Identifying Liquidity Risk

Rabih Nehme
16-18 October 2022
Muscat

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 Agenda

I. Approaching Liquidity Risk

II. Types of Liquidity Risk

III. Identification of Liquidity Risk exposures

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 Approaching Liquidity Risk

• Banks are necessarily exposed to a maturity mismatch

• Banks are highly leveraged (working on other’s money)

• High leverage boosts the impact of any liquidity crisis:

– individual basis &
– System basis

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 A Typical bank
Balance Sheet
Assets Amount Liabilities Amount
Government bonds 100 Capital 80
Cash 10 Deposits 820
Loans to other banks 200 Banks 100
Loans to SME 390 Total 1000
Mortgage Loans 200
Loans to Corporates 100
Total 1000

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 Leveraging / Gearing
• The ratio of a company’s debt (how much it
has borrowed) to the amount of capital it
holds.

Banks are
Debt Highly
Capital
Geared

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Professional and business services Debt to equity ratio
Legal services 2.5
Educational services 1.6
Newspaper publishers 1.3
Radio & television 2.2
Hospitals 1.6
Furniture and home furnishing stores 1.9
Air transportation 3.4
Life insurance companies 6.1
Automotive equipment rental and leasing 4,9
Tobacco manufacturing 1.1
Building construction and general contracting 3.2
Dairy product manufacturing 1.5
Banking sector 29 6
High Banks leverage ratio’s to fund MBS/CDO
 Approaching Liquidity Risk

• Regulators cannot remove liquidity mismatch from the system

• Trying to cope with the problem

• How?

• By forcing banks to build liquid reserves such that, while not

matching outflows in terms of maturities, they ensure that if a
stress occurs then banks can withstand cash imbalances until the
situation returns to normality.

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 Reserve Ratio

• Fraction of deposits in the form of reserve

assets: (Required reserve ratio).

• If, Required reserve ratio is 10%, then banks

must always hold:

– Portfolios of reserve assets that are at least

equal to 10% of the value of their deposit
liabilities.
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 Reserve Ratio

• Reserve assets often include:

– Cash,
– Treasury bills
– Short-term commercial bills and
– Deposits with the central bank.

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 Why is it important now?
• Due to a combination of:

– greater reliance on wholesale funding sources,

– increased competition for retail deposits,

Normal banking & Shadow banking (short-term MMF)

– Innovation: internet banking,

(easier for customers to transfer funds)

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 Liquidity Risk, Solvency and Trust

• Close relationships

• Market participants & bank customers (confidence)

• Enough funding can be raised to meet its obligations.

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 Liquidity Risk, Solvency and Trust

• Funding is about lenders' perceptions of the bank's solvency.

• Especially banks rely on wholesale funding sources,

– are sensitive to changes in bank's own credit risk profile.

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 Agenda

I. Approaching Liquidity Risk

II. Types of Liquidity Risk

III. Identification of Liquidity Risk exposures

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 Various ways of looking at liquidity

Macroeconomic Financial markets Banking

perspective perspective perspective

Monetary supply, The ability The ability

to sell securities to meet obligations
Official int. rates without triggering at a reasonable cost
significant when
Price of Credit price changes they come due

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 Types of Liquidity Risk

1. Structural Liquidity Risk

2. Funding Liquidity Risk

3. Market Liquidity Risk

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 Structural Liquidity Risk

• Investing at highest yields/ fund this investment at

lowest possible cost.

• This might mean borrowing very short-term (for

example, by taking deposits) and lending at a higher
yield for a longer term (for example, mortgages).

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 Funding Liquidity Risk

• the risk that the firm will not be able to efficiently meet
expected & unexpected current & future cash flows and
collateral needs without affecting daily operations or the
financial condition of the firm.

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 Wholesale funding

• Secured or unsecured borrowings from institutional lenders

• Providers are more sophisticated,

means what?

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 Wholesale funding
• They are more sensitive to changes in the bank's credit risk

Therefore,

• Withdraw funds when deterioration of the bank's creditworthiness.

• Normal or Stressed Times??

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 Market Liquidity Risk

• The risk that a firm cannot easily offset or eliminate a position

at the market price because of inadequate market depth or
market disruption.

