Asset and Liability Management

Financial Risk and Regulation Series

Chapter 3
Liquidity Risk in the Banking Book
Chapter 3 Outline – Liquidity Risk in the Banking Book (1)

‣ Introduction to Liquidity Risk

• Types of Liquidity
• Sources of Liquidity Problems
• Costs of Mismanaging Liquidity Risk

‣ Liquidity Risk Measurement

• Static Model — The Liquidity Ladder
• Probabilistic Models

‣ Liquidity Risk Management

• Securitization
• Broader Management Principles around Liquidity Risk

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Chapter 3 Outline – Liquidity Risk in the Banking Book (2)

‣ Funds Transfer Pricing

• Cost of funds method
• Net funding method
• Pooled funding method
• Matched maturity method

‣ Risk Reporting

‣ Basel III Liquidity Measures

• Liquidity Coverage Ratio
• Net Stable Funding Ratio
• Monitoring Tools for Intraday Liquidity Management
• Liquidity Reporting Standards

‣ Conclusions
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Chapter 3 Focus

‣ Sources and uses of liquidity

‣ Types and drivers of liquidity risk
‣ Add-on costs of liquidity risk
‣ The relationship between liquidity risk and the credit crisis of 2007 ̶ 2009
‣ Liquidity risk measurement issues
‣ Liquidity risk management alternatives
‣ Best practices in liquidity risk management
‣ Liquidity risk reporting

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What Is Liquidity Risk?

‣ The risk that sources of funds will be unable to meet the institution’s needs for outflow
of funds.

Sources of
• Retail deposit inflows
• Wholesale funding
• Cash flows from loans and Uses of funds
investments • Deposit outflows
• Sale of loans and investments • Loan commitments
• Loan and other asset growth
• Mortgage put-backs

• Liquidity Deficit
• The gap between liquid liabilities and liquid assets

• Banking firms are especially likely to face a liquidity deficit because of mortgage lending (non-liquid assets)
and short-term deposits (liquid liabilities)

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Liquidity Needs

‣ Banks do not know their liquidity requirements in advance

• In case of loans, there is a scheduled repayment structure, but prepayments are possible
• In case of deposits, levels cannot be predicted with certainty

‣ Other liabilities are difficult to predict

• Counterparty failure
• Market risk in leveraged cash or derivative positions

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Sources of Liquidity Stress

Obligations to fund assets (loans)

The variability in short-term
assets and liabilities Maturing of the bank’s own debt

Large depositor withdrawals

Fractional reserve banking Nonperforming assets

system
Bank have to repurchase assets

Repurchase agreements
The short-term components of
long-term assets and liabilities Futures margins

Counterparty collateral calls

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Types of Liquidity

‣ There are two different concepts of liquidity: market liquidity (or asset liquidity)
and funding liquidity.
• Market liquidity is the liquidity inherent in the banks’ assets which exhibit various forms of market
liquidity characteristics.
• Funding liquidity is the liquidity provided by the bank’s liability structure to fund its assets and
maturing liabilities.

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Market Liquidity

‣ Market liquidity characteristics include:

• Ability to sell asset in a liquid market rapidly, and at a bid/offer spread (the difference between the price to
the buyer and seller of the asset) that is small and minimally affected by the size of the transaction.
• Maturity of the asset: a loan with a term of one-week has far greater natural liquidity than a 10-year loan.
• Quality of the asset: a 30-year US Treasury bond is more liquid than a 30-year prime mortgage, which, in
turn, is typically more liquid than a three-year subprime mortgage.

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Funding Liquidity

‣ Funding liquidity depends on:

• Diversification of funding maturities
• Diversification of funding sources
• Availability pre-agreed funding lines
• Committed
• Un-committed
• Availability of collateral
• Market funding conditions
• Relative credit standing of the bank seeking funding

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Liquidity Problems

The
short-term
components
of long-term
assets and
liabilities

Unexpected and substantial deposit The

variability in
or loan withdrawals or funding needs short-term
assets and
liabilities

Fractional reserve
banking system

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The Vicious Liquidity Cycle

Needs to
sell
otherwise
liquid asset

Reduces Declining
liquidity asset values

Posting
Additional
additional
collateral
collateral –
requirement
liquid asset

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Repurchase Agreement (Repo) Example (1)

‣ A Repo
• Involves the sale of securities with the simultaneous commitment to repurchase those securities at a later
date at the original selling price and pay interest accrued
• Fixed at the outset of the repo
• Extended on a day-to-day basis (“open repo”)
• Uses a security as collateral to obtain a loan
• The loan amount is typically less than the value of the security by a haircut
• Behave like margin loans except that the implicit leverage is much greater

