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Liquidity Risk

Instructor ย Micky Midha
Updated On

Learning Objectives

  • Explain and calculate liquidity trading risk via cost of liquidation and liquidity- adjusted ๐‘‰๐‘Ž๐‘… (๐ฟ๐‘‰๐‘Ž๐‘…).
  • Identify liquidity funding risk, funding sources, and lessons learned from real cases: Northern Rock, Ashanti Goldfields, and Metallgesellschaft.
  • Evaluate Basel III liquidity risk ratios and BIS principles for sound liquidity risk management.
  • Explain liquidity black holes and identify the causes of positive feedback trading.
  • Video Lecture
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Introduction

  • The credit crisis of 2007-2009 was lesson with respect to the importance of liquidity risk for both financial institutions and their regulators. Some financial institutions that relied on wholesale deposits for their funding experienced problems as investors lost confidence in financial institutions. Some instruments for which there had previously been a liquid market could only be sold at fire-sale prices during the crisis.
  • It is important to distinguish solvency from liquidity.
    • Solvency refers to a company having more assets than liabilities, so that the value of its equity is positive.
    • Liquidity refers to the ability of a company to make cash payments as they become due. Financial institutions that are solvent can fail because of liquidity problems. Consider a bank whose assets are mostly illiquid mortgages, where the assets are financed 90% with deposits and 10% with equity. The bank is comfortably solvent. But it could fail if there is a run on deposits with 25% of depositors suddenly deciding to withdraw their funds. Northern Rock, a British bank specializing in mortgage lending, failed because of liquidity problems of this type.
  • Liquidity needs are uncertain. A financial institution should assess a worst-case liquidity scenario and make sure that it can survive that scenario by either converting assets into cash or raising cash in some other way.
  • Liquidity is also an important consideration in trading. A liquid position in an asset is one that can be unwound at short notice. As the market for an asset becomes less liquid, traders are more likely to take losses because they face bigger bid-offer spreads.
  • For an option or other derivative, a liquid market is important fordoing the daily trades necessary to maintain delta neutrality.

Liquidity Trading Risk

  • If a financial institution owns 100, 1,000, 10,000, or even 100,000 shares in IBM, liquidity risk is not a concern, as several million IBM shares trade on the New York Stock Exchange every day. The quoted price of the shares is very close to the price that the financial institution would be able to sell the shares for.
  • However, a $100 million investment in the bonds of a noninvestment-grade U.S. company might be quite difficult to sell at close to the market price in one day, because of low liquidity. Shares and debt of companies in emerging markets are likely to be even less easy to sell.
  • The price at which a particular asset can be sold depends on
  • The mid-market price of the asset, or an estimate of its Value
  • How much of the asset is to be sold
  • How quickly it is to be sold
  • The economic environment
  • When there is a market maker who quotes a bid and offer price for a financial asset, the financial institution can sell the asset at the bid and buy at the offer. However, a particular quote is valid for trades up to a certain size. Above that size, the market maker is likely to increase the bid-offer spread. This is because the difficulty of hedging the exposure created by the trade also increases, as the size of a trade increases.
  • When there is no market maker for a financial instrument, there is still an implicit bid-offer spread. The bid-offer spread for an asset can vary from 0.05% of the assetโ€™s mid-market price to as much as 5%, or even 10%, of its mid-market price.
  • The general nature of the relationship between bid quotes, offer quotes, and trade size is indicated in this figure. The bid price tends to decrease and the offer price tends to increase with the size of a trade. For an instrument where there is a market maker, the bids and offers are the same up to the market makerโ€™s size limit and then start to diverge.
  • Bid-offer spreads in the retail market show the opposite pattern to that in the previous figure. For example, an individual who approaches a branch of a bank wanting to do a foreign exchange transaction or invest money for 90 days. As the size of the transaction increases, the individual is likely to get a better quote.
  • The price that can be realized for an asset often depends on how quickly it is to be liquidated and the economic environment.
  • Sometimes the real estate market is referred to as a โ€œsellerโ€™s marketโ€. Whereas in other cases, it might be very difficult to sell, and the selling price has to be reduced.
  • For financial assets, liquidity is tight sometimes (e.g., after the Russian default of 1998 and after the subprime crisis of 2007-2008). Liquidating even a relatively small position can then be time consuming and is sometimes impossible. On other occasions, there is plenty of liquidity in the market and relatively large positions can be unwound without difficulty.
  • Liquidating a large position can be affected by what is termed predatory trading. This occurs when a market participant, say Company X, has a large position and other market participants guess that it will have to be liquidated in the near future. For example, if it is expected that Company X will have to sell a large position in a particular stock, they short the stock in anticipation of a price decline. This makes it more difficult than it would otherwise be for Company X to exit from its position at competitive prices. Predatory trading was an issue for the trader known as the London Whale in 2012 and for Metallgesellschaft. In the case of Long-Term Capital Management positions were unwound slowly over a period of time under the supervision of the Federal Reserve to avoid predatory trading.
  • One thing that the market has learned from the credit crisis of 2007 is that transparency is important for liquidity. It had become common practice in the years prior to 2007 to form portfolios of subprime mortgages and other assets and to create financial instruments by securitizing, re-securitizing, and re-re-securitizing the credit risk. Many of the financial instruments were even more complicated. After August 2007, market participants realized that they knew very little about the risks in the instruments they had traded. Moreover, it was very difficult for them to find out very much about this. Later, they realized they had been using credit ratings as a substitute for an understanding of the instruments. After August 2007, the instruments created from subprime mortgages became illiquid. Financial institutions lacked both the necessary models and solid information about the assets in the portfolios underlying the derivatives. Other well-defined credit derivatives, such as credit default swaps, continued to trade actively during the credit crisis.
  • The lesson from all this is that the market can sometimes get carried away trading complex products that are not transparent, but then, liquidity for the products soon disappears. When the products do trade again, prices are likely to be low and bid-offer spreads are likely to be high.

