liquidity risk management - uni-passau.de · view liquidity risk management as an enterprise-wide...

Liquidity Risk Management Managing Liquidity Risk in a New Funding

Environment

Peter Neu and Pascal Vogt

April 2012

Managing Liquidity Risk in a New Funding Environment 2

The Boston Consulting Group April 2012

TABLE OF CONTENTS

Preface .................................................................................................................................................................... 2

The Elements and Shortcomings of Liquidity Risk Management ...................................................................... 3

View Liquidity Risk Management as an Enterprise-Wide Task ......................................................................... 4

Further Diversify Funding Sources ....................................................................................................................... 5

Pass on Funding Costs via Internal Transfer Pricing .......................................................................................... 7

References ............................................................................................................................................................ 10

Recent BCG Papers on Risk Management ......................................................................................................... 10

Authors .................................................................................................................................................................. 10

Preface

The recent financial crisis has revealed shortcomings in risk management that have imperiled not just institutions but entire sectors of the financial-services industry. Banks and regulators have been quick to address some of the most serious flaws and outlined significant changes under the so-called Basel III framework. Capital and liquidity reserves are being increased, risk weights for market, securitization and counterparty risk have been raised, a leverage ratio as a second line of defence has been proposed, and stress tests and contingency plans are being reinforced. Liquidity risk is new on the regulatory agenda. Basel III introduces two key liquidity requirements (see Box 1): the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). In a 2010 quantitative impact study (QIS), the Basel Committee and the Committee of European Banking Supervisors (CEBS), estimated that the global banking industry would need an additional €1.7 trillion in liquid assets to comply with LCR if banks were to make no changes in the liquidity-risk profiles. Together, the new liquidity requirements will further complicate bank's refinancing efforts. The ability of banks to manage the wall of refinancing in the coming years will hinge on a number of factors, including the government efforts to resolve the sovereign-debt crisis. Banks can ease their refinancing burdens by deleveraging and reducing their balance sheets and showcasing their solvency – for example, by demonstrating strong wholesale-funding abilities.

But to prevent another crisis of this magnitude, banks must address the fundamental issues that compromised their ability to manage risk. For example, risk management practices have been dulled by an over-reliance on complex mathematical models, which have supplanted business judgment and have allowed quantitative measures to trump qualitative insights. Banks should take actions to strengthen risk management, in general, such as fostering a risk culture, redesigning incentive schemes, and reasserting the role of business sense in risk management.

Prior to the crisis, liquidity risk did not receive as much attention—from regulators or banks—as other threats, but it ended up magnifying and spreading the damage inflicted by credit and market risks. Few banks now doubt the urgency to strengthen liquidity risk management. It is essential for restoring the stability of banks and preventing another systemic financial crisis.

This chapter focuses on how banks should manage liquidity risk.



The Elements and Shortcomings of Liquidity Risk Management

In the broadest sense, liquidity is the capacity to obtain cash when it is needed. While this definition applies to all types of financial and non-financial enterprises, liquidity risk for a bank is more specific. It is the risk that a financial institution will be perceived as being unable to meet present and anticipated cash-flow needs.

Liquidity risk can be segmented into three categories: maturity mismatch risk, contingency liquidity risk, and market liquidity risk.

Managing mismatches in cash flows is an integral part of the business and a relatively straightforward task. Maturity transformation is, after all, one of the primary economic functions that banks provide. Banks manage this risk by holding a reserve of central-bank-eligible securities.

Contingency and market liquidity risks are far more difficult to manage. To understand these risks, banks need to anticipate how markets and customers will respond to extreme situations, and how these responses, in turn, will affect the bank’s funding ability and the saleability of its assets. Contingency liquidity risk, for example, is the risk of not having sufficient funds to meet sudden and unexpected short-term obligations. By managing this risk, a bank can safeguard its reputation to meet its obligations, especially in times of crisis. To do this, banks need to develop contingency plans, keep a comfortable level of counter-balancing capacity and capital on hand, and manage investors’ perceptions by disclosing the bank’s liquidity profile and funding needs under different scenarios.