‣ The lender takes significant risk in these transactions

‣ It is a loan that is backed by pledged investment securities (collateral)
• If the seller defaults: The purchaser sells the pledged securities
• If the purchaser defaults: The seller can use the loaned amount to replace the securities

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Repurchase Agreement Example (2)

‣ The seller benefits

• Risk and reward associated accrue to the seller
• The beneficial owner
• Change of value (price, default, etc.) accrues to the seller

‣ The buyer
• Risk is thus negligible

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Other Sources of Liquidity Risk
‣ Futures margins
• Banks trade on futures exchanges to reduce their
• Market risk – hedging
• Counterparty credit risk - transacting with a well-capitalized exchange / clearinghouse
• A great deal of liquidity risk in its futures trading
• Cash demands must be met on a one-day notice, banks can find themselves scrambling for funds, faced with the
prospect of liquidating a losing position, selling other assets to raise cash, or finding other sources of short-term liquidity
• Failing these remedies, banks could go bankrupt as a result of their hedging operations.
• Futures margins may vary with prices
• Exchange margin requirements can change unexpectedly

‣ OTC collateral calls

• Over-the-counter derivative positions
• Move against a counterparty in excess of their credit lines usually require collateral to be posted
• Can behave like futures margins as the derivative positions resemble futures contracts
• Behave like repurchase agreements in some cases. Therefore, all the liquidity risks affecting repos and futures
apply to OTC contracts as well.

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Costs of Mismanaging Liquidity Risk

Feb 2008 Sep 2008 Oct 2008

•UK - Nationalization of •US - Wells Fargo •Iceland -
Northern Rock acquisition of Nationalization of all
Wachovia its major banks

Mar 2008 Sep 2008 Oct 2008 During 2009

•US - Collapse of Bear •US - Bankruptcy of •Netherlands - •Over 140 banks failed
Stearns Lehman Brothers Nationalization of in the US alone
Dutch part of Fortis

July 2008 Sep 2008 Oct 2008 Jan 2009

•US - IndyMac Bancorp •US - WaMu seized by •US - Merrill Lynch •Ireland -
seized by federal U.S. and assets sold taken over by Bank of Nationalization of
regulators to JPMorgan America Anglo Irish Bank

Sep 2008 Sep 2008 Nov 2008 Jan 2009

•US - Federal takeover •Germany - •Latvia - Takeover of •Belgium - KBC gets
of Fannie Mae and Commerzbank buys Parex after run on the state support
Freddie Mac Dresdner bank

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Static Model – The Liquidity Ladder

Sources of Uses of ‣ The liquidity ladder is similar to

Cash Cash • Duration and repricing gap

‣ The liquidity ladder looks at the timing

Bank’s drawdown
on credit lines
Customer drawdown
of bank lines and the direction of the cash flows
• Duration gap analysis looks at the valuation
Asset sales Deposit runoffs points

Interest receivable Interest payable

Maturing assets and Maturing contractual

asset sales liabilities

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Static Model – The Liquidity Ladder

‣ Bank U has USD 1 million in cash and USD 20 million in loans coming due tomorrow
with an expected default rate of 2%
• The proceeds will be deposited overnight
• The bank owes USD 8 million on a securities purchase that settles in two days, and pays off USD
13 million in commercial paper in three days that is not expected to renew
• This is Bank U’s current liquidity ladder (without overnight lending):

Total sources Total uses Net liquidity Cumulative

Day(s)
(USD) (USD) (USD) (USD)
1 20.6 20.6 20.6
2 0.0 8.0 (8.0) 12.6
3 0.0 13.0 (13.0) (0.4)
*20.6 = (20 × 0.98) + 1

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Critique of the Static Model

‣ While the static liquidity ladder provides a useful starting point for liquidity analysis,
it is not designed for risk analysis
Example
• If loans default at a higher than expected rate, or depositors withdrew their funds, the bank would show a
worse liquidity outcome than what the model would provide.

‣ For risk analysis

• Banks perform probabilistic analysis on their assets and liabilities to determine the likely and worst
case cash requirements
• Banks do not necessarily hold enough cash to cover their worst possible liquidity outcomes

‣ Probabilistic models of liquidity need do consider the features of all the assets and
liabilities

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Probabilistic Models (1)

‣ Deposits (demand deposits – checking accounts)

• Demand deposits may theoretically be withdrawn at any instant – present a great risk
• Corporations and individuals who use demand deposit accounts are “sticky”
• Banks can expect most retail deposits to stay in place in the short term
• Long-term deposits are not withdrawn frequently and at their maturity are often rolled over

‣ Core deposits
• Serve as chief funding source for the bank.