Measuring Market Liquidity

  • One measure of the market liquidity of an asset is its bid-offer spread. This can be measured either as a dollar amount or as a proportion of the asset price.
    • The dollar bid-offer spread is

๐‘ = Offer price โ€” Bid price

  • The proportional bid-offer spread for an asset is defined as

๐‘  = Offer price โ€” Bidprice / Midโ€”market price

where

Mid โ€” market price is halfway between the bid and the offer price.

Sometimes it is convenient to work with the dollar bid-offer spread, ๐‘, and sometimes with the proportional bid-offer spread, ๐‘ .

  • The mid-market price can be regarded as the fair price. In liquidating a position in an asset a financial institution incurs a cost equal to ๐‘ ๐›ผ/2 where ๐›ผ is the dollar (mid-market) value of the position. This reflects the fact that trades are not done at the mid-market price. A buy trade is done at the offer price and a sell trade is done at the bid price.
  • The cost to liquidate a book of investments in a normal market, with n representing the number of positions, is equal to:

Cost of liquidation (normal market) = \( \sum_{i=1}^{n} \frac{s_i \alpha_i}{2} \)

where

๐‘› is the number of positions

๐‘ i is an estimate of the proportional bid-offer spread in normal market conditions for the ๐‘–th financial instrument.

  • Although diversification reduces market risk, it does not necessarily reduce liquidity trading risk. However, since ๐‘ i increases with the size of position ๐‘–, holding many small positions rather than a few large positions leads to less liquidity risk. Setting limits to the size of any one position can therefore be one way of reducing liquidity trading risk.
  • Example-Suppose that a financial institution has bought 10 million shares of one company and 50 million ounces of a commodity
  • The shares are bid $89.5, offer $90.5.
  • The commodity is bid $15, offer $15.1

Find the cost of liquidation in a normal market.

The mid-market price of share is $89.5+$90.5/2=$90.

Hence, the mid-market value of the position in the shares is 90 ร— 10 = $900 million.

The mid-market price of commodity is $15+15.1/2 = $15.05.

Hence, mid-market value of the position in the commodity is 15.05 ร— 5 = $752.50 million.

The proportional bid-offer spread for the shares is 1/90 or 0.01111. The proportional bid- offer spread for the commodity is 0.1/15.05 or 0.006645. The cost of liquidation in a normal market is

900 ร— 0.01111 + 752.5 ร— 0.006645/2 = $ 7.5 million

MEASURING MARKET LIQUIDITY โ€“ Stressed Conditions

  • Another measure of liquidity is the cost of liquidation in stressed market conditions within a certain time period. Define ๐œ‡i and ๐œŽi as the mean and standard deviation of the proportional bid-offer spread for the ๐‘–th financial instrument held.

Then:

Cost of liquidation (stressed market) = \(\sum_{i=1}^{n} \frac{(\mu_i + \lambda \sigma_i) \alpha_i}{2}\)

The parameter ๐œ† gives the required confidence level for the spread.

For example, if it is assumed that spreads are normally distributed , then for the โ€œworst caseโ€ spreads that are exceeded only 1 % of the time, ๐œ† = 2.328.