The risk manager’s mission is the same across all types of liquidity risk: to avoid a liquidity squeeze. To this end, a risk manager needs to gather up-to-date, transparent information about cash-flow mismatches, contingency outflows, saleability of assets, and counterbalancing capacity, and run scenarios that test the bank’s capacity to handle various threats. Risks are managed through policies, limits, and contingency funding plans, as well as through actions such as diversifying funding sources. A good manager will also demystify liquidity risk through clear reporting and a comprehensive transfer-pricing system.

Ultimately, however, liquidity risk managers can only be effective if they are involved in an enterprise-wide management and governance process that links risk profiles to a bank’s strategy and business model.

As critical as these practices are, many banks do not have adequate capabilities for managing liquidity risk. The crisis underscored the widespread shortcomings of liquidity risk management, which can be traced back to several factors:

Banks took the pre-crisis condition – ample market liquidity (in particular in money markets), low volatility and low interest rates – for granted and underestimated the importance and relevance of liquidity risk.

Contagion effects leading eventually to excess liquidity needs (e.g., through draw-downs on backstop facilities to conduits, collateral needs in out-of-the-money derivative contracts) were ill-understood and not sufficiently considered in stress scenarios. As a consequence liquidity reserves where too low and consisting of assets with deteriorating market value; contingency plans were inappropriate.

Pricing of liquidity risk was not implemented rigorously. In particular contingent liquidity risk in off-balance sheet positions and refinancing risk in structured tradable assets was priced wrongly leading to an incentive for traders to take excessive liquidity risk. To a considerable part, the P&L of structured desks resulted from a liquidity arbitrage without having the bank realizing and accounting for this.

Liquidity risk was not considered sufficiently in banks’ strategic discussion and planning processes. Quite often treasurers became involved very much at the end of the process leading in some banks to excessive cross-border and cross-currency funding needs to match a strong asset growth.

Regulators did not thoroughly address liquidity risk during the Basel II consolidation process.

Regulators have recognized these short-comings and have put strong emphasis on liquidity risk in the newly issued Basel III



framework by introducing a quantitative liquidity risk framework addressing both short-term and structural liquidity risk (see Box 1) Many banks were not technically

capable of monitoring their gap profile with the necessary detail and frequency. Best-practice monitoring is a daily task. It shows overall gaps as well as gaps by region and currency, and under various scenarios. Also, quantitative techniques for forecasting cash outflows were not always robust, and the counter-balancing capacity of many banks was often insufficient under various stress scenarios.

But technical faults were only part of the reason why banks had difficulty managing liquidity risk; resolving these issues would not necessarily prevent another financial meltdown. Deeper problems stemmed from banks’ reliance on purely quantitative approaches, which suffer from a lack of business judgment. In the case of liquidity risk, qualitative judgment is particularly critical—mathematical models will cover only some of the elements that contribute to a bank’s risk profile. As a result, an emphasis on quantitative, probabilistic methods severely compromised the ability of risk managers to understand implicit liquidity risk in their banks’ business models.

To begin addressing these flaws, banks need to build a better information infrastructure—one that is capable of tracking cash-flow mismatches and contingency liquidity outflows. At a more fundamental level, banks should use three levers to transform their approach for managing liquidity risk. These actions address the core issues that have impeded efforts to control liquidity risk:

View liquidity risk management as an enterprise-wide task.

Further diversify funding sources. Pass on funding costs via internal

transfer pricing. View Liquidity Risk Management as an Enterprise-Wide Task

In many banks, liquidity risk has been treated as just another risk category. Banks built discrete silos and ran isolated stress scenarios to manage liquidity risk. As a result, there has been little meaningful collaboration or communication between this functions and the “business” side of the bank, which determines the bank’s business model and strategy.

