5. reform of liquidity risk management after global financial tsunami

5. reform of liquidity risk management after global financial tsunami

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  Reform of liquidityrisk management after global financial tsunami Mr. Fai Y. LAM Senior VP, CT Risks Solutions Ltd. MSc in Financial Engineering CFA, CAIA, FRM, PRM PRIMA Award of Merit 2005 Monday 15 December 2010 5:00 am to 5:30 pm 2 Outline Revisions to Market Risk Framework Regulatory Liquidity Risk Capital Enhancement Program 3 Basel committee on liquidity risk 4 What happened during the period? Basel new capital accord (Basel II) Kicked off in January 2001 Finalized in May 2006 Glass–Steagall Act repealed on November 12, 1999 Commercial banks in US participated in investment banking activities Paper On Default Correlation: A Copula Function Approach” by Dr. David X. LI’s, RiskMetrics Group published in 2000 Acceleration of the CDO market CDS market grew to US$ 45 tn notional in 2007 Subprime mortgage market grew to US$ 1.3 tn in 2007 Financial tsunami emerged in 2007 Basel Committee issued guideline “Principles for Sound Liquidity Risk Management and Supervision” in Sep 2008 Basel Committee issued consultative paper “International framework for liquidity risk measurement, standards and monitoring “ in Dec 2009
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  5 Regulatory liquidity Standards Liquidity coverage ratio Net stable funding ratio Monitoring tools Contractual maturity mismatch Concentration of funding Available unencumbered assets Market-related monitoring tools 6 Liquidity coverage ratio To ensure existing liquidity can support the cash flows over a 30-day period under an acute liquidity stress scenario 100% 30 30 30 Stock of high quality liquid assets Net cash outflows over a day time period Stock of high quality liquid assets Cash outflows over a day time period Cash inflows over a day time period ≥ − ≥ − − − 7 High quality liquid assets Fundamental characteristics Low credit and market risks Ease and certainty of valuation Low correlation with risky assets Listed on a developed and recognised exchange market Market-related characteristics Active and sizable market Presence of committed market makers Low market concentration Flight to quality 8 High quality liquid assets Cash (100%) Qualifying central bank receivables (100%) Domestic sovereign or central bank debt in domestic currency (100%) Qualifying marketable securities from sovereigns, central banks, public sector entities, and multi-lateral development banks (100%) Qualifying corporate bonds and covered bonds rated AA to AAA (80%) Qualifying corporate bonds and covered bonds rated A- to AA- (60%)
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  9 Cash inflows Amounts receivable from retail counterparties (100% of planned inflows from performing assets) Amounts receivable from wholesale counterparties (100% of planned inflows from performing wholesale customers) Receivables in respect of repo and reverse repo transactions backed by illiquid assets and securities lending/borrowing transactions where illiquid assets are borrowed (100%) Other cash inflows, including planned contractual receivables from derivatives 10 Cash outflows (1) Retail deposits Stable deposits (minimum 7.5%) Less stable retail deposits (minimum 15%) Unsecured wholesale funding Stable, small business customers (minimum 7.5%) Less stable, small business customers (minimum 15%) Non-financial corporates, sovereigns, central banks and public sector entities with operational relationships (25% of deposits needed for operational purposes) Non-financial corporates, no operational relationship (75%) Other legal entity customers and sovereigns, central banks, and PSEs without operational relationships (100%) Secured funding Funding from repo of illiquid assets and securities lending/borrowing transactions illiquid assets are lent out (100%) 11 Cash outflows (2) Additional requirements Liabilities related to derivative collateral calls related to a downgrade of up to 3-notches (100% of collateral that would be required to cover the contracts in case of up to a 3-notch downgrade) Market valuation changes on derivatives transactions (amount to be nationally determined) Valuation changes on posted noncash or non-high quality sovereign debt collateral securing derivative transactions (20%) ABCP, SIVs, Conduits, etc: Liabilities from maturing ABCP, SIVs, SPVs, etc (100% of maturing amounts and 100% of returnable assets) Term Asset Backed Securities (including covered bonds) (100% of maturing amounts) 12 Cash outflows (3) Currently undrawn portion of committed credit and liquidity facilities to: Retail clients (10% of outstanding lines) Non-financial corporates, credit facilities (10% of outstanding lines) Non-financial corporates, liquidity facilities (100% of outstanding lines) Other legal entity customers (100% of outstanding lines) Other contingent funding liabilities (such as guarantees, letters of credit, revocable credit and liquidity facilities, etc.) (to be determined by supervisors, specific to needs at certain banks) Planned outflows related to renewal or extension of new loans (retail or wholesale) (100%) Any other cash outflows (including planned derivative payables)
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  13 Net stablefunding ratio A minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon Available amount of stable funding quired amount of stable funding 100% Re Re ≥ ≥ Available amount of stable funding quired amount of stable funding Available amount of stable funding 14 Capital Preferred stock with maturity of equal to or greater than one year Liabilities with effective maturities of one year or greater The portion of “stable” non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period in an idiosyncratic stress event 15 Required amount of stable funding The value of assets held and funded by the institution, multiplied by a specific required stable funding factor assigned to each particular asset type The amount of off-balance sheet activity (or potential liquidity exposure) multiplied by its associated required stable funding factor 16 Required stable funding (RSF) factor The RSF factors assigned to various types of assets are parameters intended to approximate the amount of a particular asset that could not be monetised through sale or use as collateral in a secured borrowing on an extended basis during a liquidity event lasting one year The RSF factor applied to the reported values of each asset or off-balance sheet exposure is the amount of that item that supervisors believe should be supported with stable funding Assets that are more liquid and more readily available to act as a source of extended liquidity in the stressed environment identified above receive lower RSF factors (and require less stable funding) than assets considered less liquid in such circumstances and, therefore, require more stable funding
