Liquidity Risk Management

REPARIS – A REGIONAL PROGRAM

The Use of IFRS for Prudential and Regulatory Purposes Liquidity Risk Management

THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

Liquidity risk management !  

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Background -  Global financial crisis -  Liquidity drying up -  Banks in difficulty -  Central banks injected liquidity -  Liquidity a key issue in the crisis Regulatory response -  Some regulators developed a fundamentally new liquidity regime -  Basel Committee issued new principles for sound liquidity management -  Basel III proposals for liquidity issued to be implemented in 2015 but observation period will start in 2011 for LCR

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Liquidity risk management

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Some key aspects of a new regulatory regime (FSA) -  Systems and controls requirements •  Governing body and senior management oversight •  Measurement and management of liquidity risk, management of collateral •  Business lines, legal entities and currencies -  Stress testing -  Contingency plan Regulator’s own stress testing -  specific criteria -  Buffer as defined by regulator Reporting

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Basel III approach -  Short term: Liquidity coverage ratio (LCR) •  Short term resiliency •  Aim is for banks to have sufficient high quality liquid resources to survive acute stress of one month •  Sufficient liquid assets to survive until day 30 (minimum) of proposed stress scenario •  Appropriate actions by management and supervisors to resolve the issues by day 30

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Liquidity risk management -  Long term: Net Stable Funding Ratio (NSFR) •  Longer term resiliency •  Incentives for banks to fund activities with more stable sources of funding •  Over a 1 year horizon •  Complement the LCR !  

Phased implementation -  LCR observation from 2011 and implementation from 2015 -  NSFR observation from 2012 and implementation from 2018 5


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Metrics to monitor liquidity risk profiles -  Contractual maturity mismatch -  Concentration of funding by counterparty, product, currency -  Available unencumbered assets by amount, type, location, currency -  Market based tools such as equity prices, debt markets, CDS spreads, etc.

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LCR -  Definition of the metric -  Stock of high quality liquid assets/Net cash outflows over a 30-day time period ≥100% -  Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future -  The stock of liquid assets should at least equal the estimated next cash outflows -  Banks are expected to meet this requirement continuously 7


LCR: Stress scenario (examples) -  Loss of unsecured wholesale funding capacity -  3 notch-downgrade in the institution’s public credit rating -  Loss of secured, short term financing transactions for all but high quality liquid assets -  Run-off of a proportion of retail deposits -  Increases in market volatilities that requires larger collateral haircuts -  Some jurisdictions may require on top: closure of FX markets which means that the banks would have to maintain buffer in forex too 8


LCR: Highly liquid assets -  Fundamental characteristics •  Low credit and market risk o  Less risky assets o  High credit standing of the issuer o  Low duration, low volatility, low inflation risk o  Denominated in currency with low foreign exchange rate risk •  Ease and certainty of valuation o  e.g. easy to value with publicly available inputs •  Low correlation with risky assets •  Listed on developed and recognised exchange market

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Market-related characteristics -  Active and sizable market -  Presence of committed market makers •  Quotes available easily -  Low market concentration •  Diverse group of buyers and sellers

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LCR: Liquid asset stock -  High quality liquid asset should be liquid in markets during a time of stress: Level 1: 60% of total stock •  Cash •  Central bank reserves •  Marketable securities with specific criteria such as o  Claims guaranteed by sovereigns, central banks o  Deep repo markets o  Securities are not issued by banks or other financial services entities •  Domestic sovereign debt for non 0% risk weighted countries issued in foreign currency that matches the currency of the bank’s operations

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Level 2: Liquid assets 40% of total stock -  Government assets qualifying for 20% risk weighting under Basel II’s standardised approach for credit risk, with 15% haircut -  Non-financial corporate and covered bonds not issued by the bank itself, AA and above with 15% haircut •  With the following conditions o  Not issued by a bank, investment or insurance firm o  Proven as a reliable source of liquidity in the markets (repo and sale even during stressed market conditions 12


Net cash outflows (I) = Cumulative expected cash outflows (II) – Cumulative expected cash inflows (III) -  I : Net cumulative liquidity mismatch position under stress scenario -  II: Calculated by multiplying outstanding balances of various categories or types of liabilities by assumed percentages that are expected to roll-off, take into account various off-balance sheet commitments -  III: Multiplying amounts receivable by a percentage of expected inflow under stress scenario 13


Liquidity coverage ratio: retail deposit run-offs -  Stable deposits: % run-off factor (assumed by scenario) at least 5% -  Less stable deposits: at least 10% -  There are criteria prescribed for stable and less stable deposits

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Wholesale run-off (assumed scenario) includes: -  Small business 5-10% -  Non-financial customers: 75% -  Other legal entity such as SPVs:100%

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LCR: Cash inflows -  As in the case of outflows, banks will have to make assumptions for inflows e.g. •  Retail inflows 100% from fully performing loans •  Lines of credit: 0% assume no credit facilities as other banks may not be in a position to hnour credit lines •  Other cash inflows e.g planned contractual receivables from derivatives: 0% 15


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NSFR= Available amount of stable funding/Required amount of stable funding >100% -  Banks are expected to meet this requirement on a continuous basis -  Account for off-balance sheet exposures -  Assumptions when performing calculations of reliable source of funds should be under conditions of extended stress

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Proposed stress scenario -  Potential downgrade in a debt, counterparty credit -  Siginficant decline in profitability or solvency arising from: •  Market risk •  Credit risk •  Operational risk No reliance on central bank as a source of funding Material event that impact on credit quality of institution -  Sufficient liquidity for survival of up to 1 year 17


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NSFR (over 1 year time horizon) -  Available stable funding = capital + preferred stock + liabilities + portion of stable non-maturity deposits -  A factor should be applied to available stable funding -  Ranges from 100% to 0% eg 100% to Tier 1 and Tier 2 Capital, 50% to unsecured wholesale funding

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Required stable funding -  There are factors applicable to various types of assets -  Required stable funding = Sum of value of assets held and funded by institution x specific required stable funding (RSF) factor + Amount of OBS x Associated RSF factor -  OBS: Off balance sheet

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RSF factors -  Ranges from 0% to 100% -  Cash, money market instruments: 0% -  Outstanding loans to financial entities with effective maturities of less than 1 year 0% -  Marketable securities 5% •  AA or higher •  0% risk weight under Basel II standardised approach -  Gold 50% -  Loans to retail clients with residual maturity of less than 1 year 85% -  Other assets 100%

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Off balance sheet categories and RSF factors -  10% of undrawn portion for some categories -  Variable % depending on national supervisors for other categories

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Can be challenging to apply

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The rules are prescriptive

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In Basel 3, rather long monitoring period which could include some reporting/disclosures

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Some jurisdictions have started before others

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Not sure how other jurisdictions would apply these rules or indeed other Basel III rules

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Level playing field is a major issue for large international banks

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As for other areas planning and preparatory work is key

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Staying on the sideline is not an option

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Prioritising is very important 22