Example โ€“ Suppose that in the previous example,

  • The mean and standard deviation for the bid-offer spread for the shares are $1.0 and $2.0, respectively.
  • The mean and standard deviation for the bid-offer spread for the commodity are both $0.1.
  • The mean and standard deviation for the proportional bid-offer spread for the shares are 0.01111 and 0.02222, respectively.
  • The mean and standard deviation for the proportional bid-offer spread for the commodity are both 0.006645.

Assuming the spreads are normally distributed, find the cost of liquidation that we will not be exceeded at the 99 percent confidence level.

\(\frac{900 \times (0.01111 + 2.328 \times 0.02222) + 752.5 \times (0.006645 + 2.328 \times 0.006645)}{2} = 36.58\)

or $36.59 million.

This is almost five times the cost of liquidation in normal market conditions.

  • In practice, bid-offer spreads are not normally distributed and it may be appropriate to use a value of ๐œ† that reflects their empirical distribution. For example, if it is found that the 99 percentile point of the distribution is 3.6 standard deviations above the mean for a particular category of financial instruments, ๐œ† can be set equal to 3.6 for those instruments.
  • The previous equations and calculations assume that spreads in all instruments are perfectly correlated. This may seem overly conservative, but it is not. When liquidity is tight and bid-offer spreads widen, they tend to do so for all instruments. It makes sense for a financial institution to monitor changes in the liquidity of its book by calculating both the unstressed and stressed measures on a regular basis. Since the bid-offer spread depends on how quickly a position is to be liquidated, these measures are therefore likely to be decreasing functions of the time period assumed for the liquidation.

LIQUIDITY TRADING RISK โ€“ ๐‹๐ข๐ช๐ฎ๐ข๐๐ข๐ญ๐ฒ_๐€๐๐ฃ๐ฎ๐ฌ๐ญ๐ž๐ ๐‘ฝ๐’‚๐‘น

  • Although ๐‘‰๐‘Ž๐‘… and liquidity risk measures deal with different types of risks, some researchers have suggested combining them into a liquidity-adjusted ๐‘‰๐‘Ž๐‘… measure. One definition of liquidity- adjusted ๐‘‰๐‘Ž๐‘… is regular ๐‘‰๐‘Ž๐‘… plus the cost of unwinding positions in a normal market. Hence

Liquidity_Adjusted VaR = \(VaR + \sum_{i=1}^{n} \frac{s_i \alpha_i}{2}\)

  • Alternatively it can be defined as regular VaR plus the cost of unwinding positions in a stressed market. Hence

Liquidity_Adjusted VaR =\( Var + \sum_{i=1}^{n} \frac{(\mu_i + \lambda \sigma_i) \alpha_i}{2}\)

LIQUIDITY TRADING RISK-Optimal Unwinding

  • A trader wishing to unwind a large position in a financial instrument has to decide on the best trading strategy. If the position is unwound quickly, the trader will face large bid-offer spreads, but the potential loss from the mid-market price moving against the trader is small. If the trader chooses to take several days to unwind the position, the bid-offer spread each day will be lower, but the potential loss from the mid-market price moving against the trader is larger.
  • The total of the costs related to the bid-offer spread is

\(\sum_{i=1}^{n} q_i \frac{p(q_i)}{2}\)

where

๐‘› is the number of days over which to liquidate the position

the dollar bid-offer spread when the trader trades ๐‘ž units in one day is ๐‘(๐‘ž) dollars

  • Suppose that mid-market price changes are normally distributed with a standard deviation of ๐œŽ per day. The variance of the change in value of the traders position on day ๐‘– is \(\sigma^2 x_i^2 \). Assuming that price changes on successive days are independent, the variance of the change in the value of the position applicable to the unwind is therefore

\(sum_{i=1}^{n} \sigma^2 x_i^2\)

A trader might reasonably wish to minimize VaR after trading costs have been considered. This corresponds to minimizing something similar to the liquidity-adjusted VaR measure. The traderโ€™s objective is to choose the ๐‘ži, so that

\(\lambda \sqrt{\sum_{i=1}^{n} \sigma^2 x_i^2 + \sum_{i=1}^{n} q_i \frac{p(q_i)}{2}}\)

is minimized subject to

\(\sigma^2 x_i^2\)

where

the total size of the position is ๐‘‰ units

LIQUIDITY TRADING RISK โ€“ Other Measures of Market Liquidity

  • Many other measures of market liquidity have been proposed which do not rely on bid-offer spread. The volume of trading per day (i.e., the number of times the asset trades in a day) is an important measure. When an asset is highly illiquid, the volume of trading in a day is often zero. The price impact of a trade of a certain size is another measure.
  • A measure somewhat similar to this, but more easily calculated, was proposed by Amihud (2002). It is the average of

\(\frac{\text{Absolute value of daily return}}{\text{Daily dollar volume}}\)

over all days in the period considered.

