The document discusses liquidity risk measurement and management through scenario analysis and cash flow projections. It outlines two likely economic scenarios - stagflation and deflation - and recommends analyzing liquidity needs across multiple scenarios and stress levels through a "buying time" framework. It also discusses measuring liquidity risk through cash flow projections and reporting, highlighting the importance of modeling behavioral assumptions around different sources and uses of liquidity.
Best Practices for Measuring and Managing Liquidity Risk
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Dodd-Frank/U.S. Basel III Implementation Series:
Initiatives for 2014 and Beyond
Best Practices in Liquidity Risk Reporting, Measurement and Management in
two likely Scenarios: Stagflation and Deflation
Aseem Elahi
Sr. Business Analyst
August 29, 2014
Executive Summary
The objective of this white paper is to demonstrate the development of internal reports that allow
management to measure, monitor and evaluate a bank’s liquidity risk. This paper outlines approaches
to each of the areas with an emphasis on two likely scenarios: Stagflation and Deflation. Liquidity risk
events are often categorized as high-probability/low-severity or low-probability/high-severity events. As
of August 2014, I submit one of the two mentioned scenarios as a “high-probability/high-severity”
event. A discussion on contingency planning and liquidity cost and pricing is also covered. Regulatory
requirements for liquidity risk are explained in an implementation model in a separate white paper,
“Liquidity Coverage Ratio (LCR).”
Finally, the greater part of the credit of this paper goes to Leonard Matz from whose two
comprehensive, insightful and incisive books the approaches are developed. The books are listed in the
Bibliography.
What is Liquidity Risk?
For you and me, Liquidity risk is the risk of not having cash flow when needed or wanted. It is much like
having sufficient cash to pay recurring bills on time, cash for emergencies, and cash to invest whenever a
great opportunity arises that requires payments over time. You can use your own cash or savings,
borrow (without having to prove you’re good for it), or use other people’s money at a cost.
For banks, liquidity is the capacity to obtain sufficient funds to meet contractual obligations while
upholding the perception in the market that they have that ability. At the same time, they need to have
the ability to fund new business or non-contractual events. And, they also have to manage it cyclically
to build their liquidity positions during opportune times. Their Liquidity Risk is the probability that not
having enough liquidity will have an adverse consequence, with bank failure being the extreme case. It
is a probability because liquidity is a fluid and fungible condition depending on the prevailing
environment, is situation specific, and the risk never ceases to exist because of the banks’ business
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model. Banks are financial intermediaries that provide maturity transformation between fund suppliers
and users. Suppliers, such as depositors and capital markets, are inclined to liquidity while users are
borrowers that are inclined to illiquidity.
The definition of liquidity, then, is “the capacity and perceived ability to meet known near-term and
projected long-term funding commitments while supporting selective business expansion in accordance
with the bank’s strategic plan.”1
Liquidity Risk arises out of three components:2
Liquidity Mismatch: also known as liquidity gap, it ensues out of the bank’s business model of
maturity transformation. It is the risk on the mismatch between contractual amounts and dates
for inflows and outflows.
Market Liquidity risk: this is the risk that unwinding investments or exposures without
incurring a loss due to conditions in capital markets.
Liquidity Contingency risk: this is the risk that a bank may need more liquidity in the future. It
arises out of situations where holders withdraw funds at other than contractual dates such as
retail depositors or credit borrowers using their drawdown facilities. It also arises from the bank
having to fund new business when its own funding is limited to protect its franchise.
Liquidity risk is a cost to banks, much like insurance. They can never have enough but having too much
impacts profitability. And, having too little risks bank failure even when the institution has valuable
assets. Further complicating the situation is that liquidity risk is a future event that ensues from [most
often] a credit event. Credit events can be idiosyncratic or systemic. Measuring or quantifying such an
event becomes challenging, and approaches to it will be discussed in the Scenario Analysis and Stress
Testing sections below. However, prudent liquidity risk management is unobservable and unrewardable
until the event occurs. A good analogy is the insignificance society places on the number of terrorist
attacks prevented by intelligence agencies. They don’t receive a bonus for preventing it. However, even
the occurrence of a single one is unforgivable.