The financial crisis has shown that liquidity risk management must be treated as an enterprise-wide task, for two reasons. First, liquidity risk can both stem from and contribute to other kinds of risk, namely credit and market risk, thereby creating a vicious cycle. Liquidity risk might emerge from problems in the bank’s loan book, large trading or operational losses, or doubts among investors or rating agencies about the bank’s business model. Markets will penalize a bank that has excessive credit risk by restricting its access to stable funding. Dependence on short-term funding will, in turn, increase liquidity risk and amplify the effects of credit and market risk. As such liquidity risk is closely connected to capital and losses in P&L.

Second, liquidity risk poses an extreme and often hidden threat. In contrast to market, operational, and credit risks—which result in realized losses nearly every day—liquidity risk is inconspicuous during normal times. Even when a bank’s level of underlying liquidity risk is extraordinary, it can stay dormant until a crisis emerges. Once triggered, however, liquidity risk can quickly threaten a bank’s existence.

Banks can take several steps to ensure that liquidity risk management becomes an enterprise-wide issue.

Set up an Extreme Risk Team. Liquidity risk managers cover a lot of ground. They must pay attention to anything in a bank’s operating or business model that might disturb the cash-flow balance or lead to concerns about the bank’s stability. To help them think and act strategically—with an enterprise-wide perspective—liquidity risk managers should participate in an Extreme Risk Team that:

Analyzes vulnerabilities in the bank’s business model, mainly by simulating extreme events. The team should also look for weak signals of increased liquidity risk, which are not always negative or necessarily alarming—a



warning sign might be a line of business that is growing too fast or is too profitable. In addition, the team should be responsible for turning weak signals into strong ones, mainly by detecting patterns.

Assesses how competitors, investors, or rating agencies regard the bank. Liquidity risk can pose a serious threat to a bank’s reputation.

Gauges the bank’s exposure to deteriorating markets. How quickly could the bank unwind assets, and at what cost against the bank’s capital? How diversified is the bank’s funding and how much depends on short-term wholesale funding? How quickly could the bank deleverage the balance sheet and at what cost against the bank’s capital?

Define suitable stress scenarios. To be relevant, stress tests cannot focus exclusively on improbable events. They must also cover some fairly plausible, even likely, scenarios. In addition, they should account for a contagion effect among markets, risk categories, and business lines. For instance, falling market values in counter-balancing capacity and increased haircuts will heighten the bank’s dependence on unsecured funding. A decrease in interest rates will drive hedges of fixed-rate loan books out of the money and trigger cash collateral calls even though there is no net P&L impact for the bank due to fair-value hedge accounting. Downgrades will lead to cuts in inter-bank credit lines and trigger collateral calls in derivative contracts and backstop lines. Treasury might even be forced to serve uncommitted lines for reputation reasons.

Recognize the link between liquidity risk and capital. As laid out before, liquidity risk is often recognized as a consecutive risk, frequently emerging from P&L-problems in banks’ loan or trading books. Albeit this is true, this can only happen if the bank has a weak balance sheet structure, e.g., strong dependence on unsecured short-term funding (often in foreign currencies), insufficient fungible assets and low term-funding ratios. Nonetheless, there is a clear link between capital- or P&L-at-risk and liquidity which is demand for collateral. Examples are CSA agreements in derivative contracts, margin calls in futures, haircuts in repo funding or overcollateralization in covered bonds. In any

case deteriorating markets and asset values lead to increased collateral demand and pose a significant liquidity risk to banks. To manage this risk banks must consider correlations between different risk factors which can enhance the problem. An example of the last crisis was the link between decreasing long-term interest rates and increasing credit spreads: Banks hedging their fix rate commercial loan book with payer swaps were faced with increasing collateral calls when term rates decreased. Simultaneously, the cash value of some of their liquidity reserve held in sovereign securities deteriorated due to increasing credit spreads. Hence prudent collateral management including appropriate haircuts on securities’ market value, bilateral collateral agreements in derivative contracts, sufficient cash reserves in all relevant currencies and foreword looking stress tests are key.

