Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 3. Early Warning Indicators

Presented by: Sudhanshu

Module 1. Early Warning Indicators for Liquidity Risk Management

Topic 1. EWI Characteristics

Topic 2. EWI Applications

Topic 3. EWI Guidelines

Topic 1. EWI Characteristics

Definition: Changes in key metrics (qualitative or quantitative) which signal a potential or pending liquidity problem. EWIs can vary in severity and priority.
Purpose of EWIs: Get management to acknowledge a situation and promote necessary dialogue and actions, together with ensuring proper documentation of all steps taken.
Key Characteristics of Sound EWIs
- Framework: EWIs require measures, escalation, reporting, integrated systems, and thresholds, with timely reporting and appropriate thresholds enabling effective escalation from initial measures.
- Future-Oriented: Focus on forecasting future cash flows and liquidity positions.
- Items Coverage: Both balance sheet and off-balance sheet items should be evaluated.
- Internal Vs External Measures: Internal measures focus on the bank's own balance sheet. External measures consider macroeconomic factors and broader market conditions.
- Leading and Granular: Leading EWIs provide warning signals before an event occurs (more effective than lagging indicators). Granular EWIs are sharper and more specific, reducing "noise".

Normal and Stressed States: Applicable in both normal operating conditions and hypothetical stress scenarios.
Different Time Horizons: Consider various durations (hourly, daily, weekly, monthly) to match the bank's asset and liability profiles.

Practice Questions: Q1

Q1. Which component of the early warning indicator (EWI) framework represents the ultimate desired outcome when measures suggest a potential liquidity problem?
A. Escalation.
B. Integrated systems.
C. Protection.
D. Reporting.

Practice Questions: Q1 Answer

Explanation: A is correct.

Measures are an important starting point in a strong EWI framework; however, it is even more important to ensure that the measures can be tied to eventual escalation (to appropriate personnel) of the problem.

Practice Questions: Q2

Q2. Which of the following statements regarding early warning indicators (EWIs) is correct?
A. The more granular the indicator, the more accurate it is.
B. To be effective, EWIs must be tied to a definitive escalation plan.
C. EWIs should focus on external metrics over internal metrics because the former are generally more reliable.
D. Lagging indicators are less prone to error than leading indicators, therefore, they are potentially more useful to liquidity risk managers.

Practice Questions: Q2 Answer

Explanation: B is correct.

EWIs can have a positive impact on liquidity risk management when they are tied to a clear escalation plan.
Increased granularity of an indicator does not mean greater accuracy. It simply means the indicator is sharper and will not go unnoticed despite the distraction of voluminous amounts of data.
EWIs should strike a reasonable balance between external and internal metrics. There is no evidence to suggest external metrics are more reliable than internal metrics.
Compared to leading indicators, lagging indicators are less useful because they report on events that have already happened.

Topic 2. EWI Applications

EWI Framework: The EWI framework consists of:
- Measures: The specific metrics and indicators.
- Escalation: A clear plan for raising the issue to the appropriate personnel.
- Reporting: Timely and focused communication of EWI results.
- Integrated Systems: Data processing systems that ensure consistent and accurate reporting.
- Thresholds: Pre-defined levels that trigger different responses.
Key Applications: Escalation: EWIs must be tied to a clear escalation plan to have a positive impact on liquidity risk management (LRM).
- Reporting: Timely reporting (e.g., daily or intraday) provides sufficient time to react to negative events. Reporting should be broad but focused on what is most important.
- Integrated Systems: Integrated data systems provide liquidity risk managers with consistent and accurate internal EWI information.
- Thresholds: A "green, amber, and red" stoplight approach is commonly used to categorize the severity of a problem. Thresholds should be carefully calibrated and backtested.
- Industry Practices: Financial institutions are increasingly using EWI dashboards to facilitate supervisory duties and improve risk reporting.

Topic 3. EWI Guidelines

OCC (Office of the Comptroller of the Currency, 2012)
- EWIs should exist for securities and derivatives with embedded options to indicate when they are likely to be exercised.
- EWIs should provide advance notice of a negative event.
- Examples: Reduced financing from lenders, regulatory changes, and spread increases on fixed-income products.
BCBS (Basel Committee on Banking Supervision, 2008)
- Banks need indicators to signal a deterioration of liquidity or an increased need for funding.
- EWIs can be quantitative or qualitative.
- Examples: a sharp increase in assets, more concentrated liabilities, and frequent breaches of limits.
BCBS (Basel Committee on Banking Supervision, 2012)
- Focuses specifically on intraday liquidity indicators.
- Examples: Daily maximum liquidity, total intraday payments and intraday lines of credit provided to customers.

Federal Reserve (SR 10-6)
- Firms should use EWIs and event triggers consistent with their liquidity risk profile.
- EWIs should provide advance notice to allow the firm time to prepare and relay information.
- Examples: bad publicity surrounding assets and increasing spreads for fixed-income products.

Practice Questions: Q3

Q3. Which supervisory guideline for early warning indicators (EWIs) focuses on intraday liquidity monitoring indicators?
A. BCBS (2008).
B. BCBS (2012).
C. OCC (2012).
D. SR 10-6.

Practice Questions: Q3 Answer

Explanation: B is correct.

Under BCBS (2012), examples of intraday liquidity indicators include:

Daily maximum liquidity.
Intraday liquidity availability.
Total intraday payments, including the timing of them.
Key obligations (e.g., time-sensitive).
Amount of payments made for financial institution customers.
Intraday lines of credit provided to financial institution customers.

Practice Questions: Q4

Q4. Which supervisory guideline for early warning indicators (EWIs) includes a specific provision on EWIs that deals with embedded options?
A. BCBS (2008)
B. BCBS (2012)
C. OCC (2012)
D. SR 10-6

Practice Questions: Q4 Answer

Explanation: C is correct.

Under OCC (2012), a bank that holds securities and derivatives with embedded options should have EWIs to indicate when those options are likely to be exercised and/or any contingent liabilities associated with the embedded options.