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Chapter 4
Risks and Risk Management
Bessis, J., 2015. Risk management in banking. John Wiley & Sons. 1
Introduction
Banks need to make financing and investing decisions depending on their cash
positions, current and expected.
For financing decisions, they need to assess how much they need, in the case
of projected deficits, from which date and until when.
Managing the funding requires projecting the existing assets and liabilities for
determining any future imbalance. These mismatches are called liquidity
gaps.
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Contents
Liquidity and Liquidity Risk
Liquidity Gap Time Profiles
Types of Liquidity Gaps
Managing Incremental Gaps
Dynamic Liquidity Gaps
Funding Liquidity Management
Liquidity Crises and Stress Scenarios
Bessis, J., 2015. Risk management in banking. John Wiley & Sons. 3
Liquidity and Liquidity Risk
Shortage of liquidity is a situation when a bank raises cash at higher cost than
usual conditions, with an extreme shortage leading to failure.
The Financial crisis of 2008 demonstrated that liquidity disruption could be
system-wide, that liquidity could evaporate in a matter of days and that
liquidity is highly scenario dependent: “One moment it is there in abundance,
the next it is gone.”
Accordingly, the cost of liquidity cannot be ignored anymore and has to be
fully recognized in the bank’s cost of funds.
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Liquidity and Liquidity Risk
Liquidity and Financing
Liquidity Risk in the Banking Book
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Liquidity and Liquidity Risk
Liquidity and Financing
Liquidity is often impaired by adverse events, which are not directly related
to liquidity issues.
Bank-specific events include adverse earnings or loss announcements, or a
downgrade of the firm.
System-wide events are market disruptions, as the last financial crisis
demonstrated.
However, the chances that events materialize in a liquidity crisis depend on
how vulnerable the sources of liquidity are at the firm level
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Liquidity and Liquidity Risk
Banks raise cash by borrowing short-term or stable resources, secured or not,
or alternatively raise cash from the sale of assets.
Funding risk has to do with the availability or unavailability of sources of
funds at a reasonable cost of funds.
The reliance on stable sources of funds mitigates funding risk.
Stable funds include bond issues, secured borrowings over a horizon beyond one
year and the stable fraction of deposits.
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Liquidity and Liquidity Risk
An alternate source of cash is the sale of market assets.
However, banks might refrain from holding large balances of high-quality and
short-term assets because of their lower earnings.
Because such assets are the unique alternate source of funds in the presence
of funding disruptions, regulators introduced the liquidity cover ratio for
imposing a minimum liquidity buffer to banks.
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Liquidity and Liquidity Risk
Cash can also be obtained without selling assets, by pledging them for raising
secured debt.
The amount of secured borrowing that can be potentially raised is the asset
current value minus haircuts required by lenders.
Good quality assets, those assets with a good credit standing of issuer and
that can be traded, can always be “turned into cash”, either through sales or
secured borrowing.
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Liquidity and Liquidity Risk
Banks tend to finance long-term assets with short-term resources. The
resulting mismatch is a major source of liquidity risk.
Mismatches of maturities generate liquidity risk because the short-term debts
need to be rolled over for financing the long-term assets.
They also have interest rate risk because the spread between long-term and
short-term interest rates fluctuates with market movements.
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Liquidity and Liquidity Risk
Liquidity Risk in the Banking Book
A significant portion of assets and liabilities within a bank’s balance sheets
typically consists of so-called “non-maturing accounts”, or accounts with an
indeterminate maturity.
The cash flows to and from these accounts are not deterministic but
stochastic, and contribute to liquidity risk.
Such accounts include
demand deposits on the liability side.
consumer loans or overdrafts on the asset side.
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Liquidity Gap Time Profiles
Liquidity gaps refer to the projected imbalances of sources and uses of funds.
Gap reports provide the necessary information for taking funding or investing
decisions.
Gap management consists of managing the projected mismatches between
assets and liabilities
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Liquidity Gap Time Profiles
The liquidity gaps are the differences, at future dates, between the
projected balances of assets and liabilities of the banking portfolio.
The existing assets and liabilities amortize (run off) gradually over time, and
the time profiles of their balances are declining.