This measure is widely used by researchers. Amihud shows that an assetโ€™s expected return increases as its liquidity decreases. In other words, investors do get compensated for illiquidity.

LIQUIDITY FUNDING RISK

  • Liquidity funding risk is the financial institutionโ€™s ability to meet its cash needs as they arise. Liquidity funding problems at a financial institution can be caused by:
  • Liquidity stresses in the economy (e.g., a flight to quality as seen during the credit crisis).
  • Overly aggressive funding decisions, using short-term instruments to fund long-term needs.
  • A poor financial performance, leading to a lack of confidence. This can result in a loss of deposits and difficulties in rolling over funding.

Often, when a company experiences severe liquidity problems, all three occur at the same time.

  • The key to managing liquidity risk is predicting cash needs and ensuring that they can be met
  • Some cash needs are predictable. For example, if a bank has issued a bond, it knows when coupons will have to be paid.
  • Others, like those associated with withdrawals of deposits by retail customers and drawdowns by corporations on lines of credit granted by the bank, are less predictable.
  • As the financial instruments have become more complex, cash needs have become more difficult to predict. For example, downgrade triggers, guarantees provided by a financial institution, and possible defaults by counterparties in derivatives transactions can have an unexpected impact on cash resources.

LIQUIDITY FUNDING RISKโ€“Sources of Liquidity

The main sources of liquidity for a financial institution are:

  • Holdings of cash and Treasury securities โ€“ Instruments like U.S. and U.K. treasury securities of developed nations (like US, UK etc.) are safe haven investments that are highly liquid, but their returns are lower as compared to risky assets. Hence there is a tradeoff between investments that offer high liquidity and low returns with those that offer lower liquidity but provide a higher return, which needs to be balanced by financial institutions.
  • The ability to liquidate trading book positions โ€“ Liquidity funding risk is related to liquidity trading risk, because one way a financial institution can meet its funding requirements is by liquidating part of its trading book. It is therefore important for a financial institution to quantify the liquidity of its trading book so that it knows how easy it would be to use the book to raise cash. The financial institution wants to make sure that it will be able to survive stressed market conditions where there is a general shortage of liquidity.
  • The ability to borrow money at short notice โ€“ In stressed market conditions, when there is a heightened aversion to risk, there might be higher interest rates, shorter maturities for loans, and in some cases a refusal to provide funds at all. Financial institutions should monitor the assets that can be pledged as collateral for loans at short notice. A financial institution can (at a cost) mitigate its funding risks somewhat by arranging lines of credit. For example, Countrywide, an originator of mortgages in the United States, had a syndicated loan facility of $11.5 billion, which it was able to use during the credit crisis of 2007. Northern Rock, a similar British mortgage lender, did not fare so well.
  • The ability to offer favorable terms to attract retail and wholesale deposits at short notice โ€“ Wholesale deposits are a more volatile source of funding than retail deposits and can disappear quickly in stressed market conditions. Even retail deposits are not as stable now as they used to be earlier. Unfortunately, liquidity problems tend to be market-wide. When one financial institution wants to increase its retail or wholesale deposit base for liquidity reasons by offering more attractive rates of interest, others usually want to do the same thing and the increased funding is likely to be difficult to achieve.
  • The ability to securitize assets (such as loans) at short notice โ€“ Banks have found the โ€œoriginate-to-distributeโ€ model attractive. Rather than keep illiquid assets such as loans on their balance sheet, they have securitized them. Before August 2007, securitization was an important source of liquidity for banks. However, this source of liquidity dried up almost overnight in August 2007 as investors decided that the securitized products were too risky.
  • Borrowings from the central bank โ€“ Central banks (e.g., the Federal Reserve Board in the United States, the Bank of England in the UK, or the European Central Bank) are often referred to as โ€œlenders of last resortโ€. When commercial banks are experiencing financial difficulties, central banks are prepared to lend money to maintain the health of the financial system. Collateral has to be posted by the borrowers and the central bank typically applies a haircut and may charge a relatively high rate of interest. In March 2008, after the failure of Bear Stearns, the Federal Reserve Board extended its borrowing facility to investment banks as well as commercial banks. Later, it also made the facility available to Fannie Mae and Freddie Mac. Different central banks apply different rules. Following the credit crisis of August 2007, the haircuts used by the European Central Bank (ECB) were lower than those of other central banks. As a result, some British banks preferred to borrow from the European Central Bank (ECB) rather than the Bank of England.

