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Friday, February 17, 2012

Funding Liquidity Risk

Basel III includes a new standard for Liquidity Risk that seems to be tripping up a few risk analysts working in this domain. In this post we briefly look at the possible outcomes from a poorly managed liquidity risk program and also the types of initiatives banks may consider for meeting the new Basel III Liquidity Risk Standard.

Funding Liquidity Risk
Presentation can be downloaded here | Framework for liquidity Risk

Perhaps some of the confusion over the new Basel III standard comes from the definition of liquidity risk itself.

Liquidity risk arises from situations in which a party interested in trading an asset cannot do so quickly enough in the market without accepting a loss of value. It is often measured by tracking the width between the bid/offer spread and adds to the market risk of an open position directly. Loosely it could be expressed as Market VaR + Exogenous Liquidity Cost. To be more accurate, there is likely to be a correlation between VaR an ELC that is overlooked by carrying out such a simple additive calculation.

Seems quite straightforward but that is not the liquidity risk agenda Basel III is referring to. 

Basel III is attempting to set down an approach for measuring Funding Liquidity Risk and we need to accept the difference between Liquidity Risk and Funding Liquidity Risk which while subtle, can be quite impacting for a bank's treasury unit.

If you think about it for a second, liquidity risk is not really that big a deal if you don't need to move into cash in the first place. If you can hold an asset to maturity or until you can find the right buyer or price for it, the consequences appear on the surface to be relatively minor. 

In the world of banking this is rarely going to be the case and all banks fail in the end from Funding Liquidity Risk. Funding Liquidity Risk is the final straw that brings the bank to its knees when other stresses occur. Whether a bank has a massive portfolio of under performing loans or a huge operational loss or pretty much any kind of unwanted catastrophic ailment, the bank will survive if it can pay for or fund its way out of the event.

This also seems quite straightforward, so what is the big deal then? 
Well, Funding Liquidity Risk is usually a tipping point where multiple risks converge, where exposures become dependent on each other and exacerbate each other in non-linear and non-normal ways. What might be a simple quirk suddenly results in a systemic funding liquidity dilemma and a meltdown for the bank.

A typical scenario which might occur is actually listed on page 4 of the Basel III liquidity standard.

Market volatility results in:
 (a) A drop in the value of collateral.
 (b) An increase in the number of defaults on the borrowing book.
 (c) A drop in share value of the bank and capital value held in reserves.
 (d) A run-off of retail deposits.
 (e) The inability for the bank to raise more cash.
 (f) A write-down in revenue as assets are sold below their market purchase prices.
 (g) A loss of secured or short term financing.
 (h) Unscheduled draws on committed but unused credit and liquidity facilities.
 (I) A downgrade on ratings.
 (J) Move back to position A so that the process can start all over again ...

So where does one begin to dimension such an outcome on this type of looped or recursive dilemma?

Here is a more scary thought, this isn't the only scenario we need to model.  There could be an infinite number of liquidity funding scenarios that banks may suffer from and each scenario is likely to play out slightly differently, or is it?

In the presentation attached to this post we review the top level elements that risk management in a bank should consider if they are to understand Funding Liquidity Risk. On slide 15 we propose that the measurement of this exposure class is going to require the integration of Counterparty Risk (on the trading book), Credit Risk (on the banking book), Market risk and the core ALM risk reporting system.

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