Projections are “static” when they ignore new loans, new deposits or debts at
future dates
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Liquidity Gap Time Profiles
Static Liquidity Gaps have a time profile depending on how assets and
liabilities run off.
At a future date, t, the liquidity gap is the algebraic difference between the
projected balances of existing assets and liabilities.
There are as many gaps as there are time points over the planning horizon. At
each future date t:
With the algebraic definition of liquidity gaps, a positive gap between assets
and liabilities is equivalent to a deficit, and vice versa
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Liquidity Gap Time Profiles
The time profiles of liquidity gaps can have three basic shapes:
assets and liabilities are matched;
there are deficits of funds;
or there are excesses of funds.
Positive gaps (underfunded) mean that the balance sheet generates projected
deficits of resources relative to assets. This is the gap profile of asset-driven banks.
These banks have to raise funds periodically to match the development of their
assets.
Negative gaps (overfunded) is that of liability-driven banks. As time passes, these
firms have excess resources and need to expand new lending or investing activities.
See Figure 4.1 which shows these typical situations for the time profiles of assets,
liabilities and gaps.
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Liquidity Gap Time Profiles
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Liquidity Gap Time Profiles
Cash matching implies that the time profiles of amortization of assets and
liabilities are – approximately – identical. In this case, there is no significant
maturity mismatch and all liquidity gaps are near zero.
The amortization of the balance sheet does not generate any deficit or excess
of funds, and the repayment schedule of debt replicates the repayment
schedule of loans. The balance sheet remains balanced, as time passes, without
generating any need or investment of funds. Full matching eliminates liquidity
risk.
Furthermore, if interest rates have the same nature – fixed or floating – on both
sides of the balance sheet, there is no uncertainty on net interest income since
all interest revenues and costs are deterministic.
Alternatively, any mismatch between maturities and interest rate generates
both liquidity risk and interest rate risk.
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Liquidity Gap Time Profiles
A standard position of banks consists of lending for longer maturities than
those of liabilities, or being asset driven.
Some banks have this position because they prefer to rely on short-term debt
for capturing a positive spread between long-term and short term rates. In
such instances, the bank has recurring deficits of funds and needs to roll over
the debt, the interest rate of which fluctuates as time passes.
In the opposite case of positive gaps, there is a recurring excess funding.
There is no liquidity risk, but there is interest rate risk, because the interest
rates of future loans or investments from excess funds are unknown viewed
from today.
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Types of Liquidity Gaps
Static liquidity gaps, derived with a scenario of the runoff of existing assets
and liabilities only.
When gaps include the new loans or debts, they are called dynamic. Under a
dynamic view, the outstanding balances of assets and liabilities often increase
with time rather than amortize, as with static gaps, because new loans and
new debts pile up over the amortizing loans and debts.
Incremental or marginal gaps are the differential variations between two
adjacent time points of assets and liabilities. The cumulated marginal gaps,
from today up to a date t, match the gap between the outstanding balances
of assets and liabilities as of the same date.
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Types of Liquidity Gaps
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Types of Liquidity Gaps
The marginal gaps represent the new funds to be raised over the period, or
the new excess funds of the period available for investing (Figure 4.2).
For example, the marginal gap for the period between date 2 and date 3 is
+100. It is the additional deficit of the period. It is also the amount of funding
required if previous deficits up to date 2 have been closed
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Types of Liquidity Gaps
Bessis, J., 2015. Risk management in banking. John Wiley & Sons. 22
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Types of Liquidity Gaps
A typical liquidity gap report
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Types of Liquidity Gaps
Figure 4.4 shows the time profile of liquidity gaps report. The gaps are
cumulative up to each future date. They decline to zero in the long term as
the balances of assets and liabilities amortize completely.
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Managing Incremental Gaps
In gap reports, projections are based on discrete scenarios, where runoffs are
seen as deterministic.
But a significant fraction of assets and liabilities generate stochastic cash
flows.
Deposits have no maturity, but are sticky; mortgages can be pre-paid or their
customer’s rate be renegotiated; credit lines of off-balance sheet
commitments can be drawn at the client’s initiative within limits; consumer
and credit card loans tend to roll over.
