risk europe april 2011

BCM International Regulatory Analytics LLC

Barbara C. MatthewsBCM International Regulatory Analytics LLCBCM International Regulatory Analytics LLC

www.bcmstrategy.comApril 2011p


OverviewThe Basel framework: summary & short politicalThe Basel framework: summary & short politicalhistoryLiquidity & Cross Border Resolution: charting theLiquidity & Cross Border Resolution: charting theintersectionsLiquidity Risk Regulation beyond the bankingLiquidity Risk Regulation beyond the bankingsector: who falls within the framework?Liquidity Risk Regulation & the Trading Book:Liquidity Risk Regulation & the Trading Book:charting the feedback effects

©2011 all rights reservedwww.bcmstrategy.com


Main themesThe measurement and management of bank fundingg gliquidity risk is not merely a quantification challengeShifts in the cost structure of bank funding will haveprofound effects on how economic growth is managed,p g g ,how sovereign debt management functions areexecuted, and how monetary policy will be formed.Public policy interests in the liquidity profile ofPublic policy interests in the liquidity profile ofsovereign debt will affect (i) the shape and contours ofbank liquidity risk management and (ii) the cost ofcorporate finance for the foreseeable future.corporate finance for the foreseeable future.Are your risk management systems ready toincorporate these non quantitative risk factors?



The Basel FrameworkThe Basel FrameworkSummary & Short Political History



G20 MembersS i S I i l G i19 Sovereign States

ArgentinaAustraliaBrazilCanadaChina

1 International GroupingEuropean Union (Council Presidency) + ECB

4 Ex Officio ParticipantsManaging Director, International MonetaryFundChina

FranceGermanyIndiaIndonesiaItalyJ

President, World BankChair, International Monetary and FinancialCommittee (IMF)Chair, Development Committee (WorldBank)

JapanMexicoRussiaSaudi ArabiaSouth AfricaSouth Korea

BUT NOTFinancial Stability BoardSouth Korea

TurkeyUnited KingdomUnited States of America

Financial Stability BoardBISBasel CommitteeIOSCOIAISIASB



Basel 1 2 3Early 1970s: Basel Committee created to addressEarly 1970s: Basel Committee created to addressFX settlement/Herstatt risk1980s: Latin American debt crisis (“sovereigns9 ( gdon’t go bankrupt”; TBTF; Continental Illinois)1988: Basel 1 (OECD sovereigns don’t go bankrupt;i k i tl i th t )risk is mostly in the assets)2000s: Basel 2 (AAA rated entities don’t gobankrupt; risk is mostly in the assets)bankrupt; risk is mostly in the assets)2010: Basel 3 (Liquidity & high reg cap can help abank avoid bankruptcy; return of ALM)p y; )



The Great Dollar Shortage

“Taken together, Graphs 2 and 3 thus show that several Europeanbanking systems expanded their long US dollar positionssignificantly after 2000 and funded them primarily bysignificantly after 2000, and funded them primarily byborrowing in their domestic currency from home countryresidents. This is consistent with European universal banksusing their retail banking arms to fund the expansion ofusing their retail banking arms to fund the expansion ofinvestment banking activities, which have a large dollarcomponent…In aggregate, European banks’ combined long USdollar positions grew to more than $800 billion by mid 2007dollar positions grew to more than $800 billion by mid 2007(Graph 5, top left hand panel), funded by short positions inpounds, sterling, euros and Swiss francs.”

l ( h )BIS Quarterly Review (March 2009), p. 52 53.



The Great Dollar Shortage

“ I h US d ll k f d f h L h“ In sum, the run on US dollar money market funds after the Lehmanfailure stressed global interbank markets because the funds bulked solarge as suppliers of US dollars to non US banks. Public policiesstopped the run and replaced the reduced private supply of dollarsstopped the run and replaced the reduced private supply of dollarswith public funding…European banks increased their dollar assetssharply (from 1999 to 2008). Since this growth outran that of theirretail dollar deposits, they bid for dollars from nonbanks andbanks As European banks relied more on the foreign exchange swapbanks…As European banks relied more on the foreign exchange swapmarket to obtain dollars against European currencies, they did notmeet US banks with a complimentary need for European currencies.Under these circumstances, this asymmetry led to skewed foreign

h i h hik d h f i i d ll ll bexchange swap prices that hiked the cost of raising dollars well abovean already elevated Libor dollar rate.”BIS Quarterly Review (March 2009), p. 65 66.



The Great Dollar ShortageThis vulnerability highlights why the IMF reform (especiallySDR f ) i h f h F h P idSDR reform) issues are at the top of the French Presidencyagenda for the G20 and why the Basel Committee wentforward with the liquidity risk framework over the objectionof European banksof European banks.However, global monetary reform requires long timeframesand implies significant shifts of economic policy sovereignty.Current experience in Europe suggests this is not likely toCurrent experience in Europe suggests this is not likely tooccur quickly, if at all. These issues and their implications forthe global economy are beyond the scope of today’spresentation.pAs the eurozone and its banks continue to experience stressin the near term, an alternative framework is needed todecrease European banks’ reliance on short term dollarf d l d h l d k f kfunding. Enter Basel 3 and the liquidity risk framework.



