Please enable JavaScript.
Coggle requires JavaScript to display documents.
Credit Risk Framework - Liquidity (Liquidity at Risk (Accessing liquidity…
Credit Risk Framework - Liquidity
Liquidity at Risk
The following is proposed to determine the likelihood of such an event to occur:
LaR = p(liquidity) – CaR
Accessing liquidity- This is dependant on:
Time to liquidate
In multiple currency frameworks, a liquidity risk manager may sell the cash amount held in other currencies before accessing other liquidity sources to cover shortfalls in currencies with negative liquidity.
Liquidity of assets held
Where LaR is Liquidity at Risk, p (liquidity) is the probability to access a certain amount of liquidity and CaR is Cash Flow at Risk.
Benefits of LaR
LaR summarises this particular risk in a single number and can be held against the risk management policy. LaR also recognises future outcomes even though they are not known.
Cash Flow at Risk
This representation helps the treasurer to prepare for unforeseen events because statements can be made about the probability of certain events, even though they have never previously arisen. For example, with the fitted distribution it can be determined that there is a 1.5% probability that the treasurer will have to fund 60million currency units.
The Basel Committee
The Basel rules define liquidity risk as being the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses.
There are 17 principles outlined by basel that seek to raise standards in the following
Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans.
Strong management of intraday liquidity risks and collateral positions.
Aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank.
Maintenance of a robust cushion of unencumbered, high quality liquid assets to be in a position to survive protracted periods of liquidity stress.
Liquidity risk measurement, including the capture of off-balance sheet exposures and other contingent liquidity risks that were not well managed during the financial market turmoil.
Regular public disclosures, both quantitative and qualitative, of a bank's liquidity risk profile and management.
There are 17 principles outlined by basel that seek to raise standards in the following
The principles also strengthen expectations about the role of supervisors, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other supervisors and public authorities, both within and across national borders.
The Basel Committee on Banking Supervision is an international committee formed to develop standards for banking regulation; it is made up of central bankers from 27 countries and the European Union.
Liquidity Risks - Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions
Funding liquidity risk
is the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm.
Market liquidity risk
is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption.
Managing Liquidity risk
Asset liquidity risk
describes the phenomenon that risk is attached to any asset that cannot be sold due to a lack of liquidity in the market where the sellers and buyers for that asset meet. In some ways it is a subset of market risk. Characteristics of a liquid asset are as follows/;
There are ready and willing buyers and sellers at all times.
The probability is that the next trade is executed at a price equal to the last one in a liquid marketplace.
It can be sold rapidly, with minimal loss of value, any time within market hours.
Liquidity risk tends to compound other risks. If a trading organisation has a position in an illiquid asset,
its limited ability to liquidate that position at short notice will compound its market risk.
Funding liquidity risk
Can only be met at an uneconomic price – for example shares in RBS when they were in free fall
Can be name-specific or systemic.
Cannot be met when they fall due
It will be necessary for any market participant to be able to have the ability to borrow funds or to borrow assets to meet funding liquidity risks in order to meet their commitments to others in the marketplace.
This development of liquidity risk refers to the risk that liabilities present liquidity risk in so far as they:
Basel recommends that a
maturity ladder
should be used to compare a firm’s future cash inflows to its future cash outflows over a series of specified time periods.
The net funding requirements are represented by the black line. Left from the vertical value date line are historic cash flows and right from the line are projected cash flows based on known maturities. The latter contain a certain element of uncertainty, which becomes greater the further into the future the cash flows are projected.
The difference between cash inflows and cash outflows in each period, the excess or deficit of funds,becomes a starting-point for a measure of a firm's future liquidity excess or shortfall at a series of points in time.
Liquidity gap analysis
Gap analysis is a technique of assessing a future scenario of excepted activities and highlighting the potential risks as gaps. It might refer to a project or business case or equally validly to a set of cash flows. Hence the name - liquidity gap analysis.
The net funding requirement at the end of the value day is the variable that has to be determined in order to gain a feeling for the magnitude of the liquidity risk.
Behavioural Analysis
The fundamental value is a function of the cash flows that an asset would generate for its owners subject to any appropriate discount rate.
Market behaviour analysis addresses the situation where prices are not reflecting intrinsic value.
The job of market behaviour analysis is to identify market movements, liquidity shifts and dislocations and to factor them into effective decisions to modify the forms of investment strategy.
Netting
is defined as the set-off of two or more cash flows, assets, or liabilities. The types of netting used are payments or settlement, close-out, bilateral or multilateral.
Closeout netting
reduces pre-settlement risk. If counterparties have multiple offsetting obligations to one another. This technique eliminates cherry picking whereby a defaulting counterparty fails to make payment on its obligations, but is legally entitled to collect on the obligations owed to it.
Payment netting
reduces settlement risk. If counterparties are to exchange multiple cash flows during a given day, they can agree to net those cash flows to one payment per currency. Not only does such payment netting reduce settlement risk, it also streamlines processing.
With
bilateral netting
, two counterparties agree to net with one another. They sign a master agreement specifying the types of netting to be performed as well as the existing and future contracts which will be affected. Bilateral netting is common in the OTC derivatives markets.
Multilateral netting
occurs between multiple counterparties. Multilateral netting has the advantage that it reduces credit exposure even more than does bilateral netting. It has the disadvantage that it tends to mutualise credit risk. Because credit exposure to each counterparty is spread across all participants, there is less incentive for each participant to scrutinise the creditworthiness of each other counterparty.
Many jurisdictions do not recognise the enforceability of closeout bilateral netting agreements, arguing that such agreements undermine the interests of third-party creditors. Responsible legal counsel should be consulted before entering into any netting arrangement.
Market Dislocation
refers to markets which are erratic and highly volatile and have moved from stable conditions to erratic scenarios.
The resulting instability and volatility created huge impact upon market and investor confidence and this is very explicitly characterised by a marked reduction in liquidity
Example is the 2008 crisis and the subsequent support from the government and increase in regulation