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  17 Regulatory effort(1) A big step from the Basel Committee guideline “Principles for Sound Liquidity Risk Management and Supervision” (Sep 2008) Formally define regulatory liquidity in a consistent and a measurable framework Relatively easy to calculate Deterministic, snapshot, rating factor approach 18 Regulatory effort (2) Recognition of government related entities as the top funding sources Appreciation of high quality covered bonds Regulatory liquidity economic liquidity Limited details on derivatives 19 Regulatory effort (3) HKMA Viewpoint article 11 June 2009 http://www.info.gov.hk/hkma/eng/viewpt/ 20090611e.htm *Source : Reorganisation of Banking Departments in April 2010, HKMA 20 Potential impacts to banking industry Competition on high quality assets = high cost of liquidity Downward pressure on BBB rated corporate bonds and covered bonds Merge and acquisition of financial institutions Political bias on funding to “too large to fail” Acceleration of coverage to life insurance businesses Stable and diversified funding from insurance premium Mortality risk uncorrelated with credit market More supervisory reporting, reviews and examinations
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  21 A simplequestion What is my bank’s funding liquidity risk? 22 Outstanding questions 1. How to set funding liquidity risk limits? 2. Is the funding liquidity risk increasing or decreasing during the last 12 months? 3. Which branch contributes the most funding liquidity risk? 4. How to diversify the funding sources? 5. How to perform funding liquidity stress testing? 6. What will be the potential loss in the next funding liquidity crisis? 7. How to plan for contingency funding? 8. How to incorporate funding liquidity risk into cost? 23 Modelling total cash inflow Probability Amount Estimated total cash inflow Total cash inflow Modelling total cash inflow Lognormal total cash inflow model μ σ = + dI Idt IdW   σ =  μ − + σ ⋅  I I T T Normal I0 : Total estimated cash inflow IT : Total realized cash inflow μ I : Drift of total cash inflow Calculated according to regulatory liquidity requirements σ I : Volatility of total cash inflow Greater than or equal to 0 Asymmetric Long right tail 24 ( ) 2 0 exp ( ) 0,1 2 I I T I I I I  
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  25 Modelling totalcash outflow Probability Amount Estimated total cash outflow Total cash outflow Modelling total cash outflow Lognormal total cash inflow model   σ 2 μ σ = + dO Odt OdW O μ σ = − O 0 exp  ( ) + ⋅ 0,1  O O T T Normal T O O O 2   O0 : Total estimated cash outflow OT : Total realized cash outflow μO : Drift of total cash outflow σO : Volatility of total cash outflow ( ) Calculated according to regulatory liquidity requirements Greater than or equal to 0 Asymmetric Long right tail 26 27 Regulatory liquidity surplus gulatory liquidity surplus Stock of high quality liquid assets inf month Total cash low next = + A random variable subject to Estimated total cash inflow and estimated total cash outflow Volatilities of total cash inflow and total cash outflow Correlation between total cash inflow and total cash outflow month Re Total cash outflow next − 28 Regulatory liquidity surplus A random variable following a multi-lognormal distribution No closed form solutions To be realized easily with Monte Carlo simulation gulatory liquidity surplus Stock of high quality liquid assets σ σ 2 2 ( ) ( ) μ I σ μ O σ I T T Normal O T T Normal 0 0 I I I O O O ( ) ( ) Re exp 0,1 - exp 0,1 2 2 Correlation 0,1 , 0,1 Normal Normal I O = ρ       +  −  + ⋅   −  + ⋅        =  
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  29 Liquidity riskmeasures Probability of regulatory liquidity shortage What is the chance of having net cash outflow not covered by current stock of high quality liquidity assets? Pr obability of regulatory liquidity shortage [ 1 Re 0 ] = gulatory liquidity surplus E 30 Monte Carlo simulation in Excel 31 Regulatory liquidity shortage 32 Findings of common sense Regulatory liquidity 0 == probability of regulatory liquidity shortage = 0 $1 mn high quality liquid assets $1 mn planned cash inflow $1 mn planned cash inflow $1 mn planned cash outflow Two small funding sources are better than one large funding source Two small lending customers are better than one large lending customer
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  Applications of liquidityrisk measures 33 Trend analysis What is the change of liquidity risk during last year? Peer analysis Which branch is the outlier? Which branch contributes the most liquidity risk? Liquidity risk limit Positive regulatory liquidity surplus at 99.9% confidence level Diversification analysis What is the benefit of adding more funding sources? Scenario analysis How much more regulatory liquidity is required if a new branch is opened in Shanghai? Stress testing Manipulation of expected cash inflow level, cash outflow level, Further extensions Internal definition of liquidity and cash flows Total cash inflow and total cash outflow broken down by business line, funding source and customer base gulatory liquidity surplus Stock of high quality liquid assets M Σ = k Σ = + inf month Total cash low next 34 volatilities and correlation = − N k Total cash outflow next 1 k 1 k month Re Your opinions To download paper and simulation model http://sites.google.com/site/quanrisk