‣ Input to the models

• Some liquidity trends are easy to predict
• Rents and mortgages are typically paid at the beginning of each month
• Around holiday-time, large funds can be withdrawn to make purchases
• Withdrawals usually increase on Fridays before the weekend
• Deposits increase on Mondays as shops and other businesses deposit the weekend’s cash collections

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Probabilistic Models (2)

‣ Longer-term models of deposit retention incorporate

• Historical behavior of different account types
• Macroeconomic overlays to reflect overall economic conditions such as changes in interest rates
and unemployment
• The balance between time deposits (such as CDs) and demand deposits tends to depend on the
same types of variables

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Aggregation

‣ The best liquidity risk models derive liquidity Day 1 of the maturity ladder under alternative scenarios
(USD millions)
risks for each asset and liability based on Normal
Institution- General
Cash inflows business
common risk drivers conditions
specific crisis market crisis

Example (1) (3) (2)

Maturing assets 100 100 90
• A downturn in the stock market may simultaneously increase
Interest receivable 20 20 10
consumers’ cash needs and their propensity to default on
credit cards. Asset sales 50 60 0
Drawdowns 10 0 5
• The bank’s assets would fall in value, perhaps triggering collateral Total 180 180 105
requirements on loans used to purchase the assets Cash outflows
• Finally, if the bank’s credit rating fell, its trading counterparts Maturing liabilities 50 50 50
would require additional capital as well. Interest payable 10 10 10
Deposit runoffs 30 100 60
‣ Given the difficulty of quantifying all these Drawdowns on lending
50 60 75
individual effects and cross effects, banks need to commitments

Total 140 220 195

• Do stress tests on their liquidity ladders to assess the
Liquidity
adequacy of their liquid assets to cover liabilities coming Excess/(Shortfall)
40 -40 -90

due

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Quantifying Liquidity Risk

‣ How do we quantify liquidity risk?

• The markets, especially, the bid-ask spreads tell use a lot
about the state of the liquidity.
Inventory
• Bid – ask spreads are driven by: carrying
costs
• Order processing costs, which tend to decrease with volumes
• Asymmetric information costs
• Inventory carrying costs
Asymmetric
‣ One way of dealing with liquidity is to adjust the information
costs
VAR rather than come up with a new risk measure.
Order processing
‣ Liquidity adjusted VAR can be calculated by costs, which tend to
decrease with
adding s/2 for each position in the book, where volumes

 is the dollar value of the position and s is

defined as (offer price – bid price) / mid-price.

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Liquidity Risk Management

‣ Liquidity risk management generally requires a detailed contingency plan with both
contracted and uncontracted liquidity provision.
• Contracted liquidity includes changing asset and liability structures to ensure liquidity is available when
needed. It also includes credit lines set up by the bank to cover surprise liquidity requirements.
• Uncontracted provisions include contingency plans developed by the bank to address liquidity shortfalls.
‣ Under normal circumstances, liquidity can be adequately managed by shifting assets
and liabilities, obtaining interbank loans, and drawing down credit lines. Under stress
conditions, a bank must think aggressively about how it might increase liquidity.
‣ The most common methods to increase liquidity in stress conditions include:
• Issuing securities such as bonds
• Obtaining interbank or government loans
• Obtaining additional credit lines
• Selling or securitizing assets
‣ The cash proceeds of these types of offerings increase bank liquidity unless the cash is
invested in less liquid assets.
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Securitization

‣ Securitization is a method by which banks sell illiquid assets.

‣ Securitization of bank assets is the process by which banks issue bonds where:
• The payment of interest and repayment of principal on the bonds depends on the cash flow generated by a
“pool” of bank assets, and
• The bank has transferred its legal rights to payment of interest and repayment of principal to the bondholders.

‣ When banks create such bond issues they greatly increase the inherent (endogenous)
liquidity of the assets that have been securitized.
• In the absence of securitization a bank could only make the assets liquid by selling them, a process that is
likely to be time consuming and expensive and to require substantial effort.

Example
• A bank that has a large number of auto loans would find it prohibitively costly to sell the loans individually to
raise cash. However, if the bank packages the auto loans into a securitized vehicle, obtains a credit rating, and
sells the low-risk tranche of the portfolio, it effectively turns illiquid loans into a security that can be sold,
whether the bank decides to sell the security or not.