Develop an integrated view of risk. As a result of such interdependencies, banks must bring together managers from all risk categories and business lines in order to understand the complicated links among scenario outcomes, the bank’s business model, market trends, and behavioral issues. Moreover, liquidity managers—either via a committee or an independent CRO function—must be allowed to mitigate excessive liquidity risk by setting limits such as maximum cash outflow, minimum reserve on counterbalancing capacity, maximum unsecured funding, minimum funding ratio, and maximum loan-to-deposit ratio.

Liquidity managers should be able to do this for the bank as a whole, as well as for individual business lines. The liquidity risk function should also have veto power over decisions involving the bank’s business model.

Further Diversify Funding Sources

The difference between non-bank loans and non-bank deposits is a good indicator of a bank’s funding need. The loan-to-deposit gap in the Euro area widened to €1.5 trillion in November 2007, resulting in a loan-to-deposit ratio of 114 percent (See Exhibit 1) Banks had to close the funding gap using inter-bank, money, and capital market instruments, but the crisis has caused these markets to dry up, leading to a dramatic liquidity squeeze for many banks. Bank's reacted by deleveraging their balance sheets and by raising stable deposits leading to a reduced funding gap



of €0.9 trillion and 108 percent loan-to-deposit ratio by the end of 2011.

Banks that are less dependent on wholesale funding have had fewer difficulties in this crisis. The retail-banking business model, for example, has proven to be much more insulated from illiquidity. However, in many countries extended government protection of retail deposits helped significantly to stabilize the system and to avoid bank-runs (e.g. in Germany). In order to avoid excessive dependence on wholesale funding, banks are trying to tap funding from retail and SME depositors. Not surprisingly, many wholesale banks have, in the wake of the crisis, reacquired or reawakened their retail branch networks, and some former investment banks are looking to build or acquire a retail portfolio.

The prominence of short-term funding strains the liquidity profile of banks. (See Box 2 “Evolution of Euro-area aggregated liability structure since 1997”) Higher dependence on volatile funding increases structural liquidity risk, while extensive off-balance-sheet commitments—including covenants, downgrade trigger, and ABCP backstop lines—increase contingency liquidity risk.

The differences between the pre- and postcrisis funding mixes are clear, and have led to a number of trends (see Box 2):

Unsecured and even secured inter-bank markets have been severely affected by concerns about banks’ stability.

Short-term unsecured money-market funding, bank bond, and securitization markets are almost completely dried up.

Central banks are trying to fill the void by boosting their open-market operations.

Funding spreads are increasing dramatically.

Banks are trying to improve their funding ratios and are concentrating on raising stable non-bank deposits.

Banks are also trying to deleverage their balance sheets and reduce their off-balance-sheet liquidity contingencies.

Understand the crisis-induced changes to funding sources. As outlined above, the crisis showed clear differences between funding needs in normal and stressed markets. We believe that the funding mix and balance-sheet structure will

continue to change dramatically. The unsecured inter-bank funding market will lose the importance it had before the crisis deepened—it will stay dry and will be more regulated. It will be replaced by secured ECB or inter-bank funding, along with a slight increase in non-bank deposits. Banks will reduce maturity transformations and contingency liquidity risk. Additionally, continued deleveraging—spurred by regulators and investors—will lead to smaller balance sheets and higher capital ratios.

As they aim to diversify their sources of funding, banks must look more closely at the changes that are affecting different markets:

Inter-bank funding suffers from a lack of trust and liquidity, brought about by uncertainty over the liquidity situation in banks and by more sensitive credit assessments. Even the inter-bank repo market has been affected.

Money and capital markets have been severely hit by the crisis. Short-term commercial paper, banking bonds, and securitization markets have gone cold. (See the sidebar “Money and capital markets have dried up.”). Recent government guarantees for bond issues in France, Germany, the United Kingdom, and the United States provide some reassurance, but these are only short- or medium-term interventions. They will not solve any underlying problems. In addition, the downturn of securitization markets has eliminated investment-banking products that were widely used before the crisis. It has also led to the downfall of profitable business models and institutions. Strategic changes have to be made in many business models.