While regulation has been focused on the most recent crisis, no two liquidity crises are alike. Further,
identifying what and where the next crisis comes from is like looking into a crystal ball. Nevertheless, I
speculate that a systemic, economic crisis is at hand and its two most likely scenarios are stagflation and
deflation.
1
Matz, L. (2005), pg. 1-10
2
(Matz, "Liquidity Risk Management", 2005), pg. 1-15
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Rationale for Stagflation and Deflation
Stagflation:
In the current environment, financial assets and US Dollar are rising while employment, GDP,
and incomes are declining. Employment is getting better but labor participation rates are
getting worse. Incomes are lower, thus consumer spending is expected to be lower. Multi-
generational housing is increasing and that means people are not focused on establishing
households. Further, interest rates are going down which means investors are not convinced
the economy is making gains, thus the flight to quality. Single family housing is not making
gains. On the other hand, food, rentals and health costs are increasing whereas industrial
commodities are sagging. While the Federal Reserve focuses on core CPI, the people’s inflation
is elevated. Full-time jobs are decreasing while part-time are increasing. There is a skills divide
in the economy where employers cannot fill jobs and there are too many people in the unskilled
market, thus suppressing household incomes. The Federal Reserve is tolerant if inflation
overshoots its target of 2%. Wage growth is an important driver of inflation and the Federal
Reserve is targeting this metric now that its inflation targets have been met.
Payrolls have been rising for the last six months and the latest unemployment (U3) edged up to
6.2%. This shows that the Brookings model is valid, i.e., previously, all those who were
considered to have left the labor force will be coming back as the labor market improves. U5 is
a better gauge since it includes discouraged and marginally attached workers, and it currently
stands at 7.3% (June 2014) albeit has been declining. Services employment CPI (60% of CPI) is
more US specific. The latest employment cost index shows wage inflation in the skills divide.
The Federal Reserve may be forced to raise interest rates not because of rising inflation in the
economy but because of the rapid increases in stock prices.
Deflation:
The regime of falling interest rates and strength in the USD has created deflation. Were interest
rates stable, companies would be investing in capex instead of stock buybacks and cash
accumulation. The US dollar is rallying against most currencies. This bodes ill for commodities,
and agricultural commodities have been under pressure. Despite the Federal Reserve’s efforts
to increase money supply, money velocity is very low. Furthermore, increased taxes and
government regulation contribute to deflation. Pensions are in trouble because they cannot
cover liabilities with such low interest rates. International funds, including central banks’ funds,
are crowding into US equity markets in search of yields higher than most countries’ government
bonds, and there are no economies as safe havens except for the US. Deflation from overseas,
particularly Europe, has been arriving on US shores in the form of capital flows bolstering equity
markets. Domestic inflation has been trending down much like Japan’s in the 1990s.
Households are focused on reducing debt instead of spending which has impacted housing and
retail sales. Additionally, the Federal Reserve is preparing a 10% exit tax on Treasuries removing
price discovery from the market. There is also the possibility of bail-in-able bonds issuance. All
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these factors will prevent corporations from investing in capex, thus putting downward pressure
on private investment to spur the economy. It is possible that long-term corporate credit might
become more valuable than Treasuries since they hold large amounts of cash when interest
rates begin to rise. That would be a first in an era of flight to quality.
Scenario Analysis and Stress Testing
“Scenarios are the language of liquidity risk.”3
Liquidity events of the past decades have shown that liquidity risk comes in various guises, and is
situation specific. They could be endogenous or exogenous events, and some may truly be black swan
events. Banks that have developed a spectrum of environments from ordinary course of business to
mild seasonal or cyclical events to severe systemic events also need to understand the causes of each
defined scenario. Successfully managing liquidity, then, is “the adoption of different approaches for
different environments.” 4
This is scenario analysis, and becomes important because the funding
source—liquidity being fungible--varies in each scenario. Scenario analysis and stress levels are not the
same exercise.