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Securitization – US

‣ In the US, it is common for banks to securitize many of their retail loan assets ̶
mortgages and revolving credit card debt ̶ on a continuous basis, and then hold the
assets in securitized form.
• The bank removes these loans from its balance sheet by selling them into a specially created entity often
called special purpose vehicle or SPV.
• The credit risk of these loans is moved into the SPV and as the SPV issues bonds to finance this purchase,
the credit risk is ultimately moved to the holders of bonds issued by the SPV.
• Makes the retail assets highly liquid and makes a bank’s balance sheet easier to manage because:
• Any lack of capital (for example, due to rapid asset growth or as a consequence of bad debt growth) can be
accommodated by selling the securitization bonds
• Any need to diversify credit risk can be accommodated by selling the bank’s own securitized bonds (which may be
naturally concentrated in a certain geographical location), and buying other bonds which increase diversification
• Any need for cash liquidity can be accommodated by securitizing assets through various bonds. Because these bonds
do not depend on the credit standing of the bank for their value, they are not likely to be affected by any change in
depositor or market sentiment towards the bank.

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Broader Management Principles around Liquidity Risk (1)

‣ The Bank for International Settlements published Principles for Sound Liquidity Risk
Management and Supervision in June, 2008.
• The principles underscore the importance of establishing a robust liquidity risk management framework
that is well integrated into the bank-wide risk management process. The primary objective of this guidance
is to raise banks’ resilience to liquidity stress. Among other things, the principles seek to raise standards in
the following areas:
• Governance and the articulation of a firm-wide liquidity risk tolerance;
• Liquidity risk measurement, including the capture of off-balance sheet exposures, securitization activities, and other
contingent liquidity risks that were not well managed during the financial market turmoil;
• Aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create
for the bank;
• Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of
effective contingency funding plans;
• Strong management of intraday liquidity risks and collateral positions;
• Maintenance of a robust cushion of unencumbered, high-quality, liquid assets to be in a position to survive protracted
periods of liquidity stress; and
• Regular public disclosures, both quantitative and qualitative, of a bank's liquidity risk profile and management.

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Broader Management Principles around Liquidity Risk (2)

• The principles also strengthen expectations about the role of supervisors, including the need to
intervene in a timely manner to address deficiencies and the importance of communication with other
supervisors and public authorities, both within and across national borders.

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Funds Transfer Pricing
‣ Funds Transfer Pricing (FTP) refers to the charging and paying of interest from a central
location within the bank, typically the Treasury.
‣ Commercial banks and investment banks have fundamentally different approaches to
funding the asset businesses they manage.
• Commercial banks base their lending on deposits taken at their own branches, while investment banks fund
themselves in the interbank and/or capital markets. As retail depositors are known to be “sticky”—not likely
to withdraw deposits even if a bank is in trouble—it is relatively safe for commercial banks to fund loans.
• Investment banks rely mostly on professional, wholesale markets for funding. This funding source is often
less costly and available in larger volume, but at the same time it is not “sticky.” It has little “staying power,”
meaning if a bank gets into trouble the professional funding sources tend to dry up very quickly.
• Both Northern Rock (2007) in the UK and Bear Stearns (2008) in the US provide examples of what happens to banks
when the wholesale markets have dried up for them.

‣ FTP is at the center of ALM, as it centralizes interest rate exposures from all business
areas within a bank.
• Helps to establish a margin over cost of funds to the liability gathering activities, as well as a margin to be
charged from the asset gathering activities of the bank.

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Funds Transfer Pricing - Benefits

‣ FTP assures that funding is available for asset gathering business lines at a reasonable
and known cost, while simultaneously assuring that liability gathering business lines can
off-load the liquidity they have gathered at a reasonable and known level of income.
‣ There are several additional benefits from operating a centralized FTP operation:
• By transferring interest rate risk to a central location, business lines' balance sheets are rendered immune
from interest rate risk
• By charging for funds transfers, FTP helps determine the Net Interest Income (NII) for each business unit
• By virtue of its position in the supply chain for funding, FTP is effectively a tool for managing a bank's
liquidity risk

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FTP - No interest rate or Liquidity Risk - Treasury Pass-through

‣ The five-year loan is match

funded, leaving no interest rate
or liquidity risk.
• When taken beyond a single loan and a
single liability, this process gives liability
gatherers a significant degree of
granularity to overcome. It would not
be practical or feasible to match each
of a bank’s millions of individual loans
with specific liabilities.
• Treasury would not be able to capture
incremental profits by funding at
different maturities that might be less
expensive. In this Figure the Net
Interest margin (NIM) contribution by
Treasury is zero.

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FTP - Interest Rate and Liquidity Management Centralized – Treasury Maturity
Transformation

‣ The deposit rate is now 1%,

which goes with a shorter
liability maturity of two years.
Under this model, the
Treasury is now contributing
net interest margin, in
addition to the NIM from
lending and deposit-taking,
respectively. The overall NIM
of the bank has increased.

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Optimizing NIM – Cost of Funds Methods

‣ Treasury calculates the weighted average rate of funds raised and uses this rate to
provide funds to all business units.
‣ Knowing their target cost of funds, business units decide which assets to acquire.
‣ This could have unintended effects, in particular a bias towards high-yield lending
opportunities when funding costs are on the rise.
‣ Over the long-run this could increase the overall credit risk in the balance sheet.
‣ The interest rollover cycles determined by Treasury may not be attractive to either
borrowers or depositors.

