Current Issues in Financial Markets

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 Total Framework
1. Forging Best Practices in Risk Management

2. Case Studies on Disruptions during the Crisis

3. Why do We Need Both Liquidity Regulations and a Lender of Last Resor

t?

4. Global Financial Markets Liquidity Study

5. Reforming LIBOR and Other Financial Market Benchmarks

6. Central Counterparties Addressing Their Too Important to Fail Nature

7. Stress Testing Convergence

8. Cybersecurity 101: A Resource Guide for Bank Executives

Forging Best Practices in Risk
Management
Trends within Risk Management ★★★ 性质
Trends and developments affected by the 2007-2009 financial crisis are:
① Longer term view of risk.
② Greater controls over counterparty risk.
③ Lack of short-term funding has resulted in more stringent rules pertaining to repos and
money market funds and the imposition of liquidity buffers on banks.
④ Increased use of the credit value adjustment (CVA) in derivatives markets.
⑤ Less reliance on credit ratings.
⑥ Increased overall levels of sovereign risk.
⑦ Increased focus on stress scenarios.
⑧ Increased regulatory activity.

Volatility Regimes ★★★ 性质

Volatility regimes are often difficult to detect if market participants are only looking back the
usual two to four years when making risk estimates. Instead, a longer period of time, say 20
years or more, may be required.
Specific Risk-Mitigating Steps ★★★ 性质
Examples of specific risk-mitigating steps taken by many individuals and firms at the same time include:
Bank runs
Collateral calls
Portfolio insurance
Credit default swaps
Deleveraging of hedge funds

Address and Alleviate Amplified Risk ★★★ 性质

Key best practices to address and alleviate amplified risk include
① Looking back and forward over longer time periods
② More stress testing scenarios that take into account regime changes
③ Considering the simultaneous risk-mitigating actions of other firms

Accurate Measurement & Protection from Amplified Risk ★★★ 性质

Firms want to have accurate risk measurement as well as protection from the amplified risk resulting
from simultaneous responses from other firms. Two activities help in achieving both objectives include
the use of provisions for loan losses and the clearing of derivatives through a central counterparty.
Case Studies on Disruptions
during the Crisis
Funding Mechanisms ★★★ 性质

① Short-term financing options including: commercial paper, asset-backed commercial

paper, money market mutual funds, repurchase agreements, credit commitments, and
dollar funding of non-U.S. banks.
② Allow institutions obtain debt and loan financing for funding requirements.
③ A maturity mismatch typically exists between the short-term funding mechanism and
the long-term assets that are funded, creates rollover risk.
④ When the supply of short-term financing dries up, governments may be forced to
provide emergency liquidity and lending.

Commercial Paper ★★★ 性质

① CP is generally unsecured.
② Primary risk: rollover risk; disruptions in the markets can increase rollover risk leading to
higher funding costs and forced asset sales.
③ Policy response to the crisis included the creation of the Commercial Paper Funding
Facility (CPFF) by the U.S. Federal Reserve to provide a liquidity back stop as temporary
support to troubled CP issuers.
Asset-Backed Commercial Paper ★★★ 性质

① ABCP is a category of CP that is secured by collateral and issued by conduits of

corporations as a form of off-balance sheet financing.
② Primary risk: same as CP.
③ Policy response to the crisis initially included providing liquidity support to struggling
banks and the creation of various liquidity facilities. In 2010, these initiatives ended with
the change in U.S. accounting rules that require consolidation of most ABCP conduits on
the sponsor's balance sheet.

Repurchase Agreements ★★★ 性质

① Short-term loans collateralized by securities, whereby a security is sold by a borrower

with the promise to buy it back in the future at a higher price.
② Policy responses included establishing funding programs to provide emergency liquidity
to dealers, strengthening investor confidence, and backstopping the tri-party repo
market.
Money Market Mutual Funds ★★★ 性质

① Important sources of liquidity in the wholesale lending markets.

② Policy responses including: (1) the Temporary Guarantee Program guaranteeing investors
against any principal losses in participating MMFs, (2) providing nonrecourse loans to
purchase eligible ABCPs from MMFs; and (3) the SEC easing the requirements by boards
to close troubled funds, and to limit the liquidity, market and credit risks of MMFs.

