Liquidity Risk Management Victor Yan, Head of Market Risk

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Objective of Liquidity Risk Management

A primary objective of the liquidity risk management framework: should be to ensure with a high degree of confidence that the firm is in a position to

both address its daily liquidity obligations and withstand a period of liquidity stress affecting both secured and unsecured funding, the source of which could be bank-specific or market-wide.

(Principles for Sound Liquidity Risk Management and Supervision – Basel Committee on Banking

Supervision)

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Case Study

China June Liquidity Event

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China June Liquidity Event

• June 6th • Short term market liquidity began to tighten going into the 3 day Dragon Boat public holidays. • overnight repo reached at 8%. • Market rumor : EverBright Bank didn’t pay 6bn CNY interbank borrowing to Industrial Bank .

• June 14th

• MOF failure to complete the bond sale; MOF only sold 2/3 of 15b CNY 9month bill.

• June 20th

• o/n repo hit as high as 30% intraday.

• June 24th • A Shares down by 5.3% to below 2000.

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Overnight repo rate

• Under the normal market condition, o/n repo rate has been in the range of 2% - 3.5%. • The short squeeze occurred during the current liquidity event hit the o/n repo rate as high as 30%.

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Impact to the Market

• IRS curve bearish flattened with short end squeezed.

• Bond curve also bearish flattened.

• China government 5Y CDS spread increased from 86bps to 147bps during the period

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What Happened?

Lesson Learned

• Over rely on short term Wholesale market borrowing to fund sticky long term assets.

• risk mismatch: short term vs long term; liquid and volatile funding vs sticky assets.

• this was what PBOC’s intended “stress test” targeted on.

• Systemic risk • Risk was suddenly created due to the increase of correlation of liquidity behavior during the event, and the market became one sided.

• No one wanted to lend during the event due to uncertainty.

• Over confidence in PBOC’s injection of market liquidity.

• maintain self liquidity sufficient.

• Put ample liquidity buffer to count for surprise cash outflow. •Don’t over rely on stress assumption. Leave excess buffer for unexpected outflow.

Enhancement of Liquidity Risk Management

• Know the bank’s daily liquidity and cash flow profile by currency. • 30 day MCO (Max Cumulative cash outflow).

• liquidity stress test: name specific / market wide. • Ensure the bank is still liquid under stress scenario.

• Avoid liquidity concentration risk in funding tenor, funding currency, funding counterparty.

• Avoid over rely on whole sale funding to sticky commercial assets.

• Ensure quick cash realization on liquid asset holdings.

• Within bank’s appetite of borrowing capacity.

Market Monitoring

• Understand PBOC’s policy objective and risk tolerance.

• Set a list of market monitoring indicators such as

• short term interbank rates

• PBOC OMO.

• Buy / sell FX by PBOC

• Feel the pulse of the market and analyze the market rumors.

• Timely assess the borrowing capacity if required.

• Pay attention of critical time period to avoid liquidity concentration.

• Market becomes one sided during liquidity crisis due to the increase of correlation of liquidity behavior.

• Self funded by currency to avoid over rely on interbank FX swap market.

Liquidity Stress Analysis

• Carry out liquidity stress scenario analysis close to the actual market condition.

• Know your client and analyze each specific cash flow with probability of IN / OUT over a target time period.

• Take into account of high correlation of liquidity behavior.

• Certain market could become less liquid as market becomes one sided during the event.

• Analyze your survival time horizon.

• Carry out forward looking scenario stress test on critical time period.

• Develop liquidity risk management approach to address any liquidity short fall.

Questions.