The Liquidity Risk Framework – The Big Picture

Underlying Premise: “During the early ‘liquidity’phase of the financial crisis that began in in 2007,

b k d it d t it l l l tillmany banks – despite adequate capital levels – stillexperienced difficulty because they did not managetheir liquidity in a prudent manner.” Para. 2(emphasis added).Focus: Funding Liquidity RiskSh t t f di i k (Li idit C R ti )Short term funding risk (Liquidity Coverage Ratio) +Longer term (1 year) funding risk (Net Stable FundingRatio)



Liquidity Coverage Ratio (LCR): An Overview

Stock of high quality unencumbered liquid assetsTotal cash outflows for 30 days (stress scenario) =100%Total cash outflows for 30 days (stress scenario) 100%

PER CURRENCY

Goal: Identify and segregate assets that can bey g gconverted into cash to support a firm under severestress assumptions to avoid emergency governmentliquidity supportliquidity support



Liquidity Coverage Ratio (LCR)What “high quality liquid asset”?What = high quality liquid asset ?

Low credit & market riskE li bl l tiEasy, reliable valuationLow correlation w/risky assetsLi d d l d & ll i d kListed on a developed & well recognized marketActive & sizeable market/low market concentrationFlight to quality beneficiaryCommitted market makers

What besides cash could fit these parameters?



Rhetorical Question:Rhetorical Question:Do eurozone sovereign bonds and/or bonds issued byEU entities (e.g., EFSF; ESM) fit these parameters ?( g , ; ) p



Tier 1Cash

Tier 2(40% cap; 15% haircut)Cash

Central Bank reservesM k t bl iti

(40% cap; 15% haircut)Marketable sovereigndebt that attracts a 20%Marketable securities

issued or guaranteed by agovernment

debt that attracts a 20%risk weightCorporate and coveredgovernment

Anything with a 0% RWLocal sovereign debt of

Corporate and coveredbonds rated at least AA(or with an equivalent PDLocal sovereign debt of

any rating or currencyNO financial firm debt

( qif using IRB)

NO financial firm debt



Liquidity Coverage Ratio (LCR)Stress ScenarioStress Scenario

Regulator determined run off rates for specific liabilities(See Annex A) over a 30 day periodThe short version:

Limited (5 10%) runoff: retail deposits if deposit insurance existsand unsecured wholesale depositspHigh (75% 100%) runoff: deposits from clearing, correspondentbanking, custody, cash management, financial institution,derivatives, ABCP or other asset backed instruments & any, yinstrument with a ratings based downgrade triggerNo (0%) runoff: reverse repos & securities borrowing withmaturities in excess of 30 days; lines of credit; operational3 y pdeposits.



Net Stable Funding Ratio (NSFR)

Goal: Limit or eliminate reliance on short term wholesalefundingMechanism: Instrument specific “required stable funding”Mechanism: Instrument specific required stable funding(RSF) coverage/haircuts based on liquidity profile of theinstrument. The higher the liquidity profile, the lower the RSF:

RSF b k t % % % % % 6 % 8 % %RSF buckets: 0%, 2%, 5%, 20%, 50%, 65%, 85%, 100%Instruments with maturity less than one year: RSF buckets structuredacross 4 maturity buckets (one per quarter), with shorter maturitiesattracting a higher RSF factorattracting a higher RSF factorNational discretion applies for setting RSF amounts on most off balancesheet instruments, including letters of credit and trade finance.

Preference for capital and preferred stock with maturities in excess ofPreference for capital and preferred stock with maturities in excess of365 days.



Additional “Tools” (just regulatory reporting – for now)

C l M i R l id if iContractual Maturity: Regulators to identify maturitymismatches/gaps using standardized raw data from banks plusregulatory assumptions regarding behavioral components (e.g.,outlays to promote going concern operation and franchise protectionoutlays to promote going concern operation and franchise protectionpayments

Funding Concentration: Regulatory reporting regarding fundingg g y p g g g gfrom significant counterparties (over 1% of balance sheet), significantproducts/investments (over 1% of balance sheet), and significantcurrencies (over 5% of total liabilities) across four quarterly maturitybucketsbuckets

Unencumbered Assets: Reporting of non client assets not otherwisepledged as collateral that are eligible at the central bank by asset andpledged as collateral that are eligible at the central bank by asset andwith any applicable haircuts



Regulatory Compliance Parameters

Reporting FrequencyLCR: monthly (but can increase to weekly, daily, etc. as needed)NSFR: quarterly

Scope: All internationally active banks on a consolidated basis+ all individual legal entities, foreign branches and subsidiaries“

g g“taking into account legal, regulatory and operationallimitations to the transferability of liquidity” in the localjurisdiction such as: ring fencing requirements; currencyconvertibility restrictions; foreign exchange controlsconvertibility restrictions; foreign exchange controls

Home State rules apply extraterritorially: except regardingt il & SME d it if th H t t t h t i tretail & SME deposits if the Host state has more stringent

standards©2011 all rights reservedwww.bcmstrategy.com


Liquidity and Cross border ResolutionLiquidity and Cross border ResolutionCharting the Intersections



Liquidity: Preventing Cross Border Resolution Problems?

