Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 9. Liquidity Stress Testing

Presented by: Sudhanshu

Module 1. Types of Liquidity and Contingent Liquidity

Module 2. Liquidity Stress Test Design Issues

Module 1. Types of Liquidity and Contingent Liquidity

Topic 1. Types of Liquidity

Topic 2. Estimating Contingent Liquidity

Topic 1. Types of Liquidity

• Funding Liquidity: The core ability of a financial institution to satisfy its liabilities without suffering excessive losses. This is the primary focus of liquidity stress testing.

• Operational Liquidity: The funds required to cover the firm's regular, day-to-day operational needs, such as clearing payment transactions. This cannot be used for nonoperational liabilities.

• Contingent Liquidity: A buffer of high-quality liquid assets and credit facilities specifically meant to satisfy general liabilities during stressed situations. The main goal of a stress test is to determine the required size of this buffer.

• Strategic Liquidity: Funds held by a firm for potential long-term investment opportunities, like fixed asset purchases or mergers and acquisitions. These funds may be reallocated in a stress event if needed.

• Restricted Liquidity: Liquid assets that have stated and pre-determined operational uses, such as being pledged as collateral. They are not available for general operational needs.

Practice Questions: Q1

Q1. Which type of liquidity is meant specifically to fund capital asset purchases?
A. Contingent.
B. Funding.
C. Restricted.
D. Strategic.

Practice Questions: Q1 Answer

Explanation: D is correct.

Strategic liquidity comprises the funds that the firm maintains to satisfy potential investment opportunities such as fixed asset purchases or mergers/acquisitions.

Topic 2. Estimating Contingent Liquidity

• Contingent liquidity is estimated through the stressed liquidity asset buffer.

• Formula:

  • (Normal) Liquidity Asset Buffer

  • - Stressed Cash Outflow

  • + Stressed Cash Inflow

• Components:

  • Normal Liquidity Asset Buffer: The amount of contingent liquidity currently held, composed of high-quality, easily valued assets.

  • Stressed Outflows: Early settlement of liabilities or inability to roll over debt. Examples include retail deposit withdrawals, loss of funding, and collateral calls.

  • Stressed Inflows: Cash coming into the firm during a stress event, such as maturing investments or customer debt repayments.

Practice Questions: Q2

Q2. Firm A has $1 billion in highly liquid assets. In a sudden stressed scenario, it estimates that retail customers will withdraw $150 million in deposits, and retail customers will be able to make $80 million of loan repayments. Firm A must deal with $60 million of margin and collateral calls on its derivatives transactions due to falling collateral values and greater volatility of the underlying assets. In addition, the firm has utilized $90 million of its available $100 million liquidity facility.

What is the estimate of Firm A’s stressed liquidity asset buffer?
A. $0.80 billion.
B. $0.88 billion.
C. $0.90 billion.
D. $0.96 billion.

Practice Questions: Q2 Answer

Explanation: D is correct.

The margin and collateral calls on the derivatives transactions are considered stressed outflows. The stressed liquidity asset buffer of $0.96 billion is calculated as $1 billion (highly liquid asset) − $150million (retail deposit outflow) + $80 million (stressed inflow) − $60million (stressed outflow) + $90million (stressed inflow).

Module 2. Liquidity Stress Test Design Issues

Topic 1. Scope of Liquidity Stress Testing

Topic 2. Scenario Development

Topic 3. Key Assumptions

Topic 4. Outputs

Topic 5. Governance

Topic 6. Integration with Other Risk Models

Topic 1. Scope of Liquidity Stress Testing

• Consolidated View: The process begins with a consolidated, firm-wide liquidity stress test.

• Individual Entity Testing: Stress testing should also be performed on specific parts of the organization:

  • Parent company

  • Subsidiary companies

  • Business lines and individual business units

• Liquidity Transfer Restrictions: Crucial to consider any restrictions that prevent liquidity from being transferred freely within the organization, such as between a parent company and a foreign subsidiary.

• Foreign Currency & Regulation: The test must account for differences in foreign currency settlement procedures and the need to perform separate tests for entities operating in different regulatory environments.

Topic 2. Scenario Development

• Benchmark: The first step is to establish a benchmark level of funding and liquidity. This benchmark provides a starting point for comparison, making it easier to evaluate the impact of a stress event and the effectiveness of any mitigation strategies.

• Types of Scenarios: A combination of historical and hypothetical scenarios is used to test a firm's resilience.

  • Historical Scenarios: These are based on past liquidity crises or market events. They are valuable because they reflect real-world outcomes and dependencies. However, their drawback is that they might not capture new or evolving risks that didn't exist in the past.

  • Hypothetical Scenarios: These are forward-looking and use the best available information to model potential future events. They should be carefully designed to differentiate between:

    • Systemic risks: Broad, market-wide events that affect all financial institutions, such as a credit market freeze.

    • Idiosyncratic risks: Firm-specific events that are unique to the institution, such as a major ratings downgrade or a reputational crisis.