LIQUIDITY FUNDING RISKโ€“Case Studies

Northern Rock โ€“

  • In 2007 , Northern Rock was one of the top five mortgage lenders in the United Kingdom. It had 76 branches and offered deposit accounts, savings accounts, loans, and house/contents insurance. The bank grew rapidly between 1997 and 2007. Some of its mortgages were securitized through a subsidiary, Granite, that was based in the Channel Islands.
  • Northern Rock relied on selling short-term debt instruments for much of its funding. Following the subprime crisis of August 2007, the bank found it very difficult to replace maturing instruments because institutional investors became very nervous about lending to banks that were heavily involved in the mortgage business. The banks assets were sufficient to cover its liabilities so it was not insolvent. To quote from the Financial Services Authority (FSA) in September 2007: โ€œThe FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement, and has a good quality loan book.โ€ But Northern Rockโ€™s inability to fund itself was a serious problem. It approached the Bank of England for funding on September 12, 2007, and borrowed about ยฃ3 billion from the Tripartite Authority (Bank of England, the Financial Services Authority, and HM Treasury) in the following few days.
  • On September 13, 2007, the BBC business editor Robert Peston broke the news that the bank had requested emergency support from the Bank of England. On Friday, September 14, there was a run on the bank. Thousands of people lined up for hours to withdraw their funds. This was the first run on a British bank in 150 years. Some customers held their funds in an Internet- onlyโ€ account, which they were unable o access due to the volume of customers trying to log on. On Monday, September 17, worried savers continued to withdraw their funds. An estimated ยฃ2 billion was withdrawn between September 12 and September 17, 2007.
  • Depositor insurance in the UK guaranteed 100% of the first ยฃ2,000 and 90% of the next ยฃ33,000. Late on September 17, 2007, the British Chancellor of the Exchequer, Alistair Darling, announced that the British government and the Bank of England would guarantee all deposits held at Northern Rock. As a result of this announcement and subsequent advertisements in major UK newspapers, the lines outside Northern Rockโ€™s branches gradually disappeared. Northern Rockโ€™s shares, which had fallen from ยฃ12 earlier in the year to ยฃ2.67, rose 16% on

Mr. Darlings announcement.

  • During the months following September 12, 2007, Northern Rockโ€™s emergency borrowing requirement increased. The Bank of England insisted on a penalty rate of interest to discourage other banks from taking excessive risks. Northern Rock raised some funds by selling assets, but by February 2008 the emergency borrowing reached ยฃ25 billion. The bank was then nationalized and the management of the bank was changed. It was split into Northern Rock pic and Northern Rock (Asset Management), with the companyโ€™s bad debt being put in Northern Rock (Asset Management). In November 2011, Northern Rock pic was bought from the British government for ยฃ747 million by the Virgin Group, which is headed by the colorful entrepreneur Sir Richard Branson.
  • The Northern Rock story illustrates just how quickly liquidity problems can lead to a bank spiraling downward. If the bank had been managed a little more conservatively and had paid more attention to ensuring that it had access to funding, it might have survived.

Ashanti Goldfields โ€“

  • Ashanti Goldfields, a West African gold-mining company based in Ghana, experienced problems resulting from its hedging program in 1999. It had sought to protect its shareholders from gold price declines by selling gold forward. On September 26, 1999, 15 European central banks surprised the market with an announcement that they would limit their gold sales over the following five years. The price of gold jumped up over 25%. Ashanti was unable to meet margin calls and this resulted in a major restructuring, which included the sale of a mine, a dilution of the interest of its equity shareholders, and a restructuring of its hedge positions.

Metallgesellschaft โ€“

  • In the early 1990s, Metallgesellschaft (MG) sold a huge volume of 5- to 10-year heating oil and gasoline fixed-price supply contracts to its customers at six to eight cents above market prices. It hedged its exposure with long positions in short-dated futures contracts that were rolled forward. As it turned out, the price of oil fell and there were margin calls on the futures positions. MGโ€™s trading was made more difficult by the fact that its trades were very large and were anticipated by others.
  • Considerable short-term cash flow pressures were placed on MG. The members of MG who devised the hedging strategy argued that these short-term cash outflows were offset by positive cash flows that would ultimately be realized on the long-term fixed-price contracts. However, the companyโ€™s senior management and its bankers became concerned about the huge cash drain. As a result, the company closed out all the hedge positions and agreed with its customers that the fixed-price contracts would be abandoned. The outcome was a loss to MG of $1.33 billion.