To simplify and capture the vast spectrum of environments, there are three broad scenario categories:
operational and seasonal liquidity needs (going concern); bank-specific crises (almost always a bank
name credit event), and systemic crises (capital market disruptions and/or economic conditions).
Each category requires a scenario and each scenario requires multiple stress levels combined with an
analysis of the duration of the stress. A well-diversified bank needs to perform this exercise for each
product/business area, currency and geographic region where business is conducted. Furthermore,
severities need to be pre-defined for each stress level. A base case—business as usual—is not included
in the chart below as those liquidity measures are most likely currently being monitored.
3
(Matz, "Liquidity Risk Measurement and Management", 2011), pg. 111
4
(Matz, "Liquidity Risk Management", 2005), pg. 5-3
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BUYING TIME (adverse durations highlighted in dark)
Month 1/Week 1 Month 1/Weeks
Day 1 Day 2 Day 3 Day 4 Day 5 Week 2 Week 3 Week 4
Scenarios
Operational and Seasonal
StressLevels
Mild
Acute
Adverse
Bank-specific
Mild
Acute
Adverse
Systemic
Mild
Acute
Adverse
BUYING TIME (adverse durations highlighted in dark, continued)
Subsequent Months
Month 2 Month 3 Month 4 Month 5 Month 6 Mths 7 - 12
Scenarios
Operational and Seasonal
StressLevels
Mild
Acute
Adverse
Bank-specific
Mild
Acute
Adverse
Systemic
Mild
Acute
Adverse
There is never enough liquidity at a bank during the normal course of business to survive a worst-case
scenario. Stress testing allows a bank to determine whether there is sufficient liquidity to buy time to
outlast the event and/or implement curative actions.
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The goal of stress testing, then, is to identify and estimate vulnerabilities vis-à-vis time buckets, liquidity
funding and needs. Its purpose is to evaluate contingency risks in the future not in the past. VaR or
extreme value theory explain only historical volatility thus making them poor choices to measure
liquidity risk. However, it is almost impossible to determine the probability of a deterministic scenario.
Data is hard to obtain, distributions are non-normal, extreme events are hard to model, and behaviors
of participants are difficult to predict. “Deterministic, scenario-based stress tests are the least-worst
solution.”5
Systemic stressed scenarios require modeling of, or assumption testing, risk factors such as interest
rates, credit spreads, market access and time required to unwind specific assets. One of IIF’s
recommendations is to use stress tests to “measure the behavior of all sources of cash inflows and
outflows that could potentially be material to the firm under various sets of assumptions.”6
In the end, stress testing is a planning exercise, not a predictive activity.
Cashflow Projections and Reporting
“The essence of liquidity risk is cash flow.”7
When management needs to know how much liquidity a bank needs or currently holds, the best tool for
measuring liquidity needs and its sources are cash flow projections. This periodic exercise determines
whether there is enough liquidity and whether it is available at the right time.
Measuring liquidity risk with cash flow projections shows its strengths in covering all sources and uses of
liquidity, whether assets, liabilities or off-balance sheet items. It highlights assets that can be used both
as a source and a use of liquidity, while revealing liabilities as either volatile or stable. The projections
are always in the future and scenario specific. And, it reveals liquidity as fungible and the risk time-
based.8
The biggest drawback to cash flow projections is that they are assumptions based, especially behaviors
of users and providers of liquidity. Examples of difficult assumptions are deposits with indeterminate
maturities, commitment drawdowns, new loans, etc. While difficult, behavioral assumptions can be
modeled for stressed scenarios. For example, a stickiness score can be calculated for each fund provider
as shown in the table below.9
A similar analysis can be conducted on users of liquidity and for haircuts
applied to saleable securities. Indeed, a detailed analysis can be performed on all assets, liabilities and
off-balance sheet products.
