodically (such as every 90 days, known as a leg or
• How many more phone users, compared to deposit holders, roll period). Time deposits must carry a minimum maturity of
are there as prospective customers around the globe? seven days and normally cannot be withdrawn before that.

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
66
98 er
1- nt
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

In 1997 the Congress, in an effort to encourage


age more
m saving for
11 ah
41 M

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

  


higher incomes to make annual tax-deductible contributions to CDs and deposits of a year or longer to maturity often carry the
their retirement accounts and families to set up new education highest interest rates that depositories offer.
savings accounts that could grow tax-free until needed to cover
The size and perceived risk exposure of offering institutions
college tuition and other qualified educational expenses. At
also play an important role in shaping deposit interest rates. For
the same time the Tax Relief Act of 1997 created the Roth IRA,
example, banks in New York and London, due to their greater
which allows individuals to make non-tax-deductible contribu-
size and strength, typically are able to offer deposits at the low-
tions to a savings fund that can grow tax free but pay no tax on
est average interest rates, while deposit rates posted by other
their investment earnings when withdrawn.
institutions are generally scaled upward from that level. Other
Concern by Congress over the fact that few workers still key factors are the marketing philosophy and goals of the offer-
appeared to be saving for retirement led to passage of the Pen- ing institution. Depository institutions that choose to compete
sion Protection Act of 2006. This law makes it easier for employ- for deposits aggressively will post higher offer rates to bid
ers to automatically enroll their employees in retirement plans deposits away from their competitors.
through payroll deductions. In some cases workplace retirement
plans periodically reallocate a worker’s payroll savings into dif-
ferent retirement assets as circumstances change, even if the Factoid
worker herself doesn’t do so (known as a “default option”). Virtual (Web-centered) banks generally offer higher deposit
These employer-engineered decisions regarding employees’ interest rates than do traditional brick-and-mortar banks. Why?
retirement accounts are subject to the proviso that the manager
running the retirement plan act not recklessly but as a “prudent Answer: This is probably due to the somewhat greater
person” would. perceived risk of the Web-based banks and their frequent
lack of a complete menu of services.
Today depository institutions in the United States hold about a
quarter of all IRA and Keogh retirement accounts outstanding,
ranking second only to mutual funds. The great appeal for the
managers of depository institutions is the high degree of stabil- Filmtoid
ity of IRA and Keogh deposits—financial managers can generally What Christmastime ritual finds James Stewart playing the
rely on having these funds around for several years. Moreover, manager of a small-town thrift with funding problems so
many IRAs and Keoghs carry fixed interest rates—an advantage severe that core depositors are lined up to withdraw all their
if market interest rates are rising—allowing depository institu- money?
tions to earn higher returns on their loans and investments that
Answer: It’s a Wonderful Life.
more than cover the interest costs associated with IRAs and
Keoghs. (These retirement accounts were made more attractive
to the public recently when the U.S. Congress voted to increase
The Composition of Deposits
FDIC insurance coverage to $250,000 for qualified deposits.)
Overall, however, Keogh and IRA retirement accounts repre- The largest of all depository institutions are commercial banks,
sented less than 5 percent of the total deposits of U.S. FDIC- whose $9.3 trillion in deposits in 2010 exceeded the deposits
insured banks. held by all nonbank depository institutions (including thrifts and
credit unions) by a ratio of more than four to one. By examining
recent trends in bank deposits we can get a pretty good idea of
12.3 INTEREST RATES OFFERED ON recent changes in the mix of deposits at all types of depository
institutions in recent years.
DIFFERENT TYPES OF DEPOSITS
In recent years, banks have been most able to sell time and
1
60

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

Chapter 12 Managing and Pricing Deposit Services ■ 225

  


Table 12.1 The Changing Composition of Deposits in the United States

Percentages for All U.S. FDIC-lnsured Banks

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

Noninterest-bearing deposits 37.9% 20.5% 20.8% 19.5% 19.9% 16.4% 18.2%


Interest-bearing deposits 62.1 79.5 79.2 80.5 80.1 83.6 81.8
Total deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Transaction deposits 31.9% 32.3% 33.4% 24.3% 21.2% 12.5% 12.3
Nontransaction deposits 68.1 67.7 66.6 75.7 78.8 87.5 87.7
Total domestic office deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Demand deposits 25.4% 22.9% 20.2% 18.9% 19.0% 8.8% 8.7
Savings deposits** 30.2 36.2 41.2 43.5 48.0 55.1 64.3
Time deposits 44.4 40.9 38.6 37.6 33.0 36.1 27.0
Total domestic office deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
*Figures based on data for September 30, 2010.
**The savings deposit figures include money market deposit accounts (MMDAs).
Source: Federal Deposit Insurance Corporation.

make up the majority of transaction and noninterest-bearing more stable, less-expensive deposit base. In 2010, according to
deposits, have declined significantly to less than 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

terest expenses (e.g., by automating their operations and reduc-


60

deposits (such as small savings accounts) can be withdrawn


5
66

ing the number of employees on the payroll).


98 er

immediately, they have an effective maturity often spanning


1- nt
20
66 Ce

years. Thus, the availability of a large block of core deposits


65 ks
06 oo

increases the duration of a depository institution’s liabilities


The Ownership of Deposits
82 B

and makes that institution less vulnerable to swings in interest


-9 ali
58 ak

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.
20
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226 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The next largest deposit owner is state and local governments or Treasury securities are sold to investors, the government
(about 4 percent of the total), representing the funds accumu- usually directs these funds into TT&L deposits first, in order to
lated by counties, cities, and other local units of government. minimize the impact of government operations on the financial
These deposits are often highly volatile, rising sharply when tax system. The Treasury then makes periodic withdrawals (directing
collections roll in or bonds are sold, and falling precipitously the money into its accounts at the Federal Reserve banks) when
when local government payrolls must be met or construction it needs to make expenditures. Today the Treasury pays fees to
begins on a new public building. Many depository institutions depository institutions to help lower the cost of handling gov-
accept state and local deposits as a service to their commu- ernment deposits and receives interest on many of the balances
nities even though these deposits frequently are not highly held with depository institutions.
profitable.
Another deposit category of substantial size is deposits held by
foreign governments, businesses, and individuals, many of which
are received in offshore offices. Foreign-owned deposits rose
Factoid rapidly during the 1960s and 1970s, climbing to nearly one-fifth
The more rapid the turnover of population in a given market of total U.S. bank deposits in 1980, reflecting the rapid growth
area, the more intensive tends to be competition among in world trade and investments by U.S. businesses abroad.
depository institutions in the sale of deposit services and the However, foreign-owned deposits then declined as a propor-
more favorable loan and deposit interest rates tend to be, tion of U.S. bank funds as domestic interest rates proved to be
unless the relocation of depositors doesn’t require a change significantly cheaper. Moreover, international crises, the tragedy
of depository institution. of 9/11, and recent economic fluctuations encouraged American
banks to scale down their overseas expansion plans. However,
as the 21st century unfolded, foreign deposits began to grow
Banks also hold comparatively small amounts of U.S. govern- again due to the availability of higher-yielding foreign invest-
ment deposits. In fact, the U.S. Treasury keeps most of its oper- ments, the continued expansion of several foreign economies
ating funds in domestic banking institutions in Treasury tax and (especially in Asia), and a deep business recession in Europe and
loan (TT&L) accounts. When taxes are collected from the public the United States.

E-BANKING AND E-COMMERCE

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

tor money. Check 21 also benefits depository institutions


ons
66
98 er

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
-9 ali

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

sending original checks to other depository institutions. www.federalreserve.gov/check21.)


20
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Chapter 12 Managing and Pricing Deposit Services ■ 227

  


The final major deposit ownership category is deposits of other income. But what are the cheapest deposits? And which depos-
banks, which include correspondent deposits, representing its generate the highest net revenues?
funds that depository institutions hold with each other to pay for
Research based upon cost-accounting techniques suggests that
correspondent services. For example, large metropolitan banks
checkable (demand or transaction) deposits—including regular
provide data processing and computerized recordkeeping,
checking accounts, special checkbook deposits (which often
investment counseling, participations in loans, and the clearing
pay no interest), and interest-bearing checking accounts—are
and collection of checks and other drafts for smaller urban and
typically among the lowest-cost deposits that depositories
outlying depository institutions. An institution that holds depos-
sell. While check processing and account maintenance are
its received from other depositories will record them as a liability
major expense items, the absence of interest payments on
on its balance sheet under the label deposits due to banks and
many demand (transaction) deposit accounts help keep their
other depository institutions. The institution that owns such
cost down relative to other sources of funds. Moreover, check-
deposits will record them as assets under the label deposits due
processing costs should move substantially lower in the period
from banks and other depository institutions.
ahead as check imaging becomes more widely used. Paper
checks are rapidly being supplanted by electronic images, per-
The Cost of Different Deposit Accounts mitting greater storage capacity and faster retrieval, cutting
costs and improving service.
Other factors held constant, the managers of depository insti-
tutions would prefer to raise funds by selling those types of Especially popular in the new century have been automatic bill-
deposits that cost the least amount of money or, when revenues paying services, including online bill payment services offered
generated by the use of deposited funds are considered, gen- by depository institutions and direct electronic debits that
erate the greatest net revenue after expenses. If a depository you authorize out of your bank account and are carried out by
institution can raise all of its funds from sales of the cheapest a credit card company or other merchant to whom you owe
deposits and then turn around and purchase the highest- money. Increasingly it is becoming possible to pay almost every
yielding assets, it will maximize its spread and, possibly, its net bill without cutting a check or visiting a list of websites. Funds

REAL BANKS, REAL DECISIONS

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

services of financial firms that also are accessible in person


persoon
06 oo

Among the depository institutions offering the highest


through traditional branch offices and automated teller
te
elle
er
82 B

deposit yields are usually leading credit card and household


-9 ali

machines.
58 ak

lenders, such as Discover Bank, Ally Bank (formerly GMAC


11 ah

Bank), and E* Trade Bank.


41 M
20
99

228 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


are simply automatically “yanked out” of your account on the While the managers of depository institutions would prefer to
same day each month. sell only the cheapest deposits to the public, it is predominantly
public preference that determines which types of deposits will
In fact, so significant has been the recent decline in paper check
be created. Depository institutions that do not wish to conform
volume that the Federal Reserve System announced recently
to customer preferences will simply be outbid for deposits by
that it was reducing the number of check processing regions in
those who do. At the same time, recent deregulation of the
the United States. This trend has gotten a favorable reception
financial markets has made it possible for more kinds of financial
from financial institutions hoping to reduce operating costs.
service firms to respond to the public’s deposit preferences.
However, check writing has generated substantial fee income for
most offering institutions—a key source of revenue that will have
to be replaced with new revenue sources as the global financial
system goes more and more electronic.
CONCEPT CHECK
Thrift deposits—particularly money market accounts, time
deposits, and savings accounts—generally rank second to 12.1. What are the major types of deposit plans that
demand deposits as the least costly deposits. Savings depos- depository institutions offer today?
its are relatively cheap because of the low interest rate they 12.2. What are core deposits, and why are they so impor-
tend to carry—one of the lowest annual interest yields (APY) tant today?
offered—and, in many cases, the absence of monthly statements
12.3. How has the composition of deposits changed in
for depositors. However, many passbook savings accounts
recent years?
have substantial deposit and withdrawal activity as some savers
attempt to use them as checking (transaction) accounts. 12.4. What are the consequences for the management
and performance of depository institutions resulting
While demand (checking or transaction) deposits have about
from recent changes in deposit composition?
the same gross expenses per dollar of deposit as time (thrift)
deposits do, the higher service fees levied against transaction 12.5. Which deposits are the least costly for depository
account customers help to lower the net cost of checkable institutions? The most costly?
deposits (after service revenues are netted out) below the net
cost of most time (thrift) accounts. This factor plus new govern-
ment regulations help explain why depository institutions today
are more aggressively pricing their checkable deposits, asking 12.4 PRICING DEPOSIT-RELATED
depositors to pay a bigger share of the activity costs they cre- SERVICES
ate when they write checks and transfer funds electronically.
When we give each type of deposit credit for the earnings it We have examined the different types of deposit plans offered
generates through the making of loans and investments, check- today and how the composition of deposits has been chang-
able (demand) deposits appear to be substantially more profit- ing over time. An equally important issue remains: How should
able than time deposits for the average depository institution. depository institutions price their deposit services in order to
Moreover, interest expense per dollar of time deposits averages attract new funds and make a profit?
about triple the interest expense associated with each dollar of
In pricing deposit services, management is caught on the horns
demand (transaction) deposits.
of an old dilemma. It needs to pay a high enough interest return
Business transaction accounts, generally speaking, are consid- to attract and hold customer funds, but must avoid paying an
erably more profitable than personal checking accounts. One interest rate so costly it erodes any potential profit margin. In
reason is the lower interest expense generally associated with fact, in a financial marketplace that approaches perfect competi-
1

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

thin in today’s market. to lose funds.


20
99

Chapter 12 Managing and Pricing Deposit Services ■ 229

  


Unfortunately, such forms of nonprice competition tended
Factoid to distort the allocation of scarce resources in the financial
Several deposit-related fees charged by depository institu- sector. Congress finally responded to these problems with
tions have increased faster than inflation in recent years. passage of the Depository Institutions Deregulation Act of
These more rapidly rising bank fees include charges for 1980, a federal law that called for a gradual phaseout of fed-
checks returned for insufficient funds, stop-payment orders, eral limits on the interest rates depositories could offer their
ATM-usage fees, and overdraft fees. customers. Today, the responsibility for setting deposit prices
has been transferred largely from public regulators to private
decision makers—that is, to depository institutions and their
customers.
12.5 PRICING DEPOSITS AT COST
PLUS PROFIT MARGIN
Factoid
The idea of charging the customer for the full cost of
deposit-related services is relatively new. In fact, until a Which type of depository institution—small banks versus
few decades ago the notion that customers should receive large banks, interstate banks versus single-state banks—tend
most deposit-related services free of charge was hailed as a to charge the highest fees for deposit-related services? As
wise innovation—one that responded to the growing chal- noted by Hannan [9], larger banks and interstate banks tend
lenge posed by other financial intermediaries that were to levy higher deposit-related fees, especially; low-balance,
invading traditional deposit markets. Many managers soon insufficient funds, and stop-payment fees.
found reason to question the wisdom of this marketing
strategy, however, because they were flooded with numer-
ous low-balance, high-activity accounts that ballooned their
Deregulation has brought more frequent use of unbundled
operating costs.
service pricing as greater competition has raised the average
The development of interest-bearing checkable deposits (par- real cost of a deposit for deposit-service providers. This means
ticularly NOWs) offered financial managers the opportunity to that deposits are usually priced separately from other services.
reconsider the pricing of deposit services. Unfortunately, many And each deposit service may be priced high enough to recover
of the early entrants into this new market moved aggressively to all or most of the cost of providing that service, using the follow-
capture a major share of the customers through below-cost pric- ing cost-plus pricing formula:
ing. Customer charges were set below operating and overhead
costs associated with providing deposit services. The result was Estimated
a substantially increased rate of return to the customer, known Unit price overhead Planned
as the implicit interest rate—the difference between the true charged the Operating expense profit
cost of supplying fund-raising services and the service fees actu- customer = expense + allocated to + margin (12.1)
for each per unit the deposit- from each
ally assessed the customer.
deposit of deposit service service
In the United States, variations in the implicit interest rate service service function unit sold
paid to the customer were the principal way most banks
competed for deposits over the 50 years stretching from Tying deposit pricing to the cost of deposit-service pro-
the Great Depression to the beginning of the 1980s. This duction, as Equation (12.1) does, has encouraged deposit
was due to the presence of regulatory ceilings on deposit providers to match prices and costs more closely and
interest rates, beginning in 1933 with passage of the Glass- eliminate many formerly free services. In the United States,
1
60

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
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230 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


12.6 NEW DEPOSIT INSURANCE Deposits placed in separate financial institutions are insured
separately, each eligible for full coverage. However, deposits
RULES-INSIGHTS AND ISSUES held in more than one branch office of the same depository
institution are added together to determine the total amount
Summary of Deposit Insurance Coverage of insurance protection available. If two formerly independent
Provided by the FDIC institutions merge, for example, and a depositor holds $250,000
A major reason depository institutions are able to sell deposits in each of these two merging institutions, the total protection
at relatively low rates of interest compared to interest rates afforded this depositor would then be a maximum of $250,000,
offered on other financial instruments is because of government- not $500,000, as it would have been before the merger. How-
supplied deposit insurance. The Federal Deposit Insurance ever, the FDIC normally allows a grace period so that, for a short
Corporation (FDIC) was established in 1934 to insure depos- time, a depositor with large deposits in two institutions that
its and protect the U.S. money supply in those cases where merge can receive expanded coverage up to at least $500,000
depository institutions having FDIC membership failed. Insured until arrangements can be made to transfer some of the deposi-
depository institutions must display an official sign at each teller tor’s funds to other institutions.
station, indicating they hold an FDIC membership certificate. Insurance coverage may also be increased at a single institution
FDIC insurance covers only those deposits made in the United by placing funds under different categories of legal ownership.
States, though the depositor does not have to be a U.S. resident For example, a depositor with $250,000 in a savings deposit
to receive FDIC protection. All types of deposits normally are and another $250,000 in a time deposit might achieve greater
covered up to at least $250,000 for each single account holder. insurance coverage by making one of these two accounts a
As the table below illustrates FDIC insurance coverage has joint ownership account with his or her spouse. Also, if a family
increased substantially in recent years in an effort to promote is composed of husband and wife plus one child, for example,
public confidence in the banking system and deal with inflation, each family member could own an account and each pair of
among other factors. family members could also hold joint accounts, resulting in insur-
ance coverage up to $1,500,000 in total. Only natural persons,
FDIC Insurance Coverage Limits: not corporations or partnerships, can set up insurance-eligible
Standard joint accounts.
Standard Coverage Each co-owner of a joint account is assumed to have equal right
Year Coverage Limit Year Limit of withdrawal and is also assumed to own an equal share of a
1934 $2,500 1968–73 $20,000 joint account unless otherwise stated in the account record. No
one person’s total insured interest in all joint accounts at the same
1934–49 5,000 1974–79 40,000
insured depository institution can exceed $250,000. For example,
suppose Mr. Jones has a joint account with Mrs. Jones amount-
1950–65 10,000 1980–2007 100,000
ing to $700,000. Then each is presumed to have a $350,000
1966–68 15,000 2008 250,000 share and each would have maximum FDIC insurance coverage
Note: *Coverage of up to $250,000 was temporary in 2008 and 2009 of $250,000 unless the deposit record shows that, for example,
and made permanent in 2010 with passage of the Dodd-Frank Wall Mrs. Jones owns $500,000 of the $700,000 deposit and Mr. Jones
Street Reform and Consumer Protection Act.
would be covered, therefore, for a maximum of only $200,000.
Savings deposits, checking accounts, NOW accounts,
IRA and Keogh retirement deposits also became fully insured
Christmas Club accounts, time deposits, cashiers’ checks,
up to $250,000 with the passage of recent legislation. Deposits
money orders, officers’ checks, and any outstanding drafts
belonging to pension and profit-sharing plans receive “pass-
normally are protected by federal insurance. Certified checks,
1

through insurance” provided the individual participants’ ben-


60

letters of credit, and traveler’s checks for which an insured


5

eficial interests are ascertainable and the depository institution


instit
nstitution
66
98 er

depository institution is primarily liable also are insured if these


1- nt
20

involved is at least “adequately capitalized.”


66 Ce

are issued in exchange for money or in return for a charge


65 ks

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
20
99

Chapter 12 Managing and Pricing Deposit Services ■ 231

  


and are added to any other single-owner accounts the individual cost we must pay today. Conversely, if interest rates are on the
business owner has and are protected at least up to $250,000. rise, the marginal cost of today’s new money may substantially
exceed the historical cost of funds. If management books new
The amount of insurance premiums each FDIC-insured deposi-
assets based on historical cost, they may turn out to be unprofit-
tory institution must pay is determined by the volume of deposits
able when measured against the higher marginal cost of raising
it receives from the public and by the insurance rate category in
new funds in today’s market.
which each institution falls. Under the current risk-based deposit
insurance system more risky depository institutions must pay higher Economist James E. McNulty [8] has suggested a way to use the
insurance premiums. The degree of risk exposure is determined by marginal, or new money, cost idea to help a depository institu-
the interplay of two factors: (1) the adequacy of capital maintained tion set the interest rates it will offer on new deposit accounts.
by each depository institution and (2) the risk class in which the To understand this marginal cost pricing method, suppose a
institution is judged to be according to its regulatory supervisors. bank expects to raise $25 million in new deposits by offering its
Well-capitalized, A-rated depositories pay the lowest deposit insur- depositors an interest rate of 7 percent. Management estimates
ance fee per each $100 of deposit they hold, while undercapital- that if the bank offers a 7.50 percent interest rate, it can raise
ized, C-rated institutions pay the greatest insurance fees. $50 million in new deposit money. At 8 percent, $75 million is
expected to flow in, while a posted deposit rate of 8.5 percent
Twice each year the board of directors of the FDIC must decide
will bring in a projected $100 million. Finally, if the bank prom-
what insurance rates to assess insured institutions. If the federal
ises an estimated 9 percent yield, management projects that
insurance fund falls below $1.25 in reserves per $100 in covered
$125 million in new funds will result from both new and existing
deposits (known as the Designated Reserve Ratio [DRR]), the
deposits that customers will keep in the bank to take advantage
FDIC will raise its insurance fees. When the amount of reserves
of the higher rates offered. Let’s assume as well that manage-
exceeds the $1.25 per $100 standard, insurance fees may be
ment believes it can invest the new deposit money at a yield of
lowered or eliminated.
10 percent. This investment yield represents marginal revenue,
The boards of the FDIC and the National Credit Union Administra- the added operating revenue the bank will generate by making
tion are authorized to increase the insurance limit every five years in new investments from new deposits. Given these facts, what
order to protect against inflation, provided this seems warranted. deposit interest rate should the bank offer its customers?
Moreover, the 1.25 percent required DRR mentioned above—
sometimes referred to as the “hard” target—may be altered at the As Table 12.2 shows, we need to know at least two crucial items
FDIC’s discretion to form a “soft” target—that is, the FDIC has the to answer this question: the marginal cost of moving the deposit
authority to allow the DRR to range between 1.15 and 1.50 percent rate from one level to another and the marginal cost rate,
of all insured deposits. Thus, the FDIC now has more flexibility in expressed as a percentage of the volume of additional funds
deciding when it needs to change insurance fees and the amount coming into the bank. Once we know the marginal cost rate,
of depositor insurance protection that it provides. we can compare it to the expected additional revenue (mar-
ginal revenue) the bank expects to earn from investing its new
Source: Federal Deposit Insurance Corporation. deposits. The items we need are:

Marginal cost = Change in total cost = New interest rate


* Total funds raised at new rate - Old interest rate (12.2)
12.7 USING MARGINAL COST TO SET
* Total funds raised at old rate
INTEREST RATES ON DEPOSITS
and
Many financial analysts argue that, whenever possible, marginal Change in total cost
cost—the added cost of bringing in new funds—and not histori- Marginal cost rate = (12.3)
Additional funds raised
cal average cost, which looks at the past, should be used to help
1
60

price funds sources for a financial-service institution. The reason For example, if the bank raises its offer rate on new deposits
5
66
98 er

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
1- nt
20
66 Ce

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
-9
58

unprofitable when compared to historical cost will now look $2 million


= 8 presentt
11

profitable when measured against the lower marginal interest $25 million
41
20
99

232 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 12.2 Using Marginal Cost to Choose the Interest Rate to Offer Customers on Deposits

Example of a Bank Attempting to Raise New Deposit Funds

Marginal Cost Expected Difference


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

$25 7.0% $1.75 $1.75 7.0% 10.0% +3% $0.75

50 7.5 3.75 2.00 8.0 10.0 +2% 1.25


75 8.0 6.00 2.25 9.0 10.0 +1% 1.50
100 8.5 8.50 2.50 10.0 10.0 +0 1.50
125 9.0 11.25 2.75 11.0 10.0 -1% 1.25

Note: Figures in millions except percentages.

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


Factoid upward to 11 percent, which exceeds marginal revenue by a full
By 2010 total estimated FDIC-insured deposits reached a percentage point. Attracting new deposits at a 9 percent offer
record $6.2 trillion compared to only $4.3 trillion three years rate adds more to cost than to revenue. Note, too, that total
before.” profits at a 9 percent deposit rate fall back to $1.25 million. The
8.5 percent deposit rate is clearly the best choice, given all the
assumptions and forecasts made.
Notice that the marginal cost rate at 8 percent is substantially
above the average deposit cost of 7.5 percent. This happens The marginal cost approach provides valuable information to
because the bank must not only pay a rate of 7.5 percent to the managers of depository institutions, not only about setting
attract the second $25 million, but it must also pay out the same deposit interest rates, but also about deciding just how far the
7.5 percent rate to those depositors who were willing to contrib- institution should go in expanding its deposit base before the
ute the first $25 million at only 7 percent. added cost of deposit growth catches up with additional rev-
enues, and total profits begin to decline. When profits start to
Because the bank expects to earn 10 percent on these new funds, fall, management needs either to find new sources of funding
marginal revenue exceeds marginal cost by 2 percent at a deposit with lower marginal costs, or to identify new assets promising
interest cost of 8 percent. Clearly, the new deposits will add more greater marginal revenues, or both.
to revenue than they will to cost. The bank is justified (assuming
its projections are right) in offering a deposit rate at least as high
as 7.5 percent. Its total profit will equal the difference between Conditional Pricing
total revenue ($50 million * 10 percent = $5 million) and total
cost ($50 million * 7.5 percent = $3.75 million), for a profit of The appearance of interest-bearing checking accounts in the
$1.25 million. New England states during the 1970s led to fierce competi-
tion for customer transaction deposits among depository
1

Scanning down Table 12.2, we note that the bank continues to


60

institutions across the United States. Out of that boiling ing


ng
5

improve its total profits, with marginal revenue exceeding mar-


66
98 er

competitive cauldron came widespread use of conditionalnditio


ditioonal
1- nt
20
66 Ce

ginal cost, up to a deposit interest rate of 8.5 percent. At that


pricing, where a depository sets up a schedule e off fees
ffe in i
65 ks

rate the bank raises an estimated $100 million in new money at


06 oo

which the customer pays a low fee or no fee e if the


he deposit
tth d
82 B

a marginal cost rate of 10 percent, matching its expected mar-


balance remains above some minimum level, evel,, but faces a
-9 ali

ginal revenue of 10 percent.


58 ak

higher fee if the average balance fallss below


below
belo w that
t minimum.
11 ah
41 M

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.
20
99

Chapter 12 Managing and Pricing Deposit Services ■ 233

  


Conditional pricing techniques vary deposit prices based on one the number of deposits and withdrawals expected, and the
or more of these factors: planned average balance. Of course, the depository institution
must also be acceptable to the customer from the standpoint of
1. The number of transactions passing through the account (e.g.,
safety, convenience, and service availability.
number of checks written, deposits made, wire transfers, stop-
payment orders, or notices of insufficient funds issued). Economist Constance Dunham [7] has classified checking
2. The average balance held in the account over a designated account conditional price schedules into three broad catego-
period (usually per month). ries: (1) flat-rate pricing, (2) free pricing, and (3) condition-
ally free pricing. In flat-rate pricing, the depositor’s cost is
3. The maturity of the deposit in days, weeks, months,
a fixed charge per check, per time period, or both. Thus,
or years.
there may be a monthly account maintenance fee of $2,
The customer selects the deposit plan that results in the lowest and each check written or charge drawn against that account
fees possible and/or the maximum yields, given the number of may cost the customer 10 cents, regardless of the level of
checks he or she plans to write, or charges planned to be made, account activity.

INSIGHTS AND ISSUES

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
60

far deposit rates can move over time. For all interest-bearing figured, the depository institution must use the full amount of
5

accounts the depository must disclose the frequency with


66

the principal in the deposit for each day, rather than count-
98 er
1- nt
20

which interest is compounded and credited. ing only the minimum balance that was in the account on n one
one
66 Ce

day during the statement period. Methods that do not ot pay


pa ay
65 ks

If a customer decides to renew a deposit that would not be


06 oo

automatically renewed on its own, the renewed deposit is interest on the full principal balance are prohibited.. Deposit
De
epos
82 B

plans covered by the Truth in Savings Act are confined


nfined to
-9 ali

considered a new account, requiring full disclosure of terms.


58 ak

Customers must also be told if their account is automatically those accounts held by individuals for a personal,
onal,, family,
fam or
11 ah

household purpose.
41 M

renewed and, if not, what will happen to their funds (e.g.,


20
99

234 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


INSIGHTS AND ISSUES

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
5
66
98 er
1- nt
20
66 Ce

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
06 oo

a monthly account maintenance fee or per-transaction investments of comparable risk. Many depository ory institutions
osito in
82 B

charge. Of course, the word free can be misleading. Even if have found free pricing decidedly unprofitable ble because
ofitab
fitab b it
-9 ali
58 ak

a deposit-service provider does not charge an explicit fee tends to attract many small, active deposits
epossits that
th earn positive
11 ah
41 M

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.
20
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Chapter 12 Managing and Pricing Deposit Services ■ 235

  


We note that Bank A in Exhibit 12.1 appears to favor high-
Factoid balance, low-activity checking deposits, while Bank B is more
Who cares most about the location of a depository lenient toward smaller checking accounts. For example, Bank A
institution—high-income or low-income consumers? Recent begins assessing a checking-account service fee when the cus-
research suggests that low-income consumers care more tomer’s balance falls below $600, while Bank B charges no fees
about location in choosing an institution to hold their deposit, for checking-account services until the customer’s account bal-
while high-income customers appear to be more influenced by ance drops below $500. Moreover, Bank A assesses significantly
the size of the financial firm holding their account. higher service fees on low-balance checking accounts than
does Bank B—$5 to $10 per month versus $3.50 per month. On
the other hand, Bank A allows unlimited check writing from its
Conditionally free deposits have come to replace both flat- regular accounts, while B assesses a fee if more than 10 checks
rate and free deposit pricing systems in many financial-service or withdrawals occur in any month. Similarly, Bank A assesses
markets. Conditionally free pricing favors large-denomination a $3 per month service fee if a customer’s savings account dips
deposits because services are free if the account balance stays below $200, while Bank B charges only a $2 fee if the customer’s
above some minimum figure. One of the advantages of this savings balance drops below $100.
pricing method is that the customer, not the offering institution,
These price differences reflect differences in the philoso-
chooses which deposit plan is preferable. This self-selection
phy of management and owners of these two banks and the
process is a form of market signaling that can give the deposi-
types of customers each bank is seeking to attract. Bank A is
tory institution valuable data on the behavior and cost of its
located in an affluent neighborhood of homes and offices and
deposits. Conditionally free pricing also allows the offering insti-
is patronized primarily by high-income individuals and busi-
tution to divide its deposit market into high-balance, low-activity
nesses who usually keep high deposit balances, but also make
accounts and low-balance, high-activity accounts.
many charges and write many checks. Bank B, on the other
As an example of the use of conditional pricing techniques for hand, is located across the street from a large university and
deposits, the fees for regular checking accounts and savings actively solicits student deposits, which tend to have relatively
accounts posted by two banks are given in Exhibit 12.1. low balances. Bank B’s pricing schedules are set up to accept

Bank A Bank B

Regular checking account: Regular checking account:


Minimum opening balance $100 Minimum opening balance $100
If minimum daily balance is If minimum daily balance is
$600 or more No fee $500 or more No fee
$300 to $599 $5.00 per mo. Less than $500 $3.50 per mo.

Less than $300 $10.00 per mo.


If the depositor’s collected monthly balance averages $1,500, If checks written or ATM transactions $0.15 per debit
there is no fee (debits) exceed 10 per month and
balance is below $500
No limit on number of checks written
Regular savings account: Regular savings account:
Minimum opening balance $100 Minimum opening balance $100
1
605

Service fees: Service fees:


66
98 er
1 - nt
20
66 Ce

If balance falls below $200 $3.00 per mo. If balance falls below $100 $2.00 per mo.
65 ks
06 oo

Balance of $200 or more No fee Balance above $100 No fee


82 B
-9 ali

Fee for more than two Fee for more than three
58 ak
11 ah

withdrawals per month $2.00 withdrawals per month $2.00


2.00
41 M

Exhibit 12.1 Example of the use of conditional deposit pricing by two banks serving the same
e market
ma area.
20
99

236 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


low-balance deposits, but the bank also recognizes that it The Role That Pricing and Other
needs to discourage excessive charges and check writing by
Factors Play When Customers Choose
numerous small depositors, which would run up costs. It does
so by charging higher per-check fees than Bank A. In these two
a Depository Institution to Hold Their
instances we can see that deposit pricing policy is sensitive to Accounts
at least two factors: To be sure, deposit pricing is important to financial firms offer-
1. The types of customers each depository institution plans ing this service. But how important is it to the customer? Are
to serve—each institution establishes price schedules that interest rates and fees the most critical factors a customer con-
appeal to the needs of individuals and businesses repre- siders when choosing an institution to hold his or her deposit
senting a significant portion of its market area. account? The correct answer appears to be no.

2. 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

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


1

2. Availability of many other services. 2. Interest rate paid, 2. Whether bank will be a reliable
60

3. Safety 3. Transactional convenience (not e.


source of credit in the future.
5
66
98 ter

4. Low fees and low minimum balance. location). 3. Quality of bank officers.
20
61 en
56 s C

5. High deposit interest rates. 4. Location. 4. Whether loans are competitively


mpettitive
66 ok

5. Availability of payroll deduction. priced.


20 o
98 a B

6. Fees charged. 5. Quality of financial


al advice
a
addvice given.
6. Whether cash management
man nage and
58 ak
11 ah

operations services
services are provided.
41 M

Source: Based on studies by the Federal Reserve Board, Survey of Consumer Finances.
20
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Chapter 12 Managing and Pricing Deposit Services ■ 237

  


CONCEPT CHECK
12.6. Describe the essential differences between the follow- 12.9. How can the historical average cost and marginal cost of
ing deposit pricing methods in use today: cost-plus funds approaches be used to help select assets. (such as
pricing, conditional pricing, and relationship pricing. loans) that a depository institution might wish to acquire?
12.7. A bank determines from an analysis of its cost- 12.10. What factors do household depositors rank most highly
accounting figures that for each $500 minimum-balance in choosing a financial firm for their checking account?
checking account it sells, account processing and other Their savings account? What about business firms?
operating costs will average $4.87 per month and over- 12.11. What does the 1991 Truth in Savings Act require
head expenses will run an average of $1.21 per month. financial firms selling deposits inside the United States
The bank hopes to achieve a profit margin over these to tell their customers?
particular costs of 10 percent of total monthly costs.
12.12. Use the APY formula required by the Truth in Sav-
What monthly fee should it charge a customer who
ings Act for the following calculation. Suppose that
opens one of these checking accounts?
a customer holds a savings deposit in a savings bank
12.8. To price deposits successfully, service providers for a year. The balance in the account stood at $2,000
must know their costs. How are these costs deter- for 180 days and $100 for the remaining days in the
mined using the historical average cost approach? year. If the savings bank paid this depositor $8.50
The marginal cost of funds approach? What are the in interest earnings for the year, what APY did this
advantages and disadvantages of each approach? customer receive?

ETHICS IN BANKING AND FINANCIAL SERVICES

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.
1
60

provider pays all your overdrafts and saves you from insuf- Still, this is a service that has remained popular, especially
5
66

ficient funds charges both from the service provider and from
98 er

in recent years when most NSF fees have been sharply on


1- nt
20

the merchants who received your bad checks. Sometimes just


66 Ce

the rise at a pace faster than the rate of inflation. Customers


mers
one bad check can run up $50 or more in fees, never mind
65 ks

seem to like the convenience, particularly in making sure their


the
06 oo

the hassle of contacting the merchant who received your bad most important bills (e.g., home mortgage payment ent and
annd util-
ut
82 B

check and straightening things out.


-9 ali

ity bills) get paid on time. For the financial-service


ce provider
provid
p
58 ak

it is an important source of fee income that flows


lowss through
thro to
11 ah

Priced correctly, deposit overdraft protection can bring in


41 M

substantial revenues for the financial firm. You pay a fee just the bottom line and increases profits.
20
99

238 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Indeed, surveys indicate that household customers tend to be attention during the 1980s and 1990s when several consumer
extremely loyal to their depository institutions—about a third groups, such as the Consumers Union and AARP, first studied
reported never changing their principal bank of deposit. When the problem and campaigned actively for resolution of the issue.
an institutional affiliation is changed, it appears to be due mainly Some depositories have been picketed and formal complaints
to customer relocation, though once a move occurs many cus- have been lodged with federal and state regulatory agencies.
tomers seem to pay greater attention to competing institutions
The dimensions of the lifeline banking issue have been hinted at
and the relative advantages and disadvantages they offer as well
in several recent consumer surveys (see, for example, Good [4]).
as pricing. Three-quarters of the households surveyed recently
During the 1990s inquiries by the Federal Reserve indicated that
by the University of Michigan’s Survey Research Center cited
about 12 percent of Americans had neither checking nor savings
location as the primary reason for staying with the financial firm
accounts and about 15 percent had no transaction deposits.
they first chose.
A more up-to-date FDIC population survey (12), carried out in
2010 in conjunction with the U.S. Census, found that a substan-
tial segment of the U.S. population is either (1) “unbanked”
Factoid (i.e., with no deposits or loans of any kind), about 8 percent
Recent research suggests that at least half of all households or 9 million households; or (2) “underbanked” (i.e., having
and small businesses hold their primary checking account at access to some critical services but not others), amounting to
a depository institution situated within three miles of their about 18 percent or 21 million households. Among the “under-
location. banked” are those families relying on expensive payday loans,
check cashing firms, pawnshops, and money order services to
pay their bills.
Business firms, on the other hand, prefer to leave their deposits
Racial and ethnic minorities are substantially more likely than
with financial institutions that will be reliable sources of credit
the general population to be “underbanked.” Moreover, most
and, relatedly, are in good financial shape. They also rate highly
families in this situation report the lowest incomes, little formal
the quality of officers and the quality of advice they receive
education, and often represent single-parent households that
from financial-service managers. Recent research suggests that
do not have trust in the banking system. Yet, only a minority of
financial-service providers need to do a better job of letting
banks seem concerned about this issue.
their customers know about the cost pressures they face today
and why they need to charge fully and fairly for any services Many members of the unbanked population represent poten-
customers use. tially profitable customers for traditional financial-service
providers. Among the financial services most in demand are
wire transfers or remittances of money sent to loved ones
12.9 BASIC (LIFELINE) BANKING: elsewhere. For example, thousands of documented and
undocumented workers regularly wire billions of dollars annu-
KEY SERVICES FOR LOW-INCOME
ally from the United States to families and friends in Latin
CUSTOMERS America. It has been estimated that the wire-transfer mar-
ket generates well over $100 billion in business annually for
Our overview in this chapter would not be complete without
participating financial firms.
a brief look at a controversial social issue—basic (or lifeline)
banking. Should every adult citizen be guaranteed access to One of the most serious problems individuals outside the finan-
certain basic financial services, such as a checking account or cial mainstream face is lack of access to a deposit account. Many
personal loan? Is there a minimum level of financial service of these potential deposit customers do not have Social Security
to which everyone is entitled? Can an individual today really numbers or other acceptable ID required to open an account
1

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
66
98 er
1- nt
20

plans too expensive to meet their needs.


66 Ce

Some authorities refer to this issue as lifeline banking because


65 ks

Without a checking or savings account, few people e can


peoplle ca get
06 oo

it originated in the controversy surrounding electric, gas, and


82 B

telephone services. Many people believe these services are so approval for credit because most lending institutions
tutio prefer to
institution
-9 ali
58 ak

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

Yet access to credit is essential for most


ost families
ffami
fam to secure
41 M

reduced prices to those who could not otherwise afford them.


The basic, or lifeline, banking issue catapulted to nationwide adequate housing, medical care, and d other
othe important services.
20
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Chapter 12 Managing and Pricing Deposit Services ■ 239

  


Several depository institutions have responded to this problem Someone must bear the cost of producing services. Who should
with basic deposit plans that allow users to cash some checks bear the cost of lifeline services? Answers to these questions are
(such as Social Security checks), make a limited number of per- not readily apparent, but one thing is certain: These issues are
sonal withdrawals or write a small number of checks (such as 10 not likely to go away.
free checks or charges per month), or earn interest on even the
smallest balances. As yet, few laws compel financial institutions
to offer basic services, except in selected states—for example, CONCEPT CHECK
Illinois, Massachusetts, Minnesota, Pennsylvania, and Rhode
12.13. What is lifeline banking? What pressures does
Island—though many states have debated such legislation.
it impose on the managers of banks and other
Another component was added to this dilemma when the U.S. financial institutions?
Congress passed the Debt Collection Improvement Act in 12.14. Should lifeline banking be offered to low-income
1996 and when the U.S. Treasury launched its Electronic Funds customers? Why or why not?
Transfer program in 1999. Both events require that government
payments, such as paychecks and Social Security checks, eventu-
ally be delivered via electronic means. This, of course, implies
that some sort of deposit account be available in the recipient’s
SUMMARY
name in which these funds can be placed.
Deposits are the vital input for banks and their closest competi-
What, if anything, should government do? Even if new legisla- tors, the thrift institutions—the principal source of financial
tion is not forthcoming, do financial institutions have a responsi- capital to fund loans and security investments and help gener-
bility to serve all customers within their communities? These are ate profits. The most important points this chapter has brought
not easy questions to answer. Most financial-service providers forward include:
are privately owned corporations responsible to their stockhold-
• In managing their deposits financial firms must grapple with
ers to earn competitive returns. Providing financial services at
two key questions centered upon cost and volume. Which
prices so low they do not cover production costs interferes with
types of deposits will help minimize the cost of fund-raising?
that important goal.
How can a depository institution raise sufficient deposits to
However, the issue of lifeline banking may not be that simple meet its fund-raising needs?
because many financial firms are not treated in public policy • The principal types of deposits offered by depository
like other private firms. For example, entry into the banking institutions today include (1) transaction (or payments)
industry is regulated, with federal and state regulatory agencies accounts, which customers use primarily to pay for purchases
compelled by law to consider “public convenience and needs” of goods and services; and (2) nontransaction (savings or
in permitting new banks to be established. Moreover, the Com- thrift) deposits, which are held primarily as savings to prepare
munity Reinvestment Act of 1977 requires regulatory agencies for future emergencies and for the expected yield they prom-
to consider whether a covered financial organization applying to ise. Transaction deposits include regular checking accounts,
set up new branch offices or merge with another institution has which often bear no interest return, and interest-bearing
really made an “affirmative effort” to serve all segments of the transaction deposits (such as NOWs), which usually pay a low
communities in which it operates. yield and, in some cases, limit the number of checks or other
drafts that can be written against the account. Nontransac-
This most recent legal requirement to fully serve the local com-
tion deposits include certificates of deposit (CDs), savings
munity may include the responsibility to offer lifeline financial
accounts, and money market accounts.
services. Moreover, depository institutions receive important aid
from the government that grants them a competitive advantage • Transaction deposits often are among the most profitable
1
60

over other financial institutions. One of the most important of deposit services because of their nonexistent or low interest es
5
66
98 er

these aids is deposit insurance, in which the government guar- rates and the higher service fees these accounts usuallyy carry.
carrry.
1- nt
20
66 Ce

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
06 oo
82 B

public’s taxes, do they have a public responsibility to offer some depository institution to reach for longer-termm and
and higher-
hig
-9 ali
58 ak

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
20
99

240 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


earn and the fees he or she may be asked to pay are condi- minimum-balance requirements, how deposit balances are
tional on the intensity of use of deposit services and the bal- determined, what yield is promised, what the depositor must
ance in the account. In contrast, the cost-plus pricing method do to earn the promised return, and any penalties or fees
calls for estimating all operating and overhead costs incurred that might be assessed.
in providing each service and adds a margin for profit. Under • Finally, one of the most controversial issues in modern
marginal cost pricing, the offering institution will set its price banking—lifeline banking—continues to be debated in the
at a level just sufficient to attract new funds and still earn a deposit-services industry. Depository institutions have been
profit on the last dollar of new funds raised. Finally, relation- asked in several states to offer low-cost financial services,
ship pricing calls for assessing lower fees or promising more especially deposits and loans, for those customers unable
generous yields to those customers who are the most loyal. to afford conventional services. Some institutions have
• Recently new rules have entered the deposit market. The responded positively with limited-service, low-cost accounts,
Truth in Savings Act requires banks and thrift institutions to while others argue that most financial firms are profit-making
make full and timely disclosure of the terms under which corporations that must pay close attention to profitability and
each deposit service is offered. This includes information on cost of each new service.

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

1
605
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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Chapter 12 Managing and Pricing Deposit Services ■ 241

  


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

PROBLEMS AND PROJECTS


1. Rhinestone National Bank reports the following figures in
Regular (passbook) 501 596 646 709
its current Report of Condition: savings deposits

Liabilities and Money market deposit 863 812 749 725


accounts
Assets (millions) Equity (millions)
Retirement deposits 650 603 542 498
Cash and interbank $ 50 Core deposits $ 50
deposits CDs under $100,000 327 298 261 244
Short-term security 15 Large negotiable 150 CDs $100,000 and over 606 587 522 495
investments CDs
3. First Metrocentre Bank posts the following schedule of fees
Total loans, gross 400 Deposits placed 65 for its household and small-business transaction accounts:
by brokers
• For average monthly account balances over $1,500,
Long-term securities 150 Other deposits 45
there is no monthly maintenance fee and no charge
Other assets 10 Money market 195 per check or other draft.
liabilities
• For average monthly account balances of $1,000 to
Total assets $625 Other liabilities 65 $1,500, a $2 monthly maintenance fee is assessed and
Equity capital 55 there is a 10¢ charge per check or charge cleared.
Total liabilities and $625 • For average monthly account balances of less than
equity capital $1,000, a $4 monthly maintenance fee is assessed and
there is a 15¢ per check or per charge fee.
a. Evaluate the funding mix of deposits and nondeposit
sources of funds employed by Rhinestone. Given the What form of deposit pricing is this? What is First Metro-
mix of its assets, do you see any potential problems? centre trying to accomplish with its pricing schedule?
What changes would you like to see management of Can you foresee any problems with this pricing plan?
this bank make? Why? 4. Fine-Tuned Savings Association finds that it can attract the
b. Suppose market interest rates are projected to rise following amounts of deposits if it offers new depositors
significantly. Does Rhinestone appear to face signifi- and those rolling over their maturing CDs at the interest
cant losses due to liquidity risk? Due to interest rate rates indicated below:
risk? Please be as specific as possible.
Expected Volume of Rate of Interest Offered
2. Kalewood Savings Bank has experienced recent changes New Deposits Depositors
in the composition of its deposits (see the following
table; all figures in millions of dollars). What changes $10 million 2.00%
have recently occurred in Kalewood’s deposit mix? Do 15 million 2.25
these changes suggest possible problems for manage- 20 million 2.50
ment in trying to increase profitability and stabilize
24 million 2.75
earnings?
26 million 3.00
1
60

One Two Three


5

Management anticipates being able to invest any new ew


66
98 er
1- nt
20

Types of Deposits This Year Years Years


66 Ce

deposits raised in loans yielding 5.50 percent. How oww far


ffa
ar
Held Year Ago Ago Ago
65 ks

should this thrift institution go in raising its deposit


epossit inter-
int
in
06 oo
82 B

Regular and special $235 $294 $337 $378 est rate in order to maximize total profits (excluding
(exxcl
cludin
ludin
-9 al

checking accounts interest costs)?