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Optimizing NIM – Net Funding Method

‣ Business units raise their own funds as needed and only turn to central Treasury to
borrow additional net funds or to park or invest surplus net funds.
‣ Leads to significant duplication of effort.
• In a modern bank there would likely have to be a funding department for each of the retail, commercial,
corporate, and investment banking divisions.
• Retail might need a separate funding department for its credit card business.
• Central Treasury function would still be needed to provide net top-up funding to, or take surplus liquidity
from each business unit.

‣ Maturity mismatches would be widespread.

• Few business units would be able to self-fund at the maturities required by the loan customers, leading to
significant problems estimating interest rate and liquidity risk in the whole bank.

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Optimizing NIM – Pooled Funding Method

‣ Business units need to be segregated into asset-focused and liability-focused divisions

to make practical use of this method.
• Treasury provides separate FTP rates for lending and deposits based on market rates and own cost of funds.
• IT systems need to be robust in order to be able to disseminate accurate market-based rates to all business
units without delay.

‣ Treasury earns a spread between the two FTP rates and in the process becomes a net
contributor to a bank's profitability.
• It is not advisable to allow Treasury the full scope to maximize profits or to play to its own self-interest.
• A more conservative approach would look at Treasury's income contribution as a way of quantifying and
managing the bank's overall NII.

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Optimizing NIM – Matched Maturity Method

‣ The Treasury is not only a central utility, but a vital market place for pricing costs of
funds and deposit returns, separately and transparently, for the whole bank.
‣ Treasury develops optimal transfer pricing curves, which effectively must match external
market yield curves to avoid building arbitrage risk into the bank's business activities.
• It must avoid pricing instruments at a level that would allow external counterparties to buy an instrument
from one business unit and sell a linked instrument back to another business unit for an overall profit to the
external counterparty and loss to the bank.

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Risk Reporting

‣ The Federal Deposit Insurance Corporation (FDIC)

• A main US banking regulator
• Suggested banks to create liquidity risk reports that address the following risk areas:
• Cash flow gaps
• Asset and funding concentration
• Critical assumptions used in credit projections
• Key early warning or risk indicators
• Funding availability
• Status of contingent funding sources
• Collateral uses

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JPMChase and Liquidity Risks – Governance

‣ JPM’s liquidity
risk management
“JPM’s liquidity risk management is centralized in the treasury function. The ALCO (asset-liability committee) is
is centralized in responsible for the execution of the liquidity policy and the contingency funding plan. In sum, the group’s
the treasury responsibility is to measure, monitor, report, and manage liquidity risk. The Annual Report says:

function In the context of the Firm’s liquidity management, Treasury is responsible for:

• Measuring, managing, monitoring, and reporting the Firm’s current and projected liquidity sources and
• The ALCO (asset- uses;
liability committee) • Understanding the liquidity characteristics of the Firm’s assets and liabilities;
is responsible for • Defining and monitoring firm wide and legal-entity liquidity strategies, policies, guidelines, and contingency
funding plans;
the execution of • Liquidity stress testing under a variety of adverse scenarios
the liquidity policy • Managing funding mix and deployment of excess short-term cash;
• Defining and implementing funds transfer pricing (“FTP”) across all lines of business and regions; and
• Defining and addressing the impact of regulatory changes on funding and liquidity.

The Firm has a liquidity risk governance framework to review, approve, and monitor the implementation
of liquidity risk policies at the firm wide, regional, and line of business levels.”

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JPMChase and Liquidity Risks – Funding

‣ “The Firm funds its global balance sheet through diverse sources of funding including a
stable deposit franchise as well as secured and unsecured funding in the capital markets.”
• Sources of funds include the stable portion of deposits, the stable portion of liability balances, and a variety
of short- and long-term instruments. The latter category includes purchased federal funds, commercial
paper, bank notes, long-term debt and trust-preferred capital debt securities.
• Flexibility in funding is afforded by JPMorgan Chase’s reserves of unencumbered and liquid securities. These
securities can be loaned in the repo market or sold in the asset securitization markets.

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JPMChase and Liquidity Risks – Credit Ratings

‣ Credit rating changes can have an enormous impact on liquidity, but for JPMorgan
Chase in 2017, the sensitivity to ratings changes was relatively low.
• “The cost and availability of financing are influenced by credit ratings. Reductions in these ratings could
have an adverse effect on the firm’s access to liquidity sources, increase the cost of funds, trigger
additional collateral or funding requirements, and decrease the number of investors and counterparties
willing to lend to the firm.”