Central banks reacted to dried-up funding by boosting their open-market operations. After the collapse of Lehman Brothers, central banks stretched their activities to calm markets and prevent knock-on effects. ECB extended its open-market transactions by 264 percent from Q1 2008 to Q4 2011. These transactions surged in September 2008, after Lehman Brothers fell. During 2009, the ECB was able to reduce its exposure slightly, but it is still at double levels



compared to its pre-crisis engagement (see Exhibit 4.). Additionally, central banks focused to extend the catalogue for central bank eligible assets and to establish programs to directly purchase assets from the market. Moreover, additional banks were enabled to benefit from central bank funding (e.g. by the transformation of the US Investment Banks into Commercial Banks). As term funding markets were again heavily affected by the sovereign crisis, the ECB reacted in December 2011 and February 2012 with two 3Y tender operations floating the market with €500bn term funding to prevent another systemic crisis.

Non-bank deposits have increased. When liquidity became expensive and scarce, many banks focused their attention on retail money. At the same time, investors were looking for a safe haven for their savings. As a consequence, Euro-area term deposits grew by more than 16 percent from 2007 to 2011, from €10.3 trillion to €12.1 trillion, driven largely by households and insurance companies.

Funding spreads are rising. Already hobbled by massive write-downs, banks will need to cope with soaring funding costs. Bank bond spreads fell by 45 percent from 2001 to 2007 but have increased by roughly 230 percent between July 2007 and January 2009. (see Exhibit 5). Despite the recovery of spread levels during 2009/10, the sovereign –crisis boosted spreads back to their peak-levels by the end of 2011. ABS and ABCP spreads were significantly underestimated by the market when it was full of liquidity, and the adjustment to a postcrisis level is not over.

Off-balance-sheet liquidity contingencies will continue to fall. Liquidity risk from off-balance-sheet commitments such as backstop lines, downgrade triggers, and other covenants will be reduced and will be much more closely managed (via limits and liquidity costs). European ABCP issuance dropped by 70 percent from 2007 to 2011 (see Exhibit 4).

Improve the funding mix. The shifts occurring among various sources of funding should compel banks to make five significant changes to the funding mix:

Reduce maturity transformation and dependence on wholesale funding that can disappear at any time, such as unsecured and secured money markets funding.

Reduce contingency liquidity risk by cutting (or at least monitoring more closely) committed and uncommitted credit lines; enforcing bilateral collateral agreements in derivative contracts; and scrutinizing covenants in loan contracts that relate to liquidity outflows (for example, downgrade trigger).

Build a stable base of retail deposits by crediting funding costs to originating units, defining target loan-to-deposit ratios in the planning process, and redefining business models (for example, allowing origination units to offer attractive client rates in order to boost deposits.)

Reduce cross-border/cross-currency funding and incentivize funding in local currencies, ideally from non-banks.

Focus on central-bank-eligible collateral as a liquidity reserve and implement a central collateral-management process that rewards liquefiable collateral.

In addition to these long-term measures, many banks already benefit in the short-term from the singular opportunity of government capital injections to overcome the current situation.

Pass on Funding Costs via Internal Transfer Pricing

The financial crisis has shown that banks overestimated the liquidity of certain asset classes such as ABS and tranches of CDOs, and underestimated potential drawdowns in some backstop credit lines to SPVs. As a consequence, credit lines were mispriced, structured credit assets came to rely on short-term funding from money markets, the cost-of-carry was underestimated, and traders increased their profits linearly with the size of their carry-trade book.

Before the crisis, many banks generated substantial liquidity risk, even if they did not fully



understand its origins and consequences. Moreover, few banks had incentives to manage or control liquidity risk. In fact, some had explicit strategies for boosting short-term profits by assuming more liquidity risk. Most banks followed this strategy without understanding the economic reason behind excess profits in structured credit products shown in traders’ P&L and paid-out bonuses.

Leading banks have since expanded their liquidity transfer-price system to include all on- and off-balance-sheet assets and liabilities. As a result, banks have reduced the incentives for their originating and trading units to generate (risk-free) profits by taking advantage of mispriced funding. They have also identified the inherent liquidity risk in products and business models and have transferred the management of this risk to a central unit in Treasury.