58 ak
11 ah

Interest-bearing check- 392 358 329 287


41 M

5. New Day Bank plans to launch a new w deposit


depo
d campaign
ing accounts next week in hopes of bringing in from $100 million to
20
99

242 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

$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

February 350 August 425


60

(check newspaper ads, call its customer service e line,


lli e,
5
66
98 er

March 300 September 550 or visit its website) with the best rates on these
ese same
hese sam
1- nt
20
66 Ce

April 550 October 600 savings instruments offered by depository ry institutions


ory ins
institut
65 ks
06 oo

May 225 November 625 quoting the highest deposit interest ratess in the
t United
82 B

States, (See websites listed in Exercise e 3.) Why


ercise
rcise W do
-9 ali

June 400 December 500


58 ak

you think there are such large interest-rate


intere
ntere
rest-r differences
11 ah
41 M

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?
20
99

Chapter 12 Managing and Pricing Deposit Services ■ 243

  


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

CASE ASSIGNMENT FOR CHAPTER 12

YOUR BANK’S DEPOSITS: VOLATILITY to select Total Deposits and view this in Percentages of Total
AND COST Assets. To assess the overall importance of deposits as a
Chapter 12 examines the major source of funds for depository source of funding, focus on total deposits to total assets.
institutions—deposits. The importance of attracting and maintain- From the Total Deposits report you will collect information
ing deposits as a stable and low-cost source of funds cannot be to break down deposits in several ways: (1) total deposits
overstated. This chapter begins by describing the different types into domestic deposits versus foreign; (2) total deposits into
of deposits, then explains why a depository institution’s manage-
interest-bearing deposits versus noninterest-bearing depos-
ment is concerned with cost, volatility (risk of withdrawals), and
the trade-off between the two. In this assignment, you will be its; and (3) domestic deposits into their basic types. All the
comparing the character of your bank’s deposits across time and data for rows 109–123 are available from the Total Deposits
with its peer group of banks to glean information concerning the report; however, you will have to derive NOW accounts in
cost and stability of this source of funds. Chapter 12’s assignment row 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
56
66
98 er
1- nt
20
66 Ce
65 ks
06 o o
82 B
-9
58
11
41
20
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244 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

your bank relied more or less on depositors than the aver- proportion of interest-bearing deposits than the peer group
age bank in the peer group? and a comparable proportion of noninterest-bearing depos-
its. The average interest cost on domestic interest-bearing
D. Use the chart function in Excel and the data by columns
deposits for BB&T for 2010 is 1.12 percent, which is 40 basis
in rows 113 through 116 to create a group of four bar charts
points above the peer group average of 0.72 percent.
illustrating the reliance on deposits as a source of funds
However, for foreign interest-bearing deposits the average
and drawing attention to the breakdown of foreign versus
interest cost for BB&T in 2010 was 0 percent—a whopping
domestic and interest-bearing versus noninterest-bearing
60 basis points lower than the peer group's average interest
deposits. You will be able to select the block and create
cost. For domestic interest-bearing deposits in 2009, BB&T
the chart with just a few clicks of the mouse, saving it as a
paid 32 basis points above the peer group’s average interest
separate sheet to insert into your document. Remember to
cost of 1.12 percent These changes in pricing deposits help
provide titles, labels, and percentages; otherwise, we have
to explain how BB&T maintained their deposit base. In fact
something reminiscent of abstract art. Write one or two
the proportion of domestic deposits-to-total assets for BB&T
paragraphs for your BHC summarizing the breakdown of
declined only slightly from 69.47 percent to 67.04 percent.
deposits. Paragraphs describing deposits at BB&T in 2010
and 2009 illustrate how to write your financial data. E. Once again use the chart function in Excel and the data
by columns in rows 119 through 123 to create a group
Deposits provide a significant portion of the funding for
of four columns charts illustrating the types of domestic
bank holding companies. In 2010 more than 70 percent of
deposits supporting assets for your BHC and its peer group.
BB&T’s assets were funded by deposits and in 2009 more
This time we will utilize the column charts that sum to
than 71 percent of their assets were funded by depos-
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%
56

30%
66
98 e r

20%
1- nt
20

20%
66 Ce

10% 10%
65 ks
06 oo

0% 0%
82 B

12/31/2010 12/31/2010 1/2009


12/31/2009 12/31/2009
-9 ali

12/31/2010 12/31/2010 12/31/2009 12/31/2009


58 ak

BB&T Peer Group BB&T Peer Group BB&T Peer Group BB&
&T
BB&T Peer Group
11 ah

Total time deposits Other savings deposits


eposits Money markets deposits
41 M

Noninterest-bearing deposits (foreign) Noninterest-bearing deposits (domestic)


(excluding MMDAs) s) accounts (MMDAs)
Interest-bearing deposits (foreign) Interest-bearing deposits (domestic) NOW accounts Demand depositsits
20
99

Chapter 12 Managing and Pricing Deposit Services ■ 245

  


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

Selected References
For a discussion of recent trends in deposit services, see these 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:

7. Dunham, Constance. ‘Unraveling the Complexity of NOW


Account Pricing.” New England Economic Review, Federal
Reserve Bank of Boston, May/June 1983, pp. 30–45.

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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246 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Managing
Nondeposit
13
Liabilities
■ Learning Objectives
After completing this reading you should be able to:

● 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.

● Describe and calculate the available funds gap.

● Discuss factors affecting the choice of non-deposit


funding sources.

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 13 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
20
99

247

  


KEY TOPICS IN THIS CHAPTER a loan request—even when deposits and other cash flows
are inadequate—usually brings in both new deposits and the
• Liability Management demand for other services as well. And the benefits may reach
far beyond the borrowing customer alone. For example, a loan
• Customer Relationship Doctrine
made to a business firm often brings in personal accounts from
• Alternative Nondeposit Funds Sources the firm’s owners and employees.
• Measuring the Funds Gap
• Choosing among Different Funds Sources
Filmtoid
• Determining the Overall Cost of Funds
What 2003 drama casts Philip Seymour Hoffman as an assis-
tant bank manager with authority over sources and uses of
13.1 INTRODUCTION funds at the bank whose love of Atlantic City gets him into
trouble?
The traditional source of funds for most depository institutions
Answer: Owning Mahowny.
is the deposit account—both checking and savings deposits
sold to individuals, businesses, and governments. The public’s
demand for deposits supplies much of the raw material for The financial community learned long ago the importance of
lending and investing and, ultimately, for the profits these insti- the customer relationship doctrine, which proclaims that the
tutions earn. But what does management do to find new money first priority of a lending institution is to make loans to all those
when deposit volume is inadequate to support all loans and customers from whom the lender expects to receive positive net
investments these institutions would like to make? earnings. Thus, lending decisions often precede funding deci-
In Chapter 9 we found part of the answer to this question is that sions; all loans and investments whose returns exceed their cost
services like standby credit letters and credit guarantees may be and whose quality meets the lending institution’s credit stan-
sold to bring in customer fees and loans may be securitized or dards should be made. If enough deposits are not immediately
sold outright to attract new funds in order to make new loans. available to cover these loans and investments, then manage-
Chapter 4 provides another part of the answer—when depos- ment should seek out the lowest-cost source of borrowed funds
its don’t bring in enough money some security investments, available to meet its customers’ credit needs.
previously acquired, may be sold to generate more cash. In Of course, the customer relationship doctrine has its limitations.
the present chapter we explore yet another important nonde- Sometimes it results in scores of poor-quality loans. For example,
posit source of funding—selling IOUs in the money and capital during the collapse of the subprime mortgage market in the
markets for periods of time that may stretch from overnight to 2007–2009 business recession regulators found that many mort-
several years. gage lenders went overboard in approving loans, falling well below
normal industry standards and made in haste with little or no docu-
mentation. Moreover, this wild lending spree was amply supported
13.2 LIABILITY MANAGEMENT by cheap money with money market borrowing rates at historic
AND THE CUSTOMER RELATIONSHIP lows. Subsequently, the volume of home foreclosures rose rapidly

DOCTRINE1 and many mortgage lenders appeared to abandon positive cus-


tomer relationship strategies in favor of a concentrated effort simply
to recover at least some of their funds from beleaguered borrowers.
Managers of lending institutions learned over the years that
turning down a profitable loan request with the usual excuse— During the 1960s and 1970s, the customer relationship doctrine
“We don’t have enough deposits or other funds sources to spawned the liquidity management strategy known as liability
1
60

support the loan”—is not well received by their customers. management as discussed in Chapters 5 and 18. Liability man- an-
n
5
66
98 er

Denial of a credit request often means the immediate loss of a agement consists of buying funds, mainly from other financial
ncial
1- nt
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

from the disappointed customer. On the other hand, granting


06 oo

satisfy any legal reserve requirements on deposits and other


othe
o
B

borrowings that law or regulation may require. A lending


nding institu-
len
82

tion may acquire funds by borrowing short term,


erm, such as in the
-9
58

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

the Eurocurrency market.


41

Canadian Banker [4] and are used with permission.


20
99

248 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 13.1 Sample Use of Nondeposit Funds Sources to Supplement Deposits and Make Loans

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

Assets Liabilities and Equity

Loans: Funding sources found to support the


New loans to be made, $100,000,000 new loans: Newly deposited funds
expected today $50,000,000
Nondeposit funds sources:
Federal funds purchased 19,000,000
Borrowings of Eurodollars abroad 20,000,000
Securities sold under agreements
to repurchase (RPs) 3,000,000
Borrowings from a nonbank subsidiary of
the bank’s holding company that
sold commercial paper in the money
market +8,000,000
Total new deposit and nondeposit
funds raised to cover the new loans $100,000,000

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.

INSIGHTS AND ISSUES

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

We note in the example of liability management in Table 13.1 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

between their shorter-term assets and shorter-term


60

Yes, but there are good reasons for “going short” in most
liabilities in order to protect against liquidity crises. Finally,
Fina ly,
5

nondeposit borrowings. For one thing, the borrowing cus-


66
98 er

should the current interest-rate forecast call for declining


ecliniing
1- nt
20

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

good position after all. With falling interest rates,


rates, tomor-
tom
06 oo

debt contracts; tomorrow may be another story and longer


82 B

term deposits may soon roll in. row’s borrowing costs should be lower than n today’s
oday’s costs.
tto
-9 a

Much depends on the reliability of the outlook ook for


outlo f interest
58 ak

Second, in the example in Table 13.1 we are dealing with


11 ah

rates and market conditions.


41 M

funding just one loan. A glance at the lender’s whole loan


20
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Chapter 13 Managing Nondeposit Liabilities ■ 249

  


Unfortunately, the money market division cannot rest on its about four times as much among large commercial bank
laurels. They know that a substantial portion of the $50 million assets (or 16 percent).
just raised will be available only until tomorrow when many of
Overall, nondeposit borrowings have often outstripped the
the borrowed funds must be returned to their owners. These
growth of traditional deposits, as Table 13.2 suggests, in part
departing funds will need to be replaced quickly to continue to
because of the greater flexibility of nondeposit borrowings,
support the new loan. Customers who receive loans spend their
which are less regulated, and the loss of some deposits in recent
funds quickly (otherwise, why get a loan?) by writing checks and
years to competing financial institutions, such as mutual funds,
wiring funds to other financial institutions. This lender, there-
insurance companies, hedge funds, and pension funds, that are
fore, must find sufficient new funds to honor all those outgoing
competing aggressively today to attract the public’s savings. In
checks and wire transfers that its borrowing customers initiate.
the sections that follow we examine the most popular nonde-
Clearly, liability management is an essential tool lenders need posit funds sources that financial firms use today.
to sustain the growth of their lending programs. However, it
also poses real challenges for financial-service managers, who
Federal Funds Market (“Fed Funds”)
must keep abreast of the market every day to make sure their
institution is fully funded. Moreover, liability management is an The most popular domestic source of borrowed reserves among
interest-sensitive approach to raising funds. If interest rates rise depository institutions is the Federal funds market. Originally,
and the lender is unwilling to pay those higher rates, funds bor- Fed funds consisted exclusively of deposits held at the Federal
rowed from the money market will be gone in minutes. Money Reserve banks. These deposits are owned by depository institu-
market suppliers of funds typically have a highly elastic response tions at the Fed primarily to satisfy legal reserve requirements,
to changes in market interest rates. clear checks, and pay for purchases of government securities.
These Federal Reserve balances can be transferred from one
Yet, viewed from another perspective, funds raised by liability
institution to another in seconds through the Fed’s wire transfer
management techniques are flexible: the borrower can decide
network (Fedwire), linking all Federal Reserve banks. Today,
exactly how much he or she needs and for how long and usu-
however, deposits that depository institutions hold with each
ally find a source of funds that meets those requirements. In
other also can be moved around the banking system the same
contrast, when deposits are sold to raise funds, it is the deposi-
day a request is made. The same is true of large collected
tor who decides how much and how long funds will be left with
demand deposit balances that securities dealers and govern-
each financial firm. With liability management institutions in
ments own. All these types of deposits make up the raw mate-
need of more funds to cover expanding loan commitments or
rial traded in the market for Federal funds. In technical terms,
deficiencies in cash reserves can simply raise their offer rate in
Fed funds are simply short-term borrowings of immediately
order to reduce their volume of money market borrowing.
available money.
Financial institutions needed little time to realize the potential
13.3 ALTERNATIVE NONDEPOSIT source of profits inherent in these same-day monies. Because
SOURCES OF FUNDS reserves deposited with the Federal Reserve banks and many
demand deposits held by business firms pay little or no inter-
As Table 13.2 suggests, the usage of nondeposit sources of est, bank and nonbank firms have a strong economic incentive
funds has fluctuated in recent years, but generally has risen to to lend excess reserves or any demand deposit balances not
provide a bigger share of funds for depository institutions. While needed to cover immediate cash needs. Moreover, there are no
smaller banks and thrift institutions usually rely most heavily on legal reserve requirements on Fed funds borrowings currently
deposits for their funding needs, leading depository institutions and few regulatory controls—features that have stimulated the
around the globe have come to regard the nondeposit funds growth of the market and helped keep the cost of borrowing
1

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

and their affinity for non-deposit borrowing. Clearly, the


82 B

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
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250 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


Table 13.2 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Banks and Thrifts
Billions of Dollars at Year-End
Nondeposit Sources
of Borrowed Funds
1990 1992 1994 1996 1998 2000 2002 2004 2007 2010*
Money market
negotiable (jumbo)
CDs ($100,000+) $431.8 $366.5 $344.9 $476.9 $671.4 $821.3 $814.0 $1,505.1 $2,382.2 $1,800.0
Eurodollar
borrowings from
own foreign offices 168.0 160.4 185.9 177.3 148.8 194.3 231.5 382.6 154.5 201.8***
Federal funds
borrowings and
security RPs 180.1 149.9 221.1 199.8 206.1 235.5 476.8 727.4 838.5 760.7
Commercial paper
issued** 420.8 406.5 443.7 601.2 936.2 1,275.8 1,194.0 1,395.0 1,788.1 1,020.0
Borrowings from
the Federal Reserve
banks 0.3 0.1 0.5 0.2 0.1 0.2 0.1 0.0 48.6 0.7
Total nondeposit
funds raised by U.S.-
insured banks and
thrifts $1,201.0 $1,083.4 $1,196.1 $1,455.4 $1,962.5 $2,527.1 $2,716.4 $4,010.1 $5,211.9 $3,791.2
Total deposits
of FDIC-insured
depository
institutions $3,637.3 $3,527.1 $3,611.6 $3,925.2 $4,386.1 $4,914.8 $5,568.7 $5,026.0 $6,590.7 $7,513.7
Ratio of nondeposit
funds to total deposits
for all FDIC-insured
banks and thrifts 33% 31% 33% 37% 45% 51% 49% 80% 79% 50%
Notes: *Figures for money market CDs, Eurodollar borrowings, and repurchase agreements (RPs) are for second quarter 2010. **Includes all finance-
company paper issued directly to investors by banks and other financial-service providers. *** Figures for Eurodollar commitments to foreign affili-
ates fourth quarter of 2009.
Sources: Federal Reserve Board and Federal Deposit Insurance Corporation.

Table 13.3 The Relationship between the Size of institutions possessing temporarily idle funds. Fed funds are also
Banks and Their Use of Nondeposit Borrowings (2007 used to supplement deposit growth and give lenders a relatively
figures for FDIC insured banks) safe outlet for temporary cash surpluses on which interest can
be earned (even for a loan lasting only a few hours). Moreover,
Percent of Assets the Fed funds market serves as a conduit for the policy initia-
Size Group end Type of Supported by tives of the Federal Reserve System designed to control the
Depository Institution Nondeposit Borrowings growth of money and credit and stabilize the economy.
1
60

The largest U.S. commercial banks By performing all of these functions, the Fed funds market k effi-
rke
5

(over $1 billion in assets each) 16%


66
98 er

ciently distributes reserves throughout the financial system


tem to
syste t
1- nt
20
66 Ce

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

assets each) 4 Fed funds in return for commissions. Large, e, accommodating


acccom
-9 ali
58 ak

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

Chapter 13 Managing Nondeposit Liabilities ■ 251

   


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

A major innovation occurred in the RP market with the inven-


60

government securities in a custody account in the name of


5

tion of General Collateral Finance (GCF) RPs in 1998, underr the


66
98 er

the lender until the loan is repaid. Term loans are longer-term
1- nt
20
66 Ce

Fed funds contracts lasting several days, weeks, or months,


65 ks
06 oo

often accompanied by a written contract. Continuing contracts


82 B

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

   


Table 13.4 The Mechanics of Borrowing and Lending Federal Funds

First Way to Lend Fed Funds


Step 1. Lending Reserve Balances Held at the Federal Reserve Banks to a Borrowing institution
Lender’s Balance Sheet Borrower’s Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Federal funds Borrower’s Federal funds purchased
sold (loaned) +100 reserves on (borrowed) to
Lender’s reserves deposit at support loans and
on deposit at the Fed +100 investments + 100
the Fed -100
Step 2. Repaying the Loan of Fed Funds through the Federal Reserve Banks
Lender’s Balance Sheet Borrower’s Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender’s reserves Borrower’s Federal funds purchased
on deposit at reserves on (borrowed) to
the Fed + 100 deposit at the support loans and
Federal funds Fed -100 investments -100
sold (loaned) -100

Second Way to Lend Fed Funds


Step 1. Lending Fed Funds by a Respondent (usually smaller) Depository Institution to a Correspondent (usually larger)
Depository Institution Who May Loan Those Funds to Another Institution (usually located in a major
money center where credit demands are often heavy)
Lender’s (respondent’s) Balance Sheet Borrower’s (correspondent’s) Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender’s deposits Federal funds purchased
held with (borrowed) to
correspondent -100 support loans and
Federal funds investments + 100
sold (loaned) +100 Respondent’s bank
deposit -100
Step 2. Correspondent Repaying the Loan to the Respondent Depository Institution
Respondent Institution Correspondent Institution
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender’s deposits Federal funds purchased
held with (borrowed) to
correspondent +100 support loans and
Federal funds investments -100
sold (loaned) -100 Respondent’s bank
01

+ 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

and lender can agree upon a variety of securities,


securi
se
ecur any of which
41 M

Conventional (fixed-collateral) repurchase agreements desig-


may serve as loan collateral. This agreed-upon
eed-
eed-u array of eligible
nate specific securities to serve as collateral for a loan, with the
20
99

Chapter 13 Managing Nondeposit Liabilities ■ 253

   


Table 13.5 Raising Loanable Funds through a Repurchase Agreement Involving the Borrower’s Securities

Step 1. Bank Sells Some of Its Securities under an RP Agreement


Commercial Bank Temporary Buyer of the Bank’s Securities
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Securities Securities
sold -100 purchased +100
Seller’s reserve Cash
balances at account -100
the Fed +100

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


Commercial Bank Temporary Buyer of the Bank’s Securities
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Securities Securities
repurchased +100 returned -100
Seller’s reserve Cash
balances at account +100
the Fed -100

REAL BANKS, REAL DECISIONS


Charging U.S. Depository Institutions mirrors the “Lombard” credit facilities used by several
a “Lombard Rate”? What’s That? European central banks. (Incidentally, the term Lombard owes
its origin to a German word for collateralized loan. One of the
The Federal Reserve’s recent changes in the rules (Regula- earliest users of above-market loan rates for banks in need
tion A) governing its discount window loans bring this aspect of funds was the Bundesbank, Germany’s central bank.) Lom-
of U.S. central banking much closer to what central banks in bard loan rates have been employed by the European Central
Europe do. Bank (ECB) and the central banks of Austria, Belgium, France,
Before 2003 the Federal Reserve’s discount rate was fre- Germany, Italy, and Sweden. Similar lending rules were
quently the lowest interest rate in the money market and adopted recently by the Bank of Canada and Bank of Japan.
often below the Fed funds interest rate. With the discount With the discount or Lombard rate set above market levels
rate so low, many depository institutions were tempted to for similar loans, central banks are less inclined to restrict
borrow from the Fed and relend the money in the Fed funds borrowing from the discount window and less concerned
market. Some did! about what borrowers do with the money. Moreover, recent
Today the U.S. primary-credit discount rate is now set slightly evidence suggests that an above-market Lombard rate
higher than the Fed funds interest rate on overnight loans, tends to act as a ceiling on overnight borrowing rates and
which the Federal Reserve is using as a target to stabilize may serve as an effective ceiling for the U.S. Fed funds
the economy. Setting the Fed’s discount rate above market interest rate.
1

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

more liquid. (For further discussion of this RP innovation,


tion,, see
ation,
06 oo

Moreover, GCF RPs may be settled on the books of the FICC,


82 B

especially Fleming and Garbade [1].)


which allows netting of obligations between lenders, borrowers,
-9 ali
58 ak

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

   


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

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

Securing a Loan from a Federal Reserve Bank


Borrowing Depository Institution Federal Reserve Bank
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Reserves on Notes payable + 100 Loan and Bank reserve accounts +100
deposit at advances +100
the Federal
Reserve Bank +100

Repaying a Loan from a Federal Reserve Bank


1
60

Borrowing Depository Institution Federal Reserve Bank


5
66
98 er
1- nt
20

Liabilities Liabilities
66 Ce

Assets and Net Worth Assets and Net Worth


orth
65 ks
06 oo

Reserves on Notes payable - 100 Loan and Bank reserve


ve
e accounts
accou - 100
82 B
-9 ali

deposit at advances -100


58 ak
11 ah

the Federal
41 M

Reserve Bank -100


20
99

Chapter 13 Managing Nondeposit Liabilities ■ 255

  


federal agency securities, high-grade commercial paper, and popular source of funding due to regulations, collateral require-
other assets judged satisfactory. ments, and cost, though the credit crisis of 2007–2009 increased
the popularity of the Fed’s “window” as a source of borrowed
Several types of loans are available from the Fed’s discount
funds for a wide range of troubled firms.
window:

1. Primary credit—loans available for short terms (usually


overnight but occasionally extending out to 90 days) to Advances from Federal Home Loan Banks
depository institutions in sound financial condition. Primary
Recently another government agency—the Federal Home Loan
credit normally carries an interest rate slightly above the
Bank (FHLB) System—has been lending huge amounts of money
Federal Reserve’s target Fed funds interest rate. Users of
to scores of home mortgage lenders. The FHLB System, com-
primary credit do not have to show (as they did in the past)
posed of 12 regional banks, was created by federal charter in
that they have exhausted other sources of funds before ask-
1932 in order to extend cash advances to depository institutions
ing the Fed for a loan. Moreover, the borrowing institution
experiencing runs by anxious depositors. By allowing these trou-
is no longer prohibited from borrowing from the Fed and
bled institutions to use the home mortgages they held in their
then loaning that money to other depository institutions in
portfolios as collateral for emergency loans, the FHLB improved
the Fed funds market.
the liquidity of home mortgages and encouraged more lenders
2. Secondary credit—loans available at a higher interest to provide credit to the housing market.
rate to depository institutions not qualifying for primary
In recent years the number of financial institutions eligible to
credit. These loans are subject to monitoring by the Federal
borrow from the FHLB has increased dramatically, especially
Reserve banks to make sure the borrower is not taking on
among smaller community banks and thrift institutions. A recent
excessive risk. The interest rate on secondary credit may
study (Maloney and Thomson [3]) found that close to 6,000 com-
be about 50 basis points above the primary credit rate and
mercial banks, more than 1,300 thrift institutions, over
150 basis points above the Fed funds rate. Such a loan can
700 credit unions, and close to 80 insurance companies had
be used to help resolve financial problems, to strengthen
FHLB loans, amounting collectively to more than $500 billion.
the borrowing institution’s ability to find additional funds
Managers of mortgage-lending institutions have been attracted
from private-market sources, and to reduce its debt to the
to FHLB loans because they represent a stable source of fund-
Fed. However, secondary credit is not supposed to be used
ing at below-market interest rates. Fully collateralized by home
to fund the expansion of a borrowing institution’s assets.
mortgages the maturities of FHLB loans range from overnight
3. Seasonal credit—loans covering longer periods than pri- to more than 20 years, bearing either fixed or variable interest
mary credit for small and medium-sized depository insti- rates. The system’s federal charter enables it to borrow money
tutions experiencing seasonal (intrayear) swings in their cheaply and pass those savings along to member institutions
deposits and loans (such as those swings experienced by who also hold FHLB stock and receive dividends on that stock.
farm banks during planting and harvesting time). The sea- Should a borrowing institution fail, the FHLB, legally, is first in
sonal credit interest rate is set at the average level of the line (even ahead of the FDIC) in recovering its funds. In general,
effective Fed funds rate and the secondary market rate on this can be a popular funds source due to lower costs and flex-
90-day certificates of deposit. ibility in the maturity of loans permitted.
Thus, each type of discount window loan carries its own loan
rate, with secondary credit generally posting the highest interest
rate and seasonal credit the lowest. Development and Sale of Large
Negotiable CDs
In 1991 the U.S. Congress passed the FDIC Improvement Act,
which places limits on how far the Federal Reserve banks can go The concept of liability management and short-term borrow-
1
60

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

   


ISSUES AND INSIGHTS

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

its held by their largest customers because these customers


5
66
98 er

The negotiable CD was an almost instant success. Large- arge-


rge-
had found other higher-yielding outlets for their cash surpluses,
1- nt
20
66 Ce

denomination CDs grew from almost zero in the ear early


arly 1960s to
rly 1960
money center banks began to search the market for new sources
65 ks

nearly $2 trillion as recently as 2011. As with allll liability


bility manage-
liab
06 oo

of funds. First National City Bank of New York (now Citibank),


82 B

ment instruments, management can control the


ol thhe quantity of CDs
e qua
one of the more innovative financial firms in the world, was the
-9 a
58 ak

outstanding simply by varying the yield offered ed to


offerred t CD customers.
first to develop the large ($100,000+) negotiable CD. Citigroup
11 ah
41 M

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

Chapter 13 Managing Nondeposit Liabilities ■ 257

   


interest-bearing basis, and the rate is computed assuming a currency of the home country and consist of accounting entries
360-day year. For example, suppose a depository institution in the form of time deposits, they are not spendable on the
promises an 8 percent annual interest rate to the buyer of a street like currency.3
$100,000 six-month (180-day) CD. The depositor will have the
The banks accepting these deposits may be foreign branches of
following at the end of six months:
U.S. banks overseas, or international banking facilities (IBFs) set up
Amount on U.S. soil but devoted to foreign transactions on behalf of a par-
Days to maturity Annual rate
due = Principal + Principal * * ent U.S. bank. The heart of the worldwide Eurodollar market is in
360 days of interest
CD customer London, where British banks compete with scores of American and
180 other foreign banks for these deposits. The Eurocurrency market is
= $100,000 + $100,000 * * 0.08 (13.2)
360 the largest unregulated financial market-place in the world.
= $104,000
A domestic financial firm can tap the Euromarket for funds by
CDs that have maturities over one year normally pay interest contacting one of the major international banks that borrow
to the depositor every six months. Variable-rate CDs have their and lend Eurocurrencies every day. The largest U.S. banks also
interest rates reset after a designated period of time (called a use their own overseas branches to tap this market. When one
leg or roll period). The new rate is based on a mutually accepted of these branches lends a Eurodeposit to its home office in the
reference interest rate, such as the London Interbank Offer Rate United States, the home office records the deposit in an account
(LIBOR) attached to borrowings of Eurodollar deposits or the labeled liabilities to foreign branches. When a U.S. financial
average interest rate prevailing on prime-quality CDs traded in firm borrows Eurodeposits from a bank operating overseas, the
the secondary market. transaction takes place through the correspondent banking sys-
The net result of CD sales to customers is often a simple transfer tem. The lending bank will instruct a U.S. correspondent bank
of funds from one deposit to another within the same deposi- where it has a deposit to transfer funds in the amount of the
tory institution, particularly from checkable deposits into CDs. Eurocurrency loan to the correspondent account of the borrow-
The selling institution gains loanable funds even from this ing institution. These borrowed funds will be quickly loaned to
simple transfer because, in the United States at least, legal qualified borrowers or, perhaps, used to meet a reserve deficit.
reserve requirements are currently zero for CDs, while checking Later, when the loan falls due, the entries on the books of cor-
accounts at the largest depository institutions carry a reserve respondent banks are reversed. This process of borrowing and
requirement of 10 percent. Also, deposit stability is likely to be lending Eurodollars is traced out in Table 13.7.
greater for the receiving depository institution because the CD Most Eurodollar deposits are fixed-rate time deposits. Begin-
normally will not be withdrawn until maturity. In contrast, check- ning in the 1970s, however, floating-rate CDs (FRCDs) and
able (demand) deposits can be withdrawn at any time. However, floating-rate notes (FRNs) were introduced in an effort to pro-
the sensitive interest rates attached to the largest negotiable tect banks and their Eurodepositors from the risk of fluctuating
CDs mean that depository institutions must work harder to com- interest rates. FRCDs and FRNs tend to be medium to long
bat volatile earnings and make aggressive use of rate-hedging term, stretching from 1 year to as long as 20 years. The offer
techniques. Nevertheless, this is a popular borrowing medium rates on these longer-term negotiable deposits are adjusted,
due to its modest cost, large volume of funds available, and usually every three to six months, based upon interest rate
flexibility. movements in the interbank Euromarket. The majority of Euro-
deposits mature within six months; however, some are as short
The Eurocurrency Deposit Market as overnight. Most are interbank liabilities whose interest yield
is tied closely to LIBOR—the interest rate money center banks
The development of the U.S. negotiable CD market came on the
quote each other for the loan of short-term Eurodeposits. Large-
heels of another deposit market that began in Europe during the
denomination Euro CDs issued in the interbank market are
1

1950s—the Eurocurrency deposit market. Eurocurrency depos-


60

called tap CDs, while smaller-denomination Euro CDs sold to oa


5

its were developed originally in Western Europe to provide liq-


66
98 er

wide range of investors are called tranche CDs. As with domes-


omees-
1- nt
20
66 Ce

uid funds that could be swapped among multinational banks or


tic CDs, there is an active resale market for these deposits.
ositts
ts.
loaned to the banks’ largest customers. Most such international
65 k
06 oo
B

borrowing and lending has occurred in the Eurodollar market.


3
82

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

nated on the receiving banks’ books in dollars rather than in the


41

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

   


Table 13.7 U.S. Bank Borrowing Eurodollars from Foreign Banks

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

ration). The proceeds from issuing finance paper can be e used


used
Commercial Paper Market
5
66
98 er

to purchase loans off the books of other financial firmsrms in the


1- nt
20
66 Ce

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

Chapter 13 Managing Nondeposit Liabilities ■ 259

   


Table 13.8 Commercial Paper Borrowing by a Holding Company That Channels the Borrowed Funds to One
of Its Affiliated Lending Institutions

Step 1. Commercial Paper Is Sold by an Affiliated Corporation in the Money Market


Lending Institution Affiliated Corporation
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Cash account +100 Commercial
paper +100

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

primary, secondary, and seasonal credit? What is a repaying this loan?


65 ks

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

achieving monetary policy goals? sourcce so


Federal Home Loan Banks? Why is this source
-9 ali
58 ak

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

  


13.14. What are the advantages and disadvantages of CDs security dealer, and then returns the borrowed funds.
as a funding source? Can you trace through the resulting accounting entries?
13.15. Suppose a customer purchases a $1 million 90-day 13.19. What is commercial paper? What types of organiza-
CD, carrying a promised 6 percent annualized yield. tions issue such paper?
How much in interest income will the customer earn 13.20. Suppose that the finance company affiliate of Citi-
when this 90-day instrument matures? What total vol- group issues $325 million in 90-day commercial paper
ume of funds will be available to the depositor at the to interested investors and uses the proceeds to pur-
end of 90 days? chase loans from Citibank. What accounting entries
13.16. Where do Eurodollars come from? should be made on the balance sheets of Citibank
13.17. How does a bank gain access to funds from the Euro- and Citigroup’s finance company affiliate?
currency markets? 13.21. What long-term nondeposit funds sources do banks
13.18. Suppose that JP Morgan Chase Bank in New York and some of their closest competitors draw upon
elects to borrow $250 million from Barclays Bank in today? How do these interest costs differ from those
London and loans the borrowed funds for a week to a costs associated with most money market borrowings?

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

of current and anticipated credit demands must be based on


11 ah

AFG = ($150 + $75 + $135)


5) - ($185
($18 + $100)
41 M

knowledge of the current and probable future funding needs of


each institution’s customers, especially its largest borrowers. Such = $306 - $285
20

projections should not be wild guesses; they should be based on = $75


99

Chapter 13 Managing Nondeposit Liabilities ■ 261

  


Most institutions will add a small amount to this available funds A sample of interest rates on money market borrowings, aver-
gap estimate to cover unexpected credit demands or unantici- aged over selected years, is shown in Table 13.9. Note that the
pated shortfalls in deposits and other inflowing funds. Various various funds sources vary significantly in price—the interest
nondeposit funds sources then may be tapped to cover the esti- rate the borrowing institution must pay for use of the money.
mated funds gap. Among the cheapest short-term borrowed funds source is usu-
ally the prevailing effective interest rate on Federal funds loaned
overnight to borrowing institutions. In most cases the interest
Nondeposit Funding Sources: Factors rates attached to domestic CDs and Eurocurrency deposits
to Consider are slightly higher than the Fed funds rate. Commercial paper
Which nondeposit sources will management use to cover a (short-term unsecured notes) normally may be issued at inter-
projected available funds gap? The answer to that question est rates slightly above the Fed funds and CD rates, depend-
depends largely upon five factors: ing upon maturity and time of issue. Today the discount rate
attached to loans from the Federal Reserve banks (known as the
1. The relative costs of raising funds from each source.
primary credit rate) is generally among the highest short-term
2. The risk (volatility and dependability) of each funding source. borrowing rates because this form of Federal Reserve credit
3. The length of time (maturity or term) for which funds are is generally priced above the central bank’s target for the Fed
needed. funds rate.

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

Interest Rate Averages Quoted for the Years

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

Federal funds borrowings 4.47% 5.30% 5.35% 6.24% 1.34% 1.35% 3.22% 5.02% 0.17%
Borrowings from the Federal 3.76 5.00 4.98 5.50 1.25 2.34 4.19 5.86 0.72
Reserve banks**
Selling commercial paper 4.65 5.43 n.a. 6.27 1.68 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

(secondary market, 1-month)


5
66
98 er
1- nt
20

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

Notes: *Selected figures based on year-end interest rates.


82 B
-9 ali

**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

points above the Federal funds interest rate target.


Source: Board of Governors of the Federal Reserve System.
20
99

262 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Note that the cost associated with attracting each funds source
Factoids is compared to the net amount of funds raised after deductions
What interest rate attached to nondeposit borrowings tends are made for reserve requirements (if any), insurance fees, and
to be among the lowest? that portion of borrowed funds diverted into such nonearn-
ing assets as excess cash reserves or fixed assets. We use net
Answer: The effective Federal funds rate is often among the
investable funds as the borrowing base because we wish to
lowest borrowing rate for depository institutions.
compare the dollar cost that must be paid out to attract bor-
Is the Fed funds interest rate usually the absolute lowest in rowed funds relative to the dollar amount of those funds that
the money market? can actually be used to acquire earning assets and cover the
Answer: No, the interest rate on the shortest-term U.S. Trea- cost of fund-raising.
sury bills is often slightly lower than the Fed funds rate.
Let’s see how the above formulas might be used to estimate
the real cost of borrowing funds. Suppose that Fed funds are
In contrast, market interest rates on CDs and commercial paper
currently trading at an interest rate of 6.0 percent. Moreover,
are usually somewhat more stable, but generally hover close
management estimates that the marginal noninterest cost, in the
to and slightly above the Fed funds rate due to their longer
form of personnel expenses and transactions fees, from raising
average maturity and because of the marketing costs spent
additional monies in the Fed funds market is 0.25 percent. Sup-
in finding buyers for these instruments. CDs and commercial
pose that a depository institution will need $25 million to fund
paper usually are less popular in the short run than Fed funds
the loans it plans to make today, of which only $24 million can
and borrowings from the central bank’s discount window when
be fully invested due to other immediate cash demands. Then
a depository institution needs money right away. In contrast, CD
the effective annualized cost rate for Fed funds would be calcu-
and commercial paper borrowings are usually better for longer-
lated as follows:
term funding needs that stretch over several days or weeks.
Current interest cost
The rate of interest is usually the principal expense in borrowing = 0.06 * $25 million = $1.5 million
on Federal funds
nondeposit funds. However, noninterest costs cannot be ignored
in calculating the true cost of borrowing nondeposit funds, includ- Noninterest cost to
= 0.0025 * $25 million = $0.063 million
ing the time spent by management and staff to find the best access Federal funds
funds sources each time new money is needed. A good formula Net investable
= $25 million - $1 million = $24 million
for doing cost comparisons among alternative sources of funds is: funds raised

Current interest Noninterest costs Therefore, the effective annualized Fed funds cost rate is
Effective cost
cost on amounts + incurred $1.5 million + $0.063 million
rate on = 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

and transaction costs cost rate $24 million


1- nt
20

(13.6)
66 Ce

$1.75 million + $0.1875 million


on
65 ks

=
06 oo

Total amount borrowed less legal reserve $24 million


82 B
-9 ali

Net investable funds requirements (if any), deposit insurance = 0.0807 or 8.07 percent
58 ak

=
11 ah

raised assessments (if any), and funds placed


41 M

in nonearning assets An additional expense associated with selling CDs to raise


h ssellin
(13.7) money is the deposit insurance fee. In th United States this fee
n the
20
99

Chapter 13 Managing Nondeposit Liabilities ■ 263

  


varies with the risk and capitalization of each depository institu- If we deduct this fee from the new amount of CDs actually avail-
tion whose deposits are insured by the Federal Deposit Insur- able for use, we get:
ance Corporation (FDIC). Effective CD $1.9375 million
=
To illustrate how the FDIC insurance fee works assume the cost rate $24 million - $0.0675 million
current insurance rate is $0.0027 per dollar of deposits—a $1.9375 million
= = 0.0810 or 8.10 percent
fee sometimes charged the riskiest insured depository insti- $23.925 million
tutions. (We should note as well that the FDIC requires an Clearly, issuing CDs would be more expensive in the above
insured depository institution to pay this insurance fee not example than borrowing Fed funds. However, CDs have the
just on the actual insured portion of a customer’s deposit advantage of being available for several days, weeks, months, or
account but on the full face amount (beyond the insured years, whereas Fed funds loans must often be repaid in 24 hours.
amount) of each deposit received from the public.) Thus, the
Nondeposit sources of funds generally are moderate in cost
total insurance cost for the riskiest depository institutions on
compared to other funding sources. Nondeposit funds tend to
the $25 million we are talking about raising through selling
be more expensive than checkable deposits but less expensive
CDs would be
than thrift (time and savings) deposits. We must add a note of
Total deposits caution here, however, because the costs and the profits associ-
Insurance fee
received from * = $25 million * 0.0027 ated with nondeposit funds tend to be more volatile from year
per dollar
the public (13.8) to year than the cost and profitability of deposits. Nondeposit
= $67,500 or $0.0675 million funds do have the advantage of quick availability compared to

FIGURING THE OVERALL COST OF FUNDS


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

The Historical Average Cost Approach


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

Average Amount of Average Rate of Total Interest Paid for Each


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

Noninterest-bearing demand deposits $100 0% $0


Interest-bearing transaction deposits 200 7% 14
Savings accounts 100 5% 5
Time deposits 500 8% 40
Money market borrowings 100 6% 6
1
60

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


5
66
98 er
1- nt
20
66 Ce

Then the average interest cost of deposits and money market borrowings is:
65 ks
06 oo
82 B

Weighted
-9 ali

All interest paid $65


58 ak

average interest = = = 6.5 percent


11 ah

Total funds raised $1,000


41 M

expense
20
99

264 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


But other operating costs, such as salaries and overhead, must also be covered. If these are an estimated $10 million, we have

Break@even
cost rate Interest + Other
on borrowed operating costs $65 + 10
= = = 10 percent
funds invested All earning assets $750
in earning
assets
This cost rate is called break-even because the borrowing institution must earn at least this rate on its earning assets
(primarily loans and securities) just to meet the total operating costs of raising borrowed funds. But what about the bor-
rowing institution’s stockholders and their required rate of return (assumed hereto be 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.

The Pooled-Funds Approach


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

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

Interest-bearing transaction
01

deposits $100 50% $50 8% $8


56
66
98 er

Time deposits 100 60% 60 9% 9


1- nt
20
66 Ce

New stockholders’ investment


65 ks

in the institution 100 90% 90 13% 13


1
06 oo
82 B
-9 ali

Total $300 $200 $30


58 ak
11 ah
41 M

(Continued )
20
99

Chapter 13 Managing Nondeposit Liabilities ■ 265

  


The overall cost of new deposits and other borrowing sources must be
Pooled
All expected
deposit and
operating expenses $30 million
nondeposit = = = 10 percent
All new $300 million
funds
funds expected
expense

But because only two-thirds of these expected new funds ($200 million out of $300 million raised) will actually be available to
acquire earning assets,

Hurdle All expected


rate of return operating costs $30 million
= = = 15 percent
over all Dollars available $200 million
earning assets to place in
earning assets
Thus, the borrowing financial firm in the example above must earn at least 15 percent (before taxes), on average, on all the new
funds it invests to fully meet its expected fund-raising costs.

most types of deposits, but they are clearly not as stable a fund- 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

that the negotiable CD, Eurodollar, and commercial paper mar-


60

and use of borrowed funds. For example, in the United States CDs C
CD
5
66

kets arc especially sensitive to credit availability risks. Funds


98 er

must be issued with maturities of at least seven days. The Federal


Feder eral
ral
1- nt
20
66 Ce

managers must be prepared to switch to alternative sources of


Reserve banks may limit borrowings from the discount window,
winddow,
do
65 ks

credit and, if necessary, pay more for any funds they receive.
06 oo

particularly by depository institutions that appear to display


dispplay sig-
displ ssi
82 B

nificant risk of failure. Other forms of borrowing may beb subjected


su
-9 ali

The Length of Time Funds Are Needed


58 ak

to legal reserve requirements by action of the e central


centtral bank.
b For
11 ah
41 M

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

  


• The use of nondeposit borrowings as a key source of funds
CONCEPT CHECK was given a boost by the emergence of the customer
relationship doctrine. This managerial strategy calls for put-
13.22. What is the available funds gap?
ting the goal of satisfying the credit requests of all quality
13.23. Suppose JP Morgan Chase Bank of New York customers at the top of management’s list. If deposits are
discovers that projected new loan demand next inadequate to fund all quality loan requests, other sources of
week should total $325 million and customers funds, including borrowings in the money and capital mar-
holding confirmed credit lines plan to draw down kets, should be used. Thus, the lending decision comes first,
$510 million in funds to cover their cash needs followed by the funding decision.
next week, while new deposits next week are pro-
• One of the key sources of nondeposit funds today is the
jected to equal $680 million. The bank also plans
Federal funds market, where immediately available reserves
to acquire $420 million in corporate and govern-
are traded between financial institutions and usually returned
ment bonds next week. What is the bank’s pro-
within 24 hours. Borrowing from selected government
jected available funds gap?
agencies—in the United States, the discount windows of the
13.24. What factors must the manager of a financial insti- Federal Reserve banks and advances from die Federal Home
tution weigh in choosing among the various non- Loan banks—has also grown rapidly in recent years.
deposit sources of funding available today?
• Other key funds sources include selling negotiable jumbo
($100,000+) CDs, borrowing Eurocurrency deposits from
international firms offshore, issuing commercial paper in the
open market through affiliated corporations, executing repur-
funds borrowing, repurchase agreements, and commercial paper
chase agreements where loans collateralized by top-quality
issued to purchase assets from affiliated lending institutions. While
assets are made available for a few hours or days, or pursuing
these particular requirements are not currently in force, it seems
longer-term borrowings in the capital markets through the
clear that in times of national emergency, government policymak-
issuance of longer-term debt.
ers would move swiftly to impose new controls, affecting both the
costs and risks associated with nondeposit borrowings. • Before tapping nondeposit borrowings, however, the
managers of financial firms must estimate their funding
requirements. One such estimate for a depository institution
SUMMARY comes from the available funds gap, the spread between the
current and expected volume of loans and investments and
Although the principal funding source for many financial institu- the current and expected volume of funds sources.
tions is deposits, nearly all depository institutions today supple- • The particular nondeposit funds source(s) chosen by man-
ment the funds they attract through sales of deposits with agement will rest upon such factors as (1) the relative cost
nondeposit borrowings in the money and capital markets. In of each source; (2) the risk or dependability of each funds
this chapter we explore the most important nondeposit funds source; (3) the length of time funds will be needed; (4) the
sources and the factors that bear on the managerial decision size of the borrowing institution and its funding needs;
about which sources of funds to draw upon. The key points in and (5) the content of government regulations affecting
the chapter include: fund-raising.
• Today’s heavy use of nondeposit borrowings by depository insti- • Among the most important government regulations bearing
tutions arose with the development of liability management, on the use of nondeposit funds are legal reserve require-
which calls upon managers of financial institutions to actively ments imposed by central banks around the world and rules
manage their liabilities as Well as their assets on the balance dictating the content of contractual agreements when fundsds
1
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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
11 ah
41 M

liability management, 248 negotiable CD, 256 interest rate risk,


sk, 266
Federal funds market, 250 Eurocurrency deposit, 258 credit availability
bility risk,
r 266
20

repurchase agreements (RPs), 252 commercial paper market, 259


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Chapter 13 Managing Nondeposit Liabilities ■ 267

  


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

PROBLEMS AND PROJECTS


1. Robertson State Bank decides to loan a portion of its of this maturity stood at 2.25 percent when these two insti-
reserves in the amount of $70 million held at the Fed- tutions agreed on the loan. The funds loaned by Morgan
eral Reserve Bank to Tenison National Security Bank for were in the reserve deposit that the bank keeps at the
24 hours. For its part, Tenison plans to make a 24-hour Federal Reserve Bank of New York. When the loan to Wells
loan to a security dealer before it must return the funds to Fargo was repaid the next day, JP Morgan used $50 million
Robertson State Bank. Please show the proper accounting of the returned funds to cover its own reserve needs and
entries for these transactions. loaned $100 million in Fed funds to Bank of America, Char-
2. Masoner Savings, headquartered in a small community, lotte, for a two-day period at the prevailing Fed funds rate
holds most of its correspondent deposits with Flagg Metro- of 2.40 percent. With respect to these transactions, (a) con-
center Bank, a money center institution. When Masoner has struct T-account entries similar to those you encountered
a cash surplus in its correspondent deposit, Flagg automat- in this chapter, showing the original Fed funds loan and its
ically invests the surplus in Fed funds loans to other money repayment on the books of JP Morgan, Wells Fargo, and
center banks. A check of Masoner’s records this morning Bank of America and (b) calculate the total interest income
reveals a temporary surplus of $11 million for 48 hours. earned by JP Morgan on both Fed funds loans.
Flagg will loan this surplus for two business days to Secoro 8. Blue Skies Bank of Florida issues a three-month (90-day)
Central City Bank, which is in need of additional reserves. negotiable CD in the amount of $20 million to ABC Insur-
Please show the correct balance sheet entries to carry out ance Company at a negotiated annual interest rate of
this loan and to pay off the loan when its term ends. 2.75 percent (360-day basis). Calculate the value of this CD
3. Relgade National Bank secures primary credit from the account on the day it matures and the amount of interest
Federal Reserve Bank of San Francisco in the amount income ABC will earn. What interest return will ABC Insur-
of $32 million for a term of seven days. Please show the ance earn in a 365-day year?
proper entries for granting this loan and then paying off 9. Banks and other lending affiliates within the holding com-
the loan. pany of Best-of-Times Financial are reporting heavy loan
4. Shad Corporation purchases a 60-day negotiable CD with a demand this week from companies in the southeastern
$5 million denomination from Bait Bank and Trust, bearing a United States that are planning a significant expansion of
2.95 percent annual yield. How much in interest will the bank inventories and facilities before the beginning of the fall
have to pay when this CD matures? What amount in total will season. The holding company plans to raise $775 million in
the bank have to pay back to Shad at the end of 60 days? short-term funds this week, of which about $700 million will
be used to meet these new loan requests. Fed funds are
5. Deep Valley Bank borrows $125 million overnight through
currently trading at 2.25 percent, negotiable CDs are trad-
a repurchase agreement (RP) collateralized by Treasury
ing in New York at 2.40 percent, and Eurodollar borrowings
bills. The current RP rate is 2.50 percent. How much will the
are available in London at all maturities under one year at
bank pay in interest cost due to this borrowing?
2.30 percent. One-month maturities of directly placed com-
6. Thyme Bank of New York expects new deposit inflows next mercial paper carry market rates of 2.35 percent, while the
month of $265 million and deposit withdrawals of $425 mil- primary credit discount rate of the Federal Reserve Bank
lion. The bank’s economics department has projected that of Richmond is currently set at 2.75 percent—a source
new loan demand will reach $400 million and customers
1

that Best-of-Times has used in each of the past two weeks.


560

with approved credit lines will need $175 million in cash.


66

Noninterest costs are estimated at 0.25 percent for Feded


98 er
1- nt
20

The bank will sell $450 million in securities, but plans to


66 Ce

funds, discount window borrowings, and CDs; 0.35 5ppercent


perrcent
add $60 million in new securities to its portfolio. What is its
65 ks

for Eurodollar borrowings; and 0.50 percent forr commercial


commme
mmer
06 oo

projected available funds gap?


82 B

paper. Calculate the effective cost rate of each


h of
ach
ch o these
the
-9 a
58 ak

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.
20
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268 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

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

to find a small bank holding company (BHC) located in your you


60

deposits are 2.50 percent, on average, while noninterest


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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
06 oo
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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.
20
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Chapter 13 Managing Nondeposit Liabilities ■ 269

  


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

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

CASE ASSIGNMENT FOR CHAPTER 13

Your Bank’s Use of Liability Management:


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

1
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11 a h
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270 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

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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Chapter 13 Managing Nondeposit Liabilities ■ 271

  




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560
1


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.