LIQUIDITY FUNDING RISKโ€“Case Studies Lessons

  • Banks try to keep their borrowing from a central bank a secret. There is a danger that the use of central bank borrowings will be interpreted by the market as a sign that the bank is experiencing financial difficulties with the result that other sources of liquidity dry up. For Example โ€“ Northern Rock.
  • Hedging Issues โ€“ Liquidity problems are liable to arise when companies hedge illiquid assets with contracts that are subject to margin requirements. Gold-mining companies often hedge their risks by entering into agreements to sell gold forward. The amount of the margin required is calculated every day to reflect the value of its forward agreements. If the price of gold rises fast, the forward agreements lose money and result in big margin calls on the gold-mining company. The losses on the forward agreements are offset by increases in the value of the gold in the ground, but this is an illiquid asset. For Example โ€“ Ashanti Goldfields.
  • The lesson from the Ashanti and Metallgesellschaft episodes is no that companies should not use forward and futures contracts for hedging, but rather that they should ensure that they have access to funding to handle the cash flow mismatches that might arise in extreme circumstances.

LIQUIDITY FUNDING RISK โ€“ Reserve Requirements

  • In some countries there are reserve requirements that require banks to keep a certain percentage of deposits as cash in the bankโ€™s vault or on deposit with the central bank. The reserve requirement applies only to transaction deposits (in essence, those made to a checking account). For large banks in the United States, the reserve requirement is currently about 10%. Some countries, such as Canada and the United Kingdom, have no compulsory reserve requirements. Others have higher compulsory reserve requirements than the United States.
  • In addition to ensuring that banks keep a minimum amount of liquidity, reserve requirements affect the money supply. When the reserve requirement is 10%, a $100 deposit leads to $90 of lending, which leads to a further $90 of deposits in the banking system, which leads to further $81 of lending, and so on. As this process continues, the total money supply (๐‘€1) that is created is 90 + 81 + 72.9 + . . . or $900 (derived in the video). If the reserve requirement is 20%, a $100 deposit leads to $80 of lending, which leads to $64 of lending, and so on. The total increase in the money supply is 80 + 64 + 51.2 + . . . ๐‘œ๐‘Ÿ $400. Most countries do not use the reserve requirement as a way of controlling the money supply. An exception appears to be China, where the Reserve requirement is changed frequently.

LIQUIDITY FUNDING RISK โ€“ Ratios and Regulations

  • Basel III introduced two liquidity risk requirements: the liquidity coverage ratio (๐ฟ๐ถ๐‘…) and the net stable funding ratio (๐‘๐‘†๐น๐‘…).
  • The ๐ฟ๐ถ๐‘… requirement is

\(\frac{\text{High quality liquid assets}}{\text{Net cash outflows in a 30-day period}} \geq 100\%\)


where

the 30_day period considered in the calculation of ๐ฟ๐ถ๐‘… is one of acute stress involving a downgrade of three notches, a partial loss of deposits, a complete loss of wholesale funding, increased haircuts on secured funding, and drawdowns on lines of credit.

  • The NSFR requirement is

\(\frac{\text{Amount of stable funding}}{\text{Required amount of stable funding}} \geq 100\%\)

where

the numerator is calculated by multiplying each category of funding (capital, wholesale deposits, retail deposits, etc.) by an available stable funding (ASF) factor, reflecting their stability.

The denominator is calculated from the assets and off-balance-sheet items requiring funding. Each category of these is multiplied by a required stable funding (RSF) factor to reflect the permanence of the funding.

  • Following the liquidity crisis of 2007, bank regulators issued a revised set of principles on how banks should manage liquidity. These are as follows:
  1. A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high-quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bankโ€™s liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.
  2. A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system. Senior management should develop a strategy, policies, and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity.
  3. Senior management should continuously review information on the bankโ€™s liquidity developments and report to the board of directors on a regular basis. A bankโ€™s board of directors should review and approve the strategy, policies, and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.
  4. A bank should incorporate liquidity costs, benefits, and risks in the internal pricing, performance measurement, and new product approval process for all significant business activities (both on- and off-balance-sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.
  5. A bank should have a sound process for identifying, measuring, monitoring, and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities, and off-balance-sheet items over an appropriate set of time horizons.
  6. A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines, and currencies, taking into account legal, regulatory, and operational limitations to the transferability of liquidity.
  7. A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund-raising capacity remain valid.
  8. A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
  9. A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilized in a timely manner.
  10. A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bankโ€™s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
  11. A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures, and be regularly tested and updated to ensure that it is operationally robust.
  12. A bank should maintain a cushion of unencumbered, high-quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory, or operational impediment to using these assets to obtain funding.
  13. A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.
  14. Supervisors should regularly perform a comprehensive assessment of a bankโ€™s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bankโ€™s role in the financial system.
  15. Supervisors should supplement their regular assessments of a bankโ€™s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports, and market information.
  16. Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position.
  17. Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management. Communication should occur regularly during normal times, with the nature and frequency of the information sharing increasing as appropriate during times of stress.