A prudent liquidity transfer-price system consists of three components: pricing structural liquidity risk, pricing contingency liquidity risk, and pricing market liquidity risk.

Price structural liquidity risk. Most banks already transfer the cost of issuing long-term debt from Treasury to the units that originate long-term sticky assets, such as term loans. With the same logic, units that originate stable deposits from retail or corporate clients should be credited opportunity funding costs.

Price contingency liquidity risk. Fewer banks have allocated contingency and market liquidity costs. Treasurers tend to retain unencumbered liquid assets, which are usually central-bank-eligible, as collateral for contingency liquidity risk arising from, say, unexpected draws on credit lines, excess collateral for out-of-the-money derivative contracts, or minimum reserves for settlement transactions. Treasurers earmark these securities either by internal lending or by a true asset transfer to their own portfolio. Depending on the bank’s liquidity risk appetite, these securities are then funded unsecured at term (from one week to up to 6 to 12 months). In a crisis, these assets are used as collateral for central bank or inter-bank repos and thereby generate excess liquidity.

The size and funding horizon of such a liquidity buffer do not depend on stringent arithmetic or statistical calculations but rather are derived from scenario analysis of the liquidity exposure under

the bank’s business model and risk appetite. A liquidity risk manager might, for example, analyze the size of credit lines, their potential drawdowns, and the potential collateral demand from the bank’s derivative portfolio.

Price market liquidity risk. Finally, market liquidity costs need to be allocated to tradable assets—a concept that recently received acceptance on trading floors due to the crisis. Before the crisis, most investment-grade assets could be sold on short notice in the market at fair value. As a result, even highly structured, opaque assets were funded short-term in the money markets. In fact, the funding at Euribor, together with a low regulatory capital charge, were the core of the business model for many banks in the end most damaging carry trade book in structured credits. During the crisis, when these assets deteriorated in price and strained banks’ capital, the secondary markets dried out and banks found themselves facing a liquidity squeeze because of their reliance on short-term funding.

As a consequence, leading banks have changed the funding strategy for running their investment and structured credits book. Instead of using the usual overnight rate, banks use the calculated cost-of-carry with respect to the unwinding horizon of positions. To implement this concept, banks must consider several details that determine the unwinding horizon and the required unsecured funding (for example, the typical daily turnover of the security relative to the bank’s position, repo eligibility, central bank eligibility, and embedding in hedge group with a derivative contract on the client side such as securities held as hedge in a total return swap).

Put liquidity pricing into practice. Implementing a liquidity transfer-pricing system is a delicate task, given that banks’ funding costs have soared. To be successful, a transfer-pricing system should strike a balance between the needs of liquidity risk managers and the sales units.

Quite often, liquidity transfer-pricing is criticized by originating units for interfering with their targets for growing market share or revenue. But a bank’s funding costs are real, and they reflect the bank’s competitive position in the market. If these costs are not passed on to the customer, the bank will not be profitable in the long run.

To ensure that a liquidity transfer-pricing system is efficient and fair, Treasury must generate



neither a profit nor a loss from the bank’s funding position. It can do this by following five principles:

Liquidity costs are calculated on the basis of the bank’s marginal funding costs. Treasury must use a blended rate for term-issues in the institution’s own funding instruments such as listed debt, private placements, and covered bonds.

Liquidity costs for business lines are debited and credited. This gives incentives to originating units to underwrite loans and raise deposits and collateral. Originating units may net these costs on a portfolio basis, thereby achieving a more competitive customer rate for key clients.

Liquidity costs are calculated assuming matched funding with respect to the liquidation horizon (See the sidebar “Transfer-pricing methodology and evolution of liquidity cost.”). Benefits from a maturity transformation are shown in the Treasury P&L. However, Treasury may lower the term funding curve according to expected profits from a target maturity transformation corresponding to a funding ratio limit below 100 percent.