● Assess the role of repo transactions in the collapses of


Lehman Brothers and Bear Stearns during the 2007–2009
financial crisis. 1
60
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Excerpt is Chapter 12 of Fixed Income Securities: Tools for Today’s Markets, Third Edition, by Bruce Tuckman
man and
a Angel Serrat.
20
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273

  


This chapter is about repurchase agreements or
repos. Repos are short-term contracts that are
used to lend money on the security of usually
high-grade collateral, to finance the purchase of
bonds, and to borrow bonds to be sold short.
Financial institutions have traditionally relied on
repos to finance some portion of fixed income inven-
tory. Repo financing, as secured, short-term borrow-
ing, is typically a relatively inexpensive way to borrow
money. The practice can leave firms in a perilous
situation, however, should lenders of cash through Figure 14.1 The initiation of a repo trade.
repos, in times of trouble, fail to renew their loans.
This turned out to be an issue in the financial crisis
of 2007–2009, which is illustrated in this chapter by
two cases, one about liquidity management at Bear
Stearns and one about the financing relationship
between Lehman Brothers and JPMorgan Chase.
The last part of the chapter focuses on repo rates
and, in particular, on the specials market in the
United States, where market participants lend
money at relatively low rates predominantly in order
to borrow the most recently issued and most liquid
U.S. Treasury bonds. The behavior of these rates is Figure 14.2 The unwinding of a repo trade.
examined in some detail and linked empirically to
the auction cycle of U.S. government bonds. Hence, at the termination or unwind of the repo, depicted in
Figure 14.2, counterparty A repurchases the €100 million face
amount of the bund from counterparty B for about €111.838
14.1 REPURCHASE AGREEMENTS: million. (Bund is another name for a DBR.)
STRUCTURE AND USES The next three subsections describe the three reasons to do
repo: to lend funds short-term on a secured basis, to finance a
A repurchase agreement or repo is a contract in which a security long position in a security, and to borrow a security in order to
is traded at some initial price with the understanding that the sell it short.
trade will be reversed at some future date at some fixed price.
Repos are used by several different types of market participants
for different purposes; Figures 14.1 and 14.2 begin the discussion Repos and Cash Management
by illustrating a simplified trade between generic counterparties. Investors holding cash for liquidity or safekeeping purposes
At initiation of the repo, depicted in Figure 14.1, counterparty A often find investing in repo to be an ideal solution. The most
sells €100 million face amount of the DBR 4s of January 4, 2037, significant example of this is the money market mutual fund
to counterparty B, for settlement on May 31, 2010, at an invoice industry, which invests on behalf of investors willing to accept
price of €111.772 million. At the same time, counterparty A relatively low returns in exchange for liquidity and safety. In
agrees to repurchase that €100 million face amount three terms of Figures 14.1 and 14.2, a money market fund would be
1
60

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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collateral and then, at maturity, collecting the loan plus inter-


nter-
1- nt

price equal to the original invoice price plus interest at a repo


20
66 Ce

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
82 B

because, in the event of a default by counterpartyrty A,


A counter-
cou
-9 ali

May 31, 2010, and August 31, 2010, the repurchase price is
58 ak

party B, in this case the money market fund, can sell


s the
t repo
11 ah
41 M

(14.1) collateral to recover any amounts owed. In summary,


su
summma relative
umma
to super-safe and liquid non-interest-bearing
ing bank
b deposits,
20
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274 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


repo investments pay a short-term rate without sacrificing much course, collect only €106 million plus interest at maturity. In
liquidity or incurring significant default risk. addition, repo agreements are normally subject to margin calls,
through which the borrower of cash supplies extra collateral in
Municipalities constitute another significant category of repo
declining markets but may withdraw collateral in advancing
investors. As the timing of tax receipts has little to do with the
markets. Again using the example of this section, should the
schedule of public expenditures, municipalities tend to run cash
value of the bund collateral decline from its initial value of
surpluses from tax receipts so as to have money on hand to
€111.772 million to €110 million, the borrower would have to
meet expenditures. These tax revenues cannot be invested in
put up the €1.772 million difference in additional collateral to
risky securities, but neither should the cash collected lie idle.
protect the investor’s loan. Combining the haircut and repric-
Short-term loans backed by collateral, like repos, again satisfy
ing features, after the drop in bund value the investor would
both revenue and safety considerations. Other institutions with
still have €111.772 million of collateral against the outstanding
similar cash management issues that choose to invest in repo
loan of €106 million.
are mutual funds, insurance companies, pension funds, and even
some nonfinancial corporations. It is worth noting, however, While repo investors care about the quality of the collateral they
that many lenders in the repo market during the recent financial accept, they do not usually care about which particular bond
crisis realized that they were not well positioned, either in exper- they accept. Hence, while repo investors can be very particular
tise or operational ability, to take possession of and liquidate about which classes of securities they will take as collateral, e.g.,
repo collateral. Euro-area government bonds with less than five years to matu-
rity, they will not insist on receiving any particular security within
Since repo investors place a premium on liquidity, they tend to
that delineated class. For this reason these investors are said to
lend overnight, rather than for term, which refers to any matu-
accept general collateral, which trades at general collateral repo
rity longer than one day. Many investors planning to lend cash
rates. The types and determination of repo rates are discussed
through the repo market for an extended period of time will,
later in this chapter.
rather than lend for term, engage in an open repo, i.e., a one-
day repo that renews itself day-to-day until cancelled by either
party. Nevertheless, investors willing to take on some additional Repos and Long Financing
liquidity and counterparty risk, in addition to interest rate risk,
do lend through term repos. These are available at various Financial institutions are the typical borrowers of cash in
maturities, out to several months, although demand declines repo markets. Say that a client wants to sell €100 million face
rapidly with term. amount of the DBR 4s of January 4, 2037, to the trading desk
of a financial institution. The desk will buy the bonds and even-
Since safety is the other key consideration of investors in repo,
tually sell them to another client. Until that buyer is found,
only securities of the highest credit quality are typically
however, the trading desk needs to raise money to pay the cli-
accepted as collateral. The most common choices are govern-
ent. Put another way, it needs to finance the purchase of the
ment securities, debt issues of government-sponsored enter-
bunds. Rather than draw on the scarce capital of the financial
prises (GSEs), and mortgage-backed securities guaranteed by
institution for this purpose, the trading desk will repo or repo
the government or the GSEs. (See the Overview for institu-
out the securities, or sell the repo. This means that it will bor-
tional descriptions.) Even taking high-quality securities as col-
row the purchase amount from someone, like a money market
lateral, however, a lender of cash faces the risk that a borrower
fund, and use the DBR 4s, which it just bought, as collateral.
defaults at the same time those securities decline in value.1 In
Thus, the trading desk acts as counterparty A in Figure 14.1.
that eventuality, selling the collateral might not fully cover the
Of course, any haircuts applied will require the trading desk to
loss of the loan amount. Therefore, repo agreements often
use some of its capital to make up the difference between the
provide haircuts through which investors require borrowers to
purchase price of the securities and the amount borrowed from
deliver securities worth more than the amount of the loan. In
1

the repo counterparty.


60

the example of this section, counterparty B might lend only


5
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€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
1- nt
20
66 Ce

will, still as counterparty A but now in Figure 14.2, 2 unwind


4.2, u
unwi
unwin
65 ks

the repo, using the proceeds from the sale of the e bunds
bun to
bu
06 oo
82 B

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
58 ak

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

were to default, the market response would probably be a “flight-to-


41 M

before the expiration of the repo, the e trading


tradi desk will have
ttr
tradin
quality trade” in which securities of the most creditworthy governments
increase in value. to roll or renew the repo for anothererr period
per with the same
20
99

Chapter 14 Repurchase Agreements and Financing ■ 275

  


The issues surrounding financial institutions’ use
of repo to finance their businesses are discussed
later in this chapter.

Reverse Repos and Short


Positions
Professional investors often want to short a
bond, either as an outright bet that interest
rates will rise or as part of a relative value bet
Figure 14.3 Back-to-back repo trades. that the price of another security will rise rela-
tive to the price of the security being sold
short. Say that a hedge fund wants to short the
counterparty or unwind that repo and find a different coun-
DBR 4s of January 4, 2037. It sells the bund, but then needs
terparty to finance the bond. This latter option is illustrated
to borrow it from somewhere in order to make delivery. In
in Figure 14.3. The trading desk, still as counterparty A, will
terms of Figure 14.1, the hedge fund is counterparty B, initi-
repay counterparty B the approximately €111.838 million due
ating the transaction not because it wants to lend cash but
and take back the bunds; then borrow funds from counter-
because it wants to borrow the bund. From the point of view
party C and deliver the bunds as collateral. Note that since the
of the hedge fund, it will do a reverse repurchase agree-
cash obtainable from counterparty C depends on the price of
ment,3 will reverse or reverse in the securities, or will buy
the bond at the time of the roll, while the cash due to coun-
the repo.
terparty B depends on the amount owed from the previously
agreed-upon transaction, this renewal of the repo may leave After initiating the reverse, the hedge fund will, at some point
counterparty A, the trading desk, with a cash surplus or deficit. in time, be ready to cover its short, i.e., to neutralize its eco-
Of course, had the trading desk hedged the price risk of its nomic exposure to the bund by buying that bund back. At
inventory, the profit and loss from the hedge would offset this that time the hedge fund will buy the bund and then unwind
cash surplus or deficit. its reverse as in Figure 14.2. Specifically, the hedge fund, as
counterparty B, will buy the bund at market and then deliver
In the example of this subsection, the financial institution used
it to counterparty A, who, in exchange, will return the hedge
the repo market to finance its inventory for the purpose of mak-
fund’s cash with interest. If the return on the bund has been
ing markets. Other uses include financing its proprietary posi-
less than the repo rate of interest, the hedge fund will have
tions2 and positions for customers. Repo for proprietary
made money on an outright short position, while if the return
positions can be described by Figures 14.1 and 14.2, with the
on the bund has been greater than the repo rate of interest,
relevant trading desk again as counterparty A, but with internal
the hedge fund will have lost money on an outright short. Of
rather than customer motivations for purchasing and then selling
course, the short might very well have been part of a larger
the bunds. Repo for financing customer positions, at initiation,
trade in which case the P&L has more components.
can be described in terms of Figure 14.3. This time a customer,
e.g., a hedge fund, is counterparty B, who wants to finance the While Figures 14.1 and 14.2 were used to explain both repo
purchase of the DBR 4s. The trading desk of the financial institu- investment and reverse repos, it is important to keep in mind
tion, counterparty A, does a repo with the customer, lending that the former are initiated in order to invest cash while the
cash and taking the DBR 4s as collateral. The trading desk then latter are initiated to borrow a bond. So while repo investors
does a back-to-back repo with counterparty C, who provides the are willing to accept general collateral, reverses require the
cash and takes the collateral originally supplied by the hedge delivery of a particular bond. Repo transactions that require the
1
60

fund. Without haircuts the cash amounts shown would be the delivery of a particular bond are called special trades and they
hey
e
5
66
98 er

take place at special collateral rates. The specials markett is dis-


d
dis-
1- nt

same, but, in practice, the haircuts charged on each leg of the


20
66 Ce

trade depend on the creditworthiness and negotiating power of cussed further later in this chapter.
65 ks
06 oo

the relevant counterparties.


82 B
-9

3
58

The practice of calling the trade a reverse repo is partic


p
particularly confus-
11

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

proprietary positions held by financial institutions. y.


security is a repo for the lender of that security.
20
99

276 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


14.2 REPO, LIQUIDITY MANAGEMENT, difficulties for regulators. Borrowers want to extend the term of
their repo borrowings,4 sometimes at the encouragement of their
AND THE FINANCIAL CRISIS regulators, so as to have more time, should conditions for refi-
OF 2007–2009 nancing deteriorate, to arrange alternate financing, to raise capi-
tal, or even to sell corporate entities. Lenders, on the other hand,
Broker-dealers rely less on repo financing currently than they did want to shorten the term of their repo lendings, sometimes at the
before the 2007–2009 crisis. A financial institution can borrow encouragement of their regulators, so as to minimize exposure to
funds in many ways, some of which are more stable than others, borrower defaults. Prices, in this case repo rates, allocate repos
i.e., some of which can be easily maintained under conditions of of various terms across borrowers and lenders, but the financial
financial stress and some of which cannot be so easily maintained. system as a whole cannot both extend the maturities of secured
The most stable source of funds is equity capital because equity financing and contract the maturities of secured lending.
holders do not have to be paid according to any particular sched-
ule and because they cannot compel a redemption of their shares. In the run-up to the financial crisis of 2007–2009, borrowers
Slightly less stable is long-term debt because bondholders have financed lower-quality collateral, like lower-quality corporate
to be paid interest and principal as set out in bond indentures. bonds and lower-quality mortgage-backed securities, at the rela-
At the other extreme of funding stability is short-term unsecured tively low rates and haircuts available in the repo market. Lenders,
funding, like commercial paper: these borrowings have to be for their part, accepted this collateral in exchange for rates some-
repaid in a matter of weeks or months, as they mature, when the what higher than those available when lending on higher-quality
institution, under adverse conditions, might not be able to borrow collateral. The resulting expansion of collateral accepted for repo
money elsewhere. Not surprisingly, the more stable sources of did not work out well during the crisis, particularly for borrowers
funds are usually more expensive in terms of the expected return who were unable to meet margin calls caused by declining security
required by the providers of funds. Through liquidity manage- values, who were unable to post sufficient collateral in response to
ment, firms balance the costs of funding against the risks of being lenders’ raising haircuts, or who were unable to replace lost financ-
caught without the financing necessary to survive. ing arrangements when lower-quality collateral found fewer and
fewer takers. The worst–hit borrowers suffered collateral liquida-
In the spectrum of financing choices, repo markets are relatively tions, losses, capital depletion, and business failure.
liquid and repo borrowing rates relatively low. On the other hand,
by nature of its short maturities repo is on the less stable side
of the funding spectrum, although more stable than short-term, Case Study: Repo Financing
unsecured borrowing. After all, repo collateral should prevent and the Collapse of Bear Stearns
repo lenders from bolting too quickly in response to unfavorable
This is an excerpt from the testimony of Paul Friedman before
rumors or news. Nevertheless, if repo investors do lose confi-
the Financial Crisis Inquiry Commission on May 5, 2010.5
dence in a financial institution, that institution’s repo financing can
Mr. Friedman, a Senior Managing Director at Bear Stearns,
disappear as fast as the repos mature, which is mostly overnight.
was responsible for its fixed income repo desk at the time of
The beleaguered institution would no longer be able to facili-
the firm’s demise in March 2008.
tate customer trades by holding inventory, would not be able to
facilitate customer financing, and might not remain an acceptable Bear Stearns generally financed its business by borrow-
counterparty for derivative and even spot security transactions. ing funds on a secured and unsecured basis and through
Furthermore, the institution would have to sell inventory and pro- the use of equity capital. During 2006, Bear Stearns
prietary positions to repay repo lenders, which sales, given their decided to reduce the amount of short-term unsecured
size and public nature, would likely turn into fire sales and result funding, primarily commercial paper, that it borrowed.
in significant losses. Essentially then, while significant business The firm made this decision primarily based on its belief,
losses rather than financing are the usual cause of a financial insti- which I shared, that commercial paper tended to be
1
60

tution’s difficulties, the loss of financing is often the killing blow. confidence-sensitive, and could become unavailable e att
ble
5
66
98 er

The same argument, of course, applies to all leveraged investors, a time of market stress, while secured borrowing based
ng ba
ased
1- nt
20
66 Ce

like part of the hedge fund world. To the extent that a firm bor-
65 ks
06 oo

rows money to finance positions, losing the confidence of repo


82 B

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
-9 ali
58 ak

substantial losses, and possible bankruptcy. substitution that enable the borrower of cashh who needs to sell a par-
o nee
11 ah

ticular bond being financed to replace thatt bo


bon
ond as collateral with other
bond
41 M

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
20
99

Chapter 14 Repurchase Agreements and Financing ■ 277

  


on high-quality collateral is generally less credit sensitive repo loans, even when the loans were supported by
and therefore more stable. high-quality collateral such as agency securities; and
counterparties to non-simultaneous settlements of
Bear Stearns implemented this strategy in late 2006 and
foreign exchange trades refused to pay until Bear
2007, and succeeded in reducing its short-term unse-
Stearns paid first . . . [T]his loss of confidence in Bear
cured financing from $25.8 billion at the end of fiscal
Stearns . . . resulted in a rapid flight of capital from the
2006 to $11.6 billion at the end of fiscal 2007, and spe-
firm that could not be survived.
cifically reduced its commercial paper borrowing from
$20.7 billion to $3.9 billion. That funding was replaced
by secured funding, principally repo borrowing . . . Case Study: JPMorgan Chase’s Repo
As part of the firm’s transition away from unsecured bor- Exposure to Lehman Brothers
rowing, Bear Stearns also substantially increased the
The counterparty risk of lending money through a repo is that
average term of its secured funding during the first half
the borrower defaults and the value of the collateral turns out
of 2007. Bear Stearns was able to obtain longer term
to be insufficient to cover the loan amount. Any sterile discus-
repo facilities of six months or more to finance assets
sion of the topic cannot do justice to the bare-knuckle fighting
such as whole loans and non-agency mortgage backed
over collateral that takes place when a counterparty is at risk of
securities, and generally limit its use of short-term
default. A striking and well-publicized example of this through
secured funding to finance Treasury or agency securities.
2008 was the repo exposure of JPMorgan Chase (JPM) to
By increasing the amount of its long-term secured fund-
Lehman Brothers.
ing, the firm believed that it could better withstand a
liquidity event. JPM was Lehman’s tri-party repo clearing agent. When repo
investors lend money to a financial institution through the tri-
From approximately August 2007 to the beginning of
party repo system,7 taking collateral as security, their loans are,
2008, however, the fixed income repo markets started
literally, overnight.8 During the day, however, the tri-party repo
experiencing instability, in which fixed income repo lend-
agent is lending this money to the financial institution on a
ers began shortening the duration of their loans and
secured basis.9 Furthermore, given the operational structure of
asking all borrowers to post higher quality collateral to
the industry, a broker-dealer could not stay in business without
support those loans. Although the firm was successful in
its tri-party agent performing this function. Returning to JPM
obtaining some long-term fixed income repo facilities,
and Lehman, before Lehman’s final week, JPM’s tri-party lending
by late 2007 many lenders, both traditional and nontra-
to Lehman typically exceeded $100 billion.10 Furthermore, JPM
ditional, were showing a diminished willingness to enter
had historically not taken any haircuts on its tri-party, intraday
into such facilities.
advances, but began to do so in early 2008. In Lehman’s case,
During the week of March 10, 2008, Bear Stearns suf- JPM phased in haircuts so as to match, by mid-August 2008, the
fered from a run on the bank that resulted, in my view, haircuts posted to overnight repo investors.
from an unwarranted loss of confidence in the firm by
Against this background, the following two excerpts describe
certain of its customers, lenders, and counterparties. In
differing viewpoints of the events of September 2008, the first
part, this loss of confidence was prompted by market
from a lawsuit filed by the estate of Lehman Brothers Holdings
rumors, which I believe were unsubstantiated and
untrue, about Bear Stearns’ liquidity position. Neverthe-
less, the loss of confidence had three related conse-
7
quences: prime brokerage clients withdrew their cash For a more complete description, see “Systemic Risk and the Tri-Party
and unencumbered securities at a rapid and increasing Repo Clearing Banks,” by Bruce Tuckman, Center for Financial Stabil-
ity Policy Paper, February 2010. www.centerforfinancialstability.org/
rate;6 repo market lenders declined to roll over or renew
1
60

research-Tri-Party-Repo20100203.pdf
5
66
98 er

8
This is the reason that overnight repo trades are called that and
d not
1- nt
20
66 Ce

one-day trades.
6
65 ks

Unencumbered securities are securities that have not been posted as 9


As of the time of this writing, an industry task force is working
orking g to e
elimi-
06 oo

collateral or otherwise committed. This part of the testimony seems to


82 B

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

(the latter could be posted as collateral to raise funds) to finance other


11 ah

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
41 M

cash and unencumbered securities are extremely unstable sources of c-stat


Inquiry Commission,” September 1, 2010, p. 2. fcic-static.law.stanford.
funding as they can be withdrawn without notice at any time. row.p
edu/cdn_media/fcic-testimony/2010-0901-Zubrow.pdf
20
99

278 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Inc. (LBHI) against JPM11 and the second from the testimony of business days before LBHI’s Chapter 11 filing, JPMorgan
Barry Zubrow, Chief Risk Officer of JPM, before the Financial seized $8.6 billion of cash collateral, including over $5
Crisis Inquiry Commission. billion in cash on the final business day. All the while that
JPMorgan was aggressively leveraging its position to
First, from Lehman’s estate:
grab increasingly more collateral, JPMorgan knew that it
On the brink of LBHI’s bankruptcy, JPMorgan leveraged was already overcollateralized by billions of dollars.
its life and death power as the brokerage firm’s primary
JPMorgan’s . . . unjustified demands for billions in addi-
clearing bank to force LBHI into a series of one-sided
tional collateral, and its refusal to return that collateral
agreements and to siphon billions of dollars in critically-
in the critical days before LBHI’s bankruptcy filing,
needed assets. The purpose of these last-minute maneu-
severely constrained LBHI’s liquidity and impeded its
vers was to leapfrog JPMorgan over other creditors by
ability to pursue and implement alternatives and initia-
putting itself in the position of an overcollateralized
tives that would have resulted in the preservation of bil-
creditor, not just for clearing obligations, but for any and
lions in value. . . .
all possible obligations of LBHI or any of its subsidiaries
that JPMorgan believed could result from an LBHI bank- Next, from Barry Zubrow of JPM:
ruptcy. The effect of JPMorgan’s actions—taken with the
Increasing margin requirements [during the course of
benefit of unparalleled inside knowledge—was devas-
2008] . . . did not protect JPMorgan fully from the risks it
tating. JPMorgan not only took billions of dollars more
faced in extending tens of billions of dollars of credit to
than it needed from LBHI, but it also accelerated LBHI’s
broker-dealers each morning . . . JPMorgan, unlike any
freefall into bankruptcy by denying it an opportunity for
single triparty investor, took on a broker-dealer’s entire
a more orderly wind-down, costing the LBHI estate tens
triparty repo book each day. This meant it would face far
of billions of dollars in lost value . . .
greater risks in a liquidation scenario. Furthermore, JPM-
In the weeks preceding LBHI’s bankruptcy filing, JPM- organ had no assurance that investors would return to
organ’s top management were the ultimate insiders to fund the broker-dealer in the evening . . . with the cash
the evolving crisis, enjoying real-time access to the key necessary to repay JPMorgan’s intraday advances. More-
decision-makers at the United States Treasury and the over, the haircuts negotiated between investors and
Federal Reserve Bank of New York. JPMorgan’s invest- the broker-dealers did not, in many cases, fully reflect
ment bankers were also attempting to assist Lehman’s the liquidation risk for the increasingly large amount of
primary potential bidder, the Korea Development Bank, structured, difficult-to-value securities that were being
and consequently had first-hand knowledge of its inten- financed through the triparty repo program . . . .
tions regarding a potential acquisition. JPMorgan also
By late August and early September 2008, Lehman’s
had direct access to internal financial information about
deteriorating financing condition was becoming increas-
Lehman, including an opportunity to review and com-
ingly apparent . . . . In addition, it came to light that
ment on Lehman’s presentation to the rating agencies.
many of the securities Lehman had pledged to JPMor-
At one crucial point, JPMorgan was invited to a meeting
gan in June were illiquid, structured debt instruments
with Lehman to consider rescue financing proposals,
that appeared to have been assigned overstated values.
but instead used it as an opportunity to probe Lehman’s
Nevertheless, JPMorgan . . . continued to . . . act on a
financial condition and business plans from a risk man-
business-as-usual basis.
agement perspective. With all of the bank’s tentacles
encircling the financial crisis at Lehman, JPMorgan was But JPMorgan’s exposure to Lehman was growing. This
uniquely positioned to capitalize on the opportunities included exposure in areas unrelated to triparty repo
that crisis presented. . . . clearing. . . . JPMorgan searched for a way to protect
1
60

itself without triggering a run on Lehman. . . . JPMor- Mo


5

JPMorgan . . . drained LBHI of desperately needed cash


66
98 er

gan determined that it could continue to face Lehman Lehm man


1- nt
20

by making repeated demands that LBHI increase the


66 Ce

in the market if it had $5 billion in additionalal collat-


ccol
collat
lat--
65 ks

amount of collateral payments it posted. In the last four


eral . . . [This] was far from sufficient to cover
cover all of o
06 oo
82 B

JPMorgan’s potential exposures to Lehman ehm an . . . but


man
-9 ali
58 ak

JPMorgan believed that it was an amount amoount that Lehman


11 ah

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
99

Chapter 14 Repurchase Agreements and Financing ■ 279

  


indicate that JPMorgan’s request was putting undue repos where any U.S. Treasury collateral is acceptable, and “the”
pressure on Lehman. . . . GC rate refers to the overnight rate for U.S. Treasury collateral.
With respect to special rates, there can be one for each security
During the second week of September 2008 . . . a broad
for each term, e.g., the 35⁄8s of August 15, 2019, to September
review of Lehman’s collateral securities . . . indicated
30, 2010. But every special rate is typically less than the GC
that some of the largest pieces of collateral pledged
rate: being able to borrow cash at a relatively low rate induces
to JPMorgan were illiquid, could not reasonably be
holders of securities that are in great demand to lend those
valued and were supported largely by Lehman’s own
securities, while being forced to lend cash at a relatively low rate
credit. . . . When the true nature of Lehman’s collat-
allocates securities that are in great demand to potential bor-
eral came to light on September 11, 2008, it became
rowers of that security. Differences between the GC rate and
apparent that JPMorgan . . . would need additional
the specials rates for particular securities and terms are called
collateral if it were to continue supporting Lehman.
special spreads.
JPMorgan decided that $5 billion in cash was . . . appro-
priate . . . even though its potential collateral shortfall Relating GC and specials trades to the market participants
was greater, as it was a number that JPMorgan believed discussed earlier in this chapter, GC trades suit repo investors:
Lehman could handle. . . . Later that night, JPMorgan they obtain the highest rate for the collateral they are willing to
sent Lehman a letter stating that, if Lehman did not post accept. Traders intending to short particular securities have to
the collateral by the open of business the next day, JPM- do specials trades and must decide whether they are willing to
organ would exercise its right to decline to extend credit lend money at rates below GC rates in order to borrow those
to Lehman. . . . Lehman delivered $5 billion of cash col- securities. Funding trades are predominantly GC. Should an
lateral during the morning and early afternoon [of Sep- institution find itself wanting to borrow money against a security
tember 12]. . . . that is trading special, however, it will lend that security in the
specials market and borrow cash at a rate below GC, rather than
Throughout all of this . . . JPMorgan continued to make
financing that security as part of a GC trade.
enormous—discretionary—extensions of credit to the
ailing bank, and it continued to trade with Lehman. . . . In the United States the GC rate is typically close to, but below,
the federal funds rate. The latter is the unsecured rate for over-
night loans between banks in the Federal Reserve system. By
14.3 GENERAL AND SPECIAL REPO contrast, repo loans secured by U.S. Treasury collateral are safer
RATES and should trade at a lower rate of interest. From October 23
through July 1, 2010, for example, the GC rate was, on average,
As mentioned earlier in this chapter, repo trades can be divided about 16 basis points below the fed funds rate. This fed funds-
into those using general collateral (GC) and those using special GC spread can vary, however, with the demand for Treasury
collateral or specials. In the former, the lender of cash is willing collateral. When the U.S. government was running surpluses
to take any particular security, although the broad categories of and paying down debt in the late 1990s and early 2000s, so that
acceptable securities might be specified with some precision. In U.S. Treasuries were becoming scarcer and expected to become
specials trading, the lender of cash initiates the repo in order to scarcer still, the fed funds-GC spread widened to reflect the
take possession of a particular security. For these trades, there- decreasing supply of Treasury collateral.
fore, it makes more sense to say that “counterparty A is lend-
The fed funds-GC spread also widens during times of financial
ing a security to counterparty B and taking cash as collateral”
stress. At such times the demand to hold Treasury bonds and
as opposed to saying that “counterparty B is lending cash and
to lend cash on Treasury collateral increases as part of flight-to-
taking a security as collateral,” although the two statements are
quality trades. In addition, willingness to lend Treasury bonds
economically equivalent. For this reason, by the way, when using
in repo declines as market participants fear that collateral may
1

the words “borrow” or “lend” in the repo context, it is best to


60

not be returned, either because a counterparty will fail to return


etur
tu
5
66
98 er

specify whether cash or securities are being borrowed or lent.


collateral or because a counterparty’s counterparty will failail to
o
1- nt
20
66 Ce

Also, as another note on market terminology, bonds most in


do so. Shortly after the collapse of Bear Stearns, for example,
exam
xam
m
mple,
demand to be borrowed are said to be trading special, although
65 k
06 oo

after the Fed had hurriedly lowered its target for thehe fed
ed funds
fe fu
82 B

any request for specific collateral is a specials trade.


rate to 2.25%, GC traded at below .50%. Similarly,rly, extremely
arly, e
extr
extre
-9 ali
58 ak

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
11 ah
41 M

each repo term. The most commonly cited GC rates are for Lehman Brothers.
20
99

280 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 14.1 Special Repo Spreads for Selected, Recently Issued U.S. Treasury Bonds as of May 28, 2010

General Collateral Rate .23%

Coupon Maturity Issue Date Designation Repo Rate Spread

312% 5/15/20 5/17/10 OTR 10yr .09% .14%

358% 2/15/20 2/16/10 Old 10yr .21% .02%

338% 11/15/19 11/16/09 Dbl-Old 10yr .21% .02%

438% 5/15/40 5/17/10 OTR 30yr .18% .05%

458% 2/15/40 2/16/10 Old 30yr .20% .03%

438% 11/15/39 11/16/09 Dbl-Old 30yr .21% .02%

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
60

example, a new 10-year issue is sold every three months. The


5
66
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most recently issued bond of a given maturity is called the on-


1- nt
20

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

Central Bank Working Paper Series, no. 1081,, Aug gust 2


August 2009. In Japan,
58 ak

old issue; the third most recent as the double-old issue; etc. As a
11 ah

liquidity characteristics develop from a mixx of the


tth au
auction cycle and
41 M

general rule, at each maturity, the OTR trades the most special, futures contract deliverability.
20
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Chapter 14 Repurchase Agreements and Financing ■ 281

  


a trading desk hedging the interest rate risk of its cur-
rent position; a corporation or its underwriter hedging an
upcoming sale of its own bonds; or an investor betting
that interest rates will rise. All else being equal, holders
of these relatively brief short positions prefer to sell par-
ticularly liquid Treasuries so that, when necessary, they
can cover their short positions quickly and at relatively low
transaction costs.

Investors and traders who are long an OTR bond for


liquidity reasons require compensation if they are to sac-
rifice that liquidity by lending that bond in the repo mar-
ket. At the same time, investors and traders wanting to
short the OTR securities are willing to pay for the liquid- Figure 14.4 On-the-run 10-year special spread, July 1997
ity of shorting these particular bonds when borrowing to July 2010, Part I.
them in the repo market. As a result, OTR securities tend
to trade special.

The auction cycle is an important determinant not only of


which bonds trade special, but also of how special individ-
ual bonds trade over the course of the auction cycle. This
will be illustrated first by examining the history of special
spreads for the OTR 10-year Treasury and then by exam-
ining the term structure of special spreads for the OTR
10-year Treasury as of May 28, 2010.

Figures 14.4 through 14.6 show the history of the OTR


10-year Treasury special spread from July 1997 to July
2010: the 13-year history is broken up into three graphs for
better readability.13 The vertical lines indicate 10-year
Treasury auctions. These are either auctions of new OTR
securities, in which case the OTR security changes over the Figure 14.5 On-the-run 10-year special spread, July 1997
vertical line, or re-openings of existing OTR securities (i.e., to July 2010, Part II.
auctions that increase the size of an already existing issue),
in which case the same security is featured on both sides
of the vertical line.

Several lessons may be drawn from these graphs. First,


special spreads are quite volatile on a daily basis, reflecting
supply and demand for special collateral each day. Second,
special spreads can be quite large: spreads of hundreds
of basis points are quite common. Third, special spreads
do attain higher levels over some periods rather than oth-
ers, a feature that will be discussed in the next subsection.
1

Fourth, and the main theme of this subsection, while the


605

cycle of OTR special spreads is far from regular, these


66
98 er
1- nt
20
66 Ce
65 ks
06 o o

13
Note that data from the aftermath of the Lehman bankruptcy,
82 B

Figure 14.6 On-the-run 10-year special spread,


ead,
ad, July
J 1997
-9 ali

from November 2008 to February 2009, is missing from Figure 14.5.


58 ak

Events at that time will be discussed in the next subsection. to July 2010, Part III.
11 ah
41 M
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282 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

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

Term Term Date Term Days Term Rate Term GC Term Spread Forward Spread

Overnight 6/1/10 4 .09% .23% .14% .14%


1 Week 6/4/10 7 .00% .23% .23% .35%
-.10%
1

TYM0 6/30/10 33 .22% .32% .34%


60
5
66
98 er

2 Months 7/28/10 61 - .05% .23% .28% .23%


23%
%
1 nt
20
66 Ce

3 Months 8/30/10 94 .00% .25% .25% 20%


.20%
65 ks
06 oo

TYU0 9/30/10 125 .04% .26% .22% .13%


82 B
-9 ali
58 ak

TYZ0 12/31/10 217 .17% .30% .13% .01%


11 ah
41 M
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Chapter 14 Repurchase Agreements and Financing ■ 283

  


basis trades, that is, trading the OTR against the futures
contract into which it is deliverable. Note that the over-
night rate is the business day following the pricing date.
The term spreads in Table 14.2 are simply the differences
between the term GC rates and the respective term
special rates. For this table the forward spreads are com-
puted from the term spreads, but forward repo trades do
exist. In any case, to illustrate the calculation, the forward
special spread from June 30, 2010, to July 28, 2010, is
such that investing at the spread to June 30 and then at
forward spread from June 30 to July 28 is equivalent to
investing to July 28. Let sfwd be this forward spread. Then,
using the numbers supplied in the table, sfwd is approxi- Figure 14.8 OTR 10-year special spread and the Fed funds
mated by target rate, July 1997 to July 2010.

(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
60

and failed to deliver upon settlement, the trader would not


5

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

Agreements with Negative Interest Rates,” by Michael Fleming emingg and


06 oo

borrow the bond overnight in the repo market at 0%, i.e., lend
82 B

Kenneth Garbade, Current Issues in Economics and Finance, ancce, Volu


Volume 10,
money at 0%, so as to be able to make delivery? The econom-
-9 ali

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
11 ah
41 M

cases no interest is earned on the proceeds from selling the 15


Liz Capo McCormick, “Treasury Traders Paid to Borro
Borrow as Fed Exam-
bond. Therefore, because no trader would borrow the bond if ines Repos,” Bloomberg, November 24, 2008.
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284 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


associated with higher opportunity costs of failing, high penal- rate, and investing that cash at the higher GC rate. The key
ties are not necessary in high-rate environments to prevent epi- assumption then, is how special the bond will trade and for how
sodes of system-wide fails. long. Professional repo traders have an opinion about how the
special spreads of particular issues will evolve over time that can
In light of the imposition of a penalty for failing to deliver, the
be used in this analysis. Another approach is to accept the mar-
new upper limit for the special spread is the penalty rate rather
ket’s view as expressed in the term structure of special spreads.
than the GC rate. In fact, soon after the imposition of the pen-
According to Table 14.2, it is reasonable to assume that the 312s
alty, demand to short the OTR Treasury in June 2009 drove the
will trade as GC past September 30, 2010: the forward special
special spread up to this limit. This episode can be seen to the
rate from then to December 31 is only one basis point. Also,
far right of Figure 14.8.
there is no reason to expect that the issue will ever in its life
trade special again. Hence, the financing value of the bond is its
Valuing the Financing Advantage financing value over the 125 days from the pricing date, May 28,
of a Bond Trading Special in Repo 2010, to September 30, 2010. But, as will now be shown, this
financing value can be easily calculated from the term special
The OTR 10-year, the 31⁄2s of May 15, 2020, was trading spread of .22 % to September 30, 2010.
extremely rich on May 28, 2010, slightly more than 2 per 100
face value, relative to the C-STRIPS curve. OTR bonds often The value of lending 100 of cash at a spread of .22% for 125
trade at a premium that is in part due to their liquidity advan- days is simply
tages, i.e., the ability to turn positions in these bonds back into (14.3)
cash with minimum effort, even in a crisis, and in part due to
their financing advantages, i.e., the ability to lend these bonds
or 7.6 cents per 100 market value of the bond. At a price of
and borrow cash at a relatively low rate. It is obvious from
101.90, therefore, assuming no haircuts, the financing advan-
Table 14.2 that, in the case of the 31⁄2s, almost all of the premium
tage of the 312s is worth only about 7.7 cents per 100 face
is due to liquidity. Nevertheless, it is useful here and even more
amount, a very small part of its total premium of over 2 dollars.
so in other situations to translate special spreads into price or
Finally, to translate the dollar value of specialness into a yield
yield premiums.
value, simply divide by the DV01. In this case, with the DV01 of
The financing value of a bond is the value, over the entire life the 312s approximately equal to .085, the value of the special
of the bond, of lending it in repo, borrowing cash at its special spread is .077
0.85 or only about .9 basis points.

1
60
5
66
98 er
1- nt
20
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65 ks
06 oo
82 B
-9 ali
58 ak
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Chapter 14 Repurchase Agreements and Financing ■ 285

  




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


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
605
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1- nt
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65 ks
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58 ak
11 ah
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Excerpt is Financial Stability Institute Occasional Paper No. 10, by Joel Grant.
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287

  


15.1 INTRODUCTION One principle of liquidity risk management that lacked attention
was LTP. In 2009, a group of prudential regulators conducted
Internal transfer pricing is an extremely important manage- an international survey to assess the progress banks are making
ment tool for banks. This paper observes that until the global to enhance LTP. The survey covered 38 banks from nine coun-
financial crisis (GFC), many banks treated liquidity as a free tries. Total assets of the banks surveyed ranged from less than
good for transfer pricing purposes, and this was one cause for US$250 billion to greater than US$1 trillion.
the very poor liquidity outcomes experienced during the GFC. The survey responses revealed that many of the LTP practices
Furthermore, although liquidity transfer pricing (LTP) practices employed by banks were short of good practice. This paper
are improving, there is little guidance publicly available to extracts the lessons learned from the survey, and makes a first
banks, regulators, and other stakeholders on what constitutes attempt at establishing better LTP practice. For confidential-
good practice. This paper makes a start on filling that gap. ity reasons, however, it is not possible to quote or reference
LTP is a process that attributes the costs, benefits and risks of directly from any of the survey responses.
liquidity to respective business units within a bank.1 LTP has
gained considerable attention since the onset of the GFC with 15.1.1 A Summary of the Major Lessons
some reports linking poor LTP practices to the funding and Learned
liquidity issues witnessed at several banks (Senior Supervisors
Group (SSG), 2008; 2009). 15.1.1.1 Governance of the LTP process
The purpose of LTP is to transfer liquidity costs and benefits from Most banks included in the survey lacked an LTP policy. As
business units to a centrally managed pool. To achieve this, LTP such, LTP was not defined nor were there any rules or principles
charges users of funds (assets/loans) for the cost of liquidity, and in regard to how LTP should operate. Typically, this outcome
credits providers of funds (liabilities/deposits) for the benefit of meant that liquidity generators (such as retail branches raising
liquidity. LTP also recoups the cost of carrying a liquidity cushion by deposits) were underpaid for their liquidity creation, and liquid-
charging contingent commitments, such as lines of credit, based ity users (such as lending, investment, and trading portfolios)
on their predicted (expected) use of liquidity. This is depicted in received free or unduly cheap liquidity.
Figure 15.1 below. Banks with poor LTP practices typically under- Where banks in the survey were operating with decentralised
price or (even worse) fail to price liquidity. Such banks are more funding centres, most had inconsistent LTP regimes. In addition,
likely to accrue illiquid assets and contingent exposures, and these banks relied on manual off-line processes to intervene and
under-value stable sources of funding. This outcome applied to to update relevant funding costs, and were more prone to arbi-
many banks and other financial institutions prior to the GFC. trage between business units and internal treasuries.
In the years preceding the GFC, liquidity was plentiful and For many of the banks in the survey with large trading businesses,
cheap, and as we now know, unsustainably plentiful and cheap. internal treasuries often lacked visibility over individual business
Some of the larger and more creditworthy banks could obtain balance sheets, limiting their understanding of individual fund-
long-term funding at only the slightest margins above swap ing requirements and contingent liquidity exposures. Most of the
rates. Such ideal funding conditions proved fruitful for banks, time this resulted in treasuries charging all trading businesses
widely encouraging leverage and maturity transformation, based on their net funding requirement, with no add-ons for the
which underpinned their record profits. At the same time these implicit risk of a blow-out in liquidity needs.
conditions led many to believe that funding would always be
Oversight of the LTP process at nearly all banks that partici-
available, and at permanently cheap rates. One consequence
pated in the survey was poor to nonexistent, especially by risk
of this belief was that it provided little incentive for banks to
and financial control functions. This was one of the factors that
devote attention to liquidity risk management. As a result,
resulted in the accumulation of highly illiquid (and often corre-
many banks failed to recognise the true nature of the liquidity
1
60

lated) assets and the excessive reliance upon short-term (oftene


risk embedded in their business activities.2
5
66
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overnight) funding.
1- nt
20
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Liquidity Management Information Systems (LMIS) employed mplo


plo
oyyed
1
65 k

In this regard, LTP forms part of the funds transfer pricing (FTP) process.
06 oo

by most of the banks surveyed were simplistic and inflex


inflexible.
infle
exible
82 B

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

principles of liquidity risk management were neglected by banks. For


41 M

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

  


Interbank market: Business unit 2 incurs charges from
Business unit 1 receives credits from
provides funds treasury based on the commitment of
treasury based on the commitment of
funds required. Additional charges will
funds provided. Credits are reduced by
apply to contingent commitments, such
any charges against contingent
as lines of credit.
commitments, such as deposit run-off.

Business unit 1: Internal treasury Business unit 2:


provides funds (central pool) uses funds

Liquidity
cushion

The trading business uses funds, provides


funds (through the sale of marketable
securities) and receives charges against
Trading business
contingent commitments, such as collateral
calls on derivative positions.
Figure 15.1 A graphical representation of the LTP process.

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

the costs, benefits and risks of liquidity to respective businesses.


60

The Basel Committee on Banking Supervision (BCBS)) has h


has been
bee
5

However, a large majority of these banks employed a pooled


66
98 er

central to regulatory developments in liquidity, first


rst publishing
pu
ublis
1- nt
20

average cost of funds approach to derive the costs and benefits


66 Ce

Sound Practices for Managing Liquidity in Banking g Organisa-


king Orga
65 ks

of liquidity. This resulted in short- and long-term assets receiving


06 oo

tions in February 2000. Following this, in 2006,


06, the
t BCBS
B
82 B

established the Working Group on Liquidity dity (WGL)


(WG to “serve
-9 ali
58 ak

as a forum for information exchange on national


nation approaches
na
11 ah

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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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 289

  


practices, and banks’ approaches to liquidity risk manage- for liquidity costs, benefits and risks”. Recommendations pro-
ment, with respect to the sound practices already established. vided in the Second Part of CEBS’s Technical Advice to the
European Commission (EC) on Liquidity Risk Management 6,
This work was the first to highlight the basic yet fundamental
and Point 14 in Annex V of the amendments to the Capital
elements that were missing from bank liquidity management.
Requirements Directive (Directive 2009/111/EC of the European
These findings formed the basis of the report Liquidity Risk:
Parliament and of the Council of 16 September 2009)7, led to
Management and Supervisory Challenges (February 2008) and
the development of CEBS’s, Guidelines on Liquidity Cost Benefit
sparked a review of the February 2000 sound practices. An
Allocation (October 2010).8
updated version of these practices, articulating 17 principles,
was released as Principles on Sound Liquidity Risk Manage- Efforts by the BCBS and others to improve LTP are acknowl-
ment and Supervision (September 2008). Since 2008 the BCBS edged, but a lack of detailed supporting guidance has left
has released Principles for Sound Stress Testing Practices and some supervisors and banks asking: “what exactly constitutes
Supervision (May 2009) and more recently, Basel III: Interna- better practice?” This paper seeks to assist with this question.
tional Framework for Liquidity Risk Measurement, Standards It focuses on some of the more widespread poor LTP practices
and Monitoring, aimed at improving the resilience of the that were identified via the international survey with the aim of
financial system (December 2010).4 As part of this, two global drawing out better practices. This more detailed guidance is
standards for liquidity risk were developed. First, a Liquidity intended to support and supplement the principles already pro-
Coverage Ratio (LCR) to ensure banks have sufficient high mulgated, and assist supervisors and banks in achieving better
quality liquid assets to survive an idiosyncratic shock and, LTP practices.
second, a Net Stable Funding Ratio (NSFR) to encourage
banks to fund their business activities using more stable
sources of funding. 15.2 GOVERNING LTP
Broadly speaking, all policies, processes and practices require
15.1.3 The Need for More Guidance on LTP governing. This is normally achieved through a combination of
The scale and extent of liquidity reform is large. But, given external control factors, such as regulation and competition, and
the weaknesses in bank liquidity risk management approaches internal control factors, such as board oversight and risk man-
unveiled by the recent crisis, it is not surprising that certain agement.9 Because external control factors affect institutions in
principles require further guidance. This is particularly the case much the same way, governance is differentiated largely by the
for LTP. internal control factors that are employed.

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
60

2010, can be accessed via http://www.eba.europa.eu/cebs/media/


(now the European Banking Authority) has also highlighted the
5

Publications/Standards%20and%20Guidelines/2010/Liquidity%20
66
98 er
1- nt
20

importance of banks having “an effective allocation mechanism cost%20benefit%20allocation/Guidelines.pdf.


66 Ce

9
65 ks

The Committee of Sponsoring Organisations of the Treadway way Com-


Com
C
06 oo

ecte
mission (COSO) defines internal control as “a process, effecteded by an
82 B

erson
rsonnel, d
entity’s board of directors, management and other personnel, designed
-9 ali

4
These papers can be accessed via http://www.bis.org/list/bcbs/sac_1/
58 ak

chievvemen
to provide “reasonable assurance” regarding the achievementemen of
index.htm.
11 ah

pera
ations reliability
objectives in the effectiveness and efficiency of operations,
41 M

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

  


problems of moral hazard and adverse selection.10 This is likely example, some business units that were able to raise wholesale
to weigh on performance. funds from external sources then sold the funds to treasury
and in some cases to other business units, at a higher rate. This
Many of the poor LTP practices that were identified across
resulted in a “risk-free” profit to the business unit at the cost of
banks that participated in the survey were the direct result of
more and possibly badly managed risk for the bank as a whole.
weak internal controls. Some of these are discussed in more
detail below. It is clear, however, that decentralised funding structures were
not the sole cause of internal arbitrage. Poor oversight and inad-
equate risk controls also played a role. Jointly, these factors lim-
15.2.1 Management of the LTP Process ited the ability of treasury and business units to know what price
Broadly speaking, there were severe deficiencies in how the LTP other business units had paid for funds from external sources
process was managed. and thus provided a basis for arbitrage. In addition to this, most
of the banks with decentralised funding structures employed
15.2.1.1 LTP Policies inconsistent LTP regimes and relied on manual off-line processes
to update funding costs.
Few banks in the survey had an effective LTP policy. As a result,
LTP was not defined, nor were there any principles and/or rules
15.2.1.3 Trading Book Funding Policies
in place to assist businesses understand how LTP should oper-
and Identifying Funding Requirements
ate. Having no LTP policy is clearly poor practice, given what we
now know about liquidity risk. Banks have traditionally relied on Probably the worst LTP practices identified in the survey were in
internal transfer pricing to manage interest rate risk in the bank- relation to trading and investment banking activities. A combi-
ing book, and to assess and monitor the performance of products nation of poorly designed trading book policies, inadequate risk
and business units, but with no or only minimal adjustments for controls and limits, as well as a lack of oversight were to blame.
liquidity costs, benefits and risks. For most banks in the survey, For example, some banks that took part in the survey lacked
the internal pricing of liquidity risk is a relatively new concept, trading book funding policies and procedures, which allowed for
brought to light by the recent breakdown in wholesale funding over-aggressive trading behaviour and the accumulation of illiq-
markets, and the consequent increase in funding costs. It will take uid assets in search of revenues, not risk-adjusted profit. Most of
time for banks to establish adequate LTP policies and procedures, the banks included in the survey did have trading book funding
but this is a necessary first step towards better LTP practice. policies, but nearly all of these policies assumed that assets were
only held short-term (ie for 180 days or less). One problem with
15.2.1.2 Internal Funding Structure – Centralised this approach is that, irrespective of whether assets are likely to
vs Decentralised be held for more than the 180-day threshold, long-term fund-
ing charges only apply when assets roll from the trading book
There is substantial debate surrounding the optimal internal
to the banking book. This provided little incentive for banks to
structure of banks – is it better to have a centralised funding
develop risk controls and limits to adequately measure, monitor
centre, whereby wholesale funding is restricted to a group or
and assess the liquidity risk in traded assets, and was evident
subsidiary treasury or, alternatively, decentralised funding cen-
through the build-up of positions that were highly illiquid.
tres, whereby certain business units are able to raise funding
themselves from their own sources to cover their own liquidity Many of the larger banks included in the survey, particularly
needs? There are reasonable academic and economic argu- those with substantial trading businesses, lacked a line of sight
ments that provide support for both approaches. However, to individual business balance sheets, and thus could not iden-
the survey identified that banks with decentralised funding tify the funding requirements of individual trading desks. As a
centres, particularly those with large prime brokerage business result, trading and investment banking activities were funded
activities, were more susceptible to poor LTP practices. For based on the total net funding requirement across all related
1
60

business units. This method essentially provides a line of credit redit


5
66
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to the trading book, and gives no regard to the liquidityuidityy risk


1- nt
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10
66 Ce

Moral hazard occurs when a party, insulated from risk, behaves


embedded in business activities. This approach iss therefore
th
heerefo
65 ks

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

occur because of information asymmetries between buyers and sellers.


58

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

hood of a market disruption, and the e extent


ext to which market
41

mechanical problems, to a buyer that is less informed.