Credit Commitments ★★★ 性质

① Banks' promises to provide liquidity insurance to corporations by extending them lines
of credit and loan commitments.
② Policy responses included federal government actions that included increasing the
deposit insurance coverage from $100,000 to $250,000 (initially temporarily, then
permanently) and providing full guarantee for non-interest bearing transaction accounts.
Alternative measures included instituting the Temporary Guarantee Program for MMFs
and adjusting the discount window.
Dollar Funding Model of Non-U.S. Bank ★★★ 性质

① Non-U.S. banks met their dollar liability funding requirements primarily through issuing
dollar wholesale debt, including commercial paper and certificates of deposits, primarily
to MMFs.
② As MMFs reduced their wholesale lending during the financial crisis, non-U.S. banks
needed to find alternative funding arrangements. These included reducing their dollar
assets and dollar requirements (deleveraging), intra firm dollar transfers, using foreign
exchange swaps, and borrowing dollars from central bank dollar liquidity facilities.
③ Policy responses to the financial crisis included the use of the discount window and the
TAF by the Fed, and the use of foreign exchange swaps through central bank liquidity
swaps.
Why do We Need Both Liquidity Regulations and
a Lender of Last Resort?
Lender of Last Resort vs. Liquidity Regulations ★★★ 性质
① Advantages associated with Federal Reserve lender of last resort (LOLR) lending: the
creation of liquidity to aid society as a whole and the promotion of optimal levels of
liquidity and maturity transformation. LOLR can help stem a liquidity crisis before it
worsens, especially if it is the result of market wide "pure liquidity" factors.
② Bank specific liquidity shocks that result from solvency issues increase credit risk for the
Fed if they solve the problem with LOLR lending and create moral hazard. As such, these
situations are best solved by liquidity regulations. Even if the bank ultimately fails, higher
liquidity requirements initially give the Fed more time to figure out the type of problem
and the best solution for resolution and/ or an orderly default.
③ Advantages of liquidity regulations include the mitigation of the costs of moral hazard,
the tax on liquidity risk, which gives institutions an incentive to minimize liquidity risk
and thus minimizes liquidity crises and the cushion that allows the central bank more
time to discern whether the liquidity problem is market wide or institution specific.
Lender of Last Resort vs. Liquidity Regulations ★★★ 性质

① The Federal Reserve has two basic challenges related to LOLR lending in the event of a
liquidity crisis.
② It takes time to figure out if the problem is a market wide pure liquidity event. The Fed
should lend quickly and aggressively if it is a systemic problem, but should wait until
liquidity buffers are run down before lending if it is a firm specific, related to solvency,
event.
③ If the central bank takes too much collateral, in other words, enough collateral to protect
it from unknown risks, that, in and of itself, can cause a run on a financial institution in
times of stress. Remaining investors will pull their funds out of fear, worsening a crisis.
④ It appears, based on all of the evidence and arguments, that the optimal policy
regarding liquidity risk management is a combination of liquidity regulations to mitigate
moral hazard in the market and lender of last resort (LOLR) solutions for solvent
institutions.
Global Financial Markets
Liquidity Study
Liquidity ★★★ 性质
Liquidity can be best described as the ability to execute large trades with
Definition
limited price impact.
① Immediacy
② Depth and resilience
Dimensions ③ Breadth
④ Tightness
⑤ Multi-dimensional aspects
① Facilitating global capital flows
② Allocating risks to those willing and able to bear them
Benefits ③ Effectively disseminating issuer information
④ Improving the effectiveness of monetary policy
⑤ Improving financial stability and market resiliency.
Liquidity ★★★ 性质
Depends on whether the market is:
Provision ① Order driven (exchanges, standardized)
of Liquidity ② Quote driven (market makers)
③ Request for quote (market makers)

Driven by:
① Issuer-specific characteristics
Liquidity ② (financial performance, creditworthiness, issuance frequency and
Differences volume, microeconomic factors)
③ Instrument-specific factors
④ (size, maturity, and coupon).