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Basel III Liquidity Measures

‣ The Basel Committee on Banking Supervision (BCBS) published a liquidity management

framework confirming two specific measures for liquidity risk management in Basel III.
‣ Two minimum standards for funding liquidity:
• Liquidity Coverage Ratio (LCR)
• Promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high quality liquid assets
(HQLA) (resources) to survive an acute stress scenario lasting for one month (assessed in each significant currency
exposure for monitoring purposes)
• Net Stable Funding Ratio (NSFR)
• Promote resilience over a longer time horizon by creating additional incentives for a bank to fund its activities with more
stable sources of funding on an ongoing structural basis. Has a time horizon of one year and provides a sustainable
maturity structure of assets and liabilities

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Quantitative Requirements for Liquidity

Definition Application

Stock of high quality liquid assets

Liquidity ≥100% • Maintain 30 days’ liquidity to prepare for
Coverage extreme stress conditions through “high
Net cash outflows over a 30 day horizon
Ratio quality liquid assets”

Stock of highly liquid assets

▪ Low credit and market risk
▪ Ease and certainty of valuation
▪ Low correlation with risky assets and existing positions
▪ Listed on a developed and recognised exchange
▪ Stable and active market, with committed market makers
▪ Low volatility
▪ Assets that tend to be bought during crisis (flight to quality)

All of the calculations must be repeated for each of the currencies, defined as 5%
or more, the bank actively funds itself in.

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LCR – Net Cash Outflows

‣ Total expected cash outflows minus total expected cash inflows in the specified stress
scenario for the subsequent 30 calendar days

Expected cash outflows Expected cash inflows

Consider outstanding balances Consider outstanding balances
of various items with of various items with
appropriate run-off weight appropriate inflow-weight
• Liabilities and OBS commitments by the • Contractual receivables by the rates at
rates at which they are expected to run which they are expected to flow in, up
off or be drawn down to a cap of 75% of outflows

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Liquidity of Various Assets for LCR – Level 1 Assets

‣ Level 1 assets – no limit, no haircut

• Cash and central bank reserves
• Accessible during stress
• Marketable securities of sovereigns, central banks, non-central government PSEs, the BIS, the IMF, the ECB,
or multilateral development banks
• 0% RW in Basel II Standardised Approach
• Trade in large, deep and active repo or cash markets
• Have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions
• Not bank obligations
• Sovereign or central bank debt issued in domestic currencies of the home country or where the liquidity risk
is being taken
• Domestic sovereign or central bank debt issued in foreign currencies, reflecting different host country needs

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Liquidity of Various Assets for LCR – Level 2A Assets

‣ Level 2A and 2B assets combined may not account for more than 40% of the total
stock of HQLAs
‣ Level 2A assets – minimum 15% haircut
• Marketable securities of sovereigns, central banks, non-central government PSEs, or multilateral
development banks
• Assigned a 20% RW in Basel II Standardised Approach
• Trade in large, deep and active repo or cash markets
• Not bank (FI) obligations
• Corporate debt and covered bonds
• Have a credit rating of at least AA-
• Trade in large, deep and active repo or cash markets characterised by a low level of concentration
• Corporate bond or covered bonds not issued by a bank (FI)
• Proven record as a reliable source of liquidity in the markets even during stressed market conditions

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Liquidity of Various Assets for LCR – Level 2B Assets

‣ Level 2B assets – maximum 15% of the liquid asset pool

• Residential mortgage-backed securities (RMBS) – 25% haircut
• Have a credit rating of at least AA
• The underlying asset pool is restricted to residential mortgages and cannot contain structured products
• Corporate debt securities (including commercial paper) – 50% haircut
• Either have a long-term credit rating between A+ and BBB- or do not have an external credit assessment and are
internally rated as having a PD corresponding to a credit rating of between A+ and BBB-
• Common equity shares – 50% haircut
• Exchange traded and centrally cleared
• A constituent of a major stock index in the home jurisdiction or where the liquidity risk is taken
• Denominated in the domestic currency of a bank’s home jurisdiction or in the currency of the jurisdiction where a
bank’s liquidity risk is taken

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The Formula for Calculating HQLA

‣ The formula for the calculation of the stock of HQLA is as follows:

• Stock of HQLA = Level 1 + Level 2A + Level 2B – Adjustment for 15% cap – Adjustment for 40% cap

‣ This can be expressed as:

• Stock of HQLA = Level 1 + Level 2A + Level 2B – Max[((Adjusted Level 2A + Adjusted Level 2B)
– 2/3 × Adjusted Level 1), (Adjusted Level 2B – 15/85 × (Adjusted Level 1 + Adjusted Level 2A), 0)].