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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 291

  


liquidity could evaporate. The severe drop in market prices units to consider the cost of liquidity as part of their decision
led to calls on margin positions and placed severe pressure on to book certain assets. Haircuts on traded assets are also being
banks’ abilities to meet funding requirements. Part of the reason widened to account for more severe and prolonged market
this occurred was because no one had previously thought of the disruptions, and to ensure that assumptions surrounding the
need to price the liquidity costs of potential margin calls. amount of liquidity that can be generated during a crisis are
appropriately conservative.
15.2.1.4 Oversight Banks that were included in the survey whose trading book
Ineffective oversight of the LTP process contributed to many of exposures are small relative to their main business activities, are
the problems that were identified at banks that took part in the attempting to curb over-trading behaviour by imposing higher
survey. For example, the accrual of long-term illiquid assets and funding charges on net funding requirements when certain
short-term volatile liabilities created a large and poorly under- funding limits are breached. Other banks in the survey, whose
stood mismatch between the maturities of assets and liabilities, trading book exposures are large relative to their main business
and therefore exposed banks to greater structural liquidity risk. activities, are devoting more attention to understanding the
Probably the most striking example highlighting the implications funding requirements of individual trading desks, and are look-
of poor oversight was how some of the banks’ LTP processes ing to apply charges on a more granular basis.
enabled them to accumulate significant amounts of highly rated,
Across all banks in the survey, there is an emphasis on improving
yet highly illiquid, tranches of collateralised debt obligations
oversight. Management at all levels, treasury functions, as well
(CDOs) in their respective trading accounts. These portfolios
as independent risk and financial control personnel are becom-
were assumed to be safely funded with much shorter-term liabil-
ing more engaged in the LTP process. In addition, meetings to
ities, typically in the order of overnight to 90-day funds.
discuss changes in funding costs are being held more regularly,
for example, monthly instead of quarterly or semi-annually, as
15.2.1.5 Towards Better LTP Practice they were prior to the financial crisis.
In one form or another, all of the banks included in the survey
In one form or another, all of the banks included in the survey
are enhancing the way LTP is managed. A large portion of the
are enhancing the way their LTP process is managed. One posi-
banks surveyed, for example, are creating LTP policies for the
tive stemming from these enhancements is that related parties
first time to outline the purpose of LTP and, to provide some
involved in the management of LTP are being forced to better
principles and/or rules to ensure business units understand
understand the LTP process. Broadly, banks are encouraged to
the reasoning behind charges relating to the use of liquidity.
continue with similar changes.
For the small proportion of banks in the survey that were oper-
ating with decentralised funding centres, they are all moving
towards having wholesale funding managed centrally by a trea- 15.2.2 Liquidity Management Information
sury function. In part, this is to restrict arbitrage between busi- Systems (LMIS)
ness units and treasury, and between business units themselves.
LMIS are widely used by management as a primary source
The survey also identified a small number of banks that are
of measuring and monitoring the performance of businesses.
developing trading book policies and procedures for the first
LMIS provide information that assists management in liquidity
time. To complement this change, these banks are also develop-
strategic decision-making. In this regard, LMIS play a pivotal role
ing risk controls and limits for trading activities to properly mea-
in helping management achieve group-wide goals. Weak LMIS
sure, monitor and assess the liquidity risk embedded in products
could easily distort the information for decision-making and
and business units.
prevent the bank from achieving its objectives.
Most of the banks included in the survey, however, were found One application of LMIS is to support internal pricing mecha-
1

to be updating existing policies. The most notable enhancement


60

nisms. In relation to LTP, LMIS enable the costs, benefits and


5
66
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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

have a higher probability of rolling from the trading book to the


06 oo

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
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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.
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292 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Another weakness in many of the LMIS that were employed by firms with fewer resources to absorb losses as risks materi-
banks in the survey was that they prevented the costs, ben- alised” (p 1).11
efits and risks of liquidity from being attributed at a sufficiently
The SSG also identified poor remuneration practices as one of
granular level.
the factors that contributed to the funding and liquidity prob-
The SSG (2009) also report similar findings. “Many firms lems witnessed at some banks during the recent crisis. Following
acknowledged shortcomings in their LMIS infrastructure and in their survey of firms, the SSG reported that remuneration was
their ability to produce useful reports during the crisis, recog- largely insensitive to the risks taken to generate income, and to
nizing that better-quality and more timely liquidity reporting costs associated with long-term funding commitments that were
was essential to effective management of liquidity and funding required to hold illiquid assets (p 24).
issues during a crisis” (p 15). In light of these shortcomings, the
Similarly, many of the banks that participated in the survey on
SSG recommended that banks improve their LMIS.
LTP failed to adequately account for the costs, benefits and
One implication of the weakness in LMIS and the poor LTP prac- risks of liquidity in the pricing and performance assessment of
tices that resulted is that businesses reported performance (and various products and business units. As a result, profit mea-
employees claimed bonuses) on a basis that might not have sures used as a basis for determining remuneration were often
reflected their actual performance. Essentially, this would limit distorted. Profit pools, for example, which are generally used
management’s ability to monitor performance, accurately dis- to determine short-term incentives, or bonuses for employees,
tinguish good performing businesses from those that were not were derived from a simple percentage of accrued revenues,
performing so well, and make reliable decisions pertaining to without any regard to the cost of liquidity (or capital). This
their objectives. placed more emphasis on maximising revenues rather than
A large proportion of the banks included in the survey are in risk-adjusted earnings.
the process of upgrading LMIS after their short-comings were Another reason the costs, benefits and risk of liquidity were
unmasked by the GFC. From a supervisory perspective, it is essen- poorly allocated through the LTP process for most of the
tial that this upgrading continues. As outlined above, LMIS are banks in the survey, was because of the way remuneration
an essential part of the decision-making process so it is vital that was structured, particularly for those employees responsible
the information they provide is accurate and reliable. Upgrading for oversight. For many staff in these areas, remuneration was
LMIS in a large bank is a costly and long-term process. But the designed such that it largely depended on the performance
benefits of appropriately charging business activities for the cost, of front-line businesses they were responsible for oversee-
benefits and risk of liquidity, and at a sufficiently granular level, ing. Thus, including the actual costs for liquidity would have
will far outweigh the costs and limitations of the basic LMIS that impacted negatively upon business unit performance, which
were previously employed. LMIS that are sufficiently advanced to inevitably would have reduced personal remuneration and ben-
achieve these outcomes will promote better LTP practice. efits for employees. Clearly, this would have also impacted the
independence of their role.

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

remuneration for persons in risk control positions consistent ent


560

with Principle 3 of the FSB’s Principles for Sound Compensa-


Comp
omp pensa
66

In 2009, the Financial Stability Board (FSB) reported that poor


98 er
1- nt
20

tion Practices. Principle 3 states that, “staff engaged


gaged
gedd in finan-
f
66 Ce

remuneration practices were one of the factors that contributed


65 ks

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
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payments to employees without adequate regard to the longer-


-9 ali

term risks they imposed on their firms.


58 ak
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11
Principles for Sound Compensation Practices,
ctice
es,
s, FS
FSB, (April 2009) is
41 M

These perverse incentives amplified the excessive risk-taking ard.or


rd.or
available at http://www.financialstabilityboard.org/list/fsb_publications/
that severely threatened the global financial system and left tid_123/index.htm.
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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 293

  


is independent of the business areas they oversee and com- 15.3.3 “Zero” Cost of Funds Approach –
mensurate with their key role in the firm” (p 2). It is envisaged
Liquidity as a “Free” Good
that this will also promote a more appropriate attribution of
liquidity costs to business activities and restore independence Probably the most striking example of poor practice identified in
in these vital roles. the survey was that some banks failed to account for the costs,
benefits and risks of liquidity in all or some aspects of their busi-
ness activities. These banks came to view funding liquidity as
15.3 LTP IN PRACTICE: MANAGING essentially free, and funding liquidity risk as essentially zero. As
a result, there was simply no charge attributed to some assets
ON-BALANCE SHEET FUNDING for the cost of using funding liquidity, and conversely no credit
LIQUIDITY RISK attributed to some liabilities for the benefit of providing funding
liquidity. This was undoubtedly the worst practice identified in
15.3.1 Why Banks Need LTP the survey. Figure 15.2 below provides a graphical representa-
In their daily operations, banks make money by funding long- tion of what this would look like in practice. Note that the rate
term loans (assets) with short-term deposits (liabilities), a pro- charged to users of funds in this instance would have been
cess that is commonly referred to as maturity transformation. As derived from the swap curve only. If we assume that interest rate
pointed out by the BCBS (September 2008), this “makes banks risk is properly accounted for using the swap curve, then a zero
inherently vulnerable to liquidity risk, both of an institution- spread above the swap curve implies a zero charge for the cost
specific nature and that which affects markets as a whole” (p 3). of funding liquidity.
But provided banks use LTP to account for the costs, benefits A zero charge for the cost of liquidity and, conversely, a zero credit
and risks of liquidity in product pricing, new product approval for the benefit of liquidity exacerbated maturity transformation to
processes and profit and performance assessments, they should the largest degree possible. This approach resulted in the hoarding
not be discouraged from engaging in maturity transformation. of long-term highly illiquid assets, and very few long-term stable
Banks with poor LTP practices are more likely to accrue larger liabilities to meet funding demands as they became due.
amounts of long-term illiquid assets, contingent commitments
and shorter-dated volatile liabilities, substantially increasing their 15.3.3.1 Why Did Some Banks Choose This
vulnerability to funding shortfalls. Approach?
Ideal funding conditions in the years preceding the crisis could
15.3.2 An Example of What Can Go provide one explanation of why some banks viewed liquidity
as a free good, and funding liquidity risk as essentially zero.
Wrong with Poor LTP
Figure 15.3 below shows how the spread between one-year
In October 2009, the SSG revealed that firms that encoun- LIBOR and the one-year swap rate changed during the period
tered the most severe funding and liquidity problems through June 2005 to October 2010.
the financial crisis were those that relied excessively on
short-term financing of longer-term illiquid assets. That
Yield
is, those that engaged most in maturity transformation. The
SSG highlighted that one of the drivers behind the devel-
opment of these business models was poor LTP practices,
which failed to penalise businesses for the liquidity risk
embedded in the assets that were booked, and which also
Swap curve
allowed banks to build up significant amounts of contingent
1

liquidity risk in off-balance sheet exposures. These banks Reference or “base” rate used
60

to price interest-rate risk


5

made large apparent profits before the GFC, but failed to


66
98 er
1- nt
20
66 Ce

recognise that these profits were based upon what proved


65 ks

to be extraordinarily fragile liquidity arrangements.


06 oo
82 B

The international survey identified many poor LTP practices,


-9 ali
58 ak

which reflected weaknesses in the LTP methods/approaches that


11 ah
41 M

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.
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294 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


rate calculated, all assets irrespective of their maturity are
charged the same rate for their use of funds (cost of liquidity), as
depicted in Figure 15.4 below.
To illustrate how charges and credits for the use and benefit
of funds would be allocated under an average cost of funds
approach, consider the following example. If the average rate
across all funding sources was 10 bps, all loans would receive
a charge of $1,000 on a principal amount of $1 million, irre-
spective of their maturity. Assuming this rate was also used to
reward fund providers, then all deposits would receive a credit
of $1,000 on a principal amount of $1 million, irrespective of
Figure 15.3 1-year LIBOR/Swap spread their maturity. This can be seen in Table 15.1.
(Currency = USD).
15.3.4.1 Problems with the Pooled “Average”
Source: Bloomberg.
Cost of Funds Approach
Despite its simplicity there are two major weaknesses with
In June 2005, at the peak of robust share market growth, the
this approach. First, it ignores the heightened liquidity
spread was only 0.5 basis points (bps). With funding conditions
risk embedded in longer-term assets. Charging one “aver-
so easy, it is likely that banks viewed spreads as pure credit risk
age” rate for the use of funds inherently assumes that all
adjustments and neglected (ignored) funding liquidity risk alto-
assets, irrespective of their maturity, pose the same liquidity
gether. If banks believed funding would always be available and
risk. Moreover, if this “average” rate is also used to credit
at permanently cheap rates, this simply could have masked the
fund providers, then an incentive to write loans will be met
need to charge assets for the cost of liquidity, and conversely,
with a direct disincentive to gather deposits. For example,
credit liabilities for the benefit of liquidity.

15.3.4 Pooled “Average” Cost Yield


Funding curve Spread=
of Funds Approach to LTP average cost/
benefit of funds
Some banks recognised the need to charge users and
credit providers of funding liquidity and employed a
pooled approach to LTP, where an average rate was Swap curve
calculated based on the interest expense (cost of
funds) across all existing funding sources. For exam-
ple, if deposits were a bank’s only source of funding
the average rate would be based on the total inter-
est expense for all deposits divided by average total
deposits, adjusted for floats and reserve requirements.
This approach is much better than the zero cost of funds Maturity
approach, but because there is only one “average”
Figure 15.4 Single average for the cost and benefit of funds.
1
60

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

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


$ million
m
06 oo
82 B

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


-9 ali
58 a k
11 ah

Charge for use of funds $1,000 $1,000 $1,000 $1,000


0 $1,000
41 M

Credit for benefit of funds $1,000 $1,000 $1,000 $1,000


0 $1,000
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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 295

  


Average cost of funds (asset) curve all deposits irrespective of their maturity receive the
Yield
same credit for the benefit of funds, as can be seen in
Average cost of funds
Table 15.2.
Swap curve Average benefit of funds Second, using an average cost of funds reflects his-
torical rates and prices, but does not appropriately
reflect the actual market cost of funds. If five-year
Average benefit of funds (liability) curve funding was to increase by 20 bps, for example, the
respective change in the average (cost of funds) rate
would be much less. Changes in the actual market
cost of funds would need to be sustained for a period
of time for the effect to be fully integrated into the
average cost of funds. Because the average cost of
Maturity
funds lags changes in the actual market cost of funds,
Figure 15.5 Separate averages for the cost and benefit
it does not appropriately reflect market perceptions
of funds.
of risk for new business entering a bank’s books.

decreasing the rate charged to fund users from 10 bps to


15.3.4.2 Implications of Pooled “Average” Cost
five bps will encourage loan generation, but at the same
of Funds Approach
time, this will provide less incentive for business units to
raise deposits. Promotes Maturity Transformation One implication of
employing a pooled “average” cost of funds approach to LTP is
Having separate “average” rates for the costs and benefits of
that it promotes unhealthy as well as healthy maturity transfor-
funds is a better approach. This is depicted in Figure 15.5 below.
mation. Business units will be unduly encouraged to write long-
To illustrate the effect of having separate average rates for the term assets because they do not receive higher charges for their
cost and benefit of funds, consider the following example. If the use of funds over a longer period. Conversely, business units will
average cost of funds is 10 bps, as in the example presented be discouraged from raising long-term liabilities because there
above, all loans would be charged $1,000 on a principal of is no premium credited to liabilities that provide funding for lon-
$1 million, irrespective of their maturity. Further, if the average ger periods of time. The net effect of this is a larger mismatch
benefit of funds is four bps, all deposits would be credited $400 between the maturities of assets and liabilities on banks’ bal-
on a principal of $1 million, irrespective of their maturity. Under ance sheets, which inherently exposes them to greater structural
this approach, lowering the average cost of funds from 10 bps liquidity risk. This point is supported by the SSG (2009), which
to five bps will encourage loan generation. However, because of claims that “borrowers had taken advantage of the opportu-
the separate rate for the average benefit of funds, this change nity the market afforded to obtain short-term (often overnight)
will not directly discourage business units from raising deposits. financing for assets that should more appropriately have been
This information is presented in Table 15.2. funded with long-term, stable funding” (p 2).

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
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20

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


on
66 Ce
65 ks

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


06 oo
82 B

Average benefit of funds 4 4 4 4 4


-9 ali
58 a k
11 ah

Charge for use of funds $1,000 $1,000 $1,000 $1,000 $1,000


41 M

Credit for benefit of funds $400 $400 $400 $400 $400


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296 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


existing funds across all funding sources to banks’ balance Marginal cost of funds curve
sheets, the lack of reference to term cash-flow matched Yield
funding entailed the cross-subsidisation of longer-dated
Term liquidity premium
liquidity risk at the expense of shorter-dated risk. Such
Average cost of funds curve
subsidisation skewed business incentives and behaviours
to the detriment of bank soundness.
Other factors, such as remuneration and information asym- Swap curve
metries, naturally encourage long-term asset generation,
but under an average cost of funds approach the incentive Charges (credits) to short-term assets (liabilities) higher
under “pooled” average cost-of-funds approach
is exacerbated. For example, if remuneration is based on
performance, which is measured via net interest income, Charges (credits) to long-term assets (liabilities) higher
under matched-maturity marginal cost-of-funds approach
businesses will ordinarily be encouraged to write long-term
loans because they generate more interest income, with less Maturity
effort, over several years. Where an average cost of funds Figure 15.6 Matched-maturity marginal cost of funds
approach is employed, this incentive becomes even more approach to LTP.
attractive for business units because assets that require fund-
ing for longer periods of time are not charged more for the of business unit managers and provides central management
cost of liquidity. In regard to information asymmetries, business with more control over group-wide objectives.
unit managers are likely to know more about their businesses’
activities than treasury. Hence, if business unit managers believe
treasury is under-charging for the use of long-term funds, it will 15.3.5 Matched-Maturity Marginal Cost
naturally encourage them to write long-term assets. But since all of Funds Approach to LTP
funds are charged the same rate for the use of funds under an
average cost of funds approach, where information symmetries A matched-maturity marginal cost of funds approach to LTP is
exist, this incentive will be magnified. A similar but opposite current best practice for assets and liabilities on the balance
effect will exist for liabilities. sheet. From banks’ actual market cost of funding, this approach
calculates the portion of the cost that is attributable to liquidity.
Distorts Profit Assessment Another implication of the pooled
It seeks to achieve this by converting fixed-rate borrowing costs
average cost of funds approach to LTP is that it distorts profit
to floating-rate borrowing costs through an internal swap trans-
assessment. As outlined above, the average cost of funds lags
action and observing the spread over the reference rate, which
changes in banks’ actual market cost of funds, especially in vola-
is depicted from the swap curve. This spread is usually referred
tile markets. Banks employing this approach found that their
to as a term liquidity premium and is the rate that charges
pricing methodologies resulted in the mispricing of and accu-
assets for the use of funds, and credits liabilities for the benefit
mulation of assets on significantly distorted risk-adjusted terms.
of funds. This is presented graphically in Figure 15.6.
This made it difficult to identify poor performing products and
business units on a risk-adjusted basis. To explain this process more fully, banks incur fixed-rate costs
when issuing unsecured wholesale term debt. Using these costs
There are several reasons why some of the banks included in
alone it is difficult to strip out the portion that is attributable to
the survey might have chosen to adapt a pooled average cost
liquidity. But swapping fixed rate costs to floating rates provides
approach to LTP. First, averaging funding costs across all assets
a solution. The process generally involves stripping structured
is much simpler than having to charge individual assets, prod-
debt issuances into embedded derivatives and floating rate cash
ucts or transactions based on their contractual or behavioural
instruments, which are pegged to a reference rate.12 The spread
(expected) maturities. Second, the simplicity of the average
above the reference rate is the rate that values the internal swap wap
1
60

cost of funds approach makes it easier for business units to


5

transaction at par. This is the term liquidity premium. Itt reflects reflects
66
98 er

understand the LTP process and therefore provides more incen-


1- nt
20

both idiosyncratic credit risks and market access p premiums


remiiums and
66 Ce

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

process could be managed efficiently using basic LMIS. Fourth,


06 oo

ity than an average cost of funds.


82 B

the average cost of funds is less susceptible to intermedi-


-9 ali
58 ak

ate changes in banks’ actual market cost of funding, thereby


11 ah
41 M

reducing net interest income volatility across businesses. This is


advantageous because it limits the subjective decision-making 12
This process is described in detail in Matz a and Neu (2007).
20
99

Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 297

  


Reference rates are generally depicted from a swap curve, Table 15.3 Pre-GFC and Current Term Liquidity
which is constructed from a combination of LIBOR or Premiums and Average Cost of Funds
Euribor rates for funding up to one year, and interest rate
In basis points
swaps for funding above one year. This curve reflects a term
structure of interbank lending rates. Although credit risk is Term in years 1 2 3 4 5
somewhat mitigated by the fact that principal amounts are not
Panel A: pre-GFC
exchanged between respective parties in a swap agreement,
swap curves are still considered to provide better estimates of Term liquidity 1 2 3 6 10
premium
“base” reference rates for the purpose of teasing out liquid-
ity than, say, government curves. This is because swap curves Average cost of 2 2 2 2 2
more closely reflect the risks to which banks are exposed when funds
borrowing and lending money in the interbank market. Swap Panel B: current
curves also capture changes in general market conditions. Term liquidity 5 10 18 28 40
premium
15.3.5.1 How are Rates for Users and Providers
Average cost of 8 8 8 8 8
of Funds Determined? funds
Under the matched-maturity marginal cost of funds approach,
rates charged for the use of funds and, conversely, rates cred-
ited for the benefit of funds are based on the term liquidity a one-year non-amortising bullet loan should have received
premiums corresponding to the maturity of the transaction, or a charge of one bp (Panel A), if originated pre-crisis, and five
in the case of amortising or indeterminate-maturity products, bps (Panel B) if originated more recently. For simplicity, if the
blended term liquidity premiums consistent with their known or principal of the loan was $1 million, this should have translated
estimated cash-flow profiles. to charges of $100 and $500, respectively to the business
unit(s) writing the loans. In much the same way, a five-year
Even though the matched-maturity marginal cost of funds approach
non-amortising bullet loan should have received a charge of
to LTP is considered to be better practice, some of the more
10 bps (Panel A) if originated pre-crisis, and 40 bps (Panel B) if
advanced banks surveyed that had employed this method failed to
originated more recently. Assuming the same loan principal of
actively update term liquidity premiums. As a result, assets were mis-
$1 million, this should have translated to charges of $1,000 and
priced and risk-adjusted profit assessments were distorted, especially
$4,000, respectively, to the business unit(s) writing the loans.
as market volatility increased in the early stages of the GFC.
In contrast, had an average cost of funds approach been applied,
both the one- and five-year non-amortising loans would have
15.3.6 Examples of Pricing Funding been charged two bps (Panel A) if originated pre-crisis, and eight
Liquidity Risk bps (Panel B) if originated more recently. Table 15.4 below pres-
ents the differences in the charges for the uses of funding for
To illustrate how the matched-maturity marginal cost of funds
each of the non-amortising bullet loans in this example.
approach should be applied in practice, and to compare it to
the average cost of funds approach, assume the following term Table 15.4 shows that non-amortising bullet loans with a term
liquidity premiums and average cost of funds were recorded by of one-year would have received a higher charge for the use of
a bank at a point in time prior to the crisis (pre-GFC), and more funding if banks applied an average cost of funds approach rather
recently (current). than a matched-maturity marginal cost of funds. However, for all
other maturities, the opposite is true. Using an average cost of
Some examples of how LTP should apply to various transactions
funds approach in the pre-crisis period, a five-year loan would
are presented below.
1
60

have been undercharged eight bps ($800 on a loan of $1 million). on


on)
5
66
98 er

If the same loan was originated more recently it would have ve been
bee
een
1- nt
20

15.3.6.1 Non-Amortising Bullet Loans


66 Ce

undercharged 32 bps ($3,200 per $1 million). This example mplee high-


h
high
65 ks
06 oo

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
99

298 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 15.4 Differences in Funding Charges In both cases, the charge for the use of funds indicates that a
funding commitment is required for somewhere between three
Basis points
and four years and not the entire term of the loan, which was
Term in years 1 2 3 4 5 five years.

Panel A: pre-GFC If an average cost of funds approach had been employed, the
Term liquidity 1 2 3 6 10 loan originated pre-crisis would have received a charge of two
premium bps (Panel A). This would have resulted in an undercharge
of 3.9 bps (5.9 - 2). If the loan had been originated more
Average cost of 2 2 2 2 2
funds recently, it would have received a charge of eight bps, which
would have resulted in an undercharge of 18.1 bps (26.1 - 8).
Difference -1 0 1 4 8
Although the differences in the funding charges are not as
Panel B: current severe as in the non-amortising bullet loan example above,
Term liquidity 5 10 18 28 40 it still highlights the weakness of the average cost of funds
premium approach in reflecting changes in the actual market cost of
funding. Once again, this would have encouraged long-term
Average cost of 8 8 8 8 8
funds loan (asset) generation.

Difference -3 2 10 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

This charge is based on the behavioural maturity of the he port-


ort--
ort
5
66
98 er

folio, which is often calculated by banks using the weig


weighted-
ghted
1- nt
20
66 Ce

13 average life (WAL) method.


65 ks

Another method used by banks to calculate the charge for the use
06 oo

of funds is the internal rate of return (IRR) approach. This involves


B

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

loan, and ti = time (in years) of payment


ment i.
41

approach, see Matz and Neu (2007).


20
99

Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 299

  


Pool wholesale, deposits should be credited for the benefit of
Principal liquidity they provide.
Repayments
Deposits should be categorised as “sticky” or “hot/volatile”
and credited based on their likelihood of withdrawal. As a
general rule, sticky money, such as term deposits, are less
likely to be withdrawn and should therefore receive larger
credits than hot/volatile money, such as demand deposits,
savings and transaction accounts, which are more likely to be
withdrawn at any time.

Time Using a matched-maturity marginal cost of funds approach,


Figure 15.7 Mortgage run-off for 3 different vintages. term deposits should receive a credit based on their matu-
rity. For example, using the same figures as presented
in Table 15.3, a one-year term deposit should have been
WAL can be interpreted as the weighted-average time it takes credited one bp if originated pre-crisis and five bps if origi-
to recoup $1 of principal (ie the time it takes for the loan to start nated more recently. Similarly, a five-year term deposit should
paying for itself).14 have received a credit of 10 bps if originated pre-crisis and 40
bps if originated more recently.
As an example, suppose a large bank writes around $2 billion
of mortgage loans on average, per month, and upon examining Had an average cost of funds approach been employed, all
the decay of its loans finds the behavioural maturity (WAL) of the term deposits would have received a credit of two bps if origi-
mortgage portfolio to be approximately four years. If a matched- nated pre-crisis and eight bps if originated more recently, irre-
maturity marginal cost of funds approach is employed, then all spective of their maturities. In the pre-crisis period, this would
mortgage loans should receive a charge, at point of origination, have resulted in over compensating the one-year term deposit
based on the four-year term liquidity premium. Using the figures by one bp (2 - 1), and by three bps (8 - 5) if originated
from Table 15.3, this would be six bps (Panel A) or 28 bps (Panel more recently. The five-year term deposit on the other hand
B) depending on when the loan was originated. would have been under compensated by eight bps (2 - 10) if
Across the entire portfolio, this would translate into dollar originated pre-crisis and a staggering 32 bps (8 - 40) if origi-
charges of $1.2 million or $5.6 million, respectively. In contrast, nated more recently. As above, this example highlights the
if an average cost of funds approach is employed, mortgage limitations of the average cost of funds approach. For banks
loans should receive a charge of two bps (Panel A) if originated employing this approach, it would have encouraged business
pre-crisis, and eight bps (Panel B) if originated more recently. units to raise short-term deposits rather than long-term, more
Collectively, for all mortgage loans, this would translate into stable sources of funding. Collectively, with the finding from
dollar charges of $400,000 or $1.6 million, respectively. above, this would have led to more structural liquidity risk on
the balance sheet.
This example further demonstrates how the average cost of
funds lags changes in banks actual market cost of funds and, at Hot/volatile sources of deposits are often referred to as inde-
the same time, highlights how costly this could be, especially terminate maturity products, given the uncertainty surround-
when products are priced at the portfolio level and comprise a ing their cash flows. However, despite being categorised as
large portion of bank assets. hot or volatile, these types of deposits sometimes provide
stable sources of funding. Demand deposits, for example,
15.3.6.3 Deposits can be withdrawn at any time without notice. But, if all similar
accounts were to be pooled and the behaviour of the cash
1

Because deposits are a source of funding for banks, busi-


60

flows modelled over time, there would be a proportion thatt is


5

ness units responsible for raising retail, and in some cases


66
98 er

rarely withdrawn (stable or core part) and a proportion that is


1- nt
20
66 Ce

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
99

300 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


banks, business units would be discouraged from raising
Liquidity cushion
demand deposits. A better approach would be to assign
larger credits to core parts of funding, based on the mod-
elled behavioural maturity, and smaller credits to hot/vola-
tile parts of funding.
Banks employing an average cost of funds approach would Wholesale Draw downs Collateral Secured
Retail deposit calls on
funding on lines of funding
have no incentive to make the distinction between core and run-off
run-off credit derivatives run-off
volatile parts of funding since, under this approach, the same
credit for the benefit of funding is applied to all deposits, Figure 15.8 Unexpected funding outflows and the need
irrespective of their maturity. for a liquidity cushion.

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

For many on-balance sheet items, calculating the charge for


5

scenarios, including those that involve the loss or impairment


pai ment
pair
66
98 er

using, or the credit for providing, funding liquidity is quite


1- nt
20

of unsecured and typically available secured funding ng sources.


ing ssourc
66 Ce

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

postings for derivatives and other financial contracts, and liquid-


-9 ali
58 ak

ity facilities to name a few. In these cases, the best approach is


11 ah
41 M

to impose a scenario model, determine a reasonable low prob- 15


For more details, see Basel III: International
nal Fr
Framework for Liquidity
ability worst-case outcome and charge at the most granular Risk Measurement, Standards and Monitoring,toring BCBS, (December 2010).
20
99

Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 301

  


15.4.2 Extant Guidance Focuses on Size, Second, most of the banks that were surveyed had liquidity
cushions comprised of assets that were thought to be highly
Composition and Marketability
liquid, but were found to be highly illiquid and highly corre-
Extant guidance provided in association with liquidity cushions lated. There were instances where some assets held as stand-
focuses mainly on size, composition and marketability of the by liquidity were not unencumbered, meaning that the bank
assets contained within the cushion. To ensure banks’ liquid- did not have legal claim over the asset or that the asset was
ity cushions are adequately sized, the BCBS recommends they not entirely free from debt.
be aligned with stress-testing outcomes that consider both
Third, nearly all of the banks included in the survey funded their
idiosyncratic and systemic scenarios, plus a combination of
liquidity cushions short-term (e.g. overnight), consistent with the
the two. The level of stress assumed in the tests should reflect
perception that funding could be easily accessed and any mar-
a bank’s overall risk tolerance. To assess their risk tolerance,
ket disruption would only be short-lived. While this minimised
banks should consider factors such as structural liquidity risk
negative carry costs, it also provided banks little incentive to
(ie the liquidity gap between the weighted average maturities
attribute the relevant costs back to the businesses that created
of assets and liabilities) and the complexities of both on- and
the need to carry additional liquidity. When assets in the cushion
off-balance sheet business activities, which affect the frequency
could not be sold to generate funding, it became apparent that
and irregularities of cash flows.
the real cost of carrying stand-by liquidity was much greater
According to the BCBS, liquidity cushions should comprise “a than what the banks had assumed.
core of the most reliably liquid assets, such as cash and high
quality government bonds or similar instruments, to guard
against the most severe stress scenarios” (p 30). Banks should 15.4.4 LTP and Liquidity Cushions – Both
also consider the marketability of these assets. Although this is Principles, Both Treated Separately
likely to vary in relation to the stress scenario and survival period
To date, there has been limited guidance about how to attribute
(ie assets will generally remain more marketable throughout less
the cost of carrying liquidity cushions, but this paper offers some
severe market disruptions), there are some generic characteris-
ideas. Even though it is common practice for banks to attribute
tics that tend to improve asset liquidity. For example, assets that
this cost via LTP, no link between LTP and liquidity cushions is
are more transparent are generally also easier to value, and the
established in extant material. In fact, LTP and liquidity cushions
certainty surrounding this will inherently improve marketability.
are very much treated as mutually exclusive principles for sound
In addition, assets that are central bank-eligible and/or have
liquidity risk management.
good market depth will generally be more marketable. A bank’s
reputation, credit rating and active participation in certain mar-
kets will also impact asset marketability (p 30). 15.4.5 Poor Attribution of Cost
of Carrying a Liquidity Cushion
Carrying a “buffer” of highly liquid assets is costly for banks
15.4.3 Problems with Banks Liquidity
because the cost of funding assets comprising the cushion
Cushions Unveiled by the GFC generally outweighs the return they generate.16 As such, banks
The recent crisis exposed some fundamental problems with often seek to minimise the size of their liquidity cushion so that
banks’ liquidity cushions. First, for the banks that participated in the negative carry does not drag on profits.
the survey, very few used the results of stress-testing to deter- Most of the banks included in the survey consider the cost of
mine the size of their liquidity cushion. For the few banks that carrying additional liquidity a cost of doing business, rather than
did consider the results of stress-tests, the size of their liquidity an opportunity cost. In this regard, the cost of carry should not
cushion was based on outcomes stemming from idiosyncratic be borne by central management (ie treasury). It should instead
1
60

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

market-wide disruptions meant that cushions were inadequately


1- nt
20

appears common practice amongst banks participating in n thee


66 Ce

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

with many of the banks’ stress-testing processes was that the


-9 ali
58 ak

parameters used were too narrow, and were based purely on


11 ah
41 M

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

  


without giving specific attention to those businesses and prod- serious implications associated with this poor practice. First, it
ucts that generate the need to carry additional liquidity. inherently assumes that all assets expose the bank to the same
unexpected (contingent) liquidity risk. Second, it completely
As a simple example, if it costs a bank $30 million to carry
neglects the contingent liquidity risk embedded in liabilities, for
a buffer of liquid assets and total assets of the bank equate
example, deposit run-off during stress environments, and off-
to $300 billion, then under the approach described above,
balance sheet activities such as drawdowns on lines of credit.
all assets would receive a charge of one bp through the LTP
Third, it makes no attempt to charge businesses based on their
process. This is depicted in Figure 15.9. Note that the one bp
predicted liquidity usage during stress environments. Fourth,
charge is in addition to the term liquidity premium, which is
the attribution of charges is not granular enough to discour-
charged to assets based on their commitment of funds. This is
age businesses from writing or buying products that pose more
highlighted in equation 2.
contingent liquidity risk than others.
One explanation of why this approach might have been adopted
Although some banks that were surveyed did attempt to charge
by most of the banks surveyed is because they underestimated
the negative cost of carry back to businesses on a predicted
the “actual” cost of carrying additional liquidity. As mentioned
usage basis, the attribution was generally at a very high level.
above, assets in the cushion most often incurred short-term
One problem with not having a granular charge is that it encour-
(overnight) funding charges on the premise that funding could
ages businesses to deal in products that are not being charged
be easily accessed and that any market disruption would be
for the contingent liquidity risk they actually present. The impli-
short-lived. This minimised the negative cost of carry, making
cation of distorting behaviour by not charging products for the
it easy for banks to recoup the cost by simply adding a small
risks they present was discussed in Section 2.
spread (liquidity premium) to the funding cost that was charged
to assets, as depicted in Equation 2.
15.4.6 Towards Better Management
(15.2) of Contingent Liquidity Risk
where FTP = funds transfer price, base rate = rate depicted In one form or another, all banks that participated in the survey
from the swap curve corresponding to the asset’s contractual/ are enhancing the way they manage contingent liquidity risk.
behavioural maturity or repricing term, whichever is less, term Many are incorporating a wider variety of scenarios as part of
liquidity premium = spread between the swap curve and the their stress-testing processes to account for different types of
bank’s marginal cost of funds curve based on the contractual/ market disruptions that might occur. These are largely in con-
behavioural maturity of the asset, and liquidity premium = cost junction with BCBS recommendations and include idiosyncratic
of carrying liquidity cushion averaged over total assets of the bank. and systemic funding shocks and a combination of the two. In
another step forward, senior management are becoming more
Generally speaking, banks would not have believed this would
engaged with stress-testing results and using them as a basis
create problems despite the fact that only assets were being
for deriving the size of the liquidity cushion. The composition
charged because the spread charged to recoup the cost of
of assets in liquidity cushions is broadly improving, once again
carrying the liquidity cushion was so small. But there are some
in line with BCBS recommendations. For example, many of the
larger banks are now holding a larger proportion of cash
and government securities than previously. This is most
Liquidity cushion Cost of carry likely due to the development of the LCR.
Probably the most substantial enhancement that is occurring
is the application of higher funding costs to liquid assets.
Before the GFC, banks believed funding could be accessed edd
1

Liabilities and
60

contingent almost immediately and always. But the recent market rk tur-
arke
5

Asset
66
98 er

commitments moil has demonstrated that funding markets can an remain


remmain
1- nt
20
66 Ce

disrupted for a significant period of time. Ass such,


suc banks
uch
ch, ba are
65 ks
06 oo

All assets receive an Both, liabilities and contingent applying higher funding charges to assetss held ld as part of
hel
he
eld
82 B

equal charge via LTP to commitments receive a zero


the liquidity cushion on the premise that
hat it
it could
cou take lon-
-9 ali

recoup the cost of carry charge via LTP for the cost of
58 ak

carry ger than expected to generate liquidity ty when


uidity wh needed. The
11 ah
41 M

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,
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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 303

  


for example, a bank assumes funding markets for a particular 1. Identify contingent commitments that are likely to create unexpected
asset could remain stressed for two years, then the cost of hold-
ing that asset as additional liquidity should be based on the Retail deposit Wholesale Draw downs on Collateral calls Secured funding
run-off funding run-off lines of credit on derivatives run-off
two-year term liquidity premium.
The move to apply higher funding costs to liquid assets is con-
sidered significant for banks because carrying a more costly 2. Perform stress tests under various
scenarios to approximate the funding
liquidity cushion creates more profit drag. As described above, that might be required.
banks previously recouped this cost by charging all assets
equally, a small liquidity premium via LTP. Following the same
approach now, however, is likely to cause conjecture amongst
3. Net approximations from above against inflows
business units and distort business unit behaviour given generated, for example, through the sale of
the larger costs. As such, this method is no longer feasible marketable securities to derive the size of the
liquidity cushion.
for banks. A better approach is to examine the contingent
liquidity risk embedded in various business activities and to
Liquidity cushion
attribute charges based on their predicted, or expected, use
of funding liquidity. Higher contingent liquidity charges should
be applied to business activities that pose more threat to large
and unexpected funding outflows. This process is depicted 4. Calculate the cost of
carry as the cost of
in Figure 15.10. funding liquid assets Cost of carry 5. Recoup cost of
minus the return they carry by charging
Some examples of pricing contingent liquidity risk are presented generate. Ensure that a liquidity
in the following section. appropriate haircuts and premium, at the
unsecured term funding most granular
charges have been level, to the
applied to assets. business unit,
product or
15.4.7 Example of Pricing Contingent transaction that
Liquidity Risk creates the need
for the bank to
The uncertainty surrounding future cash-flow demands stem- carry such liquid
assets.
ming from contingent commitments makes it particularly difficult
for banks to assess and price contingent liquidity risk. This is one
Draw downs
of the reasons why it was neglected prior to the GFC. Some of Retail deposit Wholesale
onlines of
Collateral
calls on
Secured
run-off funding run-off funding run-off
the products that received little attention but then warranted credit derivatives

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

above, assume there is a 60 per cent chance the customer will


60

based on their likelihood of drawdown. For example, suppose


5

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

drawn. The rate charged for contingent liquidity risk should be


65 ks

the three-year term liquidity premium in Table 15.3). ).. The


e rate
rat
ra
06 oo

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
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304 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Multiplying this by the limit of $10 million on the line of credit • Other banks applied a single pooled approach to LTP,
yields a dollar charge of $6,480. whereby one average rate was used to charge users of funds
and to credit providers of funds.
As explained earlier, prior to the crisis, banks applied short-term
and often overnight funding charges to assets comprising their • Liquidity cushions were not linked to stress-testing outcomes,
liquidity cushions on the belief that funding was abundant and and scenario analyses were not severe enough to account for
permanently cheap. If the overnight funding rate was 0.5 bp and prolonged market-wide disruptions.
banks had applied the same approach as in this example, the • Charges applied to fund liquid assets were often based on
dollar charge for the contingent liquidity risk would have been short-term rates, reflecting the belief that funding was abun-
$1,800. However, banks did not follow this approach. Instead dant and would remain permanently cheap.
they averaged the cost of funding their liquidity cushions across • To recoup the cost of carrying a liquidity cushion, most
all of their assets. By doing this it is likely that the lines of credit banks simply charged all assets an equal and small liquidity
such as the one in this example did not even receive a charge premium, which failed to account for the varying amounts
for the cost of contingent liquidity risk. This would have encour- of contingent liquidity risk embedded in different business
aged business units to grant lines of credit and other contingent activities.
commitments.
Collectively, these poor LTP practices encouraged long-term
A similar approach to that in the example above can be illiquid asset creation and discouraged long-term stable liability
applied to other types of contingent commitments. For exam- creation, with obvious consequences.
ple, credit card accounts will generally have a proportion of the
By and large, banks have realised that many of their LTP prac-
limit that is undrawn. With some behavioural analysis the likeli-
tices were insufficient. As a result, banks are now working
hood of drawdown can be estimated and contingent funding
towards enhancing their LTP processes to ensure their business
liquidity costs can be attributed accordingly. More advanced
activities adequately account for the costs, benefits and risks of
banks might assess the behaviour of individual customers and
liquidity. To assist banks and supervisors throughout this pro-
assign a weighted probability of drawdown. All banks, how-
cess, below is a compilation of what is considered to be better
ever, are encouraged to at least examine and attribute charges
LTP practices.
based on the behaviour of a portfolio of like- contingent
commitments.
Governing LTP
• Banks should have an LTP policy that defines LTP, states the
purpose of LTP and provides some principles and/or rules
15.5 CONCLUSION to ensure LTP achieves its intended purpose. The LTP policy
should apply to all business units that are material users or
The international survey identified some badly deficient LTP
providers of funding liquidity.
practices. The worst practices are summarised below.
• LTP should be managed centrally, within group treasury or a
• Management of the LTP process was poor. There were a lack subsidiary treasury, and applied consistently across the group.
of LTP policies, decentralised funding structures accompa- Wholesale funding should be confined to this function.
nied by weak internal risk controls and limits, inconsistent LTP
• Trading book funding policies should exist and, where appro-
regimes, off-line and manually adjusted LTP processes, a lack
priate, funding should be provided at the most granular level
of trading book funding policies, as well as poor independent
e.g., at the trading desk level as opposed to the trading
oversight by risk and financial control personnel.
book level. This requires treasury to have a full line of sight
• LMIS were often not advanced enough to incorporate to individual business balance sheets. Banks are also encour-
the costs, benefits and risks of liquidity at a sufficiently aged to examine individual positions and apply higher fund-
1

granular level.
60

ing charges to those that are more likely to become stale,


s e, or
5
66
98 er

• 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

ate such profits. • Oversight of the LTP process should be e provided


provide
proo by indepen-
-9 ali
58 ak

• 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
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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 305

  


ALCO, senior management and treasury functions to discuss • Charges for the use of liquidity and credits for the benefit of
changes in funding costs. liquidity should not be borne by central management (ie trea-
• To assist with performance assessments and decision-making, sury), but should instead be attributed, at a sufficiently granu-
LMIS should be advanced enough to attribute, at a suffi- lar level, to the business activities using or providing liquidity.
ciently granular level, all of the relevant costs, benefits and
risks of liquidity to the appropriate business activities. Managing contingent liquidity risk
• Remuneration practices should be more sensitive to the risks • The size of liquidity cushions should be derived from stress-
taken to generate profits. For example, profit pools, which testing outcomes and scenario analyses that at a minimum
are used to derive short-term incentives such as bonuses, account for idiosyncratic and systemic scenarios, including
should be adjusted for the cost of liquidity through the LTP prolonged market disruptions, and a combination of the two.
process. • Assets held as part of the liquidity cushion should be of the
highest form of liquidity.
• Funding charges applied to assets in the liquidity cush-
Using LTP to manage on-balance sheet funding liquidity
ion should not be based on short-term overnight rates
risk
but should instead be derived from longer-term rates to
• When applying LTP in practice, banks should by now have
account for the possibility of longer than expected market
come to the realisation that liquidity is not a free good.
disruptions.
Hence, employing a zero cost of funds approach to LTP is
extremely poor practice and should not be tolerated by • The cost of carrying a liquidity cushion is a cost of doing
supervisors. business and should thus be recouped from the business
activities that require the bank to carry such liquid assets. The
• Banks should instead be moving towards incorporating a
charge attributed to business activities should not be equal
matched-maturity marginal cost of funding approach to LTP.
and based on the assumption that the contingent liquid-
This approach is superior to any other established. First, it
ity risk is the same for all types of business. Instead, indi-
recognises the need to charge more for the cost of liquidity
vidual business activities should be charged based on their
for assets that require funding for longer periods of time.
expected, or predicted, use of contingent liquidity.
Conversely, it recognises the need to credit more for the
benefit of liquidity for liabilities that provide funding for lon- To conclude, one size does not fit all. Banks vary in size and
ger periods of time. Second, the rate charged for the use complexity, and the LTP process employed should reflect these
and for the benefit of funds is based on banks’ actual market factors. While banks should, at least, consider all better practices
costs of funds. This rate incorporates both idiosyncratic credit promoted through this paper, only those that are appropriate and
risk adjustments and market access premiums. will most likely improve their own LTP process should be adopted.

1
560
66
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1- nt
20
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65 ks
06 oo
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11 ah
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306 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


APPENDIX:
LTP Principles and Recommendations
Working Group Principles/Recommendations

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/.
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41 M
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Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice ■ 307

  




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


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
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1- nt
20
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65 ks
06 oo
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-9
58
11

Excerpt is BIS Working Paper No. 291, by Patrick McGuire and Götz von Peter.
41
20
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309

  


16.1 INTRODUCTION episodes with similar international dimensions include the
lengthening of the maturity of Latin American dollar debt in the
The global financial crisis has shown just how unstable banks’ early 1980s, which raised concerns about a maturity mismatch
sources of funding can become. Throughout the crisis, but on European banks’ balance sheets (McCauley (1984)). Another
particularly following the collapse of Lehman Brothers in case is the “Japan Premium” faced in the 1990’s by Japanese
September 2008, many banks faced severe difficulties securing banks, which had financed their global expansion in the eurodol-
short-term US dollar funding. In response, central banks around lar and euroyen markets (Peek and Rosengren (2001)).
the world adopted extraordinary policy measures, including The funding difficulties which arose during the crisis are directly
international swap arrangements with the US Federal Reserve, linked to the remarkable expansion in banks’ global balance
to enable them to provide US dollars to commercial banks in sheets over the past decade. Reflecting in part the rapid pace
their respective jurisdictions. What caused this global shortage of financial innovation, banks’ (particularly European banks’)
of US dollars? Which banking systems have been most affected? foreign positions have surged since 2000, even when scaled by
How could a shortage develop so quickly after dollar liquidity measures of underlying economic activity. As banks’ balance
had been viewed as plentiful? sheets grew, so did their appetite for foreign currency assets,
This paper provides a systematic analysis of the build-up of notably US dollar-denominated claims on non-bank entities.
stresses on banks’ international balance sheets which set the These assets include retail and corporate lending, loans to
stage for the shortage of US dollars.1 It relies on the BIS interna- hedge funds, and holdings of structured finance products
tional banking statistics to reconstruct the global balance sheet based on US mortgages and other underlying assets. During
positions for each of the major national banking systems.2 These the build-up, the low perceived risk (high ratings) of these
data provide information on both the currency and the counter- instruments appeared to offer attractive return opportuni-
party of banks’ foreign assets and liabilities, facilitating an analy- ties; during the crisis they became the main source of mark
sis of how banks funded their foreign currency investments. With to market losses.
this dataset, the dynamics of the crisis can be analysed along The accumulation of US dollar assets saddled banks with sig-
the contours of banks’ consolidated global balance sheets, argu- nificant funding requirements, which they scrambled to meet
ably the most appropriate framework for assessing funding pres- during the crisis, particularly in the weeks following the Lehman
sures, rather than along geographical (ie residency-based) lines. bankruptcy. To better understand these financing needs, we
Understanding the global US dollar shortage requires a depar- break down banks’ assets and liabilities by currency to examine
ture from the familiar domestic bank run story. In the open cross-currency funding, or the extent to which banks fund in
economy version of the traditional bank run model, depositors one currency and invest in another. We find that, since 2000,
run the bank and convert their domestic deposits to foreign cur- the Japanese and the major European banking systems took on
rency (Chang and Velasco (2000, 2001)) or, in the case of liability increasingly large net (assets minus liabilities) on-balance sheet
dollarization, directly withdraw dollars (Rajan and Tokatlidis positions in foreign currencies, particularly in US dollars. While
(2005)). The resulting demand for foreign currency, being pro- the associated currency exposures were presumably hedged
portional to domestic bank liabilities, can easily exhaust the off-balance sheet, the build-up of net foreign currency positions
country’s FX reserves (Obstfeld et al (2009)). While the domestic exposed these banks to foreign currency funding risk, or the risk
run story remains relevant in the emerging market context, this that their funding positions (FX swaps) could not be rolled over.
paper traces the origins of the US dollar shortage to the inter- The magnitude of this risk is gauged in a second step, where
national operations of the major banking systems and to the we attempt to quantify banks’ total short-term US dollar financ-
global funding and swap markets on which they rely. Previous ing needs at the onset of the crisis. This requires breaking down
banks’ US dollar-denominated assets and liabilities further, by
residual maturity, to quantify the degree of maturity transfor-
1

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

limitations make direct measurement of the maturity of banks’ anks’


s
1- nt
20

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

type (bank, non-bank or central bank) can serve as a pro proxy


oxy ssince
roxy
82 B

short-term US dollar funding.


the average maturity of positions is likely to varyy systematically
sysstema
tema
-9 ali

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

refers to the set of large internationally active banks headquartered


41 M

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
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310 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


funding gap—the amount of short-term US dollar funding banks 16.2 BANKS’ INTERNATIONAL
require—measured here as the net amount of US dollars chan-
nelled to non-banks. By this estimate, European banks’ need for
POSITIONS: CONCEPTS AND DATA
short-term US dollar funding was substantial at the onset of the
We first introduce concepts related to an internationally active
crisis, at least $1.0–1.2 trillion by mid-2007.
bank’s investment and funding choices. Consider a bank that
Events during the crisis led to severe disruptions in banks’ seeks to diversify internationally, or expand its presence in a
sources of short-term funding. Interbank markets seized up, and specific market abroad. This bank will have to finance a particu-
dislocations in FX swap markets made it even more expensive lar portfolio of loans and securities, some of which are denomi-
to obtain US dollars via swaps. Banks’ funding pressures were nated in foreign currencies (eg a German bank’s investment in
compounded by instability in non-bank sources of funds as well, US dollar-denominated structured finance products). The bank
notably dollar money market funds and dollar-holding central can finance these foreign currency positions in several ways:
banks. The market stress meant that the effective maturity of
1. The bank can borrow domestic currency, and convert it in a
banks’ US dollar funding shortened just as that of their US dol-
straight FX spot transaction to purchase the foreign asset in
lar assets lengthened, since many assets became difficult to sell
that currency.
in illiquid markets. This endogenous rise in maturity mismatch,
difficult to hedge ex ante, generated the global US dollar short- 2. It can also use FX swaps to convert its domestic currency
age. Our estimate of the size of banks’ US dollar funding gaps liabilities into foreign currency and purchase the foreign
at the onset of the crisis shed light on why the international pol- assets.3
icy response was necessary, and why it took the form of a global 3. Alternatively, the bank can borrow foreign currency, either
network of central bank swap lines. from the interbank market, from non-bank market partici-
One point highlighted throughout this analysis is the importance pants or from central banks.
of taking banks’ worldwide consolidated positions as the unit The first option produces no subsequent foreign currency
of analysis. Banks have become so globalised, with offices in needs, but exposes the bank to currency risk, as the on-balance
many countries around the world, that it is impossible to iden- sheet mismatch between foreign currency assets and domestic
tify vulnerabilities in their balance sheets using residency-based currency liabilities remains unhedged. Our working assumption
statistics alone (eg, domestic credit data, balance of payments is that banks employ FX swaps and forwards to hedge any on-
data, the BIS locational banking statistics by residency). Stresses balance sheet currency mismatch.4 That is, a bank funding in
build up across the global balance sheet, as mismatches in the domestic currency (option 1 or 2) is likely to do so as described
currency or maturity of assets and liabilities, and thus can be in option 2. Importantly, the second leg of the swap in option 2
understood only by looking at banks’ worldwide positions con- is not that different from funding a position through foreign cur-
solidated across all office locations. In some cases, banks’ cross- rency borrowing in the first place (option 3): in both cases, the
border assets booked by offices in a particular host country can bank needs to “deliver” foreign currency when the contractual
account for the bulk of that country’s external asset position, liability comes due.
and yet still represent a relatively small part of the consoli-
For concreteness, let Ai denote the bank’s claims (assets)
dated banking systems’ worldwide assets. This fact clouds the
denominated in currency i, with i = 0 representing the domes-
interpretation of the “national balance sheet” for many host
tic currency. The assets are financed by liabilities Li (where L0
countries, since banks’ long or short currency positions booked
includes equity). The net position in currency i equals (Ai - Li),
in one office location and offset in another may signal a “mis-
where the term “long” (“short”) is used to denote a positive
match” in the host country’s net external position when none
(negative) net on-balance sheet position. Funding option 1
may, in fact, exist.
above produces a long foreign currency position of Ai 70
The remainder of the paper is organised as follows. The next
1
60

section introduces concepts related to banks’ international


5
66
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investment and funding choices, from which we derive the data


1- nt

3
20

An FX swap is an exchange of two currencies at the current


rrent
rent sspot
66 Ce

requirements. Section 3 examines banks’ investment and fund- chan


hanng
exchange rate today, coupled with the promise to exchangege ba
bac
back at a
65 ks

future date at a fixed exchange rate.


