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: OCC (2012)

Topic 4. EWI Guidelines: BCBS (2008) and BCBS (2012)

Topic 5. EWI Guidelines: Federal Reserve (Supervision and Regulation [SR] 10-6)

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.
- 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.

Topic 2. EWI Applications

Escalation: EWIs are useful for escalating issues to relevant management and applying appropriate remedies based on severity when included within a clear escalation plan.
Reporting:
- Timely daily or intraday (hourly) EWI reporting provides sufficient time to react to negative events, particularly for banks with significant trading activity.
- EWI reporting must be sufficiently broad to cover relevant matters while remaining focused on the most important issues.
Integrated Systems: Integrated data processing systems enable consistent and accurate reporting when data is entered from multiple sources, providing liquidity risk managers with useful internal EWI information to complement external measures.
Thresholds:
- EWI thresholds utilize a "green, amber, red" stoplight approach requiring no action, additional follow-up, or immediate attention respectively.
- The transition from green to amber must be carefully calibrated using past data to avoid undetected problems or excessive false alerts.
- Historical data spanning sufficient periods (e.g., one year) incorporating recent events should be used to compute standard deviations and calibrate thresholds, with regular backtesting for recalibration.
Industry Practices: Banks and financial institutions increasingly use EWI dashboards to facilitate supervisory duties and improve risk reporting.

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 3. EWI Guidelines: OCC (2012)

EWIs should exist for securities and derivatives with embedded options (e.g., callable debt) to indicate when those options are likely to be exercised and/or any contingent liabilities associated with the embedded options.
EWIs should provide advance notice of a possible negative event to give the bank enough time to prepare. Examples of EWIs include:
- Reduced financing to be provided by lenders.
- More stringent requirements to issue long-term debt.
- Forthcoming regulatory changes.
- Capital, asset quality, management, earnings, liquidity, and sensitivity (CAMELS) rating downgrades.
- Spread increases on fixed income and swap products.
- Falling stock prices.
- Higher borrowing rates in normal market conditions.
- Reduced deposits by portfolio managers and funds.
- Higher margins required.

BCBS (2008) Guidelines
- Banks need to have indicators available to signal deterioration of liquidity or increased need for funding.
- EWIs are quantitative or qualitative and include:
  - Very sharp increase in assets.
  - More concentrated assets or liabilities.
  - More currency mismatches.
  - Lower liability durations.
  - Frequent occurrences of breaches or near breaches of limits.
BCBS (2012) Guidelines
- 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.

Topic 4. EWI Guidelines: BCBS (2008) and BCBS (2012)

Use EWIs and event triggers to identify possible constraints on liquidity. The EWIs should be consistent to the firm’s liquidity risk profile.
Advance notice of potential problems allows the firm more time to prepare and allows them a way to relay the information to relevant internal or external parties.
Examples of EWIs include:
- Bad publicity surrounding specific assets held by the firm.
- Possible worsening of the firm’s balance sheet (e.g., decreased assets, increased
  
  liabilities).
- Increasing spreads for fixed-income and swap products

Topic 5. EWI Guidelines: Federal Reserve (Supervision and Regulation [SR] 10-6)

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.