5
(Matz, "Liquidity Risk Measurement and Management", 2011), pg. 183
6
(Institute of International Finance, Inc., Mar 2007), pg. 63
7
(Matz, "Liquidity Risk Management", 2005), pg. 6-9
8
(Matz, "Liquidity Risk Management", 2005), pg. 6-2
9
(The Kamakura Corporation, 2003), Adapted from presentation, pg. 36
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The second deficiency is that cash flow projections are required for each of the stressed scenarios
shown in the Buying Time table above. Depending on the number of scenarios and stress levels the
bank wants to analyze, this would create complexity and tax resources.
Once each of the assumptions have been described, provided they are consistent with assumptions used
in the risk budgeting and other risk management, a cash flows projection report can be based on the
balance sheet. For a systemic adverse scenario such as Deflation where its description, conditions and
assumptions are documented in the bank’s Contingency Financial Plan (see discussion below), a cash
flow projection would look like:
Fiduciary Agent
or Owner
Insured or
Secured
Depositor
reliance on
market
information
Depositor
relationship
with Bank
Stickiness
Estimate
Stickiness Score Runoff
Consumers owner yes low high high 9 3%
Small Businesses owner in part low high medium 6 5%
Large Businesses owner no medium medium low 2 10%
Commercial Banks agent no high medium medium 3 7%
Municipalities agent in part high medium medium 3 7%
MMMFs quasi fiduciary no high low low 1 50%
Estimated Stickiness Scores of Fund Providers
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An alternative cash flow projection adapted from the BCBS template is shown below.10
10
(Bank for International Settlements, Last update 16 May 2014 )
Scenario: Deflation
Stress Level: Adverse Day 1 Day 2 Day 3 Day 4 Day 5 Week 2 Week 3 Week 4 Month 2
Assets
Cash
Federal Funds, repos
Trading Assets
Investment Securities
Available for Sale
Held to Maturity
Mortgages for Sale
Loans for Sale
Other Loans/Assets
Liabilities/Capital
Non-Interest Deposits
Interest Deposits
Short-term Borrowings
Accrued Expenses
Long Term Debt
Off-Balance Sheet
Contractual Obligation to extend
funds to Clients
Contigent Obligations
Trade finance-related
Guarantees and letters of
credit
Non-contractual obligations
(such as debt buy backs,
structured products, etc.)
Derivative Net Cash Flows
Collateral Swaps
Forward Cash Exposure
Counterbalance
Total Net Cash Flows
Net Cashflow Projections (combined contractual and behavioral)
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Forward Cash Exposure is the amount of liquidity needed in each time period. Counterbalance is the
liquidity that results from management remedial actions. It includes HQLAs that are unencumbered
and can be quickly converted to cash, remedial actions to reduce/delay outflows, and remedial actions
Scenario: Deflation
Stress Level: Adverse Day 1 Day 2 Day 3 Day 4 Day 5 Week 2 Week 3 Week 4 Month 2
Funding Sources
Cash
Central Bank Reserves
US Treasuries
non-US Sovereign
Corporate Bonds
Covered Bonds
Other Bonds
Outflows and Inflows
Retail Deposits
Insured Deposits
Uninsured Deposits
Term deposits
Unsecured Wholesale Funding
Insured Deposits
Uninsured Deposits
Term deposits
Operational Deposits
Non-operational Deposits
Unsecured debt issuance
Secured Funding
Backed by RMBS
Backed by non-RMBS
Backed by other Assets
Derivatives cash outflow
Undrawn committed credit and
liquidity facilities
Contractual Obligations
Contigent Obligations
Trade finance-related
Guarantees and letters of
credit
Non-contractual obligations
(such as debt buy backs,
structured products, etc.)
Reverse repo and other secured
lending or securities
borrowing
Contractual Inflows
Derivative Inflows
Forward Cash Exposure
Counterbalance
Total Net Cash Flows
Net Cashflow Projections (combined contractual and behavioral)
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to increase cash flows.11
A sample is presented in the table below as a summary for all stressed
scenarios:
Once uses and sources of liquidity are identified, a dashboard summary can be presented to
management as net cash flow ratios: actual and minimum required.