06 oo

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

banks may find it advantageous to maintain n op


pen fo
open foreign currency posi-
58

detail on the BIS international banking statistics and the con- inst a depreciation of the
tions (eg to insulate capital/asset ratios against
11

struction of the dataset.


41

domestic currency (Fukao (1991)).


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Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 311

  


financed by L0 =Ai. Option 2 couples the same on-balance sheet would find it unprofitable to eliminate maturity mismatch alto-
positions with a(n off-balance sheet) promise to repay Ai when gether (Morgan and Smith (1987), Goodhart (1995), Diamond
the swap comes due, to be met by the proceeds from, or sale and Rajan (2001), Stigum and Crescenzi (2007)). However, in a
of, Ai. Option 3 matches foreign currency funding to foreign purely domestic banking context, the central bank can act as
assets, leaving a zero net position (Ai -Li =0). The balance sheet lender of last resort and provide sufficient liquidity to eliminate
identity implies that net foreign currency positions (if positive) a domestic funding shortage; doing so is both time-honoured
are mirrored in net borrowing in domestic currency. That is, practice (Bagehot (1873), Goodhart (1995)) as well as optimal
policy (Allen and Gale (1998), Diamond and Rajan (2006)). By
(16.1) contrast, central banks cannot create foreign currencies; their
The various funding options expose the bank to funding risk, or ability to meet banks’ demand for foreign currencies is con-
the risk that funding liabilities cannot be rolled over. The magni- strained by the exchange rate regime or limited to available FX
tude of this risk depends on the degree of maturity transforma- reserves (Chang and Velasco (2000, 2001), Obstfeld et al (2009)).
tion embedded in the bank’s balance sheet. The bank is said to Banks’ foreign currency requirements may therefore have to be
face a foreign currency funding gap if the investment horizon of met from international sources (Fischer (1999), Mishkin (1999)).
its foreign currency assets Ai exceeds the maturity of its foreign Funding risk is inherently tied to stresses across the global
currency funding or FX swaps. The portfolio’s investment hori- balance sheet: mismatches between the maturity, currency
zon depends on the desired holding period, on the maturity of and counterparty of assets and liabilities. Quantifying this risk
the underlying assets and on market liquidity. If the contractual requires measurement of banking activity on a consolidated
liabilities (Li, or swaps) cannot be rolled over for some reason, basis, preferably at the level of the decision-making economic
then foreign currency assets that were intended to be held have unit (ie individual banks). Data designed to identify vulnerabili-
to be sold instead, possibly in distressed market conditions. ties in banks’ funding patterns would ideally include, for both
Suppose the bank finances its foreign currency assets Ai by fully assets and liabilities, a complete breakdown of positions by cur-
hedging currency risk, ie by a combination of foreign currency rency, maturity and counterparty type, along with the relevant
borrowing Li and FX swaps Si such that Ai = Li + Si. Denote by risk characteristics and off-balance sheet positions.
ALT LT
i (Li ) the foreign currency assets (liabilities) with a long The publicly available information on banks’ international positions
investment horizon or long effective maturity. Ideally, one typically falls far short of this ideal. Published accounts (collected
would measure short-term funding liabilities (including FX in BankScope and Bloomberg) are available at the level of individ-
swaps) in currency i directly, as (Li - LLT
i ) + Si. However, since ual (consolidated) banks, but lack the essential breakdowns (coun-
FX swaps are typically (unobserved) off-balance sheet transac- terparty, maturity and currency) needed here. Such information
tions, we use the hedging equality to replace Si and express may be collected by bank examiners in the course of their supervi-
short-term funding liabilities as (Ai - LLTi ). These short-term for- sory activity, but is not included in publicly available data sources.6
eign currency liabilities can be met with banks’ liquid or matur- Statistics compiled at the national level (from national authorities,
ing assets, worth (Ai - ALTi ). The difference yields the foreign the IMF and the OECD) generally do not provide a complete
currency funding gap:5 picture either. As shown in Section 16.3.1, banks have become so
globalised that residency-based data are insufficient for identifying
(16.2) vulnerabilities in any particular national banking system.
Why is funding risk in foreign currencies of special interest? The analysis in this paper relies on the BIS international bank-
Banks also face the risks inherent in transforming maturities in ing statistics, the most comprehensive source of information
their domestic currency market, of course. Indeed, maturity on banks’ international balance sheet positions.7 With these
transformation is an essential function of banking, and banks 1

6
60

Also, their focus on individual banks may mean that macroprudential


5

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

proceeds into domestic currency to increase A0. The resulting swap


7
position, Si = Ai - Li 6 0, represents a short-term claim on currency i,
65 ks

The Bank for International Settlements disseminates four sets ets of


o int
inte
inter-
06 oo

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

currency at short notice. If the proceeds were channelled into long-term he


monetary authorities in over 40 countries, including thee ma ajor o
major offshore
82

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

as (ALTi - Li ) + (Li - Ai) = (Li - Li ) - (Ai - Ai ). In the extreme


LT LT LT
(primarily) on two of these: the BIS consolidated bankking sstatistics on an
banking
58

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

liabilities, (Li - LLT


41

i ). by residency (LBSN).
20
99

312 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


data, it is possible to reconstruct the consolidated global banks’ total assets (row 2) and more than 70% of Canadian,
balance sheets for the major national banking systems. This Italian and UK banks’ assets. Across all banks in BankScope, the
effectively involves adding up the cross-border and local top 50 institutions account for some 80% of total bank assets in
(ie vis-à-vis residents of the host country) balance sheet posi- the database. Banks’ foreign positions (row 4) is even more
tions reported by banks’ home offices and their offices in host concentrated in the familiar names.
countries around the world into a consolidated whole for each
banking system. The end result is a dataset with the consoli-
dated balance sheet positions for 19 banking systems for the 16.3 THE LONG AND SHORT OF BANKS’
Q2 1999–Q1 2009 period at a quarterly frequency. It is impor- GLOBAL BALANCE SHEETS
tant to note that the constructed positions are estimates
based on imperfect underlying data, and in places require 16.3.1 The Structure of Banks’ Operations
assumptions to address known data limitations. More informa-
tion on these assumptions and the construction of the dataset Internationally active banks have offices in many countries
is provided in the appendix. around the world. Their currency and maturity positions are
managed across the consolidated global entity rather than
We use this dataset to investigate how banks fund their
office by office. Thus, large measured “mismatches” on the
foreign currency investments, and to derive their funding
balance sheet of an office in one location may be hedged off-
requirements across currencies and counterparties. While not
balance sheet or offset by on-balance sheet positions booked
at the individual bank level, the advantages of these data are
by offices elsewhere, leaving a matched book for the bank as
that they provide (i) the consolidated foreign assets and liabil-
a whole. This section provides some simple measures of how
ities for each banking system, (ii) estimates of the gross and
banks’ offices are organised across countries, and highlights the
net positions by currency, and (iii) information on the sources
importance of measuring stresses across the balance sheets of
of financing (ie interbank market, central banks and non-bank
consolidated entities.
counterparties).
Overall, foreign offices account for a significant share of banks’
Table 16.1 presents summary statistics on the 11 banking sys-
worldwide consolidated balance sheets. The bottom five rows of
tems analysed in later sections. Row 1 lists the number of inter-
Table 16.1 show the share of banks’ total foreign claims (assets)
nationally active banks which are headquartered in the country
which are booked by their offices in various countries/regions.9
listed in the column heading, and whose foreign claims (row 4)
In most cases, /ess than half of banks’ foreign claims are booked
are thus included in the BIS consolidated banking statistics.8
by their home offices, with French and Japanese banks being
Row 2 provides the total assets for this select group of banks in
exceptions. At the extreme are Swiss banks, with more than
each banking system. For some banking systems (eg Germany,
$3 trillion in foreign claims, accounting for over 80% of their
France and Italy), the number of individual reporting institutions
total balance sheet assets. Only 18% of their foreign claims are
is large since it includes many banks that hold small foreign
booked by offices in Switzerland. Banks’ offices in the United
exposures. However, international banking is highly concen-
Kingdom tend to be the largest outside the home country, fol-
trated. Estimated concentration ratios (row 3) for each banking
lowed by offices in the United States; combined, US and UK
system, calculated using bank-level information on total assets
offices account for roughly one third of German, Spanish and
from BankScope, indicate that the five largest institutions
Dutch banks’ foreign claims.
account for more than 90% of Belgian, Swiss, French and Dutch
Looking at these data from the perspective of host countries
shows just how large banks’ international operations really
8
A banking system’s foreign positions (assets or liabilities) are com-
are. Table 16.2, where the column headings now indicate host
posed of four components: (i) cross-border positions booked by all countries, shows the gross and net international asset position
offices worldwide and in all currencies; (ii) “local positions”, or claims
1

of each country, and compares these to banks’ cross-border


60

booked by banks’ foreign offices vis-à-vis residents of the host country


5

claims (here, including banks’ cross-border inter-office positions


e po
osition
sition
66
98 er

(in either the local currency or a foreign currency); (iii) positions booked
1- nt
20

as well). The table distinguishes between positionss boo


booked
oked by
66 Ce

by the home office vis-à-vis residents of the home country in foreign


65 ks

currencies; and (iv) cross-border positions booked by banks’ foreign


06 oo

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

  


Table 16.1 Size and Structure of Banks’ Foreign Operations
Positions at end-2007

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

  


Table 16.2 Bank Assets in Total External Assets
Positions at end-2007

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

Gross external 2,407 1,199 3,231 7,367 2,091 7,758 2,827 5,355 3,795 12,777 17,640
assets ($bn)1
Net external 141 -127 635 949 -1,081 375 -119 2,195 14 -586 -2,442
assets ($bn)
Cross-border bank claims ($bn)3
All banks 1,162 303 1,539 3,561 613 2,821 648 2,402 1,342 6,844 2,961
Domestic banks 881 282 1,235 2,953 471 2,497 478 2,169 1,133 1,966 1,113
Foreign banks 280 21 304 608 141 324 169 233 209 4,878 1,848
4
Cross-border bank claims / external assets (%)
All banks 48 25 48 48 29 36 23 45 25 54 17
Domestic banks 37 24 38 40 23 32 17 41 30 15 6
Foreign banks 12 2 9 8 7 4 6 4 5 38 10
Net cross-border bank claims ($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

Sources: IMF IFS; BIS locational statistics by nationality.


65 ks
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 ■ 315

  


investment and capital mobility.10 For at least two reasons, the banks, at 6%). Therefore, vulnerabilities in these banks’ balance
national balance sheet may be a poor indicator of vulnerabilities sheets may not be visible in the home country’s external posi-
(eg currency or maturity mismatches) faced by residents of a tion, even when combined with data on these banks’ domestic
particular country. positions (eg domestic credit and other such aggregates).
Vulnerabilities can only be measured by taking into account the
First, changes in a country’s external position can be driven to
entire balance sheet of the consolidated global entity. More-
a large extent by the activity of foreign banks’ offices, and thus
over, these vulnerabilities relate to domestic residents only to
be only loosely related to vulnerabilities in residents’ portfo-
the extent that the residents hold exposures in the national
lios. For instance, suppose banks headquartered in country A
banking system.
double their balance sheet size through greater cross-border
lending and/or acquisition of foreign banks. If the balance sheet
adjustment occurs in these banks’ foreign offices, it can gener- 16.3.2 Balance Sheet Expansion since 2000
ate large swings in other countries’ external positions without
The origins of the US dollar shortage during the crisis are
necessarily affecting country A’s external position. For instance,
linked to the expansion since 2000 in banks’ international bal-
the expansion in the global balance sheets of Swiss, German
ance sheets. The outstanding stock of banks’ foreign claims
and Dutch banks since 2000 was driven to a large extent by
grew from $10 trillion at the beginning of 2000 to $34 trillion
greater cross-border positions booked by their offices in the
by end-2007, a significant expansion even when scaled by
United Kingdom (see next section). Indeed, as shown in the
global economic activity (Figure 16.1, left panel). The year-on-
bottom rows of Table 16.2, the offices of foreign banks located
year growth in foreign claims approached 30% by mid-2007,
there saw larger changes in their net cross-border balance sheet
up from around 10% in 2001. This acceleration took place
positions in the pre-crisis period than did UK headquartered
during a period of financial innovation, which included the
banks ( -$490 billion compared to -$190 billion). Over this
emergence of structured finance, the spread of “universal
same period, foreign banks’ offices contributed significantly to
banking”, which combines commercial and investment bank-
the change in the net external position in Italy and Spain as well.
ing and proprietary trading activities, and significant growth in
In any particular host country, a long or short net cross-border
the hedge fund industry to which banks offer prime brokerage
positions in a particular currency booked by the offices of for-
and other services.
eign banks there may be offset or hedged elsewhere on those
banks’ global balance sheet. How, then, should we interpret the At the level of individual banking systems, the growth in
associated “mismatches” on the national balance sheet of the European banks’ global positions is most noteworthy (Figure 16.1,
host country? And to what extent do they reflect vulnerabilities centre panel). For example, Swiss banks’ foreign claims jumped
faced by the host country residents? from roughly five times Swiss nominal GDP in 2000 to more
than seven times in mid-2007 (Table 16.1). Dutch, French,
The converse of this point is that it is generally difficult to
German and UK banks’ foreign claims expanded considerably
identify a particular banking system’s vulnerabilities by looking
as well. In contrast, Canadian, Japanese and US banks’ foreign
at the home country’s domestic and external positions data.
claims grew in absolute terms over the same period, but did
For example, in at least six countries (BE, CH, DE, FR, JP and
not significantly outpace the growth in domestic or world GDP
NL), domestic banks’ cross-border positions account for a third
(Figure 16.1, right panel). While much of the increase for some
or more of the home country’s external position (Table 16.2).
European banking systems reflected their greater intra-euro area
Yet, Table 16.1 (bottom row) indicates that assets booked by
lending following the introduction of the single currency in 1999,
offices outside the home country account for a significant share
their estimated US dollar- (and other non-euro-) denominated
(a quarter or more) of each of these countries’ national banking
positions accounted for more than half of the overall increase in
systems’ total worldwide assets (with the exception of Japanese
their foreign assets between end-2000 and mid-2007.
1
60

16.3.3 Cross-Currency Funding Positions


ns
5
66
98 er

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

positive (negative) positions represent foreign


eign claims
c (liabilities).
41

(2009) for recent models of international portfolio choice.


20
99

316 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Foreign claims scaled by world GDP
In per cent

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

by mid-2007 (Figure 16.5, top left panel), funded by short


60

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

  


Gross foreign assets and liabilities, by currency1
In trillions of US dollars

UK banks Swiss banks German banks


USD
EUR
6 4 4
JPY
2
Domestic
Other 3 2 2
Unknown

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

business units of ABN AMRO.


1- nt
20
66 Ce

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

  


Net foreign positions, by currency1
In billions of US dollars

UK banks Swiss banks German banks


All currencies
USD 300 500 1,200
EUR
JPY
150 250 600
Other

0 0 0

–150 –250 –600

2
–300 –500 –1,200
Dom (residents)
3
Dom (crossborder)
–450 –750 –1,800
4
Spanish banks French banks Belgian banks

100 600 200

50 300 100

0 0 0

–50 –300 –100

–100 –600 –200

–150 –900 –300


5
Dutch banks Japanese banks US banks

400 1,200 800

200 600 400

0 0 0

–200 –600 –400

–400 –1,200 –800

–600 –1,800 –1,200


00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1
Net foreign positions are assets minus liabilities. 2 Implied net positions in domestic currency vis-à-vis residents of the home
country, inferred from the balance sheet identity (see data appendix). 3 For UK banks, net cross-border positions in domestic
currency booked by these banks’ home offices. 4 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-à-vis some large
1
60

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

  


positions in sterling, euros and Swiss francs.14 As banks’ cross- can be readily converted to cash depends upon the maturity of
currency funding grew, so did their hedging requirements and the underlying positions as well as on their market liquidity.
FX swap transactions, which are subject to funding risk when
These US dollar investments are funded by liabilities to various
these contracts have to be rolled over.
counterparties. Banks can borrow US dollars directly from the
interbank market, typically short-term. They can also raise US
16.3.4 Maturity Transformation across dollars via FX swaps (with bank or non-bank counterparties), which
Banks’ Balance Sheets are even shorter-term on average.17 In contrast, US dollar funding
provided directly by non-banks includes corporate and retail
As discussed in Section 2, funding risk hinges on the degree of
deposits, deposits from central banks, and financing from money
maturity transformation embedded in banks’ balance sheets.
market funds, and is thus of varying maturities.18 As described in
Unfortunately, data limitations make it difficult to obtain an
Baba et al (2009), money market funds had become an important
aggregate maturity profile of banks’ foreign assets and liabili-
source of short-term US dollar financing, providing an estimated
ties. In this section, we argue that the counterparty sector break-
$1 trillion to European banks in 2007. If the effective maturity of
down available in the BIS banking statistics can serve as a proxy
liabilities to non-banks matches that of their investments in non-
for maturity transformation, and hence funding risk, since the
banks (ie is “longer-term”), then a lower-bound estimate of their
maturity of positions is likely to vary systematically with the type
US dollar funding gap is the net US dollar position vis-à-vis non-
of counterparty.15 We use this counterparty information to con-
banks. If, on the other hand, banks’ liabilities to non-banks were all
struct a measure of banks’ US dollar funding gap, the amount of
short-term, then an upper-bound estimate of their funding gap is
US dollars invested in longer-term assets which is not supported
their gross US dollar position in non-banks. Figure 16.4, which
by longer-term US dollar liabilities, this gap being the amount
focuses on the lower-bound measure, shows the considerable het-
that banks must roll over before their investments mature (equa-
erogeneity in the way European banks met their US dollar funding
tion (16.2)). We build up this argument in several steps.
requirements. For example, Dutch, German, Swiss and UK banks
The counterparty sector breakdown for European banks’ gross had the largest funding gaps (green lines) by mid-2007.
US dollar assets and liabilities is shown in Figure 16.5 (top right
However, their reliance on the interbank market (blue line), cen-
panel). Interbank claims, which include interbank loans and debt
tral bank deposits (red line) and FX swaps (shaded area) differed
securities claims, tend to be shorter-term or can be realised at
markedly.19 UK banks maintained largely balanced net interbank
shorter notice than claims on non-banks. We think of US dollar
US dollar positions, thus implying cross-currency funding, while
claims on non-banks as banks’ desired US dollar investment
German banks relied relatively more on interbank funding.
portfolio. This portfolio of non-bank assets includes banks’ retail
and corporate lending, lending to hedge funds, and holdings of Taken together, these estimates suggest that European banks’
securities ranging from US Treasury and agency securities to US dollar investments in non-banks were subject to considerable
structured finance products.16 Whether these non-bank assets funding risk at the onset of the crisis. The net US dollar book,
aggregated across the major European banking systems, is por-
14
trayed in Figure 16.5 (bottom left panel), with the non-bank com-
Adding in Japanese banks’ $600 billion long US dollar position
(Figure 16.3) brings the estimated total to $1.3 trillion.
ponent tracked by the green line. By this measure, the major
15 European banks’ US dollar funding gap had reached $1.0–1.2
Using the counterparty sector also addresses the common problem that
the effective maturity may differ from the maturity stated on bank balance trillion by mid-2007. Until the onset of the crisis, European banks
sheets (Flannery and James (1984)). Demand deposits held by households,
for instance, are a stable source of funding with a long effective maturity. 17
Evidence from the BIS Triennial Central Bank Survey (of 2007) indi-
16 cates that 78% of FX swap turnover is accounted for by contracts with a
No counterparty sector breakdown is available for banks’ US dollar
claims on US residents booked by their offices in the United States (“Local maturity of less than seven days.
US positions” in Figure 16.5, top right panel), since these positions are 18
In the BIS banking statistics, reporting banks’ liabilities to official
taken from the CBS (see Table A in appendix). Overlaying our data set with
1
60

monetary authorities mostly reflect international deposits of foreign


the BIS consolidated banking statistics (ultimate risk basis) suggests that
5

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

  


Net US dollar-denominated foreign positions, by counterparty sector
In billions of US dollars

UK banks Swiss banks German banks


1
Monetary authorities
2
Other banks 300
Non-banks
3 400
4 200
Cross currency 200

200
100
0
0
0

–100
–200
–200
–200

–300 –400 –400


5
Spanish banks French banks Belgian banks

100 100 50

50 50 25

0 0 0

–50 –50 –25

–100 –100 –50

–150 –150 –75


6
Dutch banks Japanese banks US banks

500 250
100
0
250
–250
0 0
–500
–250
–750
–100
–500 –1,000

–200 –750 –1,250


00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1
Cross-border positions in all currencies and local positions in foreign currencies vis-à-vis official monetary authorities. Excluding
liabilities to Japanese monetary authorities placed in banks located in Japan. 2 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
01

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

reflects the sale of some business units of ABN AMRO.


41 M

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

  


European banks’ balance sheet positions1
In trillions of US dollars

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


3
2 Local US positions
USD CHF
2 Interbank 8
EUR GBP 0.8 Non-banks (international)
JPY Other
Monetary authorities
4
Unknown
0.4
0
0.0
–4

–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

terparties. For example, data on foreign exchange reserve holdings ngs


gs
1- nt

and by borrowing from central banks ($386 billion),20 and used


20
66 Ce

reported to the IMF indicate that Japanese monetary authorities ie


ess he
eld
ld
held
FX swaps ($315 billion) to convert (primarily) domestic currency roughly $118 billion in banks located in Japan in mid-2007 ($26 $26 billion
billio
b
65 ks
06 oo

in Japanese banks and $92 billion in foreign banks in Japan). pan). To


T ththe
82 B

extent that these reserves are US dollar-denominated,, the red lilines in


-9 ali

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

  


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

25
60

This is despite substantial asset writedowns of $280 billion byy end-Q3


d-Q3
5

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

interbank borrowing (dashed blue line) and cross-currency financing 26


Between end-Q3 2007 and end-Q1 2009, the outstanding stand
and ding
ing sst
stock of
65 ks

(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

to distinguish reductions in lending and asset dispos


isposal fro
disposal from writedowns
-9 ali

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

  


US dollar positions of European banks’ US offices
In billions

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

1,500 450 125

0 300 0

–1,500 150 –125

–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

access to additional facilities in their capacity as primary dealers. The


66
98 er

by the amount of the writedowns. In this case, if we assume mee


1- nt
20

borrowing of US dollars by European banks’ US offices from the Federal


66 Ce

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

the United States. This is not captured in their international liabilities to


06 oo
B

official monetary authorities (as in Figures 16.4 and 16.5), as it is neither


in foreign currency nor cross-border. 30
82

Only in the period prior to the crisis, when asset write


writedowns
edow
dow were
-9

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

foreign affiliates to smooth liquidity shortages. claims on non-banks).


20
99

324 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

Central bank network of swap lines

Bank of Canada Reserve Bank of Australia

Bank of Mexico Reserve Bank of New Zealand

Central Bank of Brazil Monetary Authority of Singapore


US Federal Reserve

Bank of England Bank of Japan People’s Bank of China

Sveriges Riksbank Bank of Korea

Swiss National Bank Eurosystem

Norges Bank National Bank of Denmark

Central Bank of Iceland


1

Magyar Nemzeti Bank


60

National Bank of Poland


65
82 r
-9 te
06
61 en
56 s C

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

Source: Central banks. Figure


e 16.7
16.
1
41
20
99

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 325

  


Central banks’ US dollar swap lines1
In billions

Eurosystem Bank of England Swiss National Bank


US dollar lending
US dollar swap line
200 100 50

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).

Source: Central banks. Figure 16.8

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

ity, which includes reserves disclosed by central government and mon-


Since then, the use of swap lines has gradually subsided, to $50
5

etary authorities (Eurosystem, Swiss National Bank and Bank of England).


66
98 e
1- nt

billion by early October 2009. In tandem, the level and spreadspread


ads
20

32
66 Ce

The Federal Reserve press release of 13 October 2008 explicitly


of US dollar interest rates, notably Libor, have receded d from
fro
om
m
65 ks

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

pledged to the Federal Reserve in exchange are best regarded as collat-


-9 ali

find evidence that the US dollar auctions reduced ed the


he level
th le and
58 ak

eral. A new set of swap arrangements (announced on 6 April 2009) was


volatility of swap spreads. The policy also helpedd avert
elped ave more
11 ah

necessary to authorise the Federal Reserve, should the need arise, to


41 M

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

  


possibly mitigated interbank rate volatility and upward pressure account currency and maturity mismatches. This paper par-
on the US dollar.33 tially fills this void, investigating how banks funded their inter-
national positions across currencies and counterparties. The
Beyond addressing the immediate exigencies, however, the
analysis shows that between 2000 and mid-2007, the major
international swap arrangements are of broader interest from
European banking systems built up long US dollar positions
an institutional perspective.34 The structure of the arrange-
vis-à-vis non-banks and funded them by interbank borrow-
ments appears to overcome two challenges commonly associ-
ing, borrowing from central banks and FX swaps. We argue
ated with international lending of last resort. First, the Federal
that this greater transformation across counterparties in fact
Reserve and its foreign counterparts have the power, in princi-
reflected greater maturity transformation across these banks’
ple, to create any amount of money, in contrast with interna-
balance sheets, exposing them to considerable funding risk.
tional financial institutions administering limited resources.35
When heightened credit risk compromised sources of short-
Demands in other currencies can similarly be met by including
term funding during the crisis, the chronic US dollar funding
the respective currency-issuing central banks in the network of
needs became acute, particularly in the wake of the Lehman
swap lines. Second, the swap network does not compound the
Brothers bankruptcy.
informational problems that can give rise to moral hazard. By
lending against collateral to foreign central banks that interme- In contrast to many previous international financial crises, it
diate those funds to banks in their jurisdictions, the Federal was banks’ international exposures to other industrialised
Reserve assumes no credit risk vis-à-vis the ultimate borrowers, countries that deteriorated, and the global interbank and FX
and delegates the task of monitoring the banks (or collateralis- swap funding structure which seized up. The build-up of such
ing the loans) to the national authorities closer to the bank stresses at the global level can only be identified by track-
supervision process.36 ing the extent of cross-currency funding, and by implication,
banks’ reliance on short-term interbank and FX swap positions.
What pushed the system to the brink was not cross-currency
16.6 CONCLUDING REMARKS funding per se, but rather too many large banks employing
funding strategies in the same direction, the funding equiva-
The recent financial crisis has highlighted just how little is
lent of a “crowded trade”. Only when examined at the aggre-
known about the structure of banks’ international balance
gate level can such vulnerabilities be identified. By quantifying
sheets and their interconnectedness. The globalisation of
the US dollar overhang on non-US banks’ global balance
banking over the past decade and the increasing complex-
sheets, this paper contributes to a better understanding of
ity of banks’ international positions have made it harder to
why the extraordinary international policy response was neces-
construct measures of funding vulnerabilities that take into
sary, and why it took the form of a global network of central
bank swap lines.

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

an international financial institution cannot play an analogous role interna-


macroprudential perspective afforded by these data shows shows
5

tionally (Capie (1998), Schwartz (1999)). The recent literature on the design
66
98 e
1- nt

that (i) stresses can build up in a national banking system em that


syste tth
20

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

vested with domestic authorities at the national level. An international


-9 ali

relative to countries’ external positions, clouding


cloud ding the interpre-
58 ak

institution may find it difficult to contain moral hazard when lending to


tation of what the “national balance sheet”
sheett” implies
et” im for domes-
11 ah

banks outside its regulatory and supervisory reach (Jeanne and Wyplosz
41 M

(2003)). tic residents.


20
99

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 327

  


DATA APPENDIX residents of that country (LCFC and LCFL, if a foreign office;
DCFC and DLFC if the home office). Importantly, these positions
are broken down by bank nationality (ie the parent country of
Reconstructing Banks’ Global Balance
the booking office) as well as by currency and counterparty sec-
Sheets tor.37 For instance, XBCrb $
represents US dollar cross-border
The analysis in this paper requires estimates of banks’ consoli- claims booked in reporting country r by banks headquartered in
dated asset and liability positions broken down by currency and parent country b. The LBSN do not include information on the
counterparty sector. This data appendix describes how we con- location (country) of the counterparty, nor do they include local
struct these estimates, and highlights known data limitations. claims and liabilities (ie vis-à-vis residents) in the domestic cur-
rency of the reporting country (LCLC and LLLC).

The BIS International Banking Statistics


Construction of the Dataset
Table A shows the relevant balance sheet components (first col-
The two sets of statistics contain complementary information
umn) and how the required breakdowns are captured in the BIS
on banks’ global balance sheets. We merge these statistics to
international banking statistics. The underlying data are taken
construct the required balance sheet components as shown
from the BIS consolidated banking statistics on an immediate
in Table A. The key step is to aggregate the LBSN data across
borrower basis (CBS) and the BIS locational banking statistics by
the 40 reporting countries to obtain total international claims
nationality (LBSN).
and international liabilities for each bank nationality (ie bank-
The CBS are organised on the principle of bank nationality. ing system), along with the currency and counterparty sector
They provide reporting banks’ worldwide consolidated foreign breakdowns that are unavailable in the CBS. As shown in the last
claims (FC), which comprise cross-border claims (XBC) booked column of Table A, combining these pieces from the LBSN with
by all offices worldwide, and local claims (LC), or positions those from the CBS splice yields a complete breakdown by cur-
booked by banks’ foreign offices vis-à-vis residents of the host rency of all foreign positions. The only remaining missing pieces
country. Local claims are denominated in either “local curren- of the balance sheet are banks’ “strictly domestic” positions, or
cies” (LCLC), ie the domestic currency of the host country, or their domestic currency assets and liabilities booked by home
in foreign currencies (LCFC). The statistics record cross-border offices vis-à-vis residents of the home country (DCLC and DLLC).
claims and local claims in foreign currencies as a joint item called While their gross “strictly domestic” positions are unknown,
international claims (INTC = XBC + LCFC). These claims can be their net position can be inferred as a residual from the balance
broken down by the country of residence of the counterparty. sheet identity, as illustrated in equation (16.1) in the main text.
Therefore, banking system b’s foreign claims on borrowers in
Consider, for example, UK-headquartered banks. Summing
country c are
across all reporting countries (indexed by r) in the LBSN where
UK banks have offices gives UK banks’ international claims and
liabilities on a global consolidated basis, or
While the counterparty sector (bank, non-bank private sec-
tor and public sector) is known for international claims, there
is no currency breakdown for these positions nor information
about the location of the booking office. Moreover, the CBS This aggregate compares to INTC in the CBS, but now comes
data contain no information on international liabilities (INTL). In with detailed breakdowns by currency and counterparty sector.
contrast to international positions, both the currency and the To match worldwide consolidated foreign claims (FC from the
location of the booking office are known for LCLC by definition. CBS), the only missing balance sheet components are UK banks’
local claims and liabilities in the domestic currencies of various
1

In addition, banks report their locally booked liabilities in local


60

host countries (LCLC and LLLC). This information is available e in


5

currencies (LLLC).
66
98 er
1- nt
20

the CBS reported by the United Kingdom.


66 Ce

In contrast to the CBS, the LBSN are collected on the principle


65 ks
06 oo

of bank residence. The “reporting unit” in the LBSN is any bank


82 B

office (head office, branch or subsidiary) in a particular country


-9 ali

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

vis-à-vis official monetary authorities and vis-à-vis bannks. T


banks. The interbank
41 M

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

  


Table A A Breakdown of Banks’ Consolidated Worldwide Positions

Breakdowns by

Booking office Residence of Sector of Currency of


Totals location counterparty counterparty positions

Domestic claims (DC)1


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

Cross-border claims (XBC) LBSN LBSN LBSN LBSN


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

Foreign liabilities (FL)


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

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

struction; for cross-border positions, the residency of the coun-


5

liabilities (FL) in the CBS.


66
98 er

terparty is unknown).
1- nt
20
66 Ce

In practice, some statistical discrepancies arise because


beca use the
au th two
65 ks
06 oo

sets of statistics are collected in fundamentally ly different


ffere ways.
dif
iffere
82 B

For many banking systems (Belgian, Canadian, n,, Dutch,


adian
dian Dut French,
-9 ali

Consistency Check and Data Limitations


58 ak

German, Italian, Spanish and UK banks) s) the e match


mat is fairly close.
11 ah
41 M

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

  


banks in the CBS differs from that reporting LBSN in various with a corresponding equation for interbank liabilities.
reporting countries.38 Second, some banking systems have The inter-office asset and liability positions must be stripped
offices in countries that do not report in the LBSN, yet those out of total foreign claims in order to make the LBSN and
offices are included in the worldwide consolidated positions CBS data comparable on a gross basis, as in Figures 16.2 and
reported in the CBS. In addition, some countries report incom- 16.5. Some LBSN-reporting countries/regions, however, do
plete positions in the LBSN; the United States, for example, not provide a complete currency breakdown (eg Singapore,
does not report foreign currency positions vis-à-vis US residents. Hong Kong SAR and the Channel Islands), while others provide
only limited currency information for inter-office positions (eg
A third problem that affects the calculations is that the resi-
France, Germany, Italy and Japan split inter-office activity into
dency, counterparty sector and currency of a portion of banks’
domestic and foreign currencies). To the extent possible, we
liabilities are unknown. These “unknown” liabilities are typi-
estimate the missing inter-office components, although some
cally debt securities issued by banks. Once these securities
uncertainty still remains in the overall interbank positions for
are traded on secondary markets, reporting banks no longer
some banking systems. This makes it difficult to pin down the
know the residency or the counterparty sector of the entity
extent of reliance on interbank financing, as shown by the two
that holds these securities. Unfortunately, when the data are
alternative estimates presented in Figures 16.4 and 16.5. On a
reported to the BIS, the currency of these “unallocated” posi-
net basis (claims minus liabilities), inter-office positions should,
tions is not reported, even though, in principle, this is known by
in principle, sum to zero across all reporting office locations.
the reporting banks. While these positions are small on a gross
This implies that net “interbank” claims (IBC - IBL) should
basis (Figure 16.2), they are large on a net basis (Figures 16.3
equal net claims on “other banks”, both of which are observ-
and 16.4), and thus should not be excluded from the analysis.
able in the data:
Across all reporting countries, the United Kingdom reports by far
the largest “unallocated” liability positions (roughly $800 billion
in mid-2007 for the major European banks’ offices located there).
The currency denomination of these liabilities can be estimated
by using the BIS international debt securities database, which
provides information on issuance of debt securities by banks The solid blue lines in Figures 16.4 and 16.5 track
located in various countries around the world. In Figure 16.2, a r(IBCrb - IBLrb), or net interbank positions calculated without
the unknown positions are plotted in their raw form, whereas in stripping out inter-office positions, while the dashed blue line
Figures 16.3, 16.4 and 16.5 the positions are allocated by currency tracks a r(OTHBCrb - OTHBLrb), or the reported positions vis-
by applying the currency split from the debt securities database. à-vis unaffiliated banks only. The dashed black lines in Figures
Because the counterparty sector of these positions, needed for 16.4 and 16.5 track the implied reliance on FX swaps which
Figures 16.4 and 16.5, remains unknown, we make the conserva- corresponds to this alternative estimate of interbank positions.
tive assumption that all unallocated US dollar liabilities are held by Which set of estimates is more accurate depends on the rela-
non-banks. This assumption biases downwards the net positions tive sizes of observed versus missing inter-office positions, and
vis-à-vis non-banks (our lower-bound estimate of the US dollar whether banks have offices with (unobserved) offsetting posi-
funding gap) in Figure 16.4 and Figure 16.5 (bottom panels). tions in non-reporting countries.

Finally, the breakdowns by sector and currency in the LBSN are


in some cases incomplete. For each banking system b, total References
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until Q1 2009, the last quarter of our sample. of International Money and Finance, forthcoming.
mingg
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332 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Covered Interest
Parity Lost:
17
Understanding
the Cross-Currency
Basis
■ Learning Objectives
After completing this reading you should be able to:

● 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.

● Identify key factors that affect the cross-currency swap


basis.
1
60
5
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65 ks
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-9
58
11

Excerpt is by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko, from BIS Quarterlyy Review.
Rev
41
20
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333

  


dollar funding markets.1 Why has arbitrage not reduced the
Covered interest parity verges on a physical law in inter- basis to zero?
national finance. And yet it has been systematically vio-
In this special feature, we argue that the answer to this puzzle
lated since the Great Financial Crisis. Especially puzzling
lies in the combination of the evolving demand for FX hedges
have been the violations since 2014, even once banks
and new constraints on arbitrage activity. The former explains
had strengthened their balance sheets and regained easy
why the basis opens up, and the latter why it does not close. A
access to funding. We offer a framework to think about
growing demand for dollar hedges on the part of banks, institu-
these violations, stressing the combination of hedging
tional investors and issuers of non-US dollar bonds has put pres-
demand and tighter limits to arbitrage, which in turn
sure on the basis. At the same time, limits to arbitrage (in the
reflect a tighter management of risks and bank balance
sense discussed by Shleifer and Vishny (1997), among others)
sheet constraints. We find empirical support for this frame-
have become more binding. These reflect lower balance sheet
work both across currencies and over time.
capacity because of tighter management of the risks involved
JEL classification: F31, G15, G2. and the associated balance sheet constraints. Empirically, we
find that proxies for the volume of hedging demand, together
with proxies for balance sheet costs, help explain CIP violations,
both across currencies and over time. If the factors we identify
Covered interest parity (CIP) is the closest thing to a physical are the right ones, CIP deviations look to be here to stay even in
law in international finance. It holds that the interest rate dif- non-crisis times, as long as the demand for currency hedges is
ferential between two currencies in the cash money markets sufficiently high and imbalanced across currencies.2
should equal the differential between the forward and spot
The rest of this feature is organised as follows. The first section
exchange rates. Otherwise, arbitrageurs could make a seem-
lays out the framework for our analysis. The second and third
ingly riskless profit. For example, if the dollar is cheaper in
sections examine, respectively, the variation of the basis across
terms of yen in the forward market than stipulated by CIP, then
currencies and over time in the yen/dollar basis. The conclusion
anyone able to borrow dollars at prevailing cash market rates
highlights some implications and outstanding questions.
could profit by entering an FX swap—selling dollars for yen at
the spot rate today and repurchasing them cheaply at the for-
ward rate at a future date.
17.1 A FRAMEWORK
Yet since the onset of the Global Financial Crisis (GFC), CIP
has failed to hold. This is visible in the persistence of a cross- The basic mechanics behind CIP are fairly simple. Interest rates
currency basis since 2007. The cross-currency basis indicates in the cash market and the spot exchange rate can be taken as
the amount by which the interest paid to borrow one currency given—these markets are much larger than those for FX deriva-
by swapping it against another differs from the cost of directly tives. Hence, it is primarily shifts in the demand for FX swaps or
borrowing this currency in the cash market. Thus, a non-zero currency swaps that drive forward exchange rates away from CIP
cross-currency basis indicates a violation of CIP. Since 2007, and result in a non-zero basis (Box 17.1). Any such deviations
the basis for lending US dollars against most currencies, nota- should, in principle, immediately trigger arbitrage transactions,
bly the euro and yen, has been negative: borrowing dollars bringing the basis back to zero. The reason is that, in an ideal
through the FX swap market became more expensive than world, CIP arbitrage is treated as riskless. By construction, FX
direct funding in the dollar cash market. For some currencies, swaps do not entail an open currency position. In addition, it is
such as the Australian dollar, it has been positive (Graph 1, left- assumed that the credit, counterparty, market and liquidity risks
hand and centre panels). involved are negligible. Unimpaired access to cash and deriva-
tives markets then allows arbitrageurs to close the basis.
Initially, the violations of CIP were seen as a reflection of
1
60

strains in global interbank markets. Specifically, heightened


5
66
98 er

concerns about counterparty risk and constrained bank access


1- nt
20
66 Ce

to wholesale dollar funding inhibited arbitrage during the


65 ks

1
Also, unlike in earlier US dollar funding stress episodes (Cetorelli
Cetorelli
Cetor
06 oo

GFC, and again during the subsequent euro area sovereign


82 B

and Goldberg (2011, 2012)), banks have drawn very little le


e on
on cent
central
debt crisis. But, puzzlingly, the violations have persisted even
-9 al

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

2014, for both short- and long-term borrowing, despite fading 2


Sushko et al (2016) treat these issues from a more
re
e tec
technical perspec-
concerns about bank credit quality and recovery in wholesale tive and provide broader econometric results.
20
99

334 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Cross-currency basis against the US dollar, interbank credit risk and market risk 1 Graph 1

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


Basis points Basis points Percentage points Percentage points

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:

A positive (“wide”) value of (F - S), above, indicates that a


where S is the spot exchange rate in units of US dollar per party lending US dollars sells the foreign currency forward
foreign currency, F is the corresponding forward exchange at a higher dollar price than warranted by the interest dif-
rate, r is the US dollar interest rate, and r* is the foreign cur- ferential. Equivalently, a party borrowing US dollars via an FX
rency interest rate. In practice, the relationship between F swap—say, to hedge its US dollar asset—is effectively paying
and S is read off market transactions in FX instruments, nota- a higher interest rate on the swapped dollars than is paid in
bly FX swaps and cross-currency swaps. the cash market.
In an FX swap, one party borrows one currency from, and A cross-currency swap is a longer-term instrument, typically
simultaneously lends another currency to, a second party above one year, in which the two parties also simultaneously
(see also Baba et al (2008)). The borrowed amounts are borrow and lend an equivalent amount of funds in two dif-
01
56

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

  


(Continued)

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

risk concerns and the wholesale US dollar funding strains that


82

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

  


demand from banks (Iida et al (2016)), from foreign currency markets. The remaining gaps between banks’ assets and liabili-
bond issuers (Liao (2016)) or from broader saving and invest- ties in a given currency would be closed using currency deriva-
ment imbalances (Du et al (2016)).3 Similarly, Shin (2016) tives such as FX swaps.5
attributes the persistent deviations from the CIP to a sys-
The second source of demand arises from the strategic hedging
temic risk factor linked to the US dollar’s role as the global
decisions of institutional investors, such as insurance companies
funding currency.4
and pension funds. Institutional investors use swaps to strategi-
Drawing on our more technical work (Sushko et al (2016)), the cally hedge foreign currency investments. In recent years, the
framework we propose in this study has two features. First, it term and credit spread compression on the back of unconven-
focuses on one key source of pressure on the basis, namely tional monetary policies in major jurisdictions has boosted these
net foreign currency hedging demand that is largely insensi- cross-currency investment and funding flows.6 These investors’
tive to the size of the basis. Second, similarly to other studies, hedge ratios tend to be quite insensitive to hedging costs and
it also assumes the presence of limits to arbitrage linked to to move slowly over time.7 Thus, anything that induces these
the costs involved in deploying balance sheets, in turn reflect- investors to increase or reduce their foreign currency invest-
ing tighter management of capital and funding risks. This ments tends to put pressure on the basis.
can create a balance sheet constraint on CIP arbitrage that
The third source of demand arises from non-financial firms’
becomes more binding as the size of the aggregate FX hedg-
debt issuance across currencies as they seek to borrow oppor-
ing positions grows.
tunistically in markets where credit spreads are narrower. Under
Our framework gives rise to two hypotheses. First, in the cross normal market conditions and for most currencies, this may
section, the size and sign of the basis across currencies should not be an important factor. But it can become quite relevant
be related to the net hedging position vis-à-vis the US dollar. when credit spreads differ systematically, for example when
Second, over time, the evolution of the basis should depend on they are compressed by central bank large-scale asset pur-
that of net dollar hedging needs. Let us first consider each of chases. Recently, for instance, many US firms needing dollars
the two components of the framework—FX hedging demand have been issuing in euros to take advantage of very attractive
and constraints on arbitrage—in more detail. spreads in that currency and have then swapped the proceeds
into dollars (Box 17.2). This allows them to use the dollars for
their business purposes while avoiding a currency mismatch in
Demand for Currency Hedges: Why euros. Essentially, through the swap market, they borrow dol-
the Basis Opens Up lars and lend euros.
Hedging of open FX positions is the main proximate driver of Other factors could also put pressure on the basis, but we
the demand for FX swaps. We focus on three sources of hedg- exclude them from our analysis because of data limitations.
ing demand that are rather insensitive to the size of the basis, Firms’ hedging of trade receivables or subsidiary cash flows are
and, hence, exert sustained pressure on it even when it is one case in point. Another could be speculative FX positions,
non-zero: demand from banks, institutional investors and which can rely on forwards and swaps (eg yen carry trades). We
non-financial firms. posit, therefore, that the sources of pressure we identify are
A first, structural source of demand for foreign currency hedges
arises from banks’ business models. For a long time, banks have 5
For example, in the second half of 2015, temporary pressure on non-
been the main players running currency mismatches on their bal- US banks’ dollar funding emerged as US money market funds (MMFs)
ance sheets (managed mainly via swaps). Banking systems may divested from their unsecured obligations. This reflected adjustment to
US MMF regulatory reform set to take effect in October 2016. Still, at
be structurally short or long in specific currencies, given their
least in aggregate, non-US banks retained $5.5 trillion in deposits off-
core deposit base. A shortfall in foreign currency funding can shore and at their US branches in the last three quarters of 2015, which
then be managed by cash borrowing in money and bond rose to $5.7 trillion in Q1 2016, according to BIS and Federal Reservee
1
60

flow of funds data.