Liquidity costs are calculated with respect to the liquidation horizon. Treasury must use behavioral and not contractual cash flows. Behavioral adjustments refer to product-types (such as project finance, sight deposits, current accounts), clients (retail, SME, wholesale), or markets (sale of securities). The aim is to use products, clients, or market specifications to lower transfer rates. For this to work, banks must introduce a mechanism that penalizes significant deviations from expected behavior.

Cost-of-carry for tradable assets must be calculated with respect to the unwinding horizon of the entire portfolio. Treasury must reduce funding costs when assets are self-funding in the repo market (inter-bank or with central banks). Some attractive products may become unprofitable when liquidity costs are correctly allocated.

* * *

The financial crisis has demonstrated, with alarming clarity, the consequences of underestimating liquidity risk. For many banks, improving liquidity risk management will require fundamental change.

Banks must elevate liquidity risk management to an enterprise-wide discipline that contributes to, and is informed by, a bank’s business model and strategy. And given the extreme (and often hidden) nature of liquidity risk, banks should develop a deep understanding of their balance-sheet dynamics—one that encompasses all risk categories and synthesizes their implications for liquidity and capital. At the same time, an empowered risk function, backed by an Extreme Risk Team, will need to be at the heart of a bank’s decision-making processes.

In addition, liquidity risk managers will need to focus squarely on the funding challenge. Funding has become much more difficult and expensive to acquire. Spreads have widened across the board, and many funding markets have dried up completely. In the short-term, banks will have to rely on money from central banks and funding from deposits, which are experiencing a renaissance. In the long term, banks will need to concentrate on diversifying their sources of funding.

A more prudent approach to liquidity management—with a strong focus on cross-border and cross-currency funding exposure, collateral management, and liquidity transfer-pricing—will be critical to success, particularly as banks’ funding mix and balance-sheet structures continue to change. The unsecured inter-bank funding market will lose its importance as a funding source, for example, and will be replaced by secured ECB or inter-bank funding and non-bank deposits. Banks will also deleverage their balance sheets, reduce maturity transformation and contingency liquidity risk, and increase capital ratios.

Banks that establish empowered, capable functions for managing liquidity risk will not only accelerate their recovery from this crisis, but will also find themselves in a much stronger strategic position.



Acknowledgments. The authors would like to thank Carsten Heinen and Kyrill Radev who supported the preparation of this article as well as Robert Fiedler and Leonard Matz for their valuable input.

References

Principles for Sound Liquidity Risk Management and Supervision, BCBS, June 2008

Second Part of CEBC’s technical advice to the European Commission on liquidity risk management, September 2008

Strengthening liquidity standards, FSA Consultation Paper, December 2008

Enterprise-wide Liquidity Risk Management—Still slipping through our fingers? Jonathan York, The RMA Journal, September 2008

The Turner Review: A regulatory response to the global banking crisis, FSA, March 2009

FSA discussion paper: A regulatory response to the global banking crisis, FSA 2009

International framework for liquidity risk measurement, standards and monitoring, BIS Consultative Document, BCBS December 2009

International framework for liquidity risk measurement, standards and monitoring – Update of Annex, BCBS, July 2010

The Basel Committee’s response to the financial crisis: report to the G20, BCBS October 2010

Recent BCG Papers on Risk Management

Operational Risk Management: Too Important to Fail, by Pierre Pourquery and Johan de Mulder, February 2009

New Risk Regime, by Philippe Morel, Peter Neu, Pierre Pourquery and Duncan Martin, December 2008

All Dried Up: The Impact of the Subprime Crisis on Liquidity Risk Management, by Peter Neu and Philippe Morel, May 2008

The Current Crisis: Is the Worst Behind Us? by Philippe Morel and Pierre Pourquery, March 2008

The Subprime Crisis: Do Not Ignore the Risks, by Philippe Morel, Pierre Pourquery and Peter Neu, September 2007

Facing new Realities in Global Banking – BCG Risk Report 2011, by Ranu Dayal, Gerold Grassoff, Douglas Jackson, Philippe Morel and Peter Neu, December 2011