With indeterminate maturities, the runoffs are stochastic rather than
deterministic. A general rule is that the liquidity scenarios should be
constructed from effective, rather than contractual, runoff schedules.
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Managing Incremental Gaps
The gaps shown are seen from date t. At this date, the liquidity gap is closed
but the gap at t + 1, viewed from t, is open.
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Managing Incremental Gaps
However, in general, the new gap at t + 1 differs from its projected value
because of random cash flows from assets and liabilities existing at t, and
because of new loans and debts.
The actual runoff of resources, deterministic or not, is now recorded at t + 1.
The entire time profiles of assets and liabilities are also updated.
Frequent updates allow gap management to be incremental, with periodic
adjustments, which allows adjusting to expected and unexpected changes as
they occur.
Incremental gap management takes care of the short-term uncertainty. But,
in general, gap reports extend over long horizons, eventually up to the
longest maturity of accounts in the balance sheet. Gaps over the next two or
three years are actively managed.
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Managing Incremental Gaps
Non-maturing accounts and mortgage runoffs have generated a considerable
debate in the industry on how to manage risks. Discrete scenarios use
projections relying on conventions and measures of effective runoffs. For
loans, statistics of amortization are available. Effective runoffs are derived
from historical data, as the average amortization for pools of loans. Statistics
allow more elaborated modeling of the behavior of the accounts, for example
for prepayments of mortgages.
On the liability side, demand deposits have a legal zero maturity because
they can be instantly withdrawn from the bank. However, a substantial
fraction of current deposits is stable over time, or “sticky”. The remaining
fraction is volatile, and is considered as short-term debt. The core deposits
(stable deposits) represent a stable resource, for which an amortization
schedule is required for projecting liquidity gaps.
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Managing Incremental Gaps
In many instances, rules rely on conservative conventions. For example, an
annual constant amortization rate of 5%, or 10%, can be chosen for gap
reports. These rates correspond to durations of, respectively, 20 or 10 years.
Such conventions generate an additional liquidity gap equal to annual
amortization, which, in general, is not in line with reality. However,
conventional amortization is a common practice because it is conservative.
The alternate solution is to define an effective runoff for the stable fraction
of deposits. Effective runoffs can be inferred from time series of the number
of accounts and of deposit balances. Only those accounts that existed at some
historical point in time, used as origin, should be monitored, which implies
that existing accounts at origin be isolated from new accounts opened later.
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Managing Incremental Gaps
The number of existing accounts decreases as time passes, as some accounts
are closed, but the behavior of their aggregated balance also depends on the
balance of each individual account.
If the average unit balance, the amount held per account, were constant, the
outstanding balance of deposits would amortize at the same rate as the
number of accounts.
But if the unit balance increases with the age of account, the aggregated
balance of accounts decreases at a slower pace than the number of accounts,
and can eventually increase over time.
Such analyses are used to support the projections of deposits.
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Dynamic Liquidity Gaps
For liquidity management purposes, it is a common practice to focus primarily
on the existing assets and liabilities and static gaps.
The rationale of the usage of static gaps is that there is no need to obtain
funds in advance for new transactions, or to manage today resources that are
not yet collected.
Funding the deficits or investing excesses of funds from new business occurs
when they appear in the balance sheet, not earlier.
Moreover, the liquidity gaps are continuously updated, and the new loans or
debts will appear gradually in the updated static liquidity gap profile.
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Dynamic Liquidity Gaps
Dynamic liquidity gaps add to the amortization profiles of existing assets and
liabilities the projected balances of new loans and new deposits, at the time
of the gap report
Such balance sheet projections are used for budgeting purposes, and also
serve to make sure that limits on financing raised at any future periods will
not be exceeded.
Total assets and liabilities, existing plus new ones, tend to increase in
general, rather than amortize.
Gaps for both existing and new assets and liabilities are required to project
the total excesses or deficits of funds between today and the future dates.
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Dynamic Liquidity Gaps
Figure 4.6 shows new transactions combined with the existing assets and
liabilities. Note that volumes of new assets and liabilities should be net from
the amortization of the new loans and of the new deposits, since the
amortization starts from the origination date of these transactions.