5
66
98 er
1- nt

6
20

Domanski et al (2015) document increasing investment in lon long-term


ng-te
66 Ce

foreign currency bonds by the German insurance sector or sse


ee
eking to
seeking
65 ks

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

dollar loans when US monetary conditions tighten. 7


58 ak

The FX-hedged investment has a payoff that at res


resembles
semb
emb the return of
11 ah

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

  


BOX 17.2 REVERSE YANKEE ISSUANCE IN THE EURO AND THE EUR/USD BASIS
Corporate credit spreads in the euro bond market have firm would save 50 basis points by issuing in euros and swap-
fallen relative to those in the US dollar bond market, largely ping back to dollars. In fact, the firm would have an incentive
driven by ECB bond purchase programmes (Graph B, left- to do that for all its new debt. One can then see the widen-
hand and centre panels). In response, US firms have found ing of the basis as tending to reconcile the different spreads
it more cost-effective to issue in euros, through so-called in the two markets.
reverse yankee bonds, and then swap the proceeds into US
According to data from Thompson Reuters, the majority of
dollars (right-hand panel). The hedging of currency risk by US
reverse yankee issuance has been long-term, with an aver-
firms issuing in the euro increases demand for cross-currency
age maturity of about 10 years and with 15- and 20-year
swaps. Hence, the widening of corporate asset swap spread
tenors also commonplace. Issuance at shorter maturities is
differentials and the surge in euro issuance since 2014 have
rare, because, from the perspective of the US non-financial
coincided with a marked widening of the currency basis (cen-
issuer, the all-in issuance costs (ie taking the currency swap
tre panel).
into account) of short-term euro-denominated debt are still
For example, consider a BBB-rated US telecoms firm whose greater than issuing short-term US dollar debt, owing to the
bonds yield 100 basis points over the interest rate swap rate wider currency basis relative to the corporate asset swap
in dollars, but only 50 basis points in euros. If CIP held, the spread differential at the short end.

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

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

tightened limits to arbitrage. Balance sheet space is rented,


ente
nte
tedd,, not
ed
65 ks

free.9 Specifically, as a result of tighter management


nt of risks
r
06 oo

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

as speculation may lead to offsetting pressure on the basis. For instance,


41 M

easy monetary policy could boost FX-hedged investments in search of


higher returns, but it could also encourage carry trades. Those carry trades
20

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

  


pricing of FX swaps, introducing a premium (or discount, mind that the sample is necessarily limited, as we have to restrict it
depending on the currency) in response to imbalances in the to freely tradable currencies in jurisdictions with no capital controls,
swap market. One result is that the currency spot-forward rela- with a highly rated sovereign and for which data are available.
tionship goes out of line with CIP (Box 17.1).
Arbitrage can be both costly and risky. Typically, it requires the Quantitative Indicators of Hedging
arbitrageur to enlarge its balance sheet, incur credit risk in both
Demand
borrowing and investing, and possibly face mark-to-market and
liquidity risk (given the need to transfer collateral or take paper Assembling estimates of hedging demand runs into two types
gains or losses) in the valuation of the positions. of limitation.

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

For institutional investors, we rely on central banks for esti-


mates of Australian, euro area and Swedish institutions’ hedged
17.2 THE CURRENCY BASIS foreign assets; and on industry sources for Japanese life insur-
IN THE CROSS SECTION ers’ holdings and hedge ratios.14 We neglect US investors’

Can our framework help explain how the sign and, possibly, the
size of the basis vary across currencies? We test this by juxtaposing
1

quantitative indicators for the various players’ hedging demands


60

12
Except in the case of Sweden, where we also look at the euro
uro (see
see
5

and the basis.11 In evaluating the results, it should be borne in


66
98 er

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

positons in the key currencies we are considering g arre relat


are relatively small
-9 al

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

aggregate, be reflected in a larger basis. 14


This means that, except for the euro area,
a,, we cannot single out US
11
Our findings also hold if price indicators are used; see Sushko et al n upp
dollar holdings, so that our estimate is an upper bound for the institu-
20

(2016). tions covered.


99

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 339

  


BOX 17.3 CIP DEVIATIONS AND MONETARY POLICY ANNOUNCEMENTS
Monetary policy can boost hedging demand through both the short-term announcement effects were even starker for
price and quantity effects. By lowering the yield curve and, the BoJ (Graph C, right-hand panel).
in particular, by compressing the term premium and credit
One possible explanation for the responsiveness of the
spreads, easing encourages investors to seek return and
basis to monetary policy announcements is that the swap
duration in foreign currency bonds and foreign issuers to
dealers that provide currency hedges expect the outflows
sell bonds in the corresponding currency to obtain cheaper
from the euro or the yen to increase when the ECB or the
funding. Large-scale asset purchases strengthen these effects
BoJ eases policy. This includes the flows hedged for cur-
by withdrawing securities from the market. And so does the
rency risk, which push up the demand for FX swaps or
adoption of negative interest rates, which can result in nega-
cross-currency swaps. Hence, the swap dealers set higher
tive yields stretching out to long maturities.➀
prices for currency hedges, which results in wider CIP devia-
Much of the widening of the USD basis since 2014 has tions. Conversely, when the ECB or the BoJ surprises with
coincided with monetary policy easing announcements by less easing than anticipated, dealers revise downwards the
the Bank of Japan (BoJ) and the ECB. Indeed, the widen- expected hedging demand coming their way, lower their
ing began in earnest with the ECB’s ramping-up of easing prices and, hence, help narrow the basis. This happened
measures, including the 5 June 2014 announcement of nega- on 3 December 2015 (green vertical line, left-hand panel):
tive rates (Graph C, left-hand panel). The announcement of the announced ECB stimulus was lower than what market
ECB government bond buying (quantitative easing, QE) on participants had expected in the run-up to the Federal
22 January 2015 also had a significant impact on the USD/ Reserve’s first rate hike. Such expectations had been firm-
JPY basis, owing perhaps to expected policy contagion or ing during the previous month following the upbeat US
more technical factors (eg French banks’ role as JPY/USD jobs data release in November (orange vertical line). After
arbitrageurs). Similarly, the BoJ’s Quantitative and Qualitative the ECB announcement, market participants revised down
Monetary Easing (QQE) announcements as well as its move their expected volumes of cross-currency flows out of the
to negative policy rates saw the USD/JPY basis widen. In fact, euro area.

Monetary policy announcements and one-year currency basis


In basis points Graph C

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

0 –12 –36

–20 –14 –38

–40 –16 –40

–60 –18 –42

–80 –20 –44


2013 2014 2015 2016 –15 –10 –5 0 5 10 15
USD/EUR basis USD/JPY basis days
Average USD/EUR basis (lhs)
Average USD/JPY basis (rhs)
1

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

Sources: Bloomberg; BIS calculations.


-9 ali
58 ak

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

  


Currency hedging by banks, institutional investors and non-financial corporates
As a percentage of 2015 GDP Graph 2

Australia Japan Sweden Euro area4


20 20 20 5.0

10 10 10 2.5

0 0 0 0.0

–10 –10 –10 –2.5

–20 –20 –20 –5.0


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

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

ratio on foreign shares in Sweden. 17


66 Ce

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

  


Currency hedging demand and three-year basis
Banks’ consolidated net USD liabilities (plus EUR reverse yankee liabilities) Graph 3

Currency basis (2015 average, bp)


AU 20
SE
0
CA
GB
NO –20

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

the fit improves significantly when we add eurodenominated


60

Where banks compete with institutional investors to borrow dol-


5
66

bonds issued by US non-financial firms (reverse yankees). This his


98 er

lars through the swap market, as in Japan, the currency basis is


1- nt
20
66 Ce

addition raises our measure of currency hedging demand ndd in


n the
negative, ie dollar borrowing via the FX swap market is in higher
65 ks

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

lion (the EA dot moves to the left in Graph 3).


same is true in the euro area, where non-financial firms’ demand
-9 ali
58 ak

for dollar borrowing via FX swaps looms large. By contrast, in


11 ah

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

  


Sources of currency hedging demand and the JPY/USD basis Graph 4

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

0.6 0.90 –50 –50

0.3 0.75 –75 –75

0.0 0.60 –100 –100


05 07 09 11 13 15 06 08 10 12 14 16 1.0 1.1 1.2 1.3
USD cross-currency funding: Total net USD positioning (lhs) Total net USD positioning, USD trn
1
JP banks’ net USD claims Three-year basis (rhs)
2
JP life ins cos’ FX hedged bonds
US corporates’ JPY bonds
Total net USD positioning

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

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

17.3 THE CURRENCY BASIS IN THE $0.9 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.

Demand for Currency Hedges


and the Basis
1
60

19
The figures for Japanese banks’ net US dollar positions, which hich
ich are
5
66

Our measure of the aggregate US dollar hedging needs of


98 er

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

firms (samurai bond issuers) has increased considerably since tate


ents (in trust accounts). As a result, the figures overstateate the
t fo former. It
06 oo

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

(Graph 4, left-hand panel).


58 ak

the absolute amount that is important. As long ong


ng ass the share of the dol-
11 ah

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

  


JPY/USD basis and US–Japan repo spreads Graph 5

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

–70 –35 –20 –200

–140 –70 –40 –400


09 10 11 12 13 14 15 16 2014 2015 2016
Lhs: Rhs: 1-week repo spread differential, US minus JP (lhs)
1-month basis 1-month repo spread differential, 1-week basis (rhs)
US minus JP (basis points)1
2
VIX (percentage points)

1 For the United States, repo rate minus federal funds rate; for Japan, repo rate minus call rate. 2 Chicago Board Options Exchange S&P 500

implied volatility index; standard deviation, in percentage points per annum. 3 Repo spreads and currency basis calculated using the
respective OIS rates.

Sources: Bloomberg; authors’ calculations.

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

government bond purchases (making them more scarce as col- col


ol-
1- nt
20

billion in assets, according to Fitch. Non-US banks, in particular, had


66 Ce

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

sources of US dollars, including through FX swaps.


06 oo

has made dollar repo funding more expensive relative tive to


t yen
ye
82 B

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

(2015). In contrast to those of life insurance companies, the hedge ratios


41 M

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

  


CIP arbitrage by banks in USD/JPY and by supranational bond issuers in USD/EUR Graph 6

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

0 400 –10 300

–20 350 –20 225

–40 300 –30 150

–60 250 –40 75

–80 200 –50 0


05 06 07 08 09 10 11 12 13 14 15 16 2014 2015 2016
3-month USD/JPY basis (lhs) Lhs: Bond issuance denominated in (rhs):
Foreign bank claims on Japanese official sector (rhs) 3-year USD/EUR basis Euros US dollars

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

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

Second, since 2014 the basis has started to exhibit quarter- (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

role of internal limits on these exposures as a factor constraining


5 60
66

arbitrage (see also Box 17.3).


98 er
1- nt
20
66 Ce

Finally, in less direct ways, developments in related markets can


65 ks

22
At the end of 2013, major euro area supranationals als ha
had
ad $6
$660 billion
06 oo

impede arbitrage activities. Markets for interest rate swaps are


82 B

equivalent in euro bonds outstanding, but only $355355


55 billion
billio
b in dollar
one such example. Top-rated European supranationals and
-9 al

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).
20
99

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 345

  


Table 17.1 Regression Analysis of the JPY/USD Basis, December 2007–December 2015

Dependent Interaction Repo Spread


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

Three- - 113.62*** - 29.30* 2.16*** -19.42*** 72 0.679


month (27.00) (17.10) (0.74) (2.54)
Three- 0.06 -1.53 −44.48*** -44.70*** 2.07*** -15.49*** 67 0.794
month (33.90) (1.16) (13.3) (13.60) (0.52) (2.3)
Two-year -16.23*** −0.91** - 26.11*** - 0.17 - 0.25 67 0.506
(4.30) (0.39) (6.00) (0.23) (0.76)
Two-year -10.02 −0.88** - 2.42 - 26.67*** - 0.14 - 0.14 67 0.509
(13.10) (0.38) (4.80) (5.98) (0.23) (0.81)
Robust standard errors in parentheses; ***/**/* denotes significance at the 1/5/10% level. Unit root test (ADF) rejects the null in levels for three-month,
which is regressed in levels; unit root test fails to reject null in levels for two-year, which is regressed in first differences. AR(1) not significant.
Source: Sushko et al (2016).

The standard specification 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

with national data to construct estimates of currency hedging


ging
ing
1- nt
20

Furthermore, for the two-year basis swap, the pressure of hedg-


66 Ce

demand for select major currencies against the US dollar.r We


lar. W
ing demand has a direct (linear) effect on the basis (Table 17.1,
65 ks

find that quantity-based indicators of hedging demandand track


trac
t the
06 oo

third row, in bold), while the interaction term is no longer sig-


82 B
-9 ali

nificant (fourth row). In particular, the estimated coefficient of


58 ak
11 ah

—0.913 indicates that 1% higher demand for currency hedges 24


41 M

See Sushko et al (2016) for broader results, including


lud
ding p
panel evidence
translates into roughly a 1 basis point wider basis. This points to that extends the key results beyond the yen/dollar ar ba
bas
basis using exclu-
the cost of long-term cross-currency swaps being a more direct sively the banks’ position, for which consistentt data are available.
20
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346 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


variation in the basis both across currencies at a given point in Fender, I and P McGuire (2010): “Bank structure, funding risk
time and, in the case of the dollar/yen basis, over time. and the transmission of shocks across countries: concepts and
measurement”, BIS Quarterly Review, September, pp 63–79.
Importantly, our analysis has been largely confined to the proxi-
mate determinants of the basis, as we have not looked much Hanajiri, T (1999): “Three Japan premiums in autumn 1997 and
into the factors driving currency hedging demand in the first autumn 1998—why did premiums differ between markets?”,
place. We have mainly limited ourselves to documenting the Bank of Japan Financial Markets Department Working Paper
possible importance of extraordinary monetary accommodation Series, no 99-E-1.
by the Bank of Japan and the ECB in widening the basis around
He, D, E Wong, A Tsang and K Ho (2015): “Asynchronous
policy announcements.
monetary policies and international dollar credit”, Hong Kong
Institute for Monetary Research, Working Papers, no 19-2015,
September.
References
Hilander, E (2014): “Short-term funding in foreign currency by
Baba, N and F Packer (2009): “From turmoil to crisis: disloca- major Swedish banks and their use of the short-term currency
tions in the FX swap market before and after the failure of swap market”, Sveriges Riksbank Economic Review, no 1, pp 1–23.
Lehman Brothers”, Journal of International Money and Finance,
Iida, T, T Kimura and N Sudo (2016): “An upsurge in a CIP devia-
vol 28, no 8, pp 1350–74.
tion during the noncrisis period and the role of divergence in
Baba, N, F Packer and T Nagano (2008): “The spillover of money monetary policy”, Bank of Japan Working Paper Series, no
market turbulence to FX swap and cross-currency swap mar- 16-E-14, August.
kets”, BIS Quarterly Review, March, pp 73–86.
Ivashina, V, D Scharfstein and J Stein (2015): “Dollar funding and
Barclays (2015): “Asia-Pacific cross-currency basis: widening the lending behavior of global banks”, Quarterly Journal of Eco-
pressure, from Japan to Asia”, 1 December. nomics, vol 130, no 3, pp 1241–81.

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,
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tion: not waving but drowning?”, BIS Working Papers, no 519, Staff Discussion Papers, 16-4.
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October.
Pozsar, Z and S Smith (2016): “Japanese banks, LIBOR
O and
LIBOR
LIBO an the
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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.
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SSRN 2768207 2768207, SSRN.


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Rush, A, D Sadeghian and M Wright (2013):


20133): “Foreign
“F currency
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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.
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Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 347

  


Shin, H S (2010): Risk and liquidity, Oxford University Press. Sushko, V, C Borio, R McCauley and P McGuire (2016): “Failure
of covered interest parity: FX hedging demand and costly bal-
(2016): “Global liquidity and procyclicality”, speech at the
ance sheets”, BIS Working Papers, forthcoming.
World Bank conference on The state of economics, the state of
the world, Washington DC, 8 June. US Treasury, Federal Reserve Bank of New York and Board of
Governors of the Federal Reserve System (2016): US portfolio
Shleifer, A and R Vishny (1997): “The limits of arbitrage”, Journal
holdings of foreign securities as of December 31, 2014, January.
of Finance, vol 52, no 1, pp 35–55.

1
60
5
66
98 er
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

  


Risk Management
for Changing Interest
18
Rates: Asset-Liability
Management
and Duration
Techniques
■ Learning Objectives
After completing this reading you should be able to:

● 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
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349

  


KEY TOPICS IN THIS CHAPTER pressures and with offensive weapons to shape portfolios of
assets and liabilities in ways that promote each institution’s
• Asset, Liability, and Funds Management goals. The key purpose of this chapter is to give the reader a
picture of how this integrated approach to managing assets,
• Market Rates and Interest Rate Risk
liabilities, and equity really works.
• The Goals of Interest Rate Hedging
• Interest-Sensitive Gap Management
• Duration Gap Management 18.2 ASSET-LIABILITY MANAGEMENT
• Limitations of Interest Rate Risk Management Techniques STRATEGIES
Asset Management Strategy
18.1 INTRODUCTION
Financial institutions have not always possessed a completely
Financial institutions today are often highly complex organiza- integrated view of their assets and liabilities. For example,
tions, offering multiple financial services through multiple through most of the history of banking, bankers tended to
departments, each staffed by specialists in making different take their sources of funds—liabilities and equity—largely for
kinds of decisions.1 Thus, different groups of individuals inside granted. This asset management view held that the amount
each modern financial firm usually make the decisions about and kinds of deposits a depository institution held and the vol-
which customers are to receive credit, which securities should be ume of other borrowed funds it was able to attract were largely
added to or subtracted from the institution’s portfolio, which determined by its customers. Under this view, the public deter-
terms should be offered to the public for loans, investment mined the relative amounts of deposits and other sources of
advice, and other services, and which sources of funding the funds available to depository institutions. The key decision area
institution should draw upon. for management was not deposits and other borrowings but
assets. The financial manager could exercise control only over
Yet, all of the foregoing management decisions are intimately the allocation of incoming funds by deciding who was to receive
linked to each other. For example, decisions on which customer the scarce quantity of loans available and what the terms on
credit requests should be fulfilled are closely related to the those loans would be. Indeed, there was some logic behind this
ability of the financial firm to raise funds in order to support asset management approach because, prior to recent deregula-
the requested new loans. Similarly, the amount of risk that a tion of the industry, the types of deposits, the rates offered, and
financial firm accepts in its portfolio is closely related to the ade- the nondeposit sources of funds depository institutions could
quacy and composition of its capital (net worth), which protects draw upon were closely regulated. Managers had only limited
its stockholders and creditors against loss. Even as a financial discretion in shaping their sources of funds.
institution takes on more risk it must protect the value of its net
worth from erosion, which could result in ultimate failure.
In a well-managed financial institution all of these diverse
Liability Management Strategy
management decisions must be coordinated across the whole Recent decades have ushered in dramatic changes in asset-
institution in order to ensure they do not clash with each other, liability management strategies. Confronted with fluctuating
leading to inconsistent actions that damage earnings and net interest rates and intense competition for funds, financial firms
worth. Today financial-service managers have learned to look at began to devote greater attention to opening up new sources
their asset and liability portfolios as an integrated whole, con- of funding and monitoring the mix and cost of their deposit
sidering how their institution’s whole portfolio contributes to and nondeposit liabilities. The new strategy was called liability
the firm’s broad goals of adequate profitability and acceptable management. Its goal was simply to gain control over funds
1
60

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

ment provides financial institutions with defensive weapons to


06 oo

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

its available funds could simply raise the offer


er rate
te on its borrow-
11 ah
41 M

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

   


profitable outlets for those funds could
leave its offer rate unchanged or even
lower that price, letting competitors out-
bid it for whatever funds were available in
the marketplace. Exhibit 18.1 charts the
goals of asset-liability 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

of credit) tends to settle at the point where the quantities of


560
66

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

18.1. What do the following terms mean: asset manage-


06 oo

In granting loans, financial institutions are onn thee supply


sup side
B

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

Similarly, financial institutions also come into the financial


41
20
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 351

   


Exhibit 18.2 Determination of the rate of interest in the financial
marketplace where the demand and supply of loanable funds (credit)
interact to set the price of credit.

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

cial instruments in a rising rate period, it must be prepared to


60

Sale or redemption
5

accept capital losses. Reinvestment risk rears its head when


66
98 er

Expected cash flow price of security


1- nt
20

market interest rates fall, forcing a financial firm to invest


66 Ce

in Period n or loan in Period n


+ g + +
65 ks

incoming funds in lower-yielding earning assets, lowering its (18.1)


(18
1
(1 + YTM)n (1 + YTM)n
06 oo

expected future income. A big part of managing assets and


82 B
-9 ali

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

two forms of risk. ple, a bond purchased today at a price of $950


0 and promising
950
41 M
20
99

352 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


an interest payment of $100 each year over the next three years, makes calculations easier but is theoretically incorrect. The pur-
when it will be redeemed by the bond’s issuer for $1,000, will chase price of a financial instrument, rather than its face amount,
have a promised interest rate, measured by the yield to matu- is a much better base to use in calculating the instrument’s true
rity, determined by: rate of return.

$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

This bond’s YTM is determined to be 12.10 percent.2 YTM


(100 - Purchase price) 365
equivalent = * (18.3)
Another popular interest rate measure is the bank discount Purchase price Days to maturity
yield
rate, which is often quoted on short-term loans and money
market securities (such as Treasury bills). The formula for For the money market security discussed previously, its
calculating the discount rate (DR) is as follows: equivalent yield to maturity would be
100 - Purchase price on loan or security
DR = ¢ ≤ (100 - 96) 365
100 YTM equivalent = * = 0.1690, or 16.90 percent
96 90
360
* (18.2) or 16 percent + 90 basis points
Number of days
to maturity While the two interest rate measures listed above are popular,
For example, suppose a money market security can be pur- we should keep in mind that there are literally dozens of other
chased for a price of $96 and has a face value of $100 to be measures of “the interest rate,” many of which we will encoun-
paid at maturity. If the security matures in 90 days, its interest ter in later chapters of this book.
rate measured by the DR must be
(100 - 96) 360 The Components of Interest Rates
DR = * = 0.16, or 16 percent
100 90
Over the years many financial managers have tried to forecast
We note that this interest rate measure ignores the effect of
future movements in market interest rates as an aid to combat-
compounding of interest and is based on a 360-day year, unlike
ing interest rate risk. However, the fact that interest rates are
the yield to maturity measure, which assumes a 365-day year
determined by the interactions of thousands of credit suppliers
and assumes that interest income is compounded at the calcu-
and demanders makes consistently accurate rate forecasting vir-
lated YTM.
tually impossible. Adding to the forecasting problem is the fact
In addition, the DR uses the face value of a financial instrument that any particular interest rate attached to a loan or security is
to calculate its yield or rate of return, a simple approach that composed of multiple elements or building blocks, including

2 Risk-free real Risk premiums to


Financial calculators and spreadsheets such as Excel will give this yield
to maturity figure directly after entering the bond’s purchase price, Nominal interest rate compensate lenders
promised interest payments, sales or redemption price, and number of (published) (such as the who accept risky IOUs
time periods covered. (Note: the YTM for bonds is parallel to the APR market inflation- to cover their default
for loans.) = + (18.4)
interest rate adjusted (credit) risk, inflation
We should also note that in the real world many bonds (including those
on a risky return on risk, term or maturity
issued by the U.S. Treasury) pay interest twice a year. This feature
changes the timing of various cash flows off each bond and affects the loan or government risk, liquidity risk, call
YTM, The YTM formula becomes security bonds) risk, and so on
Expected cash flow Expected cash flow
01

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

in Period n * k enthralled with a computer program that forecasts


recast
ecaststs interest
int
in
06 oo

+ g+
(1 + YTM/k)n * k
82 B

rate movements in the world’s money markets?


arke
rke
etss?
-9 al
58 ak

where k is the number of times interest is paid each year. Thus, the total Answer: The Bank.
11 ah

number of payment periods is n * k.


41 M
20
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 353

   


Not only does the risk-free real interest rate change over time Yield Curves
with shifts in the demand and supply for loanable funds, but the
Another key component of each interest rate is the maturity,
perceptions of lenders and borrowers in the financial market-
or term, premium. Longer-term loans and securities often carry
place concerning each of the risk premiums that make up any
higher market interest rates than shorter-term loans and securi-
particular market interest rate on a risky loan or security also
ties due to maturity risk because of greater opportunities for
change over time, causing market interest rates to move up or
loss over the life of a longer-term loan. The graphic picture of
down, often erratically.
how interest rates vary with different maturities of loans viewed
at a single point in time (and assuming that all other factors,
Factoid such as credit risk, are held constant) is called a yield curve.
True or false—interest rates cannot be negative? Exhibit 18.3 charts different U.S. Treasury yield curves plotted
Answer: Contrary to popular belief they can go negative. in October 2009 and October 2010. The maturities of Treasury
Some of the most famous examples include (1) during the securities (in months and years) are plotted along the horizon-
Great Depression of the 1930s when government securities tal axis of the chart and their yields to maturity (YTMs) appear
sometimes sold above par as frightened depositors fled from along the vertical axis.
banks; (2) briefly in the fall of 2003 in the market for repur- Yield curves constantly change their shape because the yields of
chase agreements; and (3) briefly in the Treasury bill market the financial instruments included in each curve change all the
in 2008. (See www.newyorkfed.org/research.) time. For example, we notice in Exhibit 18.3 that the relatively
steep yield curve prevailing in October 2009 had become a
Risk Premiums somewhat flatter, more shallow yield curve about one year later.
Moreover, different yields tend to change at different speeds
To cite some examples, when the economy goes into a reces-
with short-term interest rates tending to rise or fall faster than
sion with declining business sales and rising unemployment,
long-term interest rates. As illustrated in Exhibit 18.3 long-term
many lenders will conclude that some businesses will fail and
interest rates (principally distributed along the right-hand por-
some individuals will lose their jobs, increasing the risk of bor-
tion of the yield curve) had moved slightly downward during the
rower default. The default-risk premium component of the
October 2009 to October 2010 period, while short-term interest
interest rate charged a risky borrower will increase, raising the
rates (predominantly arrayed along the left-hand portion of the
borrower’s loan rate (all other factors held constant). Similarly,
yield curve) had moved over a somewhat wider range during the
an announcement of rising prices on goods and services may
same time period. Thus, relative changes in short-term interest
trigger lenders to expect a trend toward higher inflation, reduc-
rates versus long-term interest rates clearly vary over time.
ing the purchasing power of their loan income unless they
demand from borrowers a higher inflation-risk premium to com- This rate variation or changing yield “spread” based on maturity
pensate for their projected loss in purchasing power. According is very evident in the picture presented to us in Exhibit 18.4. In
to the so-called Fisher effect nominal (published) interest rates this exhibit, which plots the 3-month U.S. Treasury bill rate com-
are equal to the sum of the real interest rate (or purchasing pared to 10-year Treasury bond rates, we detect a significant
power return) on a loan plus the expected sensitivity of short-versus long-term yield spreads to changes in
rate of inflation over the life of a loan.
Many loan and security interest rates
also contain a premium for liquidity risk,
because some financial instruments are
more difficult to sell quickly at a favor-
able price to another lender. Another
1
60

rate-determining factor is call risk, which


5
66
98 er

arises when a borrower has the right to


1- nt
20
66 Ce

pay off a loan early, possibly reducing


65 ks
06 oo

the lender’s expected rate of return if


82 B

market interest rates have fallen. Finan-


-9 ali
58 ak

cial instruments with a greater call risk


11 ah

Exhibit 18.3 Yield curves for U.S. treasury securities in 2009


200
09 and
a 2010.
41 M

tend to carry higher interest rates, other


factors held equal. Source: Federal Reserve Bank of St. Louis, Monetary Trends, October 19, 2010.
2010
20
99

354 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


security holdings on the asset side of
their balance sheet tend to have longer
maturities than their sources of funds
(liabilities).
Thus, most lending institutions experience
a positive maturity gap between the
average maturity of their assets and the
average maturity of their liabilities. If the
yield curve is upward sloping, then reve-
nues from longer-term assets will outstrip
expenses from shorter-term liabilities.
Exhibit 18.4 The spread between short-term and long-term interest rates The result will normally be a positive net
on treasury securities (October 2010). interest margin (interest revenues greater
Source: Federal Reserve Bank of St. Louis, Monetary Trends, November 2010. than interest expenses), which tends to
generate higher earnings. In contrast, a
the economy. For example, in periods of recession (such as hap- relatively flat (horizontal) or negatively sloped yield curve often
pened in 1991, 2001, and 2007–2009 with the economy facing generates a small or even negative net interest margin, putting
substantial decline), short-term interest rates tended to fall rela- downward pressure on the earnings of financial firms that bor-
tive to long-term interest rates and the yield “spread” or “gap” row short and lend long.
between short and long maturities often tended to widen. In
contrast, a period of economic prosperity usually begins with a
fairly wide gap between long- and short-term interest rates, but
Responses to Interest Rate Risk
that interest-rate gap tends to narrow and sometimes becomes As noted at the outset, changes in market interest rates can
negative. damage a financial firm’s profitability by increasing its cost
In summary, yield curves will display an upward slope (i.e., a of funds, by lowering its returns from earning assets, and by
rising yield curve) when long-term interest rates exceed short- reducing the value of the owners’ investment (net worth or
term interest rates. This often happens when all interest rates equity capital). Moreover, recent decades have ushered in a
are rising but short-term rates have started from a lower level period of volatile interest rates, confronting financial managers
than long-term rates. Modern financial theory tends to associate with a more unpredictable environment to work in. A dramatic
upward-sloping yield curves with rising interest rates and with example of the huge losses associated with interest-rate risk
expansion in the economy. exposure occurred some years ago in Minnesota when First
Bank System, Inc., of Minneapolis bought unusually large quanti-
Yield curves can also slope downward (i.e., a falling yield curve)
ties of government bonds. First Bank’s management had fore-
with short-term interest rates higher than long-term rates. Such
cast a decline in interest rates. Unfortunately, bond prices fell
a negatively sloped yield curve suggests that interest rates will
as interest rates rose, and First Bank reported a loss of about
begin falling and the economy may soon head into a recession.
$500 million, resulting in the sale of its headquarters building
Finally, horizontal yield curves prevail when long-term interest (see Bailey [2]).
rates and short-term rates are approximately at the same level
so that investors receive the same yield to maturity no matter
what maturity of investment security they purchase. A horizontal Factoid
yield curve suggests that interest rates may be stable for a time
As the 21st century opened and market interest rates fell to
01

with little change occurring in the slope of the curve.


56

record lows, interest rate risk threatened to severely impact


im act
imp
66
98 er

the net asset values of what major competitor of banks?


bankks?
1- nt
20

The Maturity Gap and the Yield Curve


66 Ce
65 ks

Answer: Money market funds, which were often ten forced


ften forc to
fforce
06 oo

Typically managers of financial institutions that focus on lending


lower their fees in order to avoid reducingg the
the net value of
82 B

fare somewhat better with an upward-sloping yield curve than


-9 ali

their assets below the accepted market et standard


staandar of $1.00
58 ak

they do under a horizontal or downward-sloping yield curve.


11 ah

per share; a few money market fundss were


we forced
f to actually
41 M

The upward-sloping yield curve is usually more favorable for


“break the buck” during the 2007–2009 009 credit
2009 c crisis.
the profitability of lending institutions because their loans and
20
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 355

  


Asset-Liability Committee (ALCO) For example, suppose a large international bank records
$4 billion in interest revenues from its loans and security invest-
In recent decades managers of financial institutions have aggres-
ments and $2.6 billion in interest expenses paid out to attract
sively sought ways to insulate their asset and liability portfolios
borrowed funds. If this bank holds $40 billion in earning assets,
and their profits from the ravages of changing interest rates. For
its net interest margin is
example, many banks now conduct their asset-liability manage-
ment strategies under the guidance of an asset-liability commit- ($4 billion - $2.6 billion)
NIM = * 100 = 3.50 percent
tee, or ALCO. $40 billion

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.

In dealing with interest rate risk, one important goal is to


insulate profits—net income—from the damaging effects of Interest-Sensitive Gap Management
fluctuating interest rates. No matter which way interest rates go, as a Risk-Management Tool
managers of financial institutions want stable profits that achieve
Among the most popular interest rate hedging strategies in use
the level of profitability desired.
today is interest-sensitive gap management. Gap manage-
To accomplish this goal, management must concentrate on ment techniques require management to perform an analysis
those elements of the institution’s portfolio of assets and liabili- of the maturities and repricing opportunities associated with
ties that are most sensitive to interest rate movements. Normally interest-bearing assets and with interest-bearing liabilities.
this includes loans and investments on the asset side of the If management feels its institution is excessively exposed to
balance sheet—earning assets—and borrowings on the liability interest rate risk, it will try to match as closely as possible the
side. In order to protect profits against adverse interest rate
1
60

changes, then, management seeks to hold fixed the financial


5
66
98 er
1- nt

firm’s net interest margin (NIM), expressed as follows:


20

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

of net interest income over time, encouraging managers rss of


o finan
ffinancial
-9 al

and investments borrowed funds erest--rate


rate risk. One
institutions to find better methods for managing interest-rate
58 ak

NIM = romin
interesting management strategy that became prominent nent n near the close
11 ah

Total earning assets


41 M

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

   


In this case, the revenue from earning assets will change in the
CONCEPT CHECK same direction and by approximately the same proportion as
the interest cost of liabilities.
18.3. What forces cause interest rates to change? What
kinds of risk do financial firms face when interest What is a repriceable asset? A repriceable liability? The most
rates changes? familiar examples of repriceable assets include loans that are
about to mature or will soon to come up for renewal or repric-
18.4. What makes it so difficult to correctly forecast inter-
ing, such as variable-rate business and household loans (includ-
est rate changes?
ing credit card accounts and adjustable-rate home mortgages
18.5. What is the yield curve, and why is it important to (ARMs)). If interest rates have risen since these loans were first
know about its shape or slope? made, the lender is likely to renew them only if it can get a rate
18.6. What is it that a lending institution wishes to protect of return that approximates the higher yields currently expected
from adverse movements in interest rates? on other financial instruments of comparable quality. Similarly,
18.7. What is the goal of hedging? loans that are maturing will provide the lender with newly
released funds available to reinvest in new loans at today’s inter-
18.8. First National Bank Bannerville has posted interest
est rates.
revenues of $63 million and interest coasts from all
of its borrowings of $42 million. If this bank pos- In contrast, repriceable liabilities include a depository institu-
sesses $700 million in total earning assets, what is tion’s certificates of deposit (CDs) about to mature or eligible
First National’s net interest margin? Suppose the to be renewed, where the financial firm and its customer must
bank’s interest revenues and interest costs double, negotiate new deposit interest rates that capture current market
while its earning assets increase by 50 percent. conditions. Other examples include floating-rate deposits whose
What will happen to its net interest margin? yields move up or down automatically with market interest rates;
savings accounts that may be likely to be withdrawn at any time
to seek out more favorable returns; interest-bearing checkable
volume of assets that can be repriced as interest rates change deposits (such as NOW accounts); and nondeposit money mar-
with the volume of liabilities whose rates can also be adjusted ket borrowings whose interest rates are often adjusted several
with market conditions during the same time period. times daily to reflect the latest market developments.

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
98 er
1- nt

borrowers (about to mature) or RP borrowings) reserves) interest rate)


20
66 Ce
65 ks

Short-term loans made to Short-term savings accounts Long-term loans made at a Long-term savings
vingss and
06 oo

borrowing customers (about fixed interest rate retirement accounts


accounts
82 B
-9 ali

to mature)
58 ak
11 ah

Variable-rate loans and Money-market deposits Long-term securities carry- Equity


ty capital
caapita provided by the
41 M

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

   


If interest-sensitive assets in each planning period (day, week, We can also form the Relative IS GAP ratio:
month, etc.) exceed the volume of interest-sensitive liabilities
Relative IS GAP - $50million
subject to repricing, the financial firm is said to have a positive = = = - 0.33
IS GAP Size of financial institution $150million
gap and to be asset sensitive. Thus: (measured, for example,
Asset@sensitive Interest@sensitive assets by total assets)
= (18.8)
(positive) gap - Interest@sensitive liabilities 7 0 (18.10)

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
98 er

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

where it is or perhaps increase the NIM.


06 oo

Positive Dollar IS GAP Negative Dollar IS GAP


82 B

3. If management wishes to increase the NIM,, it must m either


e
-9 ali

Positive Relative IS GAP Negative Relative IS GAP


58 ak

develop a correct interest rate forecast or find nd ways


fin wa to real-
11 ah

Interest Sensitivity Ratio Interest Sensitivity Ratio less


41 M

locate earning assets and liabilities to increase


nccrease
ncrrease the spread
greater than one than one
between interest revenues and interest st expenses.
ex
20
99

358 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

   


4. Management must determine the volume of interest- The foregoing example reminds us that the net interest margin
sensitive assets and interest-sensitive liabilities it wants the of a financial-service provider is influenced by multiple factors:
financial firm to hold.
1. Changes in the level of interest rates, up or down.
2. Changes in the spread between asset yields and liability
Computer-Based Techniques
costs (often reflected in the changing shape of the yield,
Many institutions use computer-based techniques in which their curve between long-term rates and short-term rates).
assets and liabilities are classified as due or repriceable today,
3. Changes in the volume of interest-bearing (earning) assets a
during the coming week, in the next 30 days, and so on. Man-
financial institution holds as it expands or shrinks the overall
agement tries to match interest-sensitive assets with interest-
scale of its activities.
sensitive liabilities in each of these maturity buckets in order to
improve the chances of achieving the financial firm’s earnings 4. Changes in the volume of interest-bearing liabilities that are
goals. For example, a financial firm’s latest computer run might used to fund earning assets as a financial institution grows
reveal the following: or shrinks in size.
5. Changes in the mix of assets and liabilities that manage-
(dollars in millions) ment draws upon as it shifts between floating and fixed-rate
assets and liabilities, between shorter and longer maturity
Interest- Interest-
assets and liabilities, and between assets bearing higher
Maturity Sensitive Sensitive Size of Cumulative
Buckets Assets Liabilities Gap Gap versus lower expected yields (e.g., a shift from less cash
to more loans or from higher-yielding consumer and real
1 day $40 $30 +10 +10 estate loans to lower-yielding commercial loans).
(next 24 hours)
Table 18.1 provides a more detailed example of interest-sensitive
Day 2–day 7 120 160 -40 - 30
gap management techniques as they are applied to asset and
Day 8–day 30 85 65 + 20 -10 liability data for an individual bank. In it, management has arrayed
Day 31–day 90 280 250 + 30 + 20 (with the help of a computer) the amount of all the bank’s assets
Day 91–day 120 455 395 +60 + 80 and liabilities, grouped by the future time period when those
assets and liabilities will reach maturity or their interest rates will
• • • • •
be subject to repricing. Note that this bank is liability sensitive
• • • • • during the coming week and over the next 90 days and then
• • • • • becomes asset sensitive in later periods. Consciously or uncon-
sciously, management has positioned this institution for falling
It is obvious from the table above that the time period over interest rates over the next three months and for rising interest
which the gap is measured is crucial to understanding this finan- rates over the longer horizon.
cial institution’s true interest-sensitive position. For example, At the bottom of Table 18.1, we calculate this financial firm’s
within the next 24 hours, the institution in this example has net interest income to see how it will change if interest rates
a positive gap; its earnings will benefit if interest rates rise rise. Net interest income can be derived from the following
between today and tomorrow. However, a forecast of rising formula:
money market interest rates over the next week would be bad
Net interest income = Total interest income
news because the cumulative gap for the next seven days is
– Total interest cost = [Average interest yield on
negative, which will result in interest expenses rising by more
rate-sensitive assets * Volume of rate-sensitive assets
than interest revenues. If the interest rate increase is expected
to be substantial, management should consider taking coun- + Average interest yield on fixed (non-rate-sensitive)
1

assets * Volume of fixed assets] – [Average interest (18.12) 8.12


8.12)
60

termeasures to protect earnings. These might include selling


5

cost on rate-sensitive liabilities * Volume of interest- est-


66
98 er

longer-term CDs right away or using futures contracts to earn


1- nt
20

sensitive liabilities + Average interest cost on


66 Ce

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

   


Table 18.1 Sample Interest-Sensitivity Analysis (GAP Management) for a Bank

Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Total for
All Assets,
Liabilities, and
Next Net Worth
Next 31–90 Next More than on the Bank’s
Asset and Liability Items One Week 8–30 Days Days 91–360 Days One Year Balance Sheet

Assets
Cash and deposits owned $100 — — — — $100
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

Ratio of interest-sensitive 94.4% 51.7% 97.8% 320% 106.4%


assets to interest-sensitive
liabilities
This bank is Liability Liability Liability Asset Asset
sensitive sensitive sensitive sensitive sensitive
1
60

The bank’s net interest Interest Interest Interest Interest Interest


5
66
98 er

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

  


Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Total for
All Assets,
Liabilities, and
Next Net Worth
Next 31–90 Next More than on the Bank’s
Asset and Liability Items One Week 8–30 Days Days 91–360 Days One Year Balance Sheet

Next 31–90 Next 91–360 More than One


One Week Next 8–30 Days Days Days Year
Total interest income on 0.10 * $1,700 0.10 * $310 0.10 * $440 0.10 * $480 0.10 * $1,170
an annualized basis
+0.11 * +0.11 * + 0.11 * + 0.11 * + 0.11 *
[4,100 - 1,700] [4,100 - 310] 4,100 - 440] [4,100 - 480] [4,100 - 1,170]

Total interest costs on an -0.08 * $1,800 -0.08 * -0.08 * - 0,08 * - 0.08 *


annualized basis
-0.09 * $600 - 0.09 * $450 - 0.09 * $150 - 0,09 * $1,100 - 0.09 *
[4,100 - 1,800] [4,100 - 600] [4,100 - 45] [4,100 - 150] [4,100 - 1,100]

Annualized net interest = $83 =$84.9 =$82.10 =$80.20 =$81.30


income
Annualized net interest $83 , 4,100 $84.9 , 4,100 $82.10 , 4,100 $78.7 , 4,100 $81.3 , 4,100
margin
=2.02% =2.07% =2.00% =1,92% =1.98%
Suppose the interest rates attached to rate-sensitive assets and liabilities rise two full percentage points on an annualized basis to
12% and 10%, respectively.
Total interest income on 0.12 * $1,700 0.12 * $310 0.12 * $440 0.12 * $480 0.12 * $1,170
an annualized basis
+0.11 * [4,100- + 0,11 * + 0.11 * + 0.11 * + 0.11 *
Total interest cost on an 1,700] - 0.10 * [4,100 - 310] [4,100 - 440] +[4,100 - 480] [4,100 - 1,170]
annualized basis
$1,800 - 0.09 * - 0.10 * 600 - 0.10 * 450 -0.10 * 150 - 0.10
[4,100 - 1,800] -0.09 * [4,100 - 600] - 0.09 - 0.09 * 1,100 - 0.09
* [4,100 - 450] [4,100 - 150] [4,100 - 1,100
Annualized net interest = $81 =$79.10 =$81.90 =$85.30 =$82.70
income
Annualized net interest $81 , 4,100 $79.1 , 4,100 $81.9 , 4,100 $85.3 , 4,100 $82.7 , 4,100
margin
=1.98% =1.93% =2.00% =2.08% =2.02%
We note by comparing annualized interest income and margins for each time period (maturity bucket) that this bank’s net interest
income and margin will tend to fall if it is liability sensitive when interest rates go up. When the bank is asset sensitive and market
interest rates rise, the net interest income and margin will tend to increase.
1

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

annualized basis will be - 0.09 * [4,100 - 1,800] = $81


58 ak

$8
81 mmillion
11 ah

0.10 * $1,700 + 0.11 * [4,100 - 1,700] - 0.08 * $1,800 - 0.09


41 M

Therefore, this bank will lose $2 million in net


ne interest income
n
* [4,100 - 1,800] = $83 million on an annualized basis if market interest
erest rates rise in the coming
20
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 361

  


week. Management must decide whether to accept that risk or interest rates rise, but lose net interest income if market interest
to counter it with hedging strategies or tools. rates decline.