① stable global monetary conditions

Factors Impact ② Greater electronification & digitalization of financial markets
Global Liquidity ③ Increased size of financial markets
④ Weak growth and profitability in the banking sector.
Liquidity of Financial Markets ★★★ 性质

① Sovereign bond markets have demonstrated overall reductions in liquidity over time
with lower turnover and higher price impact costs.
② The amount of repo financing has decreased in all markets globally. In addition,
interbank daily trading volumes and nominal values of general collateral financing repos
submitted for clearing have been declining.
③ Interest rate derivatives have seen some changes in the breadth of liquidity as
demonstrated through bifurcation through various currencies and between cleared and
non-cleared derivatives.
④ Post-crisis, corporate bond markets have seen significantly increased issuance volumes
but not the same increase in trading volumes, which suggests an overall decrease in
liquidity.
⑤ Credit default swaps (CDSs) have seen an overall reduction in liquidity most often in the
form of reduced trading volume, reduced transactions, and reduced number of market
participants providing CDSs.
Liquidity of Financial Markets ★★★ 性质
① Securitized products have seen dramatic drops in issuance levels since the crisis.
Secondary markets for securitized products have seen stable or reducing trading
volumes since the crisis. Overall, liquidity has declined further since the crisis, although
there are hopes of liquidity improvements after some key regulatory changes.
② Foreign exchange markets have seen decreased liquidity in longer-term forward
contracts versus shorter-term contracts.
③ Equity markets have seen reduced trading volumes and transaction amounts over the
years, which suggests reductions in depth and liquidity.
④ Emerging markets have seen increasing trading volumes that have not kept pace with
issuance volumes, thereby resulting in lower turnover ratios and lower liquidity over the
last several years.
 Reforming LIBOR and Other
Financial Market Benchmarks
Motives for Manipulating LIBOR ★★★ 性质

① Banks do not want to appear less creditworthy than their competitors and thus have an
incentive to "low ball" their estimated borrowing rates.
② Profits on trillions of dollars of derivatives contracts are linked to LIBOR. Because the size
of positions is so large, even tiny moves in the rate one way or the other can result in
significant profits (or losses). As such, traders have an incentive to encourage banks to
under- or overestimate their borrowing costs when submitting reports.

Recommendations for Less Susceptible to Manipulation ★★★ 性质

① Base benchmark rates on transactions rather than on submissions by banks regarding

their borrowing rates or their expected borrowing rates. This is difficult to implement.
② Another option is to consider alternative benchmark rates such as Treasury bills or the
overnight indexed swap rate. Policymakers highly recommend that alternative
benchmarks be used in place of, or in addition to, LIBOR.
Advantages using Benchmark Interest Rate ★★★ 性质
① Reduce information asymmetries
② Reduce search costs
③ Create better trade executions
④ Mitigate the costs of adverse selection

Agglomeration Effect ★★★ 性质

Agglomeration means that the establishment of a benchmark results in the attraction of
related trades to the benchmark. Two primary forces that drive the agglomeration effect:
① Information-related benefits such as reduced search costs and reduced information
asymmetries.
② Reducing trading costs associated with illiquidity including lower bid-ask spreads and
faster executions that are generally associated with high volume trading.
Application of LIBOR ★★★ 性质

① LIBOR is not ideal for most derivatives contracts because LIBOR has a bank credit risk
component. Despite this mismatch, it will be difficult to move the market to an
alternative benchmark such as Treasury bills because the market is "set" on LIBOR.
② The two-rate approach is one possibility for reforming LIBOR. In it, there would still be a
LIBOR-like benchmark, but based on transactions rather than bank submissions. This
benchmark would capture movements in overall interest rates and bank credit risk. The
second benchmark, also based on transactions, would be better suited to many interest
rate derivatives contracts in the sense that it would not include a bank credit risk
component. It would be based on riskless securities, like Treasury bills, and would have a
wide-ranging, deep market.
Suggested Possibilities for a Riskless Rate ★★★ 性质
There are four suggested possibilities for a riskless rate that could be used as the second
benchmark. They are:
① A rate set by the central bank such as the rate the Federal Reserve pays banks on excess
reserves or the overnight reverse repo rate, the rate the Fed pays market participants to
borrow against its holdings of government securities;
② Treasury bill rates;
③ General collateral repurchase agreement (repo) rates which are the rates on repos that
are backed by the general class of Treasury and related securities;
④ The overnight indexed swap (OIS) rate.
 Central Counterparties:
Addressing Their Too Important
to Fail Nature
Benefits of CCP Multilateral Netting ★★★ 性质
Reduction in credit exposures Operational efficiency Transparency
Firewall of protection Trading efficiency