LIQUIDITY BLACK HOLES

  • Technological and other developments have led to an improvement in the liquidity of financial markets. Bid-offer spreads have on average declined. But there has also been an increasing tendency for situations to develop where almost everyone wants to do the same type of trade at the same time. The result has been that what are referred to as liquidity black holes occur with increasing frequency. A liquidity black hole describes a situation where liquidity has dried up in a particular market because everyone wants to sell and no one wants to buy, or vice versa. It is sometimes also referred to as a โ€œcrowded exitโ€.
  • A liquidity black hole is created when a price decline causes more market participants to want to sell, driving prices well below where they will eventually settle. During the sell-off, liquidity dries up and the asset can be sold only at a fire-sale price.
  • Changes in the liquidity of financial markets are driven by the behavior of traders. There are two sorts of traders in the market:
    • Negative feedback traders buy when prices fall and sell when prices rise;
    • Positive feedback traders sell when prices fall and buy when prices rise.

In liquid markets, negative feedback traders dominate the trading. If the price of an asset gets unreasonably low, traders will move in and buy. This creates demand for the asset that restores the price to a more reasonable level. Similarly, if the price of an asset gets unreasonably high, traders will sell. This creates supply of the asset that also restores the price to a more reasonable level. The result is that the market is liquid with reasonable prices and a good balance of buyers and sellers.

When positive feedback traders dominate the trading, market prices are liable to be unstable and the market may become one-sided and illiquid. A reduction in the price of an asset causes traders to sell. This results in prices falling further and more selling. An increase in the price of an asset causes traders to buy. This results in the price of the asset increasing further and more buying.

  • There are a number of reasons why positive feedback trading exists. For example:
  1. Trend trading โ€“ Trend traders attempt to identify trends in an asset price. They buy when the asset price appears to be trending up and sell when it appears to be trending down. A related strategy is breakout trading, which involves trading when an assetโ€™s price moves outside an established range.
  2. Stop-loss rules โ€“ Traders often have rules to limit their losses. When the price of an asset that is owned falls below a certain level, they automatically sell to limit their losses.
  3. Dynamic hedging โ€“ Hedging a short option position (call or put) involves buying after a price rise and selling after a price decline. This is positive feedback trading that has the potential to reduce liquidity. (By contrast, dynamically hedging a long position in a call or put option involves selling after a price rise and buying after a price decline. This is negative feedback trading and should not interfere with market liquidity.)
  4. Creating options synthetically โ€“ Hedging a short position in an option is equivalent to creating a long position in the same option synthetically. It follows that a financial institution can create a long option position synthetically by doing the same sort of trading as it would do if it were hedging a short option position. This leads to positive feedback trading that can cause market instability and illiquidity. The classic example here is the stock market crash of October 1987. In the period leading up to the crash, the stock market had done very well. Increasing numbers of portfolio managers were using commercially available programs to synthetically create put options on their portfolios. These programs told them to sell part of their portfolio immediately after a price decline and buy it back immediately after a price increase. The result was a liquidity black hole where prices plunged on October 19, 1987. In this case, the liquidity black hole was relatively short-lived. Within 4 months the market recovered to close to its pre-crash level.
  5. Margins โ€“ A big movement in market variables, particularly for traders who are highly leveraged, may lead to margin calls that cannot be met. This forces traders to close out their positions, which reinforces the underlying move in the market variables. It is likely that volatility increases. This may exacerbate the situation because it leads to exchanges increasing their margin requirements.
  6. Predatory trading โ€“ This has already been discussed. To avoid predatory trading, large positions must usually be unwound slowly.
  7. LTCM โ€“ The failure of the hedge fund Long-Term Capital Management (LTCM) provides an example of positive feedback trading. One type of LTCMโ€™s trade was โ€œrelative value fixed incomeโ€. LTCM would take a short position in a liquid bond and a long position in a similar illiquid bond, and wait for the prices to converge. After the Russian default in 1998, the prices of illiquid instruments declined relative to similar liquid instruments. LTCM (and other companies that were following similar strategies to LTCM) were highly leveraged and unable to meet margin calls. They were forced to close out their positions. This involved buying the liquid bonds and selling the illiquid bonds. This reinforced the flight to quality and made the prices of illiquid and liquid bonds diverge even further.