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:

(+0.01) * (- $600 million) = -$6 million Defensive Interest@Sensitive GAP Management


Set interest@sensitive GAP as close to zero as
Aggressive Interest-Sensitive GAP Management possible to reduce the expected volatility of
net interest income
Expected
Changes in Best Aggressive Problems with Interest-Sensitive GAP
interest Rates Interest-Sensitive Management’s
(Management’s GAP Position to Most Likely Management
Forecast) Be in: Action
While interest-sensitive gap management works beautifully in
Rising market Positive IS GAP Increase interest- theory, practical problems in its implementation always leave
interest rates sensitive assets financial institutions with at least some interest-rate risk expo-
Decrease interest- sure. For example, interest rates paid on liabilities (which often
sensitive liabilities are predominantly short term) tend to move faster than interest
Falling market Negative IS GAP Decrease interest- rates earned on assets (many of which are long term). Then,
interest rates sensitive assets too, changes in interest rates attached to assets and liabilities
do not necessarily move at the same speed as do interest rates
Increase interest-
sensitive liabilities in the open market. In the case of a bank, for example, deposit
interest rates typically lag behind loan interest rates.
1

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
99

362 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


The Weighted Interest-Sensitive Gap: Dealing with Basis Risk
Original Balance Interest-Rate Balance Sheet Refigured to
Sheet Entries Sensitivity Weight Reflect interest Rata Sensitivities

Asset items sensitive to


interest rate movements:
Federal funds loans $50 * 1.0 = $50.00
Government securities and 25 * 1.3 = 32.50
other investments
Loans and leases 125 * 1.5 = 187.50
Total rate-sensitive assets $200 $270.00

Liability items sensitive to


interest rate movements:
Interest-bearing deposits $159 * 0.86 = $137,00
Other borrowings in the money 64 * 0.91 = 58.00
market
Total rate-sensitive liabilities $223 $195.00
The interest-sensitive GAP -$23i +$75
How net interest income would change if the federal funds rate in the money market increases by 2 percentage points:
Original Balance Sheet Refigured Balanced Sheet
Predicted movement in net interest income - $0.46 +$1.50
(= - $23 * 0.02) (= +$75 * 0.02)

Table 18.2 Eliminating an Interest-Sensitive Gap


With Positive Gap The Risk Possible Management Responses

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
98 er
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
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 363

  


Factoid CONCEPT CHECK
Financial institutions that hold large volumes of home mort-
18.9. Can you explain the concept of gap management?
gage loans tend to be especially vulnerable to interest rate
risk due, in part, to the long average maturities of these 18.10. When is a financial firm asset sensitive? Liability
loans. A prominent example is two of the largest home- sensitive?
mortgage finance companies in the world, which were 18.11. Commerce National Bank reports interest-sensitive
created by the U.S. government and then privatized. Who assets of $870 million and interest-sensitive liabili-
are these two giant mortgage banking firms that have run ties of $625 million during the coming month. Is
into serious trouble recently? the bank asset sensitive or liability sensitive? What
Answer: The Federal National Mortgage Association (FNMA, is likely to happen to the bank’s net interest mar-
or Fannie Mae) and the Federal Home Loan Mortgage gin if interest rates rise? If they fall?
Corporation (FHLMC, or Freddie Mac), both of which have 18.12. People’s Savings Bank has a cumulative gap for
recently passed under government control and may eventu- the coming year of +$135 million, and interest
ally be disposed of. rates are expected to fall by two and a half per-
centage points. Can you calculate the expected
change in net interest income that this thrift insti-
federal funds loans; here the interest-rate sensitivity weight tution might experience? What change will occur
is estimated to be 1.3. Loans and leases are the most rate- in net interest income if interest rates rise by one
volatile of all with an interest rate sensitivity weight half again and a quarter percentage points?
as volatile as federal funds rates at an estimated 1.5. On the
18.13. How do you measure the dollar interest-sensitive
liability side, deposit interest rates and some money market
gap? The relative interest-sensitive gap? What is
borrowings (such as borrowing from the central bank) may
the interest sensitivity ratio?
change more slowly than market interest rates. In this example,
we assume deposits have a rate-sensitive weight of 0.86 and 18.14. Suppose Carroll Bank and Trust reports interest-
money market borrowings are slightly more volatile at 0.91, sensitive assets of $570 million and interest-
close to but still less than the volatility of federal funds interest sensitive liabilities of $685 million. What is the
rates. bank’s dollar interest-sensitive gap? Its relative
interest-sensitive gap and interest-sensitivity ratio?
We can simply multiply each of the rate-sensitive balance-sheet
items by its appropriate interest rate sensitivity indicator, which 18.15. Explain the concept of weighted interest-sensitive
acts as a weight. More rate-volatile assets and liabilities will gap. How can this concept aid management in
weigh more heavily in the refigured (weighted) balance sheet measuring a financial institution’s real interest-
we are constructing in the previous table. Notice that after mul- sensitive gap risk exposure?
tiplying by the interest rate weights we have created, the new
weighted balance sheet has rate-sensitive assets of $270 and
rate-sensitive liabilities of $195. Instead of a negative (liability-
sensitive) interest rate gap of -$23, we now have a positive conventionally constructed balance sheet. Indeed, when it
(asset-sensitive) rate gap of +$75. comes to assessing interest rate risk, things are not always as
they appear!
Thus, this institution’s interest-sensitive gap has changed
direction and, instead of being hurt by rising market interest Moreover, the point at which certain assets and liabilities
rates, for example, this financial firm would actually benefit can be repriced is not always easy to identify. For example,
1
60

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
99

364 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


financial firm. Wise asset-liability managers use several dif- The standard formula for calculating the duration (D) of an indi-
ferent lengths of planning periods (“maturity buckets”) in vidual financial instrument, such as a loan, security, deposit, or
measuring their possible exposure to changing market interest nondeposit borrowing, is
rates. n

a * Expected CF in Period t * Period t/(1 + YTM)


t
Finally, interest-sensitive gap management does not con- t=1
D =
sider the impact of changing interest rates on the owners’ Expected CF in Period t
(stockholders’) position in the financial firm as represented by (1 + YTM)t
the institution’s net worth. Managers choosing to pursue an (18.14)
aggressive interest rate sensitive gap policy may be able to
D stands for the instrument’s duration in years and fractions of a
expand their institution’s net interest margin, but at the cost of
year; t represents the period of time in which each flow of cash
increasing the volatility of net earnings and reducing the value
off the instrument, such as interest or dividend income, is to be
of the stockholders’ investment (net worth). Effective asset-
received; CF indicates the volume of each expected flow of cash
liability management demands that financial managers work
in each time period (t); and YTM is the instrument’s current yield
to achieve desirable levels of both net interest income and net
to maturity. We note that the denominator of the above formula
worth.
is equivalent to the instrument’s current market value (price). So,
the duration formula can be abbreviated to this form:

18.5 THE CONCEPT OF DURATION n

a Expected CF * Period t/(1 + YTM)


t

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

a $100 * t/(1 + .10) + $1,000 * 5/(1 + .10)


t 5
because the net interest margin is protected against interest
t=1
rate risk doesn’t mean an institution’s net worth is also shel- DLoan =
$1,000
tered from loss, and for most companies net worth is more
$4,169.87
important than their net interest margin. This requires the DLoan =
$1,000
application of yet another managerial tool—duration gap
management. We turn now to look at the concept of duration DLoan = 4.17 years
and its many valuable uses. We can calculate duration of this loan a little more simply by
setting up the table below to figure the components of the for-
mula. As before, the duration of the loan is $4,169.87/$1,000.00,
What Is Duration? or 4.17 years.
Duration is a value- and time-weighted measure of maturity We recognize from Chapter 5 that the net worth (NW) of any
that considers the timing of all cash inflows from earning assets business or household is equal to the value of its assets less the
and all cash outflows associated with liabilities. It measures the value of its liabilities:
1
60

average maturity of a promised stream of future cash payments


NW = A - L
5

((18.16)
18.1
66
98 er

(such as the payment streams that a financial firm expects to


1- nt
20
66 Ce

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

funds committed to an investment. institution):


11 ah
41 M
20
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 365

  


Present Value of
Period of Expected Cash Time Period Present Value of
Expected Expected Cash Flow (at 10% Cash Is to Be Expected Cash
Cash Flows Flow from Loan YTM in this Case) Received (t) Flows : t

1 $100 $90.91 1 $ 90.91


2 100 82.64 2 165.29
Expected Interest
g 3 100 75.13 3 225.39
Income from loan
4 100 68.30 4 273.21
5 100 62.09 5 318.46
Repayment of loan 5 1,000 620.92 5 3,104.61
principal
Price or Denominator of Formula = $1,000.00 PV of Cash Flows * t = $4,169.87

∆NW = ∆A - ∆L (18.17) where ∆P , P represents the percentage change in market price


and ∆i , (1 + i) is the relative change in interest rates associated
Portfolio theory teaches us that
with the asset or liability. D represents duration, and the negative
1. A rise in market rates of interest will cause the market value sign attached to it reminds us that market prices and interest rates
(price) of both fixed-rate assets and liabilities to decline. on financial instruments move in opposite directions. For example,
2. The longer the maturity of a financial firm’s assets and consider a bond held by a savings institution that carries a dura-
liabilities, the more they will tend to decline in market value tion of four years and a current market value (price) of $1,000.
(price) when market interest rates rise. Market interest rates attached to comparable bonds are about
10 percent currently, but recent forecasts suggest that market
Thus, a change in net worth due to changing interest rates
rates may rise to 11 percent. If this forecast turns out to be cor-
will vary depending upon the relative maturities of a financial
rect, what percentage change will occur in the bond’s market
institution’s assets and liabilities. Because duration is a measure
value? The answer is:
of maturity, a financial firm with longer-duration assets than
liabilities will suffer a greater decline in net worth when market ∆P
= -4 years * (0.01)/(1 + 0.10) = - 0.0364, or - 3.64 percent
interest rates rise than a financial institution whose asset dura- P
tion is relatively short term or one that matches the duration of Equation (18.18) tells us that the interest-rate risk of financial
its liabilities with the duration of its assets. By equating asset instruments is directly proportional to their durations. A financial
and liability durations, management can balance the average instrument whose duration is 2 will be twice as risky (in terms of
maturity of expected cash inflows from assets with the average price volatility) as one with a duration of 1.
maturity of expected cash outflows associated with liabilities.
Thus, duration analysis can be used to stabilize, or immunize,
Convexity and Duration
the market value of a financial institution’s net worth (NW).
The relationship between an asset’s change in price and its
Price Sensitivity to Changes in Interest change in yield or interest rate is captured by a key term in
finance that is related to duration—convexity. Convexity refers
Rates and Duration
to the presence of a nonlinear relationship between changes
1

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

point of view is that it measures the sensitivity of the market


66

number designed to aid portfolio managers in measuring and nd


98 er
1- nt
20
66 Ce

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

attached to that particular asset or liability. That is,


58 ak

Convexity increases with the duration (maturity)


rity) of
o an asset. It
11 ah
41 M

∆P ∆i tells us that the rate of change in any interest-bearing


stt-bea
-bea asset’s
≈ -D * (18.18)
P (1 + i) price (market value) for a given change in interest
inte
inter rates varies
20
99

366 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


according to the prevailing level of interest rates. For example, be insolvent!), a financial institution seeking to minimize the
an interest-bearing asset’s price movement tends to be greater effects of interest rate fluctuations would need to adjust for
at low interest rates than it does at high interest rates. Price risk leverage:
is greater when interest rates are low than when they are high.
Leverage Dollar@weighted Dollar@weighted
Moreover, the lower the degree of convexity (i.e., lower curva-
adjusted = duration - duration of
ture in the price-interest rate relationship for a given asset), the duration of asset liabilities
lower the price volatility of that asset tends to be. gap portfolio portfolio
As an illustration suppose that the interest rate or yield attached Total liabilities
to a 30-year bond decreases from 6.5 percent to 6 percent. * (18.21)
Total assets
Then this bond’s price will rise by about 8 points (i.e., by about
$8 per $1,000 in face value). In contrast, suppose the asset’s Equation (18.21) tells us that the value of liabilities must change
interest rate falls from 10 percent to 9.5 percent; then its market by slightly more than the value of assets to eliminate a financial
price will rise by just slightly more than 4 points (about $4 per firm’s overall interest-rate risk exposure.
$1,000 in face value). Moreover, if we hold the maturity and
yield constant, convexity will fall as the asset’s promised return The larger the leverage-adjusted duration gap, the more sensi-
(coupon rate) rises. Financial managers using asset-liability man- tive will be the net worth (equity capital) of a financial institution
agement techniques to protect the value of a financial firm’s to a change in interest rates. For example, if we have a positive
asset must keep in mind that asset values change differently leverage-adjusted duration gap, a parallel change in all inter-
according to their duration, their promised (coupon) rates of est rates will result in the value of liabilities changing by less (up
return, and the prevailing level of market interest rates (the con- or down) than the value of assets. In this case, a rise in interest
vexity factor).4 rates will tend to lower the market value of net worth as asset
values fall further than the value of liabilities. The owner’s equity
in the institution will decline in market value terms. On the other
18.6 USING DURATION TO HEDGE hand, if a financial firm has a negative leverage-adjusted dura-
tion gap, then a parallel change in all interest rates will generate
AGAINST INTEREST RATE RISK
a larger change in liability values than asset values. If inter-
est rates fall, liabilities will increase more in value than assets
A financial-service provider interested in fully hedging against
and net worth will decline. Should interest rates rise, however,
interest rate fluctuations wants to choose assets and liabilities
liability values will decrease faster than asset values and the net
such that
worth position will increase in value.
The dollar@weighted duration The dollar@weighted duration
≈ We can calculate the change in the market value of a financial
of the asset portfolio of liabilities
institution’s net worth if we know its dollar-weighted aver-
(18.19)
age asset duration, its dollar-weighted average liability dura-
so that the duration gap is as close to zero as possible (see tion, the original rate of discount applied to the institution’s
Table 18.3): cash flows, and how interest rates have changed during the
period we are concerned about. The relevant formula is based
Dollar@weighted Dollar@weighted upon the balance-sheet relationship we discussed earlier in
duration - duration Equation (18.17):
Duration gap =
of asset of liability
portfolio portfolio ∆NW = ∆A - ∆L
(18.20) Because ∆A/A is approximately equal to the product of asset
∆i
1

duration times the change in interest rates J -DA * R


60

Because the dollar volume of assets usually exceeds the dol- (1 + i))
5
66
98 er

lar volume of liabilities (otherwise the financial firm would


1- nt

and is ∆L/L approximately equal to liability duration


20

onn times
tim
mes the
t
66 Ce

∆i
65 ks

change in interest rates J -DL * R , it follows


llowss tha
that
06 oo

1 + i
82 B
-9 ali

4
As noted above, convexity is related to duration. Specifically, we can
58 ak

approximate the degree of curvature in the interest rate–asset price ∆i ∆i


11 ah

∆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

  


Table 18.3 Use of Duration Analysis to Hedge Interest Rate Movements
A. Calculate the dollar-weighted average duration of a financial firm’s earning assets and liabilities from the following:
Time@weighted distribution of expected cash
Dollar@weighted
inflows from loans and securities
asset duration =
Present value of loans and securities held
in years
n (Expected cash inflows * Time period received)
a (1 + Discount rate)t
t=1
DA = n Expected cash inflows
a (1 + Discount rate)t
t=1

Dollar@weighted Time@weighted distribution of expected cash


liability outflows due to interest expenses
=
duration in Present value of liabilities
years
n (Expected cash outflows * Time period paid out)
a (1 + Discount rate)t
t=1
DL = n Expected cash outflows
a (1 + Discount rate)t
t=1

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 order to protect the value of net worth (equity capital).

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

and the like; (2) weighting each of these durations by the


5

+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
20
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368 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


value-weighted durations together to derive the duration of a Duration is a measure of average maturity, which for this bank’s
financial institution’s entire portfolio. portfolio of assets is about three years. The bank can hedge
against the damaging effects of rising deposit interest rates by
For example, suppose management of a bank finds that it holds
making sure the dollar-weighted average duration of its liabili-
a U.S. Treasury $1,000 par bond with 10 years to final maturity,
ties is also approximately three years.5 In this way the present
bearing a 10 percent coupon rate with a current price of $900.
value of bank assets will balance the present value of liabilities,
Based on the formula shown in Equation (18.15), this bond’s
approximately insulating the bank from losses due to fluctuating
duration is 7.49 years.
interest rates.
Suppose this bank holds $90 million of these Treasury
The calculation of duration for liabilities proceeds in the
bonds, each with a duration of 7.49 years. The bank
same way as asset durations are calculated. For example,
also holds other assets with durations and market values as
suppose this same bank has $100 million in negotiable CDs
follows:
outstanding on which it must pay its customers a 6 percent
annual yield over the next two calendar years. The duration of
Actual or Estimated these CDs will be determined by the distribution of cash pay-
Market Values of Asset
ments made over the next two years in present-value terms.
Assets Held Assets Durations
Thus:
Treasury bonds $90 million 7.49 years
$6 * 1 $6 * 2 $100 * 2
+ +
Commercial loans 100 million 0.60 year Duration of (1.06)1 (1.06)2 (1.06)2
= = 1.943 years
Consumer loans 50 million 1.20 years negotiable CDs $100

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

+ 2.25 years * $40 million in real estate loans

+ 1.50 years * $20 million in municipal bonds)


=
($90 million + $100 million + $50 million 5
As noted earlier, we must adjust the duration of the liability port-
+ $40 million + $20 million) folio by the value of the ratio of total liabilities to total assets
1

because asset volume typically exceeds the volume of liabilities. For


60

$914.10 million
5

= example, suppose the bank described in the example above e has


66
98 er

$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

want to achieve an approximate average duration for orr liab


bilitie of
liabilities
06 oo

3.261 years (or asset duration * total assets , total otal lia
ota liabilities
abilit
abiliti =
82 B

3 years * $100 million , $92 million = 3.261 years


-9 ali

years).
rs).
58 ak
11 ah
41 M
20
99

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 369

  


REAL BANKS, REAL DECISIONS

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

$90 $20 $100 $50 $40


66
98 er

Duration of assets = * 7.49 + * 1.50 + * 0.60 + * 1.20 + * 2.25


1- nt
20

$300 $300 $300 $300 $300


66 Ce

= 3.047 years
65 ks
06 oo
82 B

$100 $125 $50


Duration of liabilities = * 1.943 + * 2.750 + * 3.198 = 2.669 years
-9 ali

$275 $275 $275


58 ak
11 ah
41 M
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370 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Current leverage@adjusted Average asset Average liability Total liabilities
= - *
duration gap duration duration Total assets
$275
= 3.047 years - 2.669 years * = +0.60 year
$300

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

the institution’s average liability duration (DL) must be as follows:


1- nt
20
66 Ce

Current Average asset Average liability


65 ks
06 oo

leverage@adjusted = duration - duration Total liabilities


82 B

*
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

  


Table 18.4 Continued
or
$275
0 = 3.047 - Average liability duration (DL) *
$300
Then:
Average liability
= 3.324 years
duration (DL)
Suppose, once again, market interest rates all rise from 8 percent to 10 percent. Then the change in the value of net worth would
be as shown below:

Change in
(-0.02) (+ 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,

The Financial Expected


If the Financial Institution’s And If Institution’s Change in Management
Leverage-Adjusted Duration Interest Net Worth Interest Rates Action Possible Outcome
Gap Is: Rates: Will:
Rates will rise Reduce DA and Net worth increases
Liabilities Rise Decrease increase DL (moving (if management’s
Positive¢DA 7 DL * ≤ closer to a negative rate forecast is
Assets Fall lncrgease
duration gap). correct).
Liabilities Rise Increase
Negative¢DA 6 DL * ≤ Rates will fall Increase DA and Net worth Increases
Assets Fall Decrease reduce DL (moving (if management’s
closer to a positive rate forecast is
Liabilities Rise No Change
Zero ¢DA = DL * ≤ duration gap). correct).
Assets Fall No Change

In the final case, with a leverage-adjusted duration gap of zero,


18.7 THE LIMITATIONS OF DURATION
1
60

the financial firm is immunized against changes in the value


5

GAP MANAGEMENT
66
98 er
1- nt

of its net worth. Changes in the market values of assets and


20
66 Ce

liabilities will simply offset each other and net worth will remain
65 ks

While duration is simple to interpret, it has limitations. ns. For


Fo one
on
06 oo

where it is.
82 B

thing, finding assets and liabilities of the same duration


urat on that
rattio th fit
-9 a

Of course, more aggressive financial-service managers may not


58 ak

into a financial-service institution’s portfolio iss often


en a frustrating
ofte f
11 ah

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
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372 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


equaled its duration; however, for financial instruments paying exists between the market values (prices) of assets and liabilities
out gradually over time, duration is always less than calendar and interest rates, which is not strictly true.
maturity. Only in the case of instruments like zero-coupon secu-
A related problem with duration analysis revolves around the
rities, single-payment loans, and Treasury bills does the duration
concept of convexity. Duration gap analysis tends to be reason-
of a financial instrument equal its calendar maturity. The more
ably effective at handling interest rate risk problems if the yield
frequently a financial instrument pays interest or pays off princi-
curve (i.e., the maturity structure of interest rates) changes by
pal, the shorter is its duration. One useful fact is that the shorter
relatively small amounts and moves in parallel steps with short-
the maturity of an instrument, the closer the match between its
term and long-term interest rates changing by about the same
maturity and its duration is likely to be.
proportion over time. However, if there are major changes
Some accounts held by depository institutions, such as check- in interest rates and different interest rates move at different
able deposits and passbook savings accounts, may have a speeds, the accuracy and effectiveness of duration gap manage-
pattern of cash flows that is not well defined, making the cal- ment decreases somewhat. Moreover, yield curves in the real
culation of duration difficult. Moreover, customer prepayments world typically do not change in parallel fashion—short-term
distort the expected cash flows from loans and so do customer interest rates tend to move over a wider range than long-term
defaults (credit risk) when expected cash flows do not happen. interest rates, for example—and a big change in market inter-
Moreover, duration gap models assume that a linear relationship est rates (say, one or two percentage points) can result in a
distorted reading of how much interest rate risk a financial man-
ager is really facing. Duration itself can shift as market interest
rates move, and the durations of different financial instruments
CONCEPT CHECK can change at differing speeds with the passage of time.
18.16. What is duration?
Fortunately, recent research suggests that duration balancing
18.17. How is a financial institution’s duration gap can still be effective, even with moderate violations of the tech-
determined? nique’s underlying assumptions. We need to remember, too,
18.18. What are the advantages of using duration as an that duration gap analysis helps a financial manager better man-
asset-liability management tool as opposed to age the value of a financial firm to its shareholders (i.e., its net
interest-sensitive gap analysis? worth). In this age of mergers and continuing financial-services
industry consolidation, the duration gap concept remains a valu-
18.19. How can you tell if you are fully hedged using
able managerial tool despite its limitations.
duration gap analysis?
18.20. What are the principal limitations of duration gap
analysis? Can you think of some way of reducing SUMMARY
the impact of these limitations?
The managers of financial-service companies focus heavily today
18.21. Suppose that a savings institution has an aver-
on the management of risk—attempting to control their exposure
age asset duration of 2.5 years and an average
to loss due to changes in market rates of interest, the inability
liability duration of 3.0 years. If the savings/insti-
of borrowers to repay their loans, regulatory changes, and other
tutiori holds total assets of $560 million and total
risk-laden factors. Successful risk management requires effec-
liabilities of $467 million, does it have a significant
tive tools that provide managers with the weapons they need to
leverage-adjusted duration gap? If interest rates
achieve their institution’s goals. In this chapter several of the most
rise, what will happen to the value of its net worth?
important risk-management tools for financial firms were dis-
18.22. Stilwater Bank and Trust Company has an aver- cussed. The most important points in the chapter include:
age asset duration of 3.25 years and an average
1
60

liability duration of 1.75 years. Its liabilities amount • Early in the history of banking managers focused principally
n ally
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to $485 million, while its assets total $512 million. upon the tool of asset management—emphasizing ngg control
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ontro
ontro
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Suppose that interest rates were 7 percent and and selection of assets to achieve institutionall goals
goals because
goa
oa be
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liabilities were assumed to be dominated by customer


cus
cuustom deci-
06 oo

then rise to 8 percent. What will happen to the


82 B

value of the Stilwater bank’s net worth as a result sions and government rules.
-9 ali
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of a decline in interest rates? • Later, liability management tools emerged


merge
ged
ed in which managers
11 ah
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discovered they could achieve a measure


ea sure of control over the
asure
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 373

  


liabilities on their balance sheet by changing interest rates their institution is asset sensitive (with an excess of interest
and other terms offered to the public, in order to raise new rate–sensitive assets) or liability sensitive (with more rate-
funds. sensitive liabilities than rate-sensitive assets). These interest-
• More recently, many financial firms have practiced funds sensitive gaps are then compared with the financial firm’s inter-
management, discovering how to coordinate the manage- est rate forecast, and management takes appropriate action.
ment of both assets and liabilities in order to achieve institu- • Managers soon discovered that interest-sensitive gap man-
tional goals. agement didn’t necessarily protect a financial firm’s net
• One of the strongest risk factors financial-service managers worth—value of shareholders’ investment in the institu-
have to deal with every day is interest rate risk. Managers tion. This job required the development of duration gap
cannot control market interest rates, but instead they must management.
learn how to react to interest rate changes in order to control • Based on the concept of duration—a value- and time-
their risk exposure. weighted measure of maturity— the managers of financial
• One of the most popular tools for handling interest rate risk institutions learned how to assess their exposure to loss in
exposure is interest-sensitive gap management, which focuses net worth from relative changes in the value of assets and
upon protecting or maximizing each financial firm’s net inter- liabilities when market interest rates change. This technique
est margin or spread between interest revenues and interest points to the importance of avoiding large gaps between
costs. Managers determine for any given time period whether average asset duration and average liability duration.

KEY TERMS
asset-liability management, 350 yield to maturity (YTM), 352 duration gap management, 365
asset management, 350 bank discount rate, 353 duration, 365
liability management, 350 maturity gap, 355 convexity, 366
funds management, 351 net interest margin, 356 duration gap, 367
interest rate risk, 351 interest-sensitive gap management, 356 portfolio immunization, 372

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374 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

PROBLEMS AND PROJECTS


1. A government bond is currently selling for $1,195 7. New Comers State Bank has recorded the following
and pays $75 per year in interest for 14 years when it financial data for the past three years (dollars in millions):
matures. If the redemption value of this bond is $1,000,
what is its yield to maturity if purchased today for Current Previous Two Years
$1,195? Year Year Ago

2. Suppose the government bond described in Problem 1 Interest revenues $82.00 $80.00 $78.00
above is held for five years and then the savings institu- Interest expenses 64.00 66.00 68.00
tion acquiring the bond decides to sell it at a price of
Loans (excluding 450.00 425.00 400.00
$940. Can you figure out the average annual yield the nonperforming)
savings institution will have earned for its five-year invest-
Investments 200.00 195.00 200.00
ment in the bond?
Total deposits 450.00 425.00 400.00
3. U.S. Treasury bills are available for purchase this week
at the following prices (based upon $100 par value) and Money market 150.00 125.00 100.00
with the indicated maturities: borrowings

a. $97.25, 182 days 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
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$25 million. If market interest rates rise by 25 percent Interest-


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from an initial level of 3 percent, what changes will occur sensitive


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in this thrift’s net interest income? liabilities


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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 375

  


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

When and by how much is the bank exposed to interest


Expected Cash Inflows Annual Period in Which
rate risk? For each maturity or repricing interval, what
of Principal and Interest Cash Receipts Are
changes in interest rates will be beneficial and which will Payments Expected
be damaging, given the current portfolio position?
341,555 Three years from today
9. Sunset Savings Bank currently has the following interest-
sensitive assets and liabilities on its balance sheet with 62,482 Four years from today
the interest-rate sensitivity weights noted. 9,871 Five years from today

Rate Sensitivity Deposits and money market borrowings are expected to


Interest-Sensitive Assets $ Amount Index require the following outflows:

Federal fund loans $50.00 1.00


Expected Cash Outflows Annual Period during Which
Security holdings 50.00 1.20 of Principal and Interest Cash Payments Must Be
Payments Made
Loans and leases 350.00 1.45
Rate Sensitivity $1,295,500 Current year
Interest-Sensitive Liabilities $ Amount Index 831,454 Two years from today
Interest-bearing deposits $250.00 0.75 123,897 Three years from today
Money-market borrowings 90.00 0.95 1,005 Four years from today
What is the bank’s cureent interest-sensitive gap? Adjust- — Five years from today
ing for these various interest rate sensitivity weights what
If the discount rate applicable to the previous cash flows
is the bank’s weighted interest-sensitive gap? Suppose
is 4.25 percent, what is the duration of Snowman’s port-
the federal funds interest rate increases or decreases 50
folio of earning assets and of its deposits and money
basis points. How will the bank’s net interest income be
market borrowings? What will happen to the bank’s total
affected (a) given its current balance sheet makeup and
returns, assuming all other factors are held constant, if
(b) reflecting its weighted balance sheet adjusted for the
interest rates rise? If interest rates fall? Given the size
foregoing rate-sensitivity indexes?
of the duration gap you have calculated, in what type
10. Sparkle Savings Association has interest-sensitive of hedging should Snowman engage? Please be spe-
assets of $400 million, interest-sensitive liabilities of cific about the hedging transactions needed and their
$325 million, and total assets of $500 million. What is expected effects.
the bank’s dollar interest-sensitive gap? What is Sparkle’s
12. Given the cash inflow and outflow figures in Problem 11
relative interest-sensitive gap? What is the value of its
for Snowman Bank, N.A., suppose that interest rates
interest sensitivity ratio? Is it asset sensitive or liability
began at a level of 4.25 percent and then suddenly rise
sensitive? Under what scenario for market interest rates
to 4.75 percent. If the bank has total assets of $20 billion,
will Sparkle experience a gain in net interest income?
and total liabilities of $18 billion, by how much would the
A loss in net interest income?
value of Snowman’s net worth change as a result of this
11. Snowman Bank, N.A., has a portfolio of loans and securi- movement in interest rates? Suppose, on the other hand,
ties expected to generate cash inflows for the bank as that interest rates decline from 4.25 percent to 3.5 per-
follows:
1

cent. What happens to the value of Snowman’s net worth


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in this case and by how much in dollars does it change?


nge?
ge?
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Expected Cash Inflows Annual Period in Which


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What is the size of its duration gap?


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of Principal and Interest Cash Receipts Are


65 ks

Payments Expected 13. Conway Thrift Association reports an average ge asset


assset
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$1,275,600 Current year duration of 7 years and an average liability ty duration


duratio
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of 4 years. In its latest financial report,, the association


asso
11 ah

746,872 Two years from today


recorded total assets of $1.8 billion and d total
tota liabilities of
tot
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376 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

$1.5 billion. If interest rates began at 5 percent and then 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?
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 377

  


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

CASE ASSIGNMENT FOR CHAPTER 18

ANALYSIS OF INTEREST RATE SENSITIVITY find net interest income (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

NIM across time. See the following illustrative paragraph for


60

than the average institution over this period.


5

BB&T using 2009 and 2010 information.


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Part Two: Interest-Sensitive Gaps and Ratios


oss
Interest Sensitivity Analysis: Ex-Post Comparison
65 ks
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with Peers. While the FDIC’s website is powerful in providing basicba icc data
dat
82 B
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nd
concerning assets, liabilities, equity, income, and d expenses
exxpen
xpens for
58 ak

The variation of NIM for an institution across time is affected


individual banks and the banking component BHCs,
BHC it does
ntt of B
11 ah

by the interest rate risk exposure of the institution. BB&T’s NIM


41 M

not provide any reports on interest sensitivity.


ty. For individual
increased from 0.66 percent in 2009 to 0.70 percent in 2010
banks such information is available in the UBPR,
UBPR and for BHCs
while the average for their peer group increased from - 0.07
information is available in the BHCPR. (Noteote that these data
Note
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378 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


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

are for the entire BHC and not an aggregation of the chartered A. Using the BHCPR created for your BHC fill in rows 73 and
bank and thrifts that we have used to this point.) We will access 74. You will find net assets repriceable in one year-to-total
the BHC reports at www.ffiec.gov and create a report for the assets in the Liquidity and Funding section and the dollar
most recent year-end. You will use information from this report
amount of average assets on page 1 of the report. Add
to calculate one-year interest-sensitive GAPs (Equation (18.7)
and one-year Relative IS GAP ratios Equation (18.11) for the two your information to the spreadsheet as follows:
most recent years.

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.

Interest Sensitivity Analysis—Implications


from Interest-Sensitive GAPs and Relative IS GAP
Ratios
Bank holding companies’ profits are affected by the inter-
est rate risk exposures of their balance sheets. The relative
1

interest-sensitivity gap ratio for BB&T was 9.92 percent in 2009


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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 379

  


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

Selected References
To examine the nature and impact of interest rate movements, 6. Rose, Peter S. “Defensive Banking in a Volatile Economy—
see, for example: Hedging Loan and Deposit Interest Rates.” The Canadian
Banker 93, no. 2 (April 1986), pp. 52–59.
1. Wu, Tao. “What Makes the Yield Curve Move.” FRBSF Eco-
nomic Letter, Federal Reserve Bank of San Francisco, no. 7. Toevs, Alden L. “Gap Management: Managing Interest-
2003-15 (June 6, 2003), pp. 1–3. Rate Risk in Banks and Thrifts.” Economic Review, Federal
Reserve Bank of San Francisco, no. 2 (Spring 1983), pp.
To explore the need for asset-liability management techniques
20–35.
and their potential effectiveness and importance, see especially:
To understand how changing market interest rates influence the
2. Bailey, Jess. “Minnesota Bank Begins to Shed Its U.S.
behavior of banks and other financial firms, see especially:
Bonds.” The Wall Street Journal, December 20, 1988, p. 3.
8. Federal Deposit Insurance Corporation. “A Changing Rate
3. Gerson, Vicki. “Starting on the Same Page,” Bank Systems
Environment Challenges Bank Interest-Rate Risk Manage-
and Technology 42, issue #4, p. 42.
ment.” Supervisory Insights, Washington, D.C., 2005 (www
4. Lopez, Jose A. “Supervising Interest Rate Risk Manage- .fdic.gov/regulations/examinations/supervisory/insights).
ment.” FRBSF Economic Letter, Federal Reserve Bank of
9. Wynne, Mark A., and Patrick Roy. “Has Greater Globaliza-
San Francisco, no. 2004-26 (September 17, 2004), pp. 1–3.
tion Made Forecasting Inflation More Difficult?” Economic
5. Sierra, Gregory E., and Timothy J. Yeager. “What Does Letter, Federal Reserve Bank of Dallas, 4, no. 5 (July 2009),
the Federal Reserve’s Economic Value Model Tell Us about pp. 1–8.
Interest-Rate Risk at U.S. Community Banks?” Review, Fed-
eral Reserve Bank of St. Louis, November/December 2004,
pp. 45–60.

To learn more about gap management techniques, see these


studies:

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380 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Illiquid Assets 19
■ Learning Objectives
After completing this reading you should be able to:

● Evaluate the characteristics of illiquid markets. ● Compare illiquidity risk premiums across and within asset
categories.
● Examine the relationship between market imperfections
and illiquidity. ● Evaluate portfolio choice decisions on the inclusion of
illiquid assets.
● Assess the impact of biases on reported returns for illiquid
assets.

● Explain the unsmoothing of returns and its properties.

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Excerpt is Chapter 13 of Asset Management: A Systematic Approach to Factor Investing, by Andrew Ang.
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19.1 CHAPTER SUMMARY hold lots of illiquid, alternative assets, especially private equity
and hedge funds. Advocated by David Swensen in his influential
After taking into account biases induced by infrequent trading book, Pioneering Portfolio Management, the endowment model
and selection, it is unlikely that illiquid asset classes have higher was based on the economic concept of diversification originally
risk-adjusted returns, on average, than traditional liquid stock attributable to Harry Markowitz (1952). Through diversification,
and bond markets. However, there are significant illiquidity pre- a portfolio of many low-correlated assets has a risk-return trade-
miums within asset classes. Portfolio choice models incorporat- off superior to that of conventional portfolios consisting of only
ing illiquidity risk recommend only modest holdings of illiquid stocks and bonds. Swensen went further and advocated holding
assets and that investors should demand high-risk premiums for large proportions of illiquid private equity and hedge funds. Not
investing in them. only were these assets supposed to have low correlations to
stocks and bonds, but they potentially carried an illiquidity risk
premium.
19.2 LIQUIDATING HARVARD Swensen argued that in liquid markets, the potential for mak-
ing excess returns (or “alpha”) was limited. In these markets,
No one thought it could happen to Harvard.1 crowded with thousands of active managers vying for an edge,
In 2008, Harvard University’s endowment—the world’s largest— information is freely available and almost everyone has access
fell victim to the worldwide plunge in asset prices triggered by to it. Illiquid asset markets, like venture capital and private
the financial crisis. In contrast to its 15% average annual returns equity, had large potential payoffs for investors who had supe-
since 1980, Harvard’s endowment suffered its worst decline in rior research and management skills. Swensen argued that
history, falling 22% between July 1 and October 31, 2008. More alpha was not competed away in illiquid assets because most
than $8 billion in value had been wiped out in three months. managers have short horizons. University endowments, with
their longer horizons, would seem to have an advantage in
Concerned with the impending budget shortfall due to the
illiquid assets. Swensen recommended that long-term institu-
collapse in the endowment, Harvard University President
tions with sufficient resources who can carefully select expert
Drew Faust and Executive Vice President Edward Forst sounded
managers in alternative, illiquid assets could achieve superior
the alarm by sending a memo to the Council of Deans on
risk-adjusted returns.
December 2, 2008. They asked each school to cut expenses
and compensation and to scale back ambitions in the face of Dutifully following Swensen’s advice, many endowments, includ-
reduced revenue. As bad as the reported losses were, they ing Harvard, loaded up with illiquid assets during the 1990s.
cautioned that the true losses were even worse: “Yet even the In 2008, HMC held 55% of its portfolio in hedge funds, private
sobering figure is unlikely to capture the full extent of actual equity, and real assets. Only 30% was in developed-world equi-
losses for this period, because it does not reflect fully updated ties and fixed income, with the remainder of its portfolio in
valuations in certain managed asset classes, most notably emerging-market equities and high-yield bonds.
private equity and real estate.”2 In its desperate need for cash, HMC tried to sell some of its
Harvard relied on endowment earnings to meet a large share of $1.5 billion private equity portfolio, which included marquee
university expenses. In its fiscal year ending June 30, 2008, more names such as Apollo Investment and Bain Capital. But buyers
than one-third of operating revenue came from endowment in secondary markets demanded huge discounts. Nina Munk, a
income. For some of the university’s individual departments, the journalist writing in Vanity Fair, recounts a surreal conversation
proportion was even higher: the Radcliffe Institute for Advanced between the CIO of HMC, Jane Mendillo, and a money man-
Study derived 83% of its revenue from the endowment, the ager specializing in alternative investments:3
Divinity School 71%, and the Faculty of Arts and Sciences 52%. FUNDS MANAGER: Hey look, I’ll buy it back from you. I’ll
1

Harvard Management Company (HMC), the funds manager of buy my interest back.
5 60

Harvard’s endowment, was one of the early adopters of the


66
98 er

MENDILLO: Great.
1- nt
20

endowment model, which recommends that long-term investors


66 Ce

FUNDS MANAGER: Here, I think it’s worth you know, now, today
tod
toda
65 ks
06 oo

the [book] value is a dollar, so I’ll pay you 50 cents.


ce
entss.
ents.
82 B
-9 ali

1
This is based on “Liquidating Harvard,” Columbia CaseWorks MENDILLO: Then why would I sell it?
58 ak

ID #100312.
11 ah
41 M

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
99

382 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


FUNDS MANAGER: Well, why are you? I don’t know. value a complicated structured credit product, for example.
You’re the one who wants to sell, not me. If you guys Few investors have sufficient capital to invest in skyscrapers
want to sell, I’m happy to rip your lungs out. If you are in major metropolitan areas. You might have to wait a long
desperate, I’m a buyer. time to transact.
MENDILLO: Well, we’re not desperate. 4. Asymmetric information

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
66
98 e
1- nt
20
66 Ce

3. Search frictions
65 ks

For many assets, you need to search to find an appropri-


06 oo

5
82 B

The lemons market was first described by George


rge
ge
e Akerlo
A
Akerlof (1970), who
ate buyer or seller. Only certain investors have the skills to
-9 al

was awarded the Nobel Prize in 2001.


58 ak
11 ah

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.
20
99

Chapter 19 Illiquid Assets ■ 383

  


Table 19.1

Asset Class Typical Time between Transactions Annualized Turnover

Public Equities Within seconds Well over 100%


OTC (Pinksheet) Equities Within a day, but many stocks over a week Approx 35%
Corporate Bonds Within a day 25–35%
Municipal Bonds Approx 6 months, with 5% of muni bonds trading more Less than 10%
infrequently than once per decade
Private Equity Funds last for 10 years; the median investment duration is Less than 10%
4 years; secondary trade before exit is relatively unusual
Residential Housing 4–5 years, but ranges from months to decades Approx 5%
Institutional Real Estate 8–11 years Approx 7%
Institutional Infrastructure 50–60 years for initial commitment, some as long as 99 years Negligible
Art 40–70 years Less than 15%

low turnover. Even among stocks and bonds, some subas- 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

Investors Hold Lots of Illiquid Assets


60

mercial mortgage-backed securities, structured credit, and the


5
66
98 er

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

mostly tied up in their house—and this is before counting the


82 B

largest and least liquid component of individuals’ wealth, human


-9 ali

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.
20
99

384 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


illiquid at the onset of the financial crisis in 2008 and at the time of twenty years and are in good health today. Lo and behold, we
writing in 2013 is still frozen. This market is dead in its present form. conclude that this select group of smokers has a slightly better
mortality rate than the general population. Is this a valid conclu-
Illiquidity crises occur regularly because liquidity tends to
sion? Of course not! We have taken a biased sample of smokers
dry up during periods of severe market distress. The Latin
blessed with longevity who are, so far, invulnerable to the detri-
American debt crisis in the 1980s, the Asian emerging market
mental effects of tobacco. If you were to take up smoking today,
crisis in the 1990s, the Russian default crisis in 1998, and of
what are the odds that you would end up in this lucky group
course the financial crisis of 2008 to 2009, were all character-
twenty years later? Or would you die from emphysema (or heart
ized by sharply reduced liquidity, and in some cases liquidity
disease, or lung cancer, etc.) before the experiment could be
completely evaporated in some markets. Major illiquidity crises
repeated in twenty years’ time?
have occurred at least once every ten years, most in tandem
with large downturns in asset markets. Surviving funds in illiquid asset management are like those lucky,
long-lived smokers. We observe the returns of surviving funds
precisely because they are still around, and they are generally
Summary above average. All of the unlucky illiquid managers disappear and
thus stop reporting returns. Of course, these nonsurvivors have
Illiquid asset classes as a whole are larger than the traditional
below-average returns.9 Industry analysis of buy-out funds, ven-
liquid, public markets of stocks and bonds. Even normally liquid
ture capital funds, or [insert your favorite illiquid asset class] tends
markets periodically become illiquid. Most investors’ wealth
to encompass only firms that have survived over the period of the
is tied up in illiquid assets. Thus asset owners must consider
analysis. But do we know that the small venture capital firm we’re
illiquidity risk in the construction of their portfolios. Doing this
investing in today will be around ten years later? Existing firms
requires estimating risk-return trade-offs of illiquid assets, but
and funds, by dint of being alive today, tend to have better-than-
measuring illiquid asset returns is not straightforward.
average track records. This produces reported returns of these
illiquid assets that are too good to be true.

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

vendors is almost always voluntary. This introduces reporting g


60

biases.10 Survivorship bias results when your fund is in


5

Survivorship bias results from the tendency of poorly performing n the


the
66
98 er
1- nt
20
66 Ce

funds to stop reporting. Many of these funds ultimately fail—but


65 ks

we only rarely count their failures. This makes true illiquid asset
06 oo

9
82 B

returns worse than the reported data. Jorion and Goetzmann (1999) argue that survivorship
vors
orsshiip bia
bias partly
-9 al

explains the high equity premium: Countries where here


e we have long his-
58 ak

Here’s an analogy: Suppose we wanted to test the hypothesis hose coun


tories of equity returns are, by definition, those countries where equity
11 ah
41 M

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).
20
99

Chapter 19 Illiquid Assets ■ 385

  


database now and you stop reporting returns because you (1991), a noted professor of real estate at MIT, and Stephen
know your returns are going to be low. Reporting bias also Ross and Randall Zisler (1991). Ross is the same professor
occurs when you don’t start reporting your returns in the first who developed multifactor models and Zisler is a real estate
place because your fund never achieves a sufficiently attractive professional who started his career as an academic. Ross and
track record. Zisler’s work originally grew out of a series of reports written for
Goldman Sachs in the late 1980s. This methodology has been
extended in what is now an extensive literature.
Infrequent Trading
Unsmoothing is a filtering problem. Filtering algorithms are
With infrequent trading, estimates of risk—volatilities, correlations, normally used to separate signals from noise. When we’re
and betas—are too low when computed using reported returns. driving on a freeway and talking on a cell phone, our phone
To illustrate the effect of infrequent trading, consider Figure 19.1. call encounters interference—from highway overpasses and
Panel A plots prices of an asset that starts at $1. Each circle tall buildings—or the reception becomes patchy when we pass
denotes an observation at the end of each quarter. I produced through an area without enough cell phone towers. Telecommu-
the graphs in Figure 19.1 by simulation and deliberately chose nication engineers use clever algorithms to enhance the signal,
one sample path where the prices have gone up and then down which carries our voice, against all the static. The full transmis-
to mirror what happened to equities during the 2000s’ Lost sion contains both the signal and noise, and so the true signal
Decade. The prices in Panel A appear to be drawn from is less volatile than the full transmission. Thus standard filtering
a series that does not seem excessively volatile; the standard problems are designed to remove noise. The key difference is
deviation of quarterly returns computed using the prices in that unsmoothing adds noise back to the reported returns to
Panel A is 0.23. uncover the true returns.

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

tion on the transfer function is right, the observed returns


60
5

first algorithms to do this were developed by David Geltner implied by Equation (19.2) should have zero autocorrelation. on.
n.
66
98 er
1- nt
20

Thus, the filter takes an autocorrelated series of observeded


66 Ce
65 ks

returns and produces true returns that are close to IIDD (or
or no
not
06 oo

11
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

vation bias on the effect of betas and correlations, respectively. Geltner


-9 al

than the observed returns:


58 ak

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

our sample becomes very large; it is a “population” problem as the next


section explains. (19.3)
20
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386 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Panel A Panel B
Quarterly Sampling Daily Sampling
3.5 3.5

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

Quarterly Sampling vol = 0.23


66
98 er
1- nt
20

Daily Sampling vol = 0.28


66 Ce
65 ks

Figure 19.1
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
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Chapter 19 Illiquid Assets ■ 387

  


since |f| 6 1, so we are adding variance to the observed returns In many cases, we expect the true illiquid asset returns to
to produce estimates of the true returns. be autocorrelated as well.14 Illiquid asset markets—like real
estate, private equity, timber plantations, and
Another way to interpret the unsmoothing process in Equa-
infrastructure—are markets where information is not avail-
tions (19.1) and (19.2) is that it is equivalent to assuming that the
able to all participants, information does not spread rapidly,
smoothed, or reported, return follows:
and capital cannot be immediately deployed into new
(19.4) investments. Informationally inefficient markets with slow-
moving capital are characterized by persistent returns.15
r*t
and thus the unsmoothed return at time t, is a weighted aver-
age of the unsmoothed, or true, return at time t, rt, and the 3. Unsmoothing is an art.
lagged unsmoothed return in the previous period, r*t -1. Thus the The unsmoothing example in Equations (19.1) and (19.2) uses
smoothed returns only slowly update—they partly reflect what the simplest possible auto correlated process, an AR(I), to
is happening in the true returns, but there are lags induced from describe reported returns. Many illiquid assets have more
the appraisal process. than first-order lag effects. Real estate, for example, has a
The unsmoothing process has several important properties: well-known fourth-order lag working with quarterly data aris-
ing from many properties being reappraised only annually.16
1. Unsmoothing affects only risk estimates and not expected
A good unsmoothing procedure takes a time-series model
returns.
that fits the reported return data well and then with a general
Intuitively, estimates of the mean require only the first and transfer function assumption, the filter for true returns in
last price observation (with dividends take “total prices,” Equation (19.2) becomes a very complicated function of pres-
which count reinvested dividends).12 Smoothing spreads ent and past lagged observed returns.17 Doing this properly
the shocks over several periods, but it still counts all the requires good statistical skills. It also requires underlying eco-
shocks. In Figure 19.1, we can see that the first and last nomic knowledge of the structure of the illiquid market to
observations are unchanged by infrequent sampling; thus interpret what is a reasonable lag structure and to judge how
unsmoothing changes only the volatility estimates. much unsmoothing is required.
2. Unsmoothing has no effect if the observed returns are
uncorrelated. Unsmoothed Real Estate Returns
In many cases, reported illiquid asset returns are autocor- To illustrate the effects of unsmoothing, Figure 19.2 plots
related because illiquid asset values are appraised. The direct real estate returns from the National Council of Real
appraisal process induces smoothing because appraisers
Weisskopf (2010)). The aggregation process in constructing indexes of
use, as they should, both the most recent and comparable
illiquid asset returns induces further smoothing. Indexes combine many
sales (which are transactions) together with past appraised individual indications of value, either market transactions or appraised
values (which are estimated, or perceived, values). The arti- values, and typically the values are appraised at different points through-
ficial smoothness from the appraisal process has pushed out the year. Note that if f = 0, then Equations (2) and (3) coincide and
unsmoothed returns are exactly the same as reported returns. Figure 19.1,
many in real estate to develop pure transactions-based, which shows the effects of infrequent observations, is produced with a
rather than appraisal-based indexes.13 Autocorrelation also year-on-year autocorrelation of 0.4.
results from more shady aspects of subjective valuation 14
When the true returns are auto correlated, the horizon matters in stat-
procedures—the reluctance of managers to mark to market ing volatilities, correlations, and Sharpe ratios. From point 1, the means
in down markets. are unaffected. See Lo (2002) for formulas to convert the risk measures
for different horizons.
15
12 See Duffie (2010) and Duffie and Strulovici (2012).
Technically taking means of both the right and left sides in
16
Equation (19.2) results in the same means in large samples. This is noted in the seminal Geltner (1991) and Ross and Zisler (1991)
1
60

13 papers.
This literature includes both repeat-sales methodologies (see
5
66
98 er

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
66 Ce

(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

to those returns in past periods continue to have an effect on n pr


pre
resent
esen
present
06 oo

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

  


30 30

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
66
98 er
1- nt
20

and is a measure of risk.


66 Ce

Sample selection bias results from the tendency of returns only


65 ks

Panel B illustrates the sample selection problem.


blemm. Bad
Ba returns,
06 oo

to be observed when underlying asset values are high.


82 B

which are shaded gray, are not observed d in the


t databases—
d
-9 ali
58 ak

we record transactions only when prices


ces are
a high.
h Now only
11 ah

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
20
99

Chapter 19 Illiquid Assets ■ 389

  


is zero. The slope of the fitted SML is flatter than the slope of Panel A
the true SML in panel A, and hence we underestimate beta.
Excess
When we compute the volatility of the observed returns, we Return
only count those returns that are high, and so the volatility
estimate is biased downward. Thus we overestimate expected
return, and we underestimate risk as measured by beta and True
volatility.
The statistical methodology for addressing selection bias was
developed by James Heckman (1979), who won the Nobel Prize
in 2000 for inventing these and other econometric techniques.
Studies that use models to correct for these biases do not take
such an extreme view as Figure 19.3, they allow the threshold Excess Market
above which returns are observed to vary over time and depend
on company or property-level characteristics.19 The model of
risk is sometimes extended to multifactor models (see Chapters
1 and 2), rather than just using the market portfolio as the sole
risk factor.
The effect of selection bias can be enormous. Cochrane (2005)
estimates an alpha for venture capital log returns of over
90% not taking into account selection bias, which reduces to
–7% correcting for the bias. Korteweg and Sorensen (2005) Panel B
estimate that expected returns for the same asset class are Excess
reduced downwards by 2% to 5% per month (arithmetic Return
returns) taking into account selection bias. The effect of selec-
tion bias in real estate is smaller, perhaps because the underly-
ing volatility of real estate returns is lower than private equity. True
Fisher et al. (2003) implement selection bias corrections for
real estate. They estimate that average real estate returns Fitted

reduce from 1.7% to 0.3% and standard deviation estimates


increase by a factor of 1.5. The small means of real estate
returns are due to their sample period of 1984 to 2001, which
includes the real estate downturn in the early 1990s and in the Excess Market
early 2000s. They miss the bull market in real estate during
the mid-2000s.

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
98 er

downward. Put simply, reported returns of illiquid assets are too


1- nt
20
66 Ce

good to be true. 19.5 ILLIQUIDITY RISK PREMIUMS


MS
S
65 ks
06 oo
82 B

Illiquidity risk premiums compensate investorss forr the


-9 ali

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.
20
99

390 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Harvesting Illiquidity Risk Premiums This conventional view is flawed for the following reasons:

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

reward to bearing illiquidity across asset classes.


5
66

Taking into account data biases, the evidence for higher


her average
gher a
aver
avera
98 er
1- nt
20
66 Ce

20 returns as asset classes become more illiquid is decidedly


eccidedly mixed,
edly
This large literature begins with a seminal contribution by Demsetz
65 ks

(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
82 B

Wang (2012).
-9 ali

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).
20
99

Chapter 19 Illiquid Assets ■ 391

  


18

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

There were pronounced illiquidity effects in Treasuries during


60

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).
-9 ali

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
11 ah
41 M

cialness.” See Duffie (1996). 2012).


(2011), and Dick-Nielsen, Feldhutter, and Lando (2012).
24 27
See Goyenko, Subrahmanyam, and Ukhov (2011). See the summary article by Amihud, Mendelson,
son, a
and Pedersen (2005).
20
99

392 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


called the “Amihud measure” based on his paper of 2002), the and rarely treat them consistently as a whole. This happens on
price impact of large trades, informed trading measures (which both the sell-side, where fixed income, equity desks, and other
gauge adverse, informed trading; see below), quote size and divisions rarely talk with each other, and on the buy-side, where
depth, the frequency of trades, how often there are “zero” each asset class is managed by separate divisions. (Canada
returns (in more liquid markets returns will bounce up and Pension Plan’s factor investing strategy is a notable exception to
down), and return auto correlations (which are a measure of this.) The potential mispricing of illiquidity across asset classes
stale prices).28 These are all illiquidity characteristics, which are could reflect institutional constraints, slow-moving capital, and
properties unique to an individual stock. There are also illiquidity limits to arbitrage.31
risk betas. These are covariances of stock returns with illiquidity
On the other hand, perhaps asset class illiquidity risk premi-
measures, like market illiquidity or signed volume.
ums might be small because investors overpay for illiquid asset
Estimates of illiquidity risk premiums in the literature range classes; they chase the illusion of higher returns and bid up the
between 1% and 8% depending on which measure of illiquid- prices of these illiquid assets until the illiquidity premiums go
ity is used. However, Ben-Rephael, Kadan, and Wohl (2008) away. Lack of integrated asset class markets cause investors
report that these equity illiquidity premiums have diminished to make ill-informed decisions for illiquid asset classes. In con-
considerably—for some illiquidity measures the risk premiums trast, within asset classes—especially the more liquid stock and
are now zero! In pink sheet stock markets, which are over-the- bond markets—illiquidity-shy investors are willing to pay for the
counter equity markets, Ang, Shtauber, and Tetlock (2013) find privilege to trade as soon as they desire. As investors compete
an illiquidity risk premium of almost 20% compared to about 1% within an asset class, they covet and pay up for liquidity.
for comparable listed equities.