• Combined Scenarios: Testing a combination of both systemic and idiosyncratic risks is critical to understanding how the firm would perform in a complex, multi-faceted crisis.
• Reverse Liquidity Stress Tests: These tests are a useful supplement to traditional scenarios. They assume the end result of a business failure and work backward to determine the specific sequence of events and the most crucial factors that would lead to that failure. This helps identify vulnerabilities that might be missed in forward-looking scenarios.

Practice Questions: Q1

Q1. Which liquidity stress impact factor would generally be the largest threat to a bank’s liquidity?
A. Deposit run-off.
B. Derivatives cash flows.
C. Loss of secured funding.
D. Loss of wholesale funding.

Practice Questions: Q1 Answer

Explanation: A is correct.

Deposit run-off in the form of depositors withdrawing their demand deposits immediately or suddenly and term depositors withdrawing their investments early (assuming such rights exist) are generally the largest threat to liquidity to banks. Therefore, they are the most important customer behavior to attempt to model.

Topic 3. Key Assumptions

• The principle of "garbage in, garbage out" applies; assumptions must be backed by sufficient historical or market data.

• Investment Portfolio Haircuts: Valuation discounts are expected to widen in a systemic crisis. Models should account for different haircuts based on security type.

• Deposit Outflows: It is crucial to model sudden or early withdrawals. Assumptions should use a behavioral segmentation approach and consider factors like FDIC coverage and relationship tenure.

• Unsecured Wholesale Funding: Banks should generally assume very little or no availability of this funding source during a major stress event.

• Collateral Requirements: Assumptions should account for the need for significantly more collateral due to reduced values and additional calls on derivatives positions.

• Other Contingent Liabilities: Model potential cash outflows from things like customer credit line usage and letters of credit, using conservative assumptions where historical data is lacking.

• Business Reduction: Assumptions should consider the firm's ability to curtail liquidity-reducing transactions, like issuing new loans, without harming its reputation.

Topic 4. Outputs

• Outputs are used to evaluate structural and tactical liquidity within internal limits.

• Four Deliverables for each entity:

  1. Stress Testing Assumptions: A detailed summary of the scenario, including the stress level and the contribution of various events.

  2. Current Liquidity Position Metrics: Compares available liquidity against net cash outflows. Differentiates between tactical (e.g., 30 days) and structural (e.g., 12 months) liquidity.

  3. Future Liquidity Position Metrics: Analyzes liquidity metrics over the stress horizon to detect overconcentration and reliance on wholesale funding.

  4. Capital and Performance Metrics: Goes beyond short-term liquidity to analyze the firm's long-term viability by considering the impact on capital adequacy.

Practice Questions: Q2

Q2. In the context of deposit outflows, which behavioral assessment factor is relevant for individual, small business, and commercial/institutional customers of the bank?
A. Credit usage.
B. FDIC coverage.
C. Industry segment.
D. Relationship tenure.

Practice Questions: Q2 Answer

Explanation: D is correct.

Relationship tenure is a behavioral assessment factor to consider for all three groups of bank customers. Credit usage applies more to small business and commercial/institutional customers and not individuals. FDIC coverage applies only to individuals and small businesses but not commercial/institutional customers. Industry segment does not apply to individuals and generally only applies to commercial/institutional customers.

Topic 5. Governance

• Oversight of the overall liquidity risk management process is delegated to key roles, often structured in a three-lines-of-defense model.

• Asset-Liability Committee (ALCO): The ALCO is responsible for the overall governance framework. It creates and finalizes the liquidity stress testing policy, defines the scenarios to be used, and sets internal limits and tolerances.

• Treasury Unit (First Line of Defense): This unit is responsible for the day-to-day management and execution of the stress testing process. It suggests assumptions, administers the test, and reports the results to the ALCO.

• Risk Management (Second Line of Defense): Acting as an independent oversight function, this group validates the scenarios and assumptions. It highlights any weaknesses in the process and confirms that the tests are consistent with regulatory requirements and internal policy.

• Internal Audit (Third Line of Defense): The final line of defense. Internal Audit conducts regular checks to ensure that the liquidity stress testing process and controls are being followed correctly and that the firm is adhering to all relevant policies and regulations.

Topic 5. Integration with Other Risk Models

• Liquidity stress testing should not be a standalone process; it must account for dependencies and correlations with other risks.

• Capital Stress Testing: Scenarios should account for necessary capital injections to subsidiaries and analyze the negative impact on the firm's overall capital adequacy.

• Asset-Liability Management (ALM): Stress tests should consider the impact of interest rate changes on liquidity, such as how falling rates increase the value of bond-like liabilities or how rising rates can lead to deposit disintermediation.

• Funds Transfer Pricing (FTP): The FTP framework should accurately establish the price of liquidity, ensuring that any costs arising from liquidity stress tests are charged to the appropriate business areas.

Practice Questions: Q3

Q3. How often is it generally recommended that the liquidity stress test be done to allow review by the asset-liability management committee?
A. Monthly.
B. Quarterly.
C. Semiannually.
D. Annually.

Practice Questions: Q3 Answer

Explanation: B is correct.

At a minimum, the liquidity stress test should be done at least quarterly to allow for proper analysis by the asset-liability management committee. Some banks are able to do the test more frequently (e.g., monthly or daily) by investing in the
necessary technology and other tools.