‣ The HQLAs consist of the sum of Level 1, 2A, and 2B assets minus the maximum of
three possible variables:
• L2A + L2B – (2/3 of L1);
• L2B – (17.65% of L1+L2A); or
• Zero.

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The Formula for Calculating HQLA – Example (1)

‣ A bank holds 150 Adjusted Level 1, 43 Adjusted Level 2A, and 17 Adjusted Level 2B
assets. Using the formula, the result is:
• 150 + 43 + 17 – Max{[(43 + 17) – (2/3 × 150)], [17 – ((15/85) × (150+43))], 0}. This becomes
• 150 + 43 + 17 − Max(−40, −17, 0), or
• 150 + 43 + 17 − 0 = 210.

‣ This is effectively the maximum allowed net cash outflow for a bank for the next 30
days. This is not too bad, since all assets count in this case. L2A and L2B assets could
be higher, but only 40% of the sum is eligible in the calculation.
‣ If L1 = 17, L2A = 43 and L2B = 150, the calculation looks like this:
• 17 + 43 + 150 – Max{[(43 +150) – (2/3 × 17)], [150 – ((15/85) × (17 + 43))], 0}, or
• 17 + 43 + 150 – Max(181.67, 139.41, 0), or
• 17 + 43 + 150 – 181.66 = 28.34.

48 © 2020 Global Association of Risk Professionals. All rights reserved.

The Formula for Calculating HQLA – Example (2)

‣ If this bank has USD 100 million cash inflow and USD 100 million cash outflow over the
next 30 days, the HQLA's are just barely enough to allow the bank to continue
operating, with a ratio of (28.34/(100 − 75% × 100)) = 113.36%. Just 13.36% more
cash outflows than inflows and the ratio goes down to 100%.

49 © 2020 Global Association of Risk Professionals. All rights reserved.

Projected Timeline of International Implementation

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Quantitative Requirements for Liquidity

Definition Application

Net Stable Available amount of stable funding • A longer-term (one-year) “structural” ratio
≥100%
Funding based on a bank’s funding for its expected
Ratio Required amount of stable funding portfolio

Stable funding = those types and amounts of equity and liability funding expected to be a reliable source
over a one-year horizon (i.e. funding likely to remain for a year in a difficult period for the bank)

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NSFR – ASF and RSF Factors

Available Stable Funding (ASF) factors Required Stable Funding (RSF) factors

100% – capital, preferred stock, secured and unsecured borrowings and 0% – cash, central bank reserves, securities with maturity less than 1 year
liabilities with maturities more than 1 year
5% – debt issued/guaranteed by sovereigns with 0% RW, undrawn
95% – stable retail and small business demand and term deposits with amount of committed credit and liquidity facilities
maturities less than 1 year – “core deposits”
50% – loans to non-FI corporates, sovereigns, PSEs with maturities less
90% - Less stable non-maturity (demand) deposits and/or term deposits than 1 year
with residual maturities of less than one year provided by retail and
small business customers 65% – unencumbered residential mortgages with 35% RW with maturities
less than 1 year
50% – unsecured wholesale funding, non-maturity and term deposits
with maturities less than 1 year provided by non-FI corporates, 85% – other loans to retail and small business with maturities less than 1
sovereigns, etc. year

0% – liabilities (including FIs) and equities not addressed explicitly 100% – all other assets not explicitly noted

National discretion – other contingent funding obligations (e.g.

Guarantees)

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NSFR of Large European Banks, Year-End 2013
Large European Banks’ Reported Net Stable Funding Ratios (%) as at End of 2013

ABN AMRO Bank NV 105

Barclays Bank PLC 110
Rabobank Nederland NV 114
Credit Suisse AG >100
Erste Group Bank AG >1001
KBC Group NV 111
Royal Bank of Scotland PLC 122
Standard Chartered Bank 110-120
Swedbank AB 97
UBS AG 109
1As of the third quarter of 2013

Source: Standard & Poor’s

Monitoring Tools for Intraday Liquidity Management
‣ Principle 8 of the BCBS Principles for Sound Liquidity Risk Management and Supervision
(September 2008) document gives clarity on six operational elements that requires
management on an intraday basis. These are:
• Capacity to measure inflows and outflows and anticipate their timing
• Capacity to monitor liquidity positions against expectations
• Acquisition of intraday funds
• Ability to manage and mobilize collateral
• Capacity to manage the timings of inflows and outflows
• Preparedness to deal with disruptions to liquidity flows

‣ The BCBS Monitoring tools for intraday liquidity management (2013) document sets out
a number of issues to monitor and manage in order to achieve good intraday liquidity
management. These are:
• Detailed design of the intraday liquidity monitoring tools
• Intraday liquidity stress scenarios
• Scope of application of the tools

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Daily maximum intraday liquidity usage

Source: Monitoring tools for intraday liquidity management, bcbs248.pdf, BCBS, April 2013

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Liquidity Risk Reporting

‣ Both LCR and NSFR should be used on an ongoing basis to help monitor and control
liquidity risk
• Requirements to be met continuously

‣ The LCR should be reported at least monthly

• During crisis – weekly or even daily

‣ The NSFR should be calculated and reported at least quarterly

‣ NSFR initially used as a monitoring tool but became a requirement from 2018

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LCR Common Disclosure Template

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NSFR Common Disclosure Template - ASF

58 © 2020 Global Association of Risk Professionals. All rights reserved.