Illiquid Assets Market Making


There are higher returns to hedge funds that are more illiquid, in A market maker supplies liquidity by acting as an intermediary
the sense that they place more restrictions on the withdrawal of between buyers and sellers.32 Liquidity provision is costly.
capital (called lockups) or for hedge funds whose returns fall Market makers need capital to withstand a potential onslaught
when liquidity dries up.29 Franzoni, Nowak, and Phalippou of buy or sell orders, and at any time they can be transacting
(2012) report that there are significant illiquidity premiums in with investors who have superior information. In compensation
private equity funds—typically 3%. In real estate, Liu and Qian for these costs, market makers buy at low prices and sell at
(2012) construct illiquidity measures of price impact and search prices around “fair value.” Investors transacting with the market
costs for U.S. office buildings. They find a 10% increase in these maker pay the bid–ask spread.
illiquidity measures leads to a 4% increase in expected returns. In liquid stock and bond markets, market making is now synony-
mous with high frequency trading by investors who build mas-
Why Illiquidity Risk Premiums Manifest sive computer infrastructure to submit buy and sell orders within
within but Not across Asset Classes fractions of a second. More than 70% of dollar trading volume
To my knowledge, we have yet to develop formal equilibrium on U.S. equity exchanges is believed due to high frequency
models explaining the large illiquidity risk premiums within asset traders.33 Many successful hedge funds specialize in high fre-
classes but not across asset classes. quency trading.

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

Dimensional Funds Advisors (DFA) is a funds management com- om-


5 60

pany that started in 1981 by specializing in small-cap


p equities.
equ
uities
66
98 er

28
Sorting stocks on all these variables results in spreads in average
1- nt
20
66 Ce

returns. But some of these illiquidity measures produce spreads in


65 ks

expected returns opposite to an illiquidity risk premium. Stocks with


06 oo

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.
-9 ali
58 ak

29 32
See Aragon (2007) and Sadka (2010), respectively. O’Hara (1995) provides a summary of theoretical
eorettical
ical m
models of market
11 ah
41 M

30 making.
See Kapadia and Pu (2012) for evidence of lack of integration across
33
stock and bond markets. See Zhang (2010).
20
99

Chapter 19 Illiquid Assets ■ 393

  


DFA’s strategies have deep roots in academic factor models, Secondary markets for LPs, which allow them to exit from pri-
and its founders, David Booth and Rex Sinquefield, roped in the vate equity funds, are much smaller and more opaque. Even
big guns of the finance literature, Fama, French, and others, in industry participants acknowledge this market “still remains rela-
building the company. From the start, DFA positioned itself as a tively immature . . . and still represents a very small percentage
liquidity provider of small stocks, and market making was an of the primary market.”37 Bid–ask spreads in these transactions
integral part of its investment strategy.34 When other investors are enormous. As Cannon (2007) notes, the secondary market
seek to urgently offload large amounts of small stocks, DFA for LPs was dominated in the 1990s by distressed sellers.
takes the other side and buys at a discount. Similarly, DFA Specialized firms on the other side of these deals got discounts
offers small-cap equities at a premium to investors who of 30% to 50%; there was a reason these firms were called
demand immediate liquidity. “vultures.” In the 2000s, discounts fell to below 20% but shot
up during the financial crisis. Harvard University found this out
Large asset owners, like sovereign wealth funds and large pen-
when it tried to disinvest in private equity funds during 2008
sion funds, are in a position to act as liquidity providers, espe-
and faced discounts of 50%.
cially in more illiquid markets. They can accept large blocks of
bonds, shares, or even portfolios of property at discount and Discounts for hedge funds are much smaller than private
sell these large blocks at premiums. They can do this by calcu- equity. This reflects the fact that hedge funds investors can, in
lating limits within their (benchmark tracking error) constraints most cases, access capital at predetermined dates after lock-
on how much they are willing to transact. That is, they can ups have expired and notice requirements have been satisfied
provide liquidity in different securities up to a certain amount (unless the hedge fund imposes gates). Reflecting this greater
so that they do not stray too far from their benchmarks. Buyers underlying liquidity, hedge fund discounts in secondary mar-
and sellers will come to them as they develop reputations for kets in 2007 and 2008 were around 6% to 8%.38 (A few hedge
providing liquidity. funds that are closed to new investors actually trade at
premiums.)
Secondary Markets for Private Equity The nascent secondary markets for private equity and hedge
and Hedge Funds funds are tremendous opportunities for large asset owners to
Exchanges for secondary transactions in hedge funds and pri- supply liquidity. Secondary private equity is like second-hand
vate equity have sprung up, but these markets are still very cars that are still brand new. When you drive a new car off the
thin.35 Many transactions do not take place on organized sec- lot, it immediately depreciates by a quarter, even though it
ondary market platforms. is exactly the same as a car sitting in the dealer’s inventory.
Secondary private equity is still private equity, and you can get
There are two forms of secondary markets in private equity.
it a lot cheaper than direct from the dealer.
First, in secondary (and tertiary) market buyout markets, private
equity firms trade private companies with each other. These
markets have blossomed: in 2005, secondary buyouts repre-
Adverse Selection
sented around 15% of all private equity buy-out deals.36 From A market maker faces a risk that a buyer has nonpublic infor-
the perspective of asset owners (limited partners [LPs]), this mation, and the stock is selling at a price that is too high or
market provides no exit opportunities from the underlying pri- too low relative to true, fundamental value. A buyer knowing
vate equity funds and is at worst a merry-go-round of private that the stock will increase in value will continue to buy and
equity firms swapping companies in circular fashion. At best, increase the price. In this case, the market maker has sold
more transactions at market prices (assuming there is no fina- too early and too low. This is adverse selection. Glosten and
gling between the transacting funds) allow asset owners to Milgrom (1985) and Kyle (1985)—the papers that started the
better value their illiquid investments. The LPs are still stuck in market-making microstructure literature—developed theo-
the fund, but they might receive some cash when a company in ries of how the bid–ask spread should be set to incorporate
1
60

their fund’s portfolio is sold to another private equity firm. the effects of adverse selection. DFA provides some exam--
5
66
98 er

ples of how to counter adverse selection. To avoid being ng


1- nt
20
66 Ce

exploited, DFA trades with counterparties that fully disclose


disscclose
65 k
06 oo

34
See Keim (1999) and the Harvard Business School case study,
82 B

Dimensional Fund Advisors, 2002, written by Randolph Cohen.


-9 ali
58 ak

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
11 ah
41 M

Vasvari (2012). and Campbell Lutyens.


36 38
Report of the Committee on Capital Markets Regulation, 2006. See Ramadorai (2012).
20
99

394 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


their information on stocks. At the same time, DFA itself index reconstitution premiums instead of paying them. They can
operates in a trustworthy way by not front running or do this by using their own proprietary benchmarks. Candidate
manipulating prices.39 indexes could emphasize illiquidity security characteristics but
more generally would be built around harvesting factor risk
premiums. Even an index without illiquidity tilts allows asset
Rebalancing owners to harvest a liquidity premium collected from all the
The last way an asset owner can supply liquidity is through other investors forced to track standard indexes.
dynamic portfolio strategies. This has a far larger impact on
the asset owner’s total portfolio than liquidity security selec-
Summary
tion or market making because it is a top-down asset allocation
decision. Of all the four ways to collect an illiquidity premium: (i) holding
passive allocations to illiquid asset classes, (ii) holding less liquid
Rebalancing is the simplest way to provide liquidity, as well as
securities within asset classes, (iii) market making at the indi-
the foundation of all long-horizon strategies. Rebalancing forces
vidual security level, and (iv) dynamic rebalancing at the aggre-
asset owners to buy at low prices when others want to sell. Con-
gate level; the last of these is simplest to implement and has the
versely, rebalancing automatically sheds assets at high prices,
greatest impact on portfolio returns.
transferring them to investors who want to buy at elevated
levels. Since rebalancing is counter-cyclical, it supplies liquidity.
Dynamic portfolio rules, especially those anchored by simple
valuation rules, extend this further—as long as they buy when
19.6 PORTFOLIO CHOICE WITH
others want to sell and vice versa. It is especially important to ILLIQUID ASSETS
rebalance illiquid asset holdings too, when given the chance
(see also below). In deciding on how much of their portfolios to devote to illiquid
assets, investors face many considerations specific to their own
Purists will argue that rebalancing is not strictly liquidity provi- circumstances. Investors have different horizons. Illiquid markets
sion; rebalancing is an asset management strategy. Rebalanc- don’t have tradeable indices, so investors have to find talented
ing, in fact, can only occur in the context of liquid markets. But active portfolio managers. Then they face agency issues and
prices exhibit large declines often because of blowouts in asym- evaluating and monitoring portfolio managers requires skill.
metric information, or because funding costs rapidly increase Thus the premium for bearing illiquidity risk might be individual-
so that many investors are forced to offload securities—some specific. Computing these illiquidity premiums requires asset
of the key elements giving rise to illiquidity listed at the start of allocation models with liquid and illiquid assets. These models
an earlier section. Brunnermeier (2009) argues that these effects also prescribe an optimal amount of illiquid assets to hold.
played key roles in the meltdown during the financial crisis. In
the opposite case, rebalancing makes available risky assets to Practitioners generally use one-period investment models—
new investors, potentially with lower risk aversions than existing usually the restrictive Markowitz (1952) mean-variance model
clientele or those who chase past high returns, or to investors with ad hoc adjustments (yes, most of the industry is still using
who load up on risky assets when prices are high because they models from the 1950s)—which are inappropriate for illiquid
have abundant access to leverage and they perceive asymmetric asset investing. The fact that you cannot trade an illiquid asset
information is low. In this general framework, rebalancing pro- now but will do so in the future makes illiquid asset investing a
vides liquidity. dynamic, long-horizon problem. There are two important
aspects of illiquidity—large transaction costs and long times
Large asset owners give up illiquidity premiums by sheepishly between trading—that have been captured in portfolio choice
tracking standard indexes. When indexes change their constitu- models with illiquid assets.41
ents, asset owners demand liquidity as they are forced to follow
1
60

these changes. Index inclusion and exclusion induce price


5
66
98 er

Asset Allocation with Transactionss Co


Costs
osts
1- nt

effects of 3% to 5%, and these effects have become stronger in


20
66 Ce

more recent data.40 Large asset owners should be collecting


65 ks

George Constantinides (1986) was the first to develop


devellop ana asset
06 oo
82 B

allocation model where the investor had to payy transaction


trans
t costs.
-9 a
58 ak

39 Selling $100 of equities, for example, results


sults in a final
f position of
See MacKenzie (2006).
11 ah
41 M

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

Chapter 19 Illiquid Assets ■ 395

  


$90 with 10% transactions costs. Not surprisingly, the investor assets only at randomly occurring liquidity events. This notion of
trades infrequently—to save on transactions costs. Constantinides illiquidity is that usually illiquid assets are just that—illiquid and
proved that the optimal strategy is to trade whenever risky asset cannot be traded. But when the liquidity event arrives, investors
positions hit upper or lower bounds. Within these bounds is an can trade.
interval of no trading. The no-trading band straddles the optimal
I model the arrival of liquidity events by a Poisson arrival process
asset allocation from a model that assumes you can continuously
with intensity l. The interval between liquidity events is 1>l. For
trade without frictions (the Merton 1971 model).42
real estate or private equity, intervals between trading would
The no-trade interval is a function of the size of the transac- occur every ten years or so, so l = 1>10. As l increases to
tions costs and the volatility of the risky asset. Constantinides infinity, the opportunities to rebalance become more and more
estimates that for transactions costs of 10%, there are no-trade frequent and in the limit approach the standard Merton (1981)
intervals greater than 25% around an optimal holding of 25% for model where trading occurs continuously. Thus l indexes a
a risky asset with a 35% volatility. (I bet Harvard wished it could range of illiquidity outcomes.
have received just a 10% discount when it tried to sell its private
Poisson arrival events have been used to model search-based
equity investments in 2008.) That is, the asset owner would not
frictions since Peter Diamond (1982), who won his Nobel Prize
trade between (0%, 50%)—indeed, very large fluctuations in the
in 2010. The following year, he was nominated to serve on the
illiquid asset position. Illiquid asset investors should expect to
Federal Reserve Board of Governors, but Republican opposition
rebalance very infrequently.
blocked his confirmation.
Constantinides’ model can be used to compute an illiquid-
Illiquidity risk causes the investor to behave in a more risk-averse
ity risk premium, defined as the expected return of an illiquid
fashion toward both liquid and illiquid assets. Illiquidity risk
asset required to bring the investor to the same level of utility
induces time-varying, endogenous risk aversion. Harvard discov-
as in a frictionless setting. This is the risk premium the inves-
ered in 2008 that although it is wealthy, it cannot “eat” illiquid
tor demands to bear the transactions costs and is a certainty
assets. Illiquid wealth and liquid wealth are not the same; agents
equivalent calculation. For transaction costs of 15% or more, the
can only consume liquid wealth. Thus the solvency ratio of illiq-
required risk premium exceeds 5%. Compare this value with (the
uid to liquid wealth affects investors’ portfolio decisions and
close to) zero additional excess returns, on average, of the illiq-
payout rules—it becomes a state variable that drives investors’
uid asset classes in data.
effective risk aversion.
A major shortcoming of the transaction costs models is that they
The takeaways from the Ang, Papanikolaou and Westerfield
assume trade is always possible by paying a cost. This is not true
model are:
for private equity, real estate, timber, or infrastructure. Over a
short horizon, there may be no opportunity to find a buyer. Even
if a counterparty can be found, you need to wait for due dili- Illiquidity Markedly Reduces Optimal Holdings
gence and legal transfer to be completed and then the counter- Start with the bottom line in Panel A of Table 19.2, which
party can get cold feet.43 Many liquid assets also experienced reports a baseline calibration where the investor holds 59% in
liquidity freezes during the financial crisis where no trading—at a risky asset that can always be traded. This weight is close to
any price—was possible because no buyers could be found. the standard 60% equity allocation held by many institutions.
As we go up the rows, the asset becomes more illiquid. If the
risky asset can be traded on average every six months, which is
Asset Allocation with Infrequent Trading
the second to last line, the optimal holding of the illiquid asset
In Ang, Papanikolaou, and Westerfield (2013), I develop an contingent on the arrival of the liquidity event is 44%. When the
asset allocation model in which the investor can transact illiquid average interval between trades is five years, the optimal alloca-
tion is 11%. For ten years, this reduces to 5%. Illiquidity risk has
1
60

a huge effect on portfolio choice.


5

42
Chapter 4 discusses extensions of Constantinides (1986) to double
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bands, contingent bands, and rebalancing to the edge or center of


66 Ce

the bands.
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Rebalance Illiquid Assets to Positions


06 oo

43
For some illiquid assets, investors may not be even willing to trans-
below the Long-Run Average Holding g
82 B

act immediately for one cent; some investments do not have liability
-9 ali
58 ak

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
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396 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


Table 19.2 Investors do not load up on illiquid assets because these assets
have illiquidity risk and cannot be continuously traded to con-
Panel A struct an “arbitrage.”
Average Time between
Liquidity Events (or Optimal Rebalance Investors Must Demand High Illiquidity
Average Turnover) Value Hurdle Rates

10 Years 0.05 How much does an investor need to be compensated for illi-
quidity? In Panel B of Table 19.2, I compute premiums on an
5 Years 0.11
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

The Case for Illiquid Asset Investing


g
5

There Are No Illiquidity “Arbitrages”


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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
-9 ali
58 ak

models, and professionals employ lots of ad hoc fixes, and conditions for illiquid asset investing; these
hesee conditions
con simply
11 ah
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
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Chapter 19 Illiquid Assets ■ 397

  


passively them is not compelling. Illiquid investing also poses management theorists. In a 2012 paper, they provocatively
huge agency problems; asset owners, for example, find it tough argue that the optimal allocation policy for successful universi-
to monitor external managers. Many institutions face “fief- ties is to hold large amounts of fixed income, not risky assets,
dom risk” as illiquid assets are run as separate empires within and by extension not illiquid risky assets.
an organization, detrimentally affecting how the aggregate
Gilbert and Hrdlicka model universities as creators of “social div-
portfolio is allocated.
idends,” which are research and teaching. Universities can invest
In addition, investors in illiquid markets face high idiosyncratic internally, in research and teaching projects, or they can invest
risk because there is no “market” portfolio. It is exactly this externally through the endowment. If the endowment is taking
large idiosyncratic risk, however, that is the most compelling on external risk—via equities, for example—this signals that the
reason for investing in illiquid assets. university does not have enough good internal risky projects
generating social dividends. If the endowment is invested in safe
Suppose you are a skilled investor (assume you have true alpha)
assets, through bonds, the university takes on risk through inter-
and have a choice between investing in (i) a market where prices
nal research and teaching projects. Gilbert and Hrdlicka argue
quickly reflect new information, almost everyone sees the same
that a university endowment’s large investment in risky assets is
information, and news gets spread around very quickly, or (ii)
a sign that it does not have enough fruitful research and teach-
a market where information is hard to analyze and even harder
ing assignments!
to procure, only a select few have good information, and news
takes a long time to reach everyone. Obviously you pick (ii). Harvard, with its large endowment heavily invested in risky
This, in a nutshell, is the Swensen (2009) justification for choos- illiquid assets, would take issue with Gilbert and Hrdlicka. An
ing illiquid assets. The argument is not that illiquid asset classes endowment allows a university to be more independent,
have higher risk-adjusted returns. Empirical evidence suggests rather than depend entirely on grants from government or
they don’t. private foundations. As Dershowitz argues, the endowment
could be used as a rainy day account to be tapped precisely
Investing in illiquid assets allows an investor to transfer idiosyn-
during times like 2008. Harvard’s endowment has historically
cratic risk from liquid equity and bond markets, which are largely
yielded a predictable stream of cash for operating budgets,
efficient, to markets where there are large information asymme-
but 2008 blew this predictability away. Harvard claims its
tries, transactions costs are punishing, and the cross-sections of
endowment allows for future generations to share in its riches,
alpha opportunities are extremely disperse. These are the mar-
saying, “Although their specific uses vary, endowment funds
kets, in other words, where you can make a killing!
have a common purpose: to support activities not just for one
The Swensen case crucially relies on one word: “skilled.” year, or even one generation, but in perpetuity.45 The price of
Whereas skilled investors can find, evaluate, and monitor these education, however, has been rising in real terms, and if
illiquid investment opportunities, assuming they have the education is costlier in the future than in the present, being
resources to take advantage of them, unskilled investors get stingy on research and teaching now makes no sense because
taken to the cleaners. If you are unskilled, you lose. Harvard, it substitutes a more expensive good in the future for a
Yale, Stanford, MIT, and a few other select endowments have cheaper one today.46
the ability to select superior managers in illiquid markets
Henry Hansmann, a professor at Yale Law School, describes
because of their size, their relationships, and their commitment
large private universities as “institutions whose business is to run
to support these managers through long investment cycles.
large pools of investment assets. . . . They run educational insti-
What about the others? An endowment specialist says, “It’s a
tutions on the side, that can expand and contract to act as buf-
horror show. [Performance has] been flat to even negative. The
fers for investment pools.”47 He contends that a large part of
strong get stronger and the weak get stuck with non-top quar-
why universities like large endowments is prestige, pursued as
tile managers and mediocre returns and high fees.44
its own objective. Journalist Kevin Carey puts it another way,
1
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Investment Advice for Endowments


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45
“About HSPH: Endowment Funds: What Are Endowmentt Fund Fun
Funds?”
ds?”
65 ks

Thomas Gilbert and Christopher Hrdlicka at the University


06 oo

d.edu
u/ab
u/abo
Harvard School of Public Health, http://www.hsph.harvard.edu/about/
82 B

of Washington are probably the world’s only endowment what-are-endowment-funds


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46
See Hansmann (1990).
11 ah
41 M

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
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398 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

  


echoing the cadences of the Book of Common Prayer when he 2. Cut expenses.
says that large endowments per se are “aspiration without limit, Universities are like government bureaucracies: big,
accumulation without end.”48 bloated, and inefficient. You can hardly fire anyone. So
there is a limit to how much can be cut.
Liquidate Harvard? 3. Increase donations.
Did Harvard generate excess returns, or an illiquidity risk pre- It’s embarrassing to ask for funds to replace those lost as a
mium, from its large investments in illiquid, alternative assets? result of mismanagement.
Yes. Harvard could extract value from illiquid asset investing 4. Increase other revenue.
not because illiquid asset classes have a large risk premium but
Harvard could rescind its need-blind financial-aid policy. But
because it is a skillful investor. And it is one of the few investors
it turns out this doesn’t save much money.
able to do so.
5. Borrow.
But this didn’t help Harvard solve its cash crunch. The worst
failing of Harvard was in basic asset-liability management. Even Harvard did (5). It issued $2.5 billion in bonds and more than
without using the asset allocation models with illiquidity risk or doubled its leverage ratio between 2008 and 2009. It did try
the advice given by Gilbert and Hrdlicka, Harvard should have to cut expenses and deferred its Allston campus expansion.
recognized that its assets did not match its liabilities. In technical Was the endowment a rainy day fund Joseph could use to save
terms the duration of its liabilities was shorter than the duration his family and all of Egypt, as suggested by Dershowitz? No.
of its assets. Harvard actually reduced its payout ratio in 2009, preferring to
Harvard faced five choices: keep as much of the endowment intact as it could.49 Maybe
Hansmann is right in suggesting that prestige maximization is
1. Liquidate a portion of the endowment. the driving motivation in endowment management. After all,
But a lot of the endowment is illiquid and cannot be sold. everyone likes to be well-endowed.

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
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Chapter 19 Illiquid Assets ■ 399

  




99
20
41 M
11 ah
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1


INDEX

dealer banks, 160


A
strategy, 350
active risk management, 126
asset purchases/funding, 122
adverse price impact, 38, 40–41
available assets
amortising loans, 299–300
bond
Ang, A., 397
buy/sellback and sell/buyback, 148
Ang, Papanikolaou, and Westerfield (2013) model, 396–397
lending and borrowing, 148
arbitrages, 397
purchase, 146
Ashanti Goldfields, 8
repo and reverse repo, 147
asset conversion, 91
selling, 146
asset-liability committee (ALCO), 181
buy/sellback transactions, 144
asset-liability management (ALM), 350
contracts types, 145
convexity and duration, 366–367
repo transactions, 144
definition, 350
reverse repo transactions, 144
duration gap
security borrowing, 145
limitations, 372–373
security lending, 144
management, 365, 367–372
sell/buyback transactions, 144
funding liquidity risk measurement, 38
available funds gap (AFG), 261
interest rate risk, 351
components, 353–355
forces determining, 351–352 B
measurement, 352–353 balanced liquidity management strategies, 93
responses to, 355–356 balance sheet risk, see funding liquidity risk
interest-sensitive gap management, 356 bank discount rate, 353
net interest margin (NIM), 356 bankers’ acceptances, 59–60
price sensitivity to changes in interest rates, 366 Bank for International Settlements (BIS), 121
01
56

problems with interest-sensitive GAP management, 362–364 bank liquidity


66
98 er

risk-management tool, 365 fragility of commercial banking, 21–22


1- nt
20
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sample interest-sensitivity analysis (GAP Management), 360–362 liquidity transformation by banks, 20–21
65 ks

strategies banks’ global balance sheets, US dollar shortage


06 oo
82 B

asset management strategy, 350 balance sheet expansion since 2000, 316
-9 ali
58 ak

funds management, 351 cross-currency funding positions, 316–320


11 ah

liability management strategy, 350–351 alancce sh


maturity transformation across banks’ balance sheets, 320–323
41 M

asset liquidity management strategies, 91–92 structure of banks’ operations, 313–316


asset management, 350 banks’ international positions, 311–313
20
99

401

  


bank size and borrowing, 109–110 central bank borrowing, 8
bank specific indicators, 52–54 central bank reserve requirements, 111
Basel Committee on Banking Supervision (BCBS), 121, 289, 307 certificate of deposit (CD), 59
principles for sound liquidity risk management and supervision, clearing balance rules, 106
301–302 client intraday credit usage, 128
baseline scenario, 177 collateral markets, 131
basic (lifeline) banking, 239–240 economic function of markets, 28–29
BCBS recommended early warning indicators, 47 prime brokerage and hedge funds, 29
bid-ask spread, 38 risks in, 29–31
BIS international banking statistics, 328 securitization process, 26
black holes, liquidity, see also liquidity risk structure
diversity, importance of, 14 margin loans, 26–27
irrational exuberance, 13–14 repurchase agreements, 27
leveraging and deleveraging, 12–13 securities lending, 27
positive and negative feedback traders, 11–12 total return swaps, 27
regulation, impact of, 14 collateral pledging, 122
board of directors, 212 collateral requirements, 180
bond commercial paper, 60
buy/sellback and sell/buyback, 148 commercial paper market, 259–260
lending and borrowing, 148 Committee for European Banking Supervisors (CEBS), 290, 307
purchase, 146 Committee on Payment and Settlement Systems (CPSS), 121
repo and reverse repo, 147 Committee on Payments and Market Infrastructures (CPMI), 121
selling, 146 conditional pricing, 233
borrow, ability to, 7 consistency check and data limitations, 329–330
borrowed liquidity (liability) management strategies, 92–93 Constantinides, G., 395
borrowing, 92 Constantinides’ model, 396
Federal reserve banks, 255–256 contingency funding plan (CFP), 10
liquidity, 92 actions in liquidity crisis, 210
business dial back, 180 capabilities and enhancements, 210
business risk, 70–71 design considerations
buy/sellback transactions, 144 align to business and risk profiles, 210–211
appropriate stakeholder groups, 211
broader risk management frameworks, 211
C communication plan, 211
call risk, 71 operational, actionable, but flexible playbook, 211
capital and performance metrics, 181 different types of institutions, 218
capital market investment instruments framework and building blocks
corporate bonds, 61 contingent actions, 214–215
corporate notes, 61 data and reporting, 218
municipal bonds, 60–61 governance and oversight, 212–213
municipal notes, 60–61 monitoring and escalation, 215–218
treasury bonds, 60 scenarios and liquidity gap analysis, 213–214
treasury notes, 60 liquidity and capital, 219
capital stress testing, 184 organizational structure of, 218–219
cash and treasury securities, 6 contingent liabilities, 180
1

cash balances, 125 contingent liquidity, 131


605

cash flow requirements, measurement, 173


66
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classifications, 134 contingent liquidity risk management


66 Ce

liquidity risk reporting banks liquidity cushions unveiled by GFC, 302


65 ks
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asset and liability, 194 extant guidance focuses on size, 302


82 B

survival horizon, 197, 198 liquidity cushions, 301


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58 ak

treatment, 204 poor attribution of cost of carrying, 302–303


11 ah
41 M

at risk, 150–154 pricing contingent liquidity risk, 304–305


taxonomy, 134 towards better management, 303–304
20

cash management, repurchase agreements and, 274–275 contracts types, 145


99

402 ■ Index

  


convexity, 366 deposits
core deposits, 226 conditional pricing, 233–237
corporate bonds by depository institutions
capital market investment instruments, 61 nontransaction (savings/thrift), 224
illiquidity risk premiums, 392 retirement savings, 224–225
corporate notes transaction (payments/demand), 222–224
capital market investment instruments, 61 insurance coverage by FDIC, 231–232
corporate treasury, 212 interest rates
cost of trade processing, 37 composition, 225–226
cost-plus pricing, 230 cost of different deposit accounts, 228–229
Counterparty Risk Management Policy Group III (CRMPGIII), 307 ownership, 226–228
counterparty stress, 129 LTP, 299–300
covered interest parity (CIP) marginal cost to set interest rates on, 232–233
factors, 335 outflows, 179–180
hedging demand, quantitative indicators, 339–343 ownership of, 226–228
limits to arbitrage, 338–339 pricing deposit
mechanics, 334 at cost plus profit margin, 230
regression results, 345–346 services, 229
tighter limits to arbitrage and basis, 344–345 total customer relationship vs. depository, pricing, 237–239
violations, 334 wholesale and retail, 7–8
yen/dollar case, 343–344 depth, characteristics of market liquidity, 38
crash of 1987, 12 Dershowitz, A., 383
credit availability risk, 266 Dimensional Funds Advisors (DFA), 393
credit crisis, 2 discount window, 255
credit/default risk, 69–70 distorts profit assessment, 297
cross-currency swaps, 335 duration, 365
currency, 176 duration gap, 367
customer relationship doctrine, 248 limitations, 372–373
customer stress, 129 management, 365, 367–372
cyclical component, 95 duration, maturity management
cyclical element, 95 immunization, 77–78
portfolio immunization, 78

D
daily maximum intraday liquidity usage, 127–128 E
data aggregation, 126 early warning indicators (EWI)
daylight overdraft (DOD), 42, 120, 131 bank specific indicators, 52–54
dealer banks BCBS recommended, 47
failure mechanisms beyond, 46
derivatives counterparties, 164–165 dashboard, 46
flight of prime brokerage clients, 162–164 dimensions, 49
flight of short-term creditors, 161–162 key supervisory guidelines, 46, 48
loss of cash settlement privileges, 165 market indicators, 51
internal hedge funds, 157 M.E.R.I.T.
off-balance-sheet financing, 160–161 environments, both normal and stressed, 50
1

over-the-counter derivatives, 158–160 escalation, 50


560

policy responses, 165–166 forward looking bias/view, 49–50


66
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prime brokerage and asset management, 160 industry practices, 51


66 Ce

securities dealing, 158 integrated systems, 50


65 ks
06 oo

trading, 158 measures, 47, 49


82 B

underwriting, 158 reporting, 50


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58 ak

deleveraging, 12–13, 18 spanning various time horizons, 50


11 ah
41 M

deposit behavioral characteristics, 180 thresholds, 50–51


depositors, 156 regulatory emphasis in recent times, 46
20

Depository Trust and Clearing Corporation (DTCC), 159 risk identification and, 47, 49
99

Index ■ 403

  


e-banking, 227 transactions measurement
e-commerce, 227 adverse price impact, 40–41
endowments, investment advice, 398–399 transaction cost liquidity risk, 39–40
equities funding optimization, 183
illiquidity risk premiums, 392–393 funds approach, sources and uses, 94–96
private, 394 funds management, 351
Eurocurrency deposit, 59, 92, 258 funds transfer pricing, 184
market, 258–259
European Commission (EC), 290, 307
expected rate of return, 65
G
Geltner, D., 386
Geltner-Ross-Zisler unsmoothing process, 386
F Gilbert, T., 398
Faust, D., 382 global financial crisis (GFC), 46, 288, 310, 334
federal agency securities, 59 Goldman Sachs Global Core Excess, 38
Federal Deposit Insurance Corporation (FDIC), 231–232 Greenspan, A., 14
federal funds borrowings, 92
federal funds market (Fed funds), 109, 250–252 H
Federal Home Loan Bank (FHLB), 92 Hansmann, H., 398
advances from, 256 Harvard Management Company (HMC), 382
feedback traders, positive and negative, 11–12 hedge funds
financial market utilities (FMUs) risk cash, 39
collateral, 131 collateral markets, prime brokerage and, 29
contingent liquidity, 131 dynamic, 11
liquidity savings mechanism, 131 funding liquidity management, 39
management, 129–130 funding liquidity risk, 24
monitoring, 130–131 funding liquidity risk measurement, 39
net debit caps, 130–131 issues, 8
settlement windows, 131 secondary markets for, 394
financial market utility, 131 unpledged assets, 39
financial stress, 129 unused borrowing capacity, 39
foreign exchange (FX) swaps, 335 holding period yield (HPY), 65
Forst, E., 382 Hrdlicka, C., 398
fragility, commercial banking, 21–22
funding liquidity
bank liquidity I
fragility of commercial banking, 21–22 illiquid assets
liquidity transformation by banks, 20–21 consume less with, 397
definition, 18 liquidating HARVARD, 382–383
hedge funds, 24 liquidating HARVARD redux
liquidity transformation, 19–20 case for investing, 397–398
maturity transformation, 18–19 investment advice, endowments, 398–399
measurement markets
asset-liability management, 38 characteristics of, 383–385
Goldman Sachs Global Core Excess, 38 sources of, 383
1

hedge funds, 39 portfolio choice with asset allocation


605

money market mutual funds, 23–24 infrequent trading, 396–397


66
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structured credit and off-balance-sheet funding, 22–23 transactions costs, 395–396


66 Ce

systematic, 24–25 rebalance, long-run average holding, 396–397


65 ks
06 oo

and system risk returns are not returns


82 B

interconnectedness, 43 infrequent trading, 386


-9 ali
58 ak

and market liquidity, 42 selection bias, 389–390


11 ah
41 M

and plumbing, 42 survivorship bias, 385–386


solvency, 41 unsmoothing returns, 386–389
20
99

404 ■ Index

  


illiquidity international interest, 121
asymmetric information, 383 measurement, 126
causes of, 38 measures for understanding flows
clientele effects and participation costs, 383 other cash transactions, 127
crises, 385 settlement positions, 127
funding constraints, 383 time sensitive obligations, 127
hurdle rates, 397 total bank intraday credit lines available and usage, 127
optimal holdings reduction, 396 total intraday credit lines to clients and counterparties, 127
price impact, 383 total payments, 127
risk premiums quantifying measurement and monitoring risk levels
across asset classes, 391–392 client intraday credit usage, 128
within asset classes, 392–393 daily maximum intraday liquidity usage, 127–128
market making, 393–395 intraday credit relative to tier 1 capital, 128
rebalancing, 395 payment throughput, 128
search frictions, 383 stress testing role, 128–129
sources of, 383 uses and sources, 121, 123, 124
transaction costs, 383 asset purchases/funding, 122
immunization, 77–78 cash balances, 125
impact factors, 178, 179 collateral pledging, 122
inflation risk, 72 funding of nostro accounts, 122
infrequent trading, 396–397 intraday credit, 125
illiquid assets returns are not returns, 386 liquid assets, 125
Institute for International Finance (IIF), 307 other term funding, 125
interconnectedness, 43 outgoing wire transfers, 122
interest-bearing transaction deposits, 223 overnight borrowings, 125
interest rate settlements, at PCS systems, 122
asset-liability management, 351 inventory management by dealers, 37
components, 353–355 investments, 56
forces determining, 351–352 advantages and disadvantages, 58
measurement, 352–353 capital market instruments, 57
responses to, 355–356 corporate bonds, 61
deposits corporate notes, 61
composition, 225–226 municipal bonds, 60–61
cost of different deposit accounts, 228–229 municipal notes, 60–61
ownership, 226–228 treasury bonds, 60
risk, 69, 262, 266, 351 treasury notes, 60
interest-sensitive gap management, 356 factors affecting
internal audit, 182 business risk, 70–71
internal hedge funds, dealer banks, 157 call risk, 71
international Eurocurrency deposits, 59 credit/default risk, 69–70
intraday credit, 125 expected rate of return, 65
intraday credit relative to tier 1 capital, 128 inflation risk, 72
intraday liquidity, 132 interest rate risk, 69
intraday liquidity risk, 132 liquidity risk, 71
intraday liquidity risk management pledging requirements, 72–73
1

FMU risk prepayment risk, 71–72


5 60

collateral, 131 tax exposure, 65–69


66
98 er
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contingent liquidity, 131 maturity management tools


66 Ce

liquidity savings mechanism, 131 duration, 77–78


65 ks
06 oo

management, 129–130 yield curve, 76–77


82 B

monitoring, 130–131 maturity strategies


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58 ak

net debit caps, 130–131 back-end load maturity policy, 75


11 ah
41 M

settlement windows, 131 barbell strategy, 75


governance of, 125–126 front-end load maturity policy, 74–75
20
99

Index ■ 405

  


investments (continued ) vs. capital, 183
ladder/spaced-maturity policy, 73–74 definition, 2, 18
rate expectations approach, 75–76 demand for and supply of, 88–90
money market instruments, 57 problems in financial firms, 90
bankers’ acceptances, 59–60 sources of
certificate of deposit (CD), 59 ability to borrow, 7
commercial paper, 60 cash and treasury securities, 6
federal agency securities, 59 central bank borrowing, 8
international Eurocurrency deposits, 59 hedging issues, 8
short-term municipal obligations, 60 securitization, 8
treasury bills, 57 trading book positions, 6–7
treasury bonds, 59 wholesale and retail deposits, 7–8
treasury notes, 59 vs. yield, 182–183
portfolio haircuts, 179 liquidity coverage ratio (LCR), 9
recent development, instruments liquidity crisis team, 212
securitized assets, 61–63 liquidity dashboard, 183
structured notes, 61 liquidity gap, 94
securities held by banks, 63–64 liquidity generation capacity (LGC)
security portfolio, 57 AFS bonds, 143
irrational exuberance, 13–14 classification, 142
definition, 141
security-linked liquidity, 142
L security-unlinked liquidity, 142
lagged reserve accounting (LRA), 103 liquidity indicator approach, 94, 100–101
legal reserves, 103 liquidity management, 206–207
clearing balance rules, 106 Liquidity Management Information Systems (LMIS), 288, 292–293
required reserves calculation, 104–106 liquidity managers strategies
reserve computation, 103–104 asset liquidity management strategies, 91–92
reserve maintenance, 104 balanced liquidity management strategies, 93
reserve requirements, 104 borrowed liquidity (liability) management strategies, 92–93
leverage guidelines for, 93
asset volatility and, 37 liquidity needs estimation
definition, 31 funds approach, sources and uses, 94–96
derivatives, 35–36 liquidity gap, 94
liquidity black holes, 12–13 liquidity indicator approach, 100–101
margin loans and leverage, 33 structure of funds method, 97–100
measurement, 31 ultimate standard, 101–103
short positions, 34 liquidity options, 135–136
structured credit, 36–37 liquidity position metrics, 181
liability management, 92, 248, 350 prospective, 181
strategy, 350–351 liquidity risk, 71
liquid asset, 91, 125 adjusted VaR, 5
buffer, 174 bid–offer spread, market liquidity., 6
liquidating HARVARD, 382–383 credit crisis, 2
liquidating HARVARD redux definition, 137, 138
1

case for investing, 397–398 in funding


605

investment advice, endowments, 398–399 regulation, 9–10


66
98 er
1- nt
20

liquidity, 88 reserve requirements, 9


66 Ce

black holes (see also liquidity risk) sources of, 6–9


65 ks
06 oo

diversity, importance of, 14 funding cost risk, 137


82 B

irrational exuberance, 13–14 market liquidity measurement, 4


-9 ali
58 ak

leveraging and deleveraging, 12–13 quantitative measurement


11 ah
41 M

positive and negative feedback traders, 11–12 causes of, 138


regulation, impact of, 14 sources of, 138
20
99

406 ■ Index

  


solvency from, 2 liquidity vs. capital, 183
in trading liquidity vs. yield, 182–183
bid–offer, 2 organizational scope
predatory trading, 3 currency, 176
transparency, importance of, 3 liquidity transfer restrictions, 175
unwinding position optimally, 5–6 regulatory jurisdiction, 176
liquidity risk reporting outputs of model, 180
cash flow capital and performance metrics, 181
asset and liability, 194 liquidity position metrics, 181
survival horizon, 197, 198 prospective liquidity position metrics, 181
treatment, 204 stress testing assumptions, 181
cumulative liquidity report, 195 planning horizon, 176
daily liquidity report, 188–192 position data collection and aggregation, 183
deposit tracker report, 188 regulatory report generation, 183
firm-specific funding yield curve, 201 with related risk models, integration of, 184
frequency of reporting, 202–203 scenario development
funding concentration report, 192–193, 198 historical scenarios, 177
funding maturity gap (“mismatch”) report, 192 hypothetical scenarios, 177–178
group treasury qualitative reporting, 203 stressed inflows, 174
liability profile, 193, 200 stressed liquid asset buffer, 174
liquid securities list, 193 stressed outflows, 174
maturity gap report, 196 sustainable infrastructure, 183
stress test reports, 203–207 testing techniques
summary and qualitative reports, 201–202 deterministic models, 177
UK liquidity reporting requirements, 203 historical statistical techniques, 176
undrawn commitment report, 193 Monte Carlo simulation, 177
wholesale pricing and volume, 200–201 liquidity transfer pricing (LTP)
liquidity savings mechanism, 131 application, 289
liquidity stress test contingent liquidity risk management
analytics, 183 banks liquidity cushions unveiled by GFC, 302
and asset liability management, 184 extant guidance focuses on size, 302
assumptions development liquidity cushions, 301
business dial back, 180 poor attribution of cost of carrying, 302–303
collateral requirements, 180 pricing contingent liquidity risk, 304–305
contingent liabilities, 180 towards better management, 303–304
deposit behavioral characteristics, 180 definition, 288
deposit outflows, 179–180 governance of, 288–289
impact factors, 178, 179 governing, 290–291
investment portfolio haircuts, 179 Liquidity Management Information Systems (LMIS), 292–293
unsecured wholesale funding, 180 management
baseline scenario, 177 internal funding structure, centralised vs. decentralised, 291
and capital stress testing, 184 oversight, 292
design components, 176 policies, 291
funding optimization, 183 trading book funding policies and identifying funding
and funds transfer pricing, 184 requirements, 291–292
1

governance and controls need for more guidance on, 290


5 60

asset-liability committee (ALCO), 181 on-balance sheet funding liquidity risk management
66
98 er
1- nt
20

internal audit, 182 matched-maturity marginal cost of funds, 297–298


66 Ce

model risk management, 182 maturity transformation, 294


65 ks
06 oo

risk management, 182 pooled “average” cost of funds approach, 295 5


82 B

treasury, 182 poor LTP practices, 294


-9 ali
58 ak

liquid asset buffer, 174 pricing funding liquidity risk, 298–301


11 ah
41 M

liquidity dashboard, 183 “zero” cost of funds approach, 294


liquidity optimization principles and recommendations, 307
20
99

Index ■ 407

  


liquidity transfer pricing (LTP) (Continued ) mobile apps, 223
purpose, 288 model risk management, 182
regulatory developments, 289–290 money market deposit accounts, 223
remuneration practices, 293–294 money market investment instruments
sizing and attributing costs, 289 bankers’ acceptances, 59–60
liquidity transfer restrictions, 175 certificate of deposit (CD), 59
locational banking statistics by nationality (LBSN), 328 commercial paper, 60
long financing, 275–276 federal agency securities, 59
long-term capital management (LTCM), 12 international Eurocurrency deposits, 59
LTP, see liquidity transfer pricing (LTP) short-term municipal obligations, 60
treasury bills, 57
treasury bonds, 59
M treasury notes, 59
management committee, 212 money market mutual funds, 23–24
margin, 12 money position
margin loans, 26–27 management, 106–110
market indicators, 51 manager, 103
market liquidity, 42 Monte Carlo simulation, 177
markets structure, collateral markets mortgage-backed bond, 61
margin loans, 26–27 municipal bonds, 60–61
repurchase agreements, 27 municipal notes, 60–61
securities lending, 27 municipal obligations, short-term, 60
total return swaps, 27
market-wide credit/liquidity stress, 129 N
Markowitz, H., 382, 395
National Council of Real Estate Investment Fiduciaries (NCREIF),
maturity gap, 355
388–389
maturity management tools
negotiable CD, 256–258
duration
negotiable order of withdrawal (NOW) accounts, 223
immunization, 77–78
net debit cap, 130–131, 132
portfolio immunization, 78
net interest margin, 356
yield curve
net interest margin (NIM), 356
carry trade, 77
net liquidity position, 89
forecasting interest rates and economy, 76
net stable funding ratio (NSFR), 9
riding, 77
netting/net settlement, 132
risk-return trade-offs, 76–77
non-amortising bullet loans, 298
maturity strategies, investments
nondeposit funds
back-end load maturity policy, 75
demand for, 261
barbell strategy, 75
factors to consider, 262–267
front-end load maturity policy, 74–75
sources, 249
ladder/spaced-maturity policy, 73–74
long-term, 260
rate expectations approach, 75–76
noninterest-bearing transaction (demand) deposits, 223
maturity transformation, 18–19
nontransaction (savings/thrift) deposits, 224
M.E.R.I.T.
Northern Rock, 7
early warning indicators
nostro account, 122, 132
environments, both normal and stressed, 50
NOW accounts, 223
escalation, 50
1
60

forward looking bias/view, 49–50


5

O
66
98 er
1- nt

industry practices, 51
20
66 Ce

integrated systems, 50 off-balance-sheet financing, 160–161


65 ks
06 oo

measures, 47, 49 off-balance-sheet funding, 22–23


82 B

reporting, 50 off-the- run (OFR), 281


-9 ali
58 ak

spanning various time horizons, 50 ntt


on-balance sheet funding liquidity risk management
11 ah

thresholds, 50–51 298


matched-maturity marginal cost of funds, 297–2988
41 M

Metallgesellschafi (MG), 9 maturity transformation, 294


20
99

408 ■ Index

  


pooled “average” cost of funds approach, 295 2007–2009 crisis, 277–280
poor LTP practices, 294 and long financing, 275–276
pricing funding liquidity risk, 298–301 rates, 280–281
“zero” cost of funds approach, 294 reverse repos and short positions, 276
on-the-run (OTR), 281 in United States
opportunity cost, 91 and auction cycle, 281–284
order-driven system, 38 and level of rates, 284–285
other term funding, 125 reserves
outgoing wire transfers, 122 computation, 103–104
overdraft penalties, 110 computation period, 103
overnight borrowings, 125 maintenance, 104
over-the-counter derivatives, 158–160 required calculation, 104–106
requirements, 104
sources of, 110
P
resiliency, 38
passbook savings deposits, 224
retirement savings deposits, 224–225
payment finality, 132
reverse repos
payments, clearing, and settlement services (PCSs), 132
and short positions, 276
settlements, 122
transactions, 144
Payment System Risk (PSR) policy, 121
reverse Yankee issuance, 338
payment throughput, 128
risk assessment, 126
Pioneering Portfolio Management, 382
Ross, S., 386
pledging requirements, 72–73
plumbing, system and funding liquidity risk, 42
policy responses, 165–166 S
portfolio immunization, 78, 372 seasonal component, 95
portfolio shifting, 68 seasonal credit, 256
predatory trading, 12 secondary credit, 256
prepayment risk, 71–72 securitization process, 8, 26
price sensitivity to changes in interest rates, 366 securitized assets, 61–63
pricing deposit security
at cost plus profit margin, 230 borrowing, 145
services, 229 dealing, 158
primary credit, 256 held by banks, 63–64
primary obligor, 59 lending, 27, 144
prime brokerage, 160 linked liquidity, 142
private equity, secondary markets, 394 portfolio, 57
problems with interest-sensitive GAP management, 362–364 unlinked liquidity, 142
selection bias, illiquid assets returns, 389–390
Q sell/buyback transactions, 144
seller’s market, see real estate market
quote-driven system, 38
settlement windows, 131
solvency, 2
R system and funding liquidity risk, 41
real estate market, 3 sources and uses, funds approach, 94–96
rebalance, long-run average holding, 396–397 stop-loss rules, 11
1
60

Recommendations for Securities Settlement Systems (RSSS), 121 stress testing assumptions, 181
5
66
98 er
1- nt

regulatory jurisdiction, 176 stripped security, 62


20
66 Ce

relationship pricing, 237 3


structured credit and off-balance-sheet funding, 22–23
65 ks
06 oo

repo transactions, 144 structured notes, 61


B

repurchase agreements (repo), 27, 92, 252–255 Super NOWs, 223


82

back-to-back trades, 276 survivorship bias, 385–386


-9

bond trading special, 285 sweep accounts, 107


58
11

and cash management, 274–275 Swensen, D., 382


41
20
99

Index ■ 409

  


system and funding liquidity risk transparency, 3
interconnectedness, 43 treasury, 182
and market liquidity, 42 treasury bills, 57
and plumbing, 42 treasury bonds, 59, 60
solvency, 41 treasury notes, 59, 60
systematic funding liquidity risk, 24–25 trend component, 95
Systemically Important Financial Institutions (SIFIs), 132 trend trading, 11
systemic risk, 132 Truth in Savings Act, 234
definition, 18

U
T underwriting, dealer banks, 158
tax exposure, 65–69 unsecured wholesale funding, 180
tax swap, 67 unsmoothing returns
term structure of expected cash flows (TSECF), 138–141 dramatic effect, 389
term structure of expected liquidity (TSLe), 149–150 Geltner-Ross-Zisler unsmoothing process, 386
thrift deposits, 224 illiquid assets returns are not returns, 386–389
time critical payment, 132 properties, 388
time deposits, 224 real estate, 388–389
total return swaps, 27 transfer function, 386
trading US dollar shortage
book positions, 6–7 banks’ international positions, 311–313
dealer banks, 158 during crisis, 310
liquidity risk international policy response, 325–327
bid–offer, 2 long and short of banks’ global balance sheets
predatory trading, 3 balance sheet expansion since 2000, 316
transaction cross-currency funding positions, 316–320
cost liquidity risk, 39–40 maturity transformation across banks’ balance sheets, 320–323
costs, portfolio choice with asset allocation, 395–396 structure of banks’ operations, 313–316
(payments/demand) deposits, 222–224 magnitude, risk, 310
liquidity, definition, 18 market conditions, 323
measurement U.S. Treasury bill, 57
adverse price impact, 40–41 U.S. Treasury market, 392
transaction cost liquidity risk, 39–40
transactions liquidity risk
causes
W
adverse selection, 37 wholesale and retail deposits, 7–8
cost of trade processing, 37
differences of opinion, 38 Y
inventory management by dealers, 37 yen/dollar case, 343–344
order-driven system, 38 yield curve
quote-driven system, 38 carry trade, 77
characteristics of market liquidity forecasting interest rates and economy, 76
adverse price impact, 38 riding, 77
bid-ask spread, 38 risk-return trade-offs, 76–77
depth, 38 yield to maturity (YTM), 65, 352
1
60

resiliency, 38
5
66
98 er

slippage, 38
Z
1- nt
20
66 Ce

tightness, 38
65 ks

definition, 18 Zisler, R., 386


06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
99

410 ■ Index

  

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