LIQUIDITY BLACK HOLES-Leveraging

  • When banks are having many sources of liquidity (e.g., because they have developed ways of securitizing assets or because deposit levels are higher than usual), they make credit easily available to businesses, investors, and consumers. Credit spreads decrease. The easy availability of credit increases demand for both financial and nonfinancial assets and the prices of these assets rise. Assets are often pledged as collateral for the loans that are used to finance them. When the prices of the assets rise, the collateral underlying loans (when measured at market prices) is greater and borrowing can increase further. This leads to further asset purchases and a repeat of the cycle. This cycle is referred to as โ€œleveragingโ€ because it leads to more borrowing throughout the economy.

LIQUIDITY BLACK HOLES-Deleveraging

  • Deleveraging is the opposite process to leveraging. Banks find themselves less liquid for some reason (e.g., because there is less demand for the products of securitization). They become more reluctant to lend money. Credit spreads increase. There is less demand for both nonfinancial and financial assets and their prices decrease. The value of the collateral supporting loans decreases and banks reduce lines of credit. This leads to asset sales being necessary and a further reduction in asset prices. The period leading up to 2007 was characterized by leveraging for many of the worldโ€™s economies. Credit spreads declined and it was relatively easy to borrow money for a wide range of different purposes. From the middle of 2007 onward, the situation changed and the deleveraging process started. Credit spreads increased, it became much less easy to borrow money, and asset prices decreased Hedge funds are particularly affected by the deleveraging cycle.

LIQUIDITY BLACK HOLES โ€“ Irrational Exuberance

  • The term irrational exuberance was used by Alan Greenspan, Federal Reserve Board chairman, in a speech in December 1996 when, in reference to the stock market, he asked, โ€œHow do we know when irrational exuberance has unduly escalated asset values?โ€. Most liquidity black holes can be traced to irrational exuberance of one sort or another. What happens is that traders working for many different financial institutions become irrationally exuberant about a particular asset class or a particular market variable. When many financial institutions choose to take a particular position, prices increase, making the position look profitable. This creates extra desire on the part of financial institutions to take the position and yet more profits. Risk managers working for the financial institution should (and probably will) complain about the risks being taken, but in many instances senior management are likely to ignore their concerns because high profits are being made. To quote Chuck Prince, ex-CEO of Citigroup, on July 10, 2007: โ€œWhen the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, youโ€™ve got to get up and dance. Weโ€™re still dancing.โ€
  • At some stage the bubble must burst. Many traders then try to get out of their positions at the same time, causing illiquid markets and huge losses. Examples are โ€“ 1987 stock market crash, 1994 bond market crash, the 1997-1998 Asian monetary crisis, and the 1998 LTCM failure.

LIQUIDITY BLACK HOLES โ€“ The Impact of Regulation

  • Even though regulations are important, a uniform regulatory environment comes with costs. All banks tend to respond in the same way to external events. Consider for example market risk. When volatilities and correlations increase, market risk VaR and capital required for market risks increase. Since banks often have similar positions to each other, they try to do similar trades to reduce their exposures. A liquidity black hole can develop. There is a similar issue with credit risk. During the low point of the economic cycle, default probabilities are higher and capital requirements for loans under the Basel II IRB models tend to be high. Hence, banks may be less willing to make loans, creating problems for small and medium-sized businesses. During the high point of the business cycle, default probabilities are lower and banks may be too willing to grant credit. The Basel Committee has recognized this problem and has dealt with it by asserting that the probability of default should be an average of the probability of default through the economic or credit cycle, rather than an estimate applicable to one particular point in time.
  • Other financial institutions like life insurance companies and pension funds should not be regulated in the same way as banks, as these have longer time horizons than banks. They should not be penalized for investing in illiquid assets. They should not be required to adjust their portfolios

when volatilities and correlations increase. These parameters tend to be mean reverting and so they eventually decrease again.

LIQUIDITY BLACK HOLES โ€“ The Importance of Diversity

  • Models in economics usually assume that market participants act independently of each other. But this is often not the case. It is this lack of independence that causes liquidity black holes. Traders working for financial institutions tend to want to do the same trades at the same time. To solve the problem of liquidity black holes, we need more diversity in financial markets. One way of creating diversity is to recognize that different types of financial institutions have different types of risks and should be regulated differently.
  • Hedge funds have become important market participants. They are much less regulated than banks or insurance companies and can follow any trading strategy they like. To some extent they do add diversity (and therefore liquidity) to the market. But, as mentioned earlier, hedge funds tend to be highly leveraged. When liquidity tightens as it did in the second half of 2007, all hedge funds have to unwind positions accentuating the liquidity problems.
  • One conclusion is that a contrarian investment strategy has some merit. If markets overreact, an investor can do quite well by buying when everyone else is selling and there is very little liquidity. However, it can be quite difficult for a financial institution to follow such a strategy if it is subject to short-term VaR-based risk management.


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