NSFR Common Disclosure Template - RSF

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Summary (1)

‣ Introduction to Liquidity Risk

• Interest rate risk in the banking book is the risk of loss due to adverse changes in interest rates.
• Liquidity risk in the banking book is the risk of not being able to fund the holding of an asset or the retirement of a liability.
• Liquidity risk management is a vital area of risk control.
• Historically, liquidity management was focused on by estimating depositor behavior and drawdowns on credit lines.
• Currently, liquidity problems can arise due to leveraged lending (if asset values fall), margin requirements, and
counterparty defaults.
• Banks address their needs with their endogenous, exogenous, and external liquidity.
• Endogenous liquidity is the liquidity inherent in bank assets themselves.
• Exogenous liquidity (often called funding liquidity) is the liquidity provided to the bank by its liability structure, including its
ability to borrow and obtain contingent lines.
• External liquidity is the non-contractual contingent capital supplied by investors and other institutions to support a bank
during times of liquidity stress
• Liquidity mismatches can cause serious problems, as was highlighted by the crisis at Long-Term Capital Management
(LTCM), a US hedge fund.
• As a direct result of the LTCM crisis, many trading businesses now ensure that they have better access to long-term
funding through instruments such as committed funding lines (i.e., commercial bank commitments to lend to them).

60 © 2020 Global Association of Risk Professionals. All rights reserved.

Summary (2)
‣ Liquidity Risk Measurement
• The classic tool for measuring the bank’s liquidity position is the liquidity ladder, a snapshot of the bank’s projected cash
flow sources and uses.
• The liquidity ladder is usually produced to assess short-term liquidity requirements.
• Gaps in liquidity can be filled by selling assets, drawing down credit lines, or issuing securities.
• The biggest problem with the liquidity ladder approach is that it does not address the probabilistic nature of cash flow
requirements.
• No one can predict with certainty runs on the bank or customer demands for cash on their credit lines.
• As a result, the best models consider the range of possible outcomes for liquidity demand, and the drivers of those
outcomes.
• Liquidity models have the same level of complexity as VaR models and credit models, and the same shortfalls, such as
reliance on past relationships and problems integrating risks across related assets.

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Summary (3)
‣ Liquidity Risk Management
• Under normal circumstances, liquidity risk is well-behaved and relatively easy to manage.
• During times of stress, banks turn to security issuance, interbank or government loans, obtaining additional credit lines,
and selling or securitizing assets.
• As an example of security issuance, during the global financial crisis, Goldman Sachs issued USD 5 billion in preferred
stocks to Warren Buffett in order to help the company improve its liquidity position.
• Securitization of bank assets is the process by which banks issue bonds where the payment of interest and repayment of
principal on the bonds depends on the cash flow generated by a “pool” of bank assets, and the bank has transferred its
legal rights to payment of interest and repayment of principal to the bondholders.
• When banks create such bond issues they greatly increase the inherent (endogenous) liquidity of the assets that have
been securitized.
• In the US it is common for banks to securitize many of their retail assets on a continuous basis and then hold the assets in
securitized form.

‣ Risk Reporting
• At a minimum, banks should prepare liquidity ladders, probabilistic analysis, and stress tests of their liquidity requirements.
• In addition, in the US the FDIC recommends reports related to cash flow gaps, asset and funding concentration, critical
assumptions used in credit projections, key early warning or risk indicators, funding availability, status of contingent
funding sources, and collateral uses.

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About GARP | The Global Association of Risk Professionals is a non-partisan, not-for-profit membership organization
focused on elevating the practice of risk management. GARP offers role-based risk certification – the Financial Risk
Manager® and Energy Risk Professional® – as well as the Sustainability and Climate Risk™ certificate and on-going
educational opportunities through Continuing Professional Development. Through the GARP Benchmarking Initiative and
GARP Risk Institute, GARP sponsors research in risk management and promotes collaboration among practitioners,
academics and regulators.

Founded in 1996, governed by a Board of Trustees, GARP is headquartered in Jersey City, NJ, with offices in London,
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