Act|Min = Actual|Minimum Projected Cash Inflow/Outflow Ratios
0 - 30 Days 31 - 60 Days 61 - 90 Days 91 - 180 Days
ScenarioswithStressSeverities
Operational and Seasonal
Mild Act|Min
Acute Act|Min
Adverse Act|Min
Bank-specific
Mild Act|Min
Acute Act|Min
Adverse Act|Min Act|Min
Systemic
Mild Act|Min
Acute Act|Min
Adverse Act|Min Act|Min
11
(Matz, "Liquidity Risk Measurement and Management", 2011), pg. 170
Excess Reserves Borrowings Stock Liquidity
Cash Flows from
Assets and
Liabilities
Operational and Seasonal
Mild
Acute
Adverse $ $ $
Bank-specific
Mild
Acute
Adverse $ $ $
Systemic
Mild
Acute
Adverse $ $ $ $
Funding Sources, 0 - 30 Days
ScenarioswithStressSeverities
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Additionally, management will benefit from liquidity in stressed scenarios expressed in time horizons. A
sample is show below:12
A Note on Contingency Planning and Liquidity Costs and Pricing
Liquidity contingency risk arises out of the inability to replace maturing deposits and borrowings;
customers’ exercise to withdraw deposits, and counterparties’ exercise of options on off-balance sheet
commitments. Worst case scenarios trigger implementation of the contingency plan. A contingency
plan is an early warning signal of a crisis and is an advanced preparation tool. It is a board approved
plan for managers’ guidance on remedial actions to reduce outflows and increase inflows.
One early warning tool is Key Risk Indicators (KRIs) that can be either quantitative or qualitative. They
can include an uptrend in consumer delinquencies or corporate non-performance. They can also be a
drop in the bank’s stock price above a certain percentage, investors’ unwillingness for the bank’s long
tenor loans, or turndown of borrowing requests. In advanced preparation, action plans are outlined
with flexibility of remedial actions where funding sources are identified based on scenarios. A source of
funding in one scenario may not be available in another. The reports developed above are
substantiation for a well-developed contingency plan.
Liquidity is not a free. Its optimal management requires a balance between income and liquidity risk.
While best practices on liquidity costs and pricing are scarce, there is a consensus that pricing
methodology should reward the providers of liquidity and penalize the users. Also, quantifying the cost
has been a debatable issue. However, one approach suggested has been to use the difference between
the swap curve and the bank’s senior AA-rated notes. The issues surrounding this approach are its
implementation based on products and its application of term structure to the bank’s products. Further
debate continues on pricing the mismatch risk (going concern) versus pricing of contingency risk (bank-
specific or systemic). Mismatch risk is structural and relatively stable while most of the liquidity risk
arises from its contingency portion.
Liquidity risk is a cost like insurance against a catastrophic loss. A bank should plan for the worst case
liquidity scenario, and then some more.
12
(Matz, "Liquidity Risk Measurement and Management", 2011), pg. 393 (adapted)
Scenario Description Stress Level Stress Test Forecast Result Required Minimum Observation Minimum
Operational Forecast > 12 Months > 12 Months
Bank-specific Loan Losses Mild > 12 Months > 12 Months
Acute > 12 Months > 12 Months
Adverse 3 Weeks 9 Months
Systemic Global Recession Mild > 12 Months > 12 Months
Acute > 12 Months > 12 Months
Adverse > 12 Months 9 Months
Survival Horizon Summary Report
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Conclusion and Perspective
The current extremely low interest rate environment forces a bank to reach for yield to meet ROE
targets using leverage (funding risk), increase its credit and interest rate risk and is under pressure to
lower operational costs. However, this is environment is a consequence of too much liquidity and in
turn increases liquidity risk. For this reason alone, liquidity risk management is crucial. Notwithstanding
excess reserves at the Federal Reserve, now is the ideal time for banks to build up “sleep-well” liquidity.