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 Agenda

I. Approaching Liquidity Risk

II. Types of Liquidity Risk

III. Identification of Liquidity Risk exposures

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 Identification of Liquidity Risk Exposures

I. Asset liquidity

II. Liabilities Liquidity

III. Off-balance sheet exposures.

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 Asset Liquidity

• How assets can fuel banks with liquidity?

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 Asset Liquidity

1. interest income (earning assets)

2. repayment of maturing assets

3. Asset sales

4. Using qualifying assets as collateral to enhance the bank's

borrowing capacity.

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 Asset Liquidity

• Certain asset are illiquid

• Why banks holding Liquid assets?

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 Asset Liquidity

• Certain asset are illiquid

• Why banks holding Liquid assets?

• Funding assets growth

• accommodating unanticipated withdrawals of funds

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 What is a Liquid Asset?

• Can be sold at any time, (including times of stress)

• with little or no loss of value.

• Can be pledged to key counterparties or central bank (to get funds)

EX: High-quality securities that are actively traded

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 Assessing asset Liquidity

• The difficult trade-offs: earnings or liquid assets?

What is the optimal level of LA?

• Balance between:

Sufficient amount of LA without affecting profitability.

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 Liquid Asset Characteristics

• Key determinants:

1. Quality & price sensitivity

2. Marketability

3. Maturity

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 Quality & price sensitivity

• Low levels of default risk (greater demand)

• not materially vulnerable to IR, FX rates, or equity prices.

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 Marketability
Trade in active & liquid market,
Ease & certainty of valuation

Maturity

lower residual maturities (lower price volatility)

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 Marketability

Exceptions:
• Some assets that are not traded in an active and liquid market
may still be marketable, if they are accepted as collateral by
counterparties to enhance the bank's borrowing capacity.

EX:
• High-quality residential mortgage loans, which may be accepted
by the central bank as collateral in exchange for cash.

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I. Identification of Liquidity Risk Exposures

I. Asset liquidity

II. Liabilities Liquidity

III. Off-balance sheet exposures.

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 Liability Liquidity

• Attracting deposits

• Increasing borrowings from retail or wholesale.

• Drain on Liquidity:
unanticipated withdrawals of deposits or borrowings.

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 Liability Liquidity

• Retail funds (individuals & small businesses).

• Wholesale funds (More volatile)

• Equity funds

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 Core & Non-core Funding

Core funding sources:

expected to be stable & remain with the bank under a range of
stressed scenarios.

Non-core funding sources:

volatile & more likely to leave the bank, particularly in periods of
market or bank-specific stress.

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 Core & Non-core Funding

Core funding sources:

expected to be stable & remain with the bank under a range of
stressed scenarios.

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 Core & Non-core Funding

Core funding sources:

expected to be stable & remain with the bank under a range of
stressed scenarios.

Non-core funding sources:

volatile & more likely to leave, (periods of market or bank-
specific stress)

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 Core and Non-core Funding

• liabilities available in one-year's time considered core funding.

• Retail depositors more stable than wholesale funding sources

– Some retail depositors are “non-core”,

– Some wholesale funding sources may be “core”

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 Core and Non-core Funding

• Complex assumptions by management to differentiate

• key factors to distinguish:

1. Deposit size & existence of deposit insurance

2. Residual Maturity (long term wholesale ≠ checking accounts)

3. Rates of interest (below average are usually more stable)

4. Deposit gathering channel (Internet banking)

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 Identification of Liquidity Risk Exposures

I. Asset liquidity

II. Liabilities Liquidity

III. Off-balance sheet exposures.

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 Off-B. sheet exposure & liquidity implications

• Committed lines of credit enhance overall liquidity position.

• Bank commitments to lend to corporates (contingent LR):

– Probability, Size & Timing

• Financial derivatives through posting of collateral:

– decline in the price of the underlying collateral or
– a downgrade in the bank's credit rating

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 EX: Credit Derivatives (LR & AIG)
• One of AIG's financial subsidiaries had written CDS contracts
worth billions of US dollars

• This was in favor of many large international banks over a

number of years on numerous mortgage related indices.

• Drops in the prices of MBS’s led to large, growing and

successive collateral calls from AIG's main derivatives
counterparties.

• The group was taken into public ownership just before it ran out
of collateral, preventing it from defaulting on its obligations
toward its banking counterparties.
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