“taking into account legal, regulatory and operationallimitations to the transferability of liquidity” in the localjurisdiction such as: ring fencing requirements; currencyj g g q ; yconvertibility restrictions; foreign exchange controlsVickers Report (UK)/subsidiarization?IMF sanctioned FX controlsIMF sanctioned FX controlsVienna InitiativeDodd Frank resolution authority at FDIC (wind upy pactivities should seek to maximize the value of the entityin administration)EU Commission resolution proposals (goingp p (g gconcern/stability priorities)



A Few Questions for CROs & Scenario Analysis Designers

1 How do you adjust your liquidity risk models and scenario analysis for the1. How do you adjust your liquidity risk models and scenario analysis for thepossibility that access or distribution of liquidity within your firm orcounterparties could be constrained due to political or economic policy priorities?

2 How do you track regulatory and economic policy trends that will impact the2. How do you track regulatory and economic policy trends that will impact theability of governments to implement the Basel framework for the flow of liquiditysupport within a financial firm? Are you evaluating the impact that a tradeableSDR could have on (i) liquidity profiles and/or (ii) the performance of existingsovereign debt?g

3. Have you simulated the market impact of a bank tapping its liquidity reserves toavoid a bail out or other government support? Would reliance on the liquiditycushion require you to restrict credit or trading relationships with that bank evenq y g pif no resolution activity were triggered?

4. Have you simulated potential differences in path dependencies and correlationsin interest rate inputs if a firm (a) begins to stockpile sovereign debt to meet Baselp ( ) g p gstandards and/or (b) begins to liquidate sovereign debt in order to meet the Baselstandards? In other words: are you ready for sovereign debt market dynamics toshift based on different demand profiles?



Mapping Liquidity & Cross Border ResolutionTiming & Behavioral ConsiderationsTiming & Behavioral Considerations

• Cash

Government Policies

• Short term?• Gov’t securities • Competition

• Fiscal Policy• Monetary Policy

d l

• Going Concern?• CPrelationships?

Liquidity support

• MacroprudentialPolicy

• FX Controls Liquidity Needs



Liquidity Risk Beyond the Banking Sector:Liquidity Risk Beyond the Banking Sector:Who Falls Within the Framework?



Focus: INDIRECT Impactsp

WinnersI f S i D bt (d ’t

LosersCCP C t di d C hIssuers of Sovereign Debt (don’t

worry; supply will be plentiful foryears to come)

CCPs, Custodians, and CashManagers

Any company requiring short termNiche (non bank) financial firms

specializing in short term lending

Maybe the covered bond market

y p y q g(below 365 days) funds

Banks seeking to serve as marketmakersMaybe the covered bond market,

but only up to a point

Exchanges

makers



Liquidity Risk and the Trading BookLiquidity Risk and the Trading Book



Feedback Effects Point to Longer MaturitiesAnd Higher Costs for Corporatesg p

Increased costd t it

Bank demandfor corporate

and maturitystructure forcorporate debt

Disincentives forbanks to holdcorporate bondsin the liquidity

pdebt limited tothe bankingbook (hold tomaturity), andthen subject to

Shortermaturitiesgenerate higherLCR and NSFR

in the liquiditycushion = fewerbank purchases

then subject toLCR and NSFRcoverage;Disincentivesfor banks to

k


LCR and NSFRrequirements

serve as marketmakers.


Rhetorical Question:Rhetorical Question:Why bother with the Volcker Rule when the Baselliquidity framework exists?liquidity framework exists?



Timeframe

Currently: QISJ fi t ti t tJanuary 2012: first reporting startsMid 2013: LCR revisionsMid 6 NSFR i iMid 2016: NSFR revisions1 January 2015: LCR final1 January 2018: NSFR final



ConclusionThe debate regarding appropriate bank funding modelsThe debate regarding appropriate bank funding modelsis only just starting.Changes to bank funding models will profoundlyimpact the shape and cost of corporate finance andimpact the shape and cost of corporate finance….and,thus, the scale and scope of economic recovery.A broader range of policymakers will have a voice ind fi i b k f i d f di idefining banks functions and funding structures goingforward given the fiscal and monetary policyimplications of new funding liquidity profiles for banks.The definition , measurement, and application ofliquidity risk standards will be driven as much by nonquantitative and economic policy priorities as by formali k A d ?risk measurement processes. Are you ready?



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Awareness – The Risk Telescope Analytics

Confidential, customized analysis of howspecific regulatory and political trendsmay affect the strategic interests ofi di id l liindividual clients.

Twice monthly analysis of keydevelopments for chief executives, chiefrisk officers, and chief strategists linkingG liti ith b t ti hG20 politics with substantive researchand analysis of regulatory policy trends

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risk europe april 2011

Documents

basel committee

worldbanky chair

trading book

foreseeable future

th t riskismostlyintheassetsy

addressy early1970s

retail banking arms