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Funding Liquidity Management
Controlling liquidity risk implies spreading over time the required amounts of
funding, and avoiding unexpected gaps or gaps in excess of what the firm
usually raises in the market.
Limits serve for making sure that funds raised in future periods will remain
within acceptable boundaries.
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Funding Liquidity Management
Illustrated below are two examples of profiles of existing assets and
liabilities with initial deficits. In both cases, the resources amortize
quicker than assets and the deficits extend, with varying amplitude,
up to the horizon.
The purpose of the examples is to show how gaps can be managed.
It is assumed that the ALM committee wishes to close all gaps. This
means that new resources should be contracted in order to raise the
time profile of resources up to the one of assets.
The issue is to define which new debts are consistent with the new
goal.
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Funding Liquidity Management
For defining how much cash should be raised, when and until which
date, defining a planning horizon is a prerequisite.
New debts are defined by their size and by the initial date when they
are contracted and by the final dates when they are repaid.
“Layers” of debts starting from the final horizon are combined in
order to raise the time profile of liabilities until it reaches the time
profile of assets
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Funding Liquidity Management
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Funding Liquidity Management
Figure 4.7 illustrates a first case. In the left-hand side, the gaps
continuously decline until the horizon. Because the sizes of gaps vary
with dates, several layers of debt are required to close them.
More funds are needed today than at the management horizon, and
cash has to be raised today. Layers of debts of varying maturities
ensure that the resources profile replicates the asset profile. A first
debt serves for closing the final gap, which is smaller than the current
gap. Other debts close the intermediate gaps.
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Funding Liquidity Management
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Funding Liquidity Management
A second case is illustrated in Figure 4.8. In this second case, it is not
feasible to close all gaps with debts contracted today.
The same process does not apply because the gap starts increasing
before declining again until the horizon.
Closing the final gap with debt raised today would result in excess
cash today because the final gap is larger than the initial gap. The
maximum amount of debt contracted today, without having excess
funds, is the initial gap.
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Funding Liquidity Management
Since this initial gap is open until horizon, the debt contracted should
be in place until the final horizon.
The final gap is not closed with this financing because the gap
increases with time, peaks and then narrows down. It is easy to
observe that intermediate liquidity gaps remain open. From a liquidity
standpoint, this not an issue as long the required debts for closing
those intermediate gaps do not exceed limits.
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Liquidity Crises and Stress Scenarios
Liquidity crises can be triggered by many adverse events, which can
be specific to
a firm or
system-wide.
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Liquidity Crises and Stress Scenarios
At the level of the firm:
An unexpected release of information might cause usual lenders to cut
down their credit lines.
Unexpected and sudden losses threaten solvency and disrupt the
willingness to lend by other financial players.
A downgrade of the bank’s rating can also have major effects on both the
asset and the liability side.
The cost of funding will increase and the bank might become
ineligible for further lending by other institutions. The same cause can
trigger margin calls, through which the bank is supposed to post more
collateral in its debt, or, alternatively, reduce its debt.
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Liquidity Crises and Stress Scenarios
Global events include: a system-wide “run on deposits”; a liquidity
crunch caused by failures; and the fear of contagion of adverse events
across financial institutions causing an increase of risk aversion and
reluctance to lend.
There are several examples of such crises: the Russian debt crisis, the
“Y2K” fear of information systems failure; the 9/11 crisis; and the
subprime crisis of 2007 and 2008, which showed that a freeze of the
most liquid markets could effectively happen.
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Liquidity Crises and Stress Scenarios
Stress tests consist of simulating what could happen in a worst-case
event. The possible origins of a crisis and the historical events provide
examples of such situations and can serve as a reference for designing
the stress scenarios.
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Liquidity Crises and Stress Scenarios
Contingent plans serve for assessing the ability to generate cash flows to
meet debt commitments and deposit withdrawals, or margin calls on
collaterals, under extreme circumstances.
In order to provide some practical inputs to such plans, banks have to
consider the size of the liquid asset portfolio, balance sheet and funding
limits, maximum repos that can be contracted, the diversification of sources
of funding and the levels of unsecured funding.
Once these are identified, a bank can further diversify sources of funding,
increase the base for repo financing, etc.
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