Costs of a CCP Structure ★★★ 性质

Increased systemic risk due to risk concentration if a CCP fails
Increased participation costs.

Margin Calls and Collateral Requirements ★★★ 性质

Increased margin calls and collateral requirements during a financial crisis will create
liquidity stress for CCP clearing members.

Loss/Risk Waterfall ★★★ 性质

Describes the process of loss sharing with other CCP members.
Measures Decreasing the impact of a CCP Failure ★★★ 性质
increased regulation and standards for CCPs, recovery planning, emergency liquidity
available through the central bank, bank capital requirements to cover CCP exposures, and
resolution planning.
Interconnections with Other Institutions ★★★ 性质
① Interconnections with other CCPs and G-SIBs increases systemic risk due primarily to lack
of liquidity in a crisis and increased market volatility with simultaneous collateral sales
for multiple CCPs. Failure of a G-SIB could lead to global market disruptions due to
contagion loss effects for interconnected CCPs.
② The interconnected links of a CCP to other CCPs, financial institutions, and CCP members
can provide channels to contagion.

★★
Measures to Reduce the Interconnections and Systemic Risk 性质
★
① Strengthen international standards
② Strengthen regulation and supervision
③ Create a common global central bank approach
④ Establish direct relationships between central securities depositories and CCPs.
Stress Testing Convergence
CCAR System ★★★ 性质
① The regulatory environment for bank capital management has evolved from the dual
scenario test of SCAP to the CCAR system where banks must annually submit a report to
the Federal Reserve covering four key elements.
② Two key factors encouraging BHCs to manage capital with narrower buffers: 1) equity
markets are directly rewarding companies that pursue profits above conservative capital
management. 2) the stability of CCAR results themselves.
③ Bank stress testing results hinge on the Fed's standards. This single focus has the
potential to expand systemic risk because all testing is reliant on the same set of
variables and the same levels of those variables. Model risk is therefore a concern.
Cybersecurity 101: A Resource
Guide for Bank Executives
Core Functions of the NIST’s Cybersecurity Framework ★★ 性质
Identify Protect Detect Respond Recover
Facets of the Risk Assessment Process ★★ 性质
Classifying information Measuring risk
Identifying threats and vulnerabilities Communicating risk

Dimensions Considered when Measuring Risk ★★ 性质

Value Level of Risk Firm Actions in Response to the Risk
Primary Protection Measures ★★ 性质
Customer authentication. Secure configuration.
Access controls.
Firewalls.
Data security.

General Categories of Detection Tools ★★ 性质

Network behavior anomaly detection Intrusion detection systems
Security information and event management Configuration management tools
systems Integrity monitoring tools
 ★★
Other Key Points 性质
★
① A system within the firm needs to be developed to communicate with top-level
management and the board of directors regarding the cyber risks faced by the bank,
how those risks are currently handled, how to mitigate those risks, and who is
responsible for doing so.
② An incident response team needs to be established in order to develop an incident
response plan. The overall objective is to discover the breach as soon as possible, limit
the damage, repair the damage caused by the breach, and return the IT system back to
normal as soon as possible.
③ A recovery plan consists of both a restoration component and a review component. Key
elements involved in restoration include reconstructing any damaged IT assets based on
the firm's most up-to-date IT infrastructure images/layouts, restoring deleted or altered
data from prior backups made, and reconnecting service with little or no disruption. The
review component should include auditing and testing the incident response plan as
well as reviewing third-party vendors.