Authors Peter Neu Partner and Managing Director, Risk Expert Team BCG Frankfurt +49 69 9150 2160 [email protected] Pascal Vogt Project Leader, Risk Expert Team BCG Cologne +49 221 5500 5213 [email protected]



Box 1: Basel III introduces key ratios for Liquidity Management Basel II covered liquidity risk originally under Pillar 2 referring to the Sound practices paper from the BCBS from 2000. In this document all relevant topics were addressed. However, implementation of these standards lagged with banks being more than busy and budgets being more than tight with Pillar 1 topics. In addition there was ample liquidity in the market leading to different priorities at both the regulatory and the banking side. The crisis has shown however that liquidity risk is real and its proper management is crucial. In December 2009 the BCBS has proposed two new global measures for managing liquidity risk – going for the first time from the previous qualitative to a quantitative approach: a (stressed) 1-month liquidity coverage ratio (LCR) and a structural (> 1 year) net stable funding ratio. The former ratio is to immunise banks for short-term liquidity shocks (liquidity reserve). The latter limits the refinancing risk and the maturity transformation in funding. See the BIS document International framework for liquidity risk measurement, standards and monitoring from December 2009 and the update from July 2010 for the definition of qualifying liquid assets and the product specific weighting factors to determine the net cash outflows.

Source: International framework for liquidity risk measurement, standards and monitoring, BIS-consultation document, Dec 2009, update of Annex in July 2010



Exhibit 1: Aggregated funding gap of Euro-area credit institutions

1. Loans to non-banks 2. Deposits of non-banks 3. Certified liabilities issued by banks and building associations 4. Dezember 2011 Source: ECB; Bloomberg

Exhibit 2: Euro-area1 aggregated balance sheet in December 2011

1. MFI (exkl. Eurosystem), ex Euro zone positions allocated 2. Incl. reverse repos 3. Securities and loans to banks vs. short term liabilities (<1Y) 4. Loans to non-banks and other assets vs. >1Y liabilities

Source: ECB, Bloomberg, BCG analysis

Exhibit 3: Evolution of European1 ABCP issuances

1. Incl. UK

Source: 2006-Q3 2011 AFME Securitisation Data Report



Box 2: Evolution of Euro-area aggregated liability structure since 1997

1. Percentage points; Source: ECB, Bloomberg

10

0

1.8 %

2011

33.6

2010

32.2

2009

31.1

2008

31.8

2007

29.5

2006

26.0

2005

23.6

2004

21.4

2003

19.8

40

2002

18.8

2001

18.2

2000

16.7

8.4 %30

20

€ Trillion

CAGR 2000-2008 and 2008-2011

Equity & other liabilities

2.2

Issuedbonds

-1.1

Deposits of non-banks

-1.2

Depositsof banks

-3.6

3.1ECB funding

Money marketfunds

0.7

0.9

-6.6

2.4

-0.9

-0.4

4.8

Share of total liabilitiesDelta 2008 vs. 2000 in PP1

Share of total liabilitiesDelta 2011 vs. 2008 in PP

Box 3: Money and capital markets have dried up in 2009

1. ECB statistic 2. UK resident MFI 3. Year-end levels financials 4. Non-convertible bonds; incl. non-Euro area countries (Thomson Financial category); Source: Bank of England; ECB; Federal Reserve volume statistics; Thompson Financial; Bloomberg



Exhibit 5: Evolution of bank-financing1

1. Spread over government securities of comparable maturity

Source: Bloomberg; ECB

Exhibit 4: ECB open market transactions and lending1

1. Marginal lending and other claims on Euro area credit institutions, main refinancing, long-term refinancing and fine-tuning operations

Source: ECB



Box 4: Transfer-pricing methodology and evolution of liquidity cost

1. Exemplary European Bank funding curve 2. Euro Swap curve 3. European Sovereign Benchmark curve 4. Euribor 5. Eurepo

Note: Curves as of 31 Dec 2010, 31 Dec 2011 and 29 Feb 2012 respectively.

Source: Bloomberg; BCG analysis

liquidity risk management - uni-passau.de · view liquidity risk management as an enterprise-wide...

Documents