Chapter 5 looks more at governance rules and processes to adequately control liquidity risks, looking at regulatory indications and providing insights on reporting and control standards, limit setting and contingency planning.
CHAPTER 1
Funding and Market Liquidity
We introduce funding liquidity risk in this first chapter and the stance of some regulators on the controls expected. The first section highlights some facts, events and changes in market conditions that have increased the importance of this risk type, so relevant in recent years. It should also provide an overview of the challenges that banks' treasury functions will face and will suggest how a financial institution could address and possibly manage them, in particular when one is experiencing stressed, difficult market conditions. The second section presents some indications on the management of liquidity funding risk, based on the author's experience and lessons learnt. The third and longest section describes and comments on regulatory frameworks – focusing on the International Basel Committee, EBA, PRA, USA FED – on liquidity and funding liquidity requirements and indications.
1.1 LIQUIDITY IN THE FINANCIAL MARKETS
Like seatides going up and down, the financial markets history shows a recurrence of events and conditions can be seen as recursive. Further, we can see that something influential at times of abundance becomes suddenly crucial and pricey under other market conditions that are stable, and prices that are reliable when the tide goes out could then change substantially as it comes in. So it was, for example, in the money markets and interbank lending, with the exchange of deposits and funds amongst banks and companies, and then across government and countries. The term liquidity risk can refer to different aspects of risk exposure, indeed though generically indicated as liquidity, one has quite a range of exposures. Possibly, the first distinction we want to make is that between trading versus banking book liquidity exposure, the market liquidity risk and funding liquidity risk. We can define market liquidity risk as the impact on the price of an asset when one disposes of it onto the market/liquidates it. The varying market conditions at the moment of the liquidation of that specific asset are commonly addressed as market liquidity risk or liquidity at risk and this is usually an additional risk element of the overall market risk that takes specifically into account the cost of selling or trying to sell the whole stock of a specific asset. It is quantified in terms of changes in the bid-ask spread and asset price itself as a result of the sale. While many markets are very liquid and deep, this is not the case for some securities and markets, and situations vary depending on market conditions as stress market conditions and rating deterioration will have a great impact. Funding liquidity risk is instead conceptually related to the banking book and the bank's capacity to ensure its payment obligations as due contractually. This is also referred to as the refinancing risk (Figure 1.1 below presents the European Central Bank official refinancing rate from March 2008 through March 2013) and it can be divided, in turn, into short-term refinancing – where banks have to meet deadlines in a few days or a few months, sometimes having to ensure balancing of cash inflows and outflows of billions – and that of long-term equilibrium or imbalances in funding maturity profiles and invested assets.
Figure 1.1 Central banks' official rates.
Source: ECB, BoE, FED.
For banks, liquidity represents the capacity to secure the necessary funding, either through attracting deposits – wholesale or individual – or from their own immediately available cash or through pledging unencumbered assets to other financial institutions that can easily be converted into cash in the markets. Banks' current operations also generate income flows that can be considered for liquidity ends, as any means of attracting additional inflows over time can also be considered part of banks' cash sources.
So then, liquidity risk is the diminished capacity to gather cash against payment needs in normal market conditions. The capacity for meeting financing obligations ought to include sudden reductions in funding capacity or unexpected peaks in cash demands. The assets available for funding capacity should be sufficient to offset the net outflow in both normal conditions and during financial market crises; the available counterbalancing capacity is a measure of banks' refinancing, buffers or liquidity reserve that will permit banks to tackle unexpected adverse net cash flows. However, on the government side, systemic risk is the paramount risk; sudden deposit runs and withdrawals may require larger buffers than banks might desire in terms of risk appetite and cost efficiency.
Banks' liquidity buffers encompass cash and securities, kept to sustain liquidity needs in periods of market stress: these consist of cash and other unencumbered stocks and allow them to meet payments in critical market conditions, setting also a target minimum survival period. One should build counterbalancing capacity during normal market conditions, therefore anticipating this complexity when a liquidity crisis heats up is a core part of regular liquidity refinancing and target plans, balancing the cash inflows and outflows to guarantee adequate sources of funding are provided and appropriately used.
Regulators typically address both sides of the balance sheet and the importance of timing: liquidity becomes the ability to make payments as they fall due and to ensure asset growth or lending renewal. More recently, there has been a focus on the negative impact on earnings and capital. Regulators may differentiate between several subsets of liquidity risk depending on the time horizon considered (e.g. strategic vs. tactical), distinguishing between normal and stressed periods (contingency liquidity risk) and types of risks (e.g. funding vs. market liquidity risk).
Liquidity risk is the current or prospective risk arising from an institution's inability to meet its liabilities/obligations as they come due without incurring unacceptable losses. This is usually referred to as funding liquidity risk. There is also a market dimension to liquidity risk that has become more relevant in recent years as institutions' reliance on market or wholesale funding has increased.
Market liquidity risk is the risk that a position cannot easily be unwound or offset at short notice without significantly influencing the market price, because of inadequate market depth or market disruption.
One way to cover a funding shortfall is through asset sales, here the ability to obtain funds through the sale of assets mitigates funding liquidity risk. Market illiquidity or reduced market liquidity can disrupt an institution's ability to raise cash, and thus its ability to manage its funding liquidity risk.
Expert discussion suggests this definition of market liquidity risk might be considered too narrow, in that the absence of market liquidity to unwind or offset a position, which only affects changes in value, does not impact cash flows. The change in value could result in liquidity demand via margin calls or additional collateral requirements and could be of such a magnitude as to cause a material erosion in the capital strength of the institution and/or a rating downgrade.
Beyond the general definition of liquidity, attention should be paid to the liquidity of each individual asset. The general liquidity squeeze prompted by the Lehman crisis, during which presumed highly liquid assets became completely illiquid for more than six months, calls for fresh contemplation of what constitutes a liquid asset and the definition and application in banks of sound liquidity risk management.
In assessing the liquidity value of liquid assets, the time-to-cash period (the time necessary to convert assets into cash) should be considered. A distinction can be made between assets pledged/deposited at central banks, which can be drawn on immediately, and assets on the balance sheet that may have been pledged as eligible collateral, which may take some time to draw on. The time needed to convert a drawn currency to the currency required should also be considered.
Central banks are an important potential provider of funding through refinancing operations, which are distinct from intraday credit. But institutions do not know in advance how much funding they will receive: they receive only what they are allocated in the auction process. In addition,