Also, this is the ideal time to build “opportunistic liquidity” to take advantage when interest rates rise
and less prudent banks have to turn away business. While deflation currently rules with low interest
rates and increased bank profitability, contingency planning should focus on the time when interest
rates start to increase driving up money velocity and creating inflation.
Behavioral Assumptions in Stagflation and Deflation scenarios: retail customers will be strained to pay
down debt increasing the duration of loans and shortening those of deposits. Corporate clients who
have issued debt have also increased banks’ asset durations. Only in a Deflation will HQLAs decrease in
value. On the banks’ liability side, retail depositors will be inclined to withdraw funds for their cash
needs in a declining economic environment while capital markets will be inclined to shorter durations.
This is the opposite of what needs to happen to increase liquidity at a bank. Notwithstanding the
current high profitability at banks, these two likely events are sure to cause a tempering of profits in the
near future. In such environments, banks will have to rely on their excess reserves, high quality HQLAs
and bank capital to manage liquidity. The current regulatory requirements will add stress to banks’
compliance. A switch to very short US Treasuries will not require haircuts to LCR. A switch to equities
and non-financial corporate bonds will deliver capital gains with the caveat that LCR haircuts required
will be steep. However, with low interest rates, market conditions are favorable for lengthening liability
maturities. Bank management will, indeed, need to be extremely prudent in managing liquidity going
forward.
The way to manage liquidity risk is to have multi-period cash flow projections for multiple scenarios
each of which have multiple stress levels. Further, the format of management reports is crucial to
determine the net cash flows that need to be plugged in order to encompass assets, liabilities and off-
balance sheet commitments. Emphasis should be on short-term funding sources since liquidity
management provides time to deal with the crisis. Since liquidity scenarios evolve over time and never
unfold smoothly, KRIs and triggers need to be frequently reviewed. The perception of maintaining
abundant liquidity is the goal of prudent management.
Diversification of counterparties will require investment banking, economists and underwriting
perspectives be included in the planning. Market confidence management is also a key variable that can
be utilized advantageously. Having liquidity is a competitive advantage when others are illiquid. Its
prudent management builds strong, stable earnings which facilitates a bank to successfully manage all
areas of its business. Its most important utility is that it buys time when and in sufficient quantity.
Basel III is in the right direction but will also prove to be inadequate just as Basel I and II were. The next
event is virtually assured. In the final analysis, liquidity risk management is the responsibility of the
bank. Even the regulatory agencies have explicitly deferred this responsibility to bank management.
Indeed, the Federal Reserve is focusing on helping banks develop their CLAR. “The Liquidity Risk Policy
Statement also emphasizes the central role of corporate governance, cash-flow projections, stress
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testing, ample liquidity resources, and formal contingency funding plans as necessary tools for
effectively measuring and managing liquidity risk.”13
Aseem Elahi is a Sr. Business Analyst who can serve as a Liquidity Risk reporting SME. He can be reached
at aseem_elahi@hotmail.com.
13
Federal Reserve, et al. (November 29, 2013), 71820.
14. Page | 14
Bibliography
Bank for International Settlements. (Last update 16 May 2014 ). Basel Committee on Banking
Supervision. Retrieved from Basel III Monitoring: http://www.bis.org/bcbs/qis/
Federal Reserve, Department of Treasury OCC and FDIC. (2013). “Liquidity Coverage Ratio: Liquidity Risk
Measurement, Standards, and Monitoring; Proposed Rule.” Federal Register / Vol. 78, No. 230 /
Friday, November 29, 2013 / Proposed Rules. Washington, DC: Federal Reserve.
Institute of International Finance, Inc. (Mar 2007). Principles of Liquidity Management. IIF, www.iif.com.
Matz, L. (2005). "Liquidity Risk Management". Austin, TX: ALEX eSolutions, Inc.
Matz, L. (2011). "Liquidity Risk Measurement and Management". Xlibris Corporation.
The Kamakura Corporation, L. M. (2003). Effective Liquidity Risk Measurement and Management.
Presented in South Africa: The Kamakura Corporation.