Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 6. Intraday Liquidity Risk Management

Presented by: Sudhanshu

Module 1. Uses and Sources of Intraday Liquidity

Module 2. Managing and Measuring Intraday Liquidity Risk

Module 1. Uses and Sources of Intraday Liquidity

Topic 1. Uses of Intraday Liquidity

Topic 2. Sources of Intraday Liquidity

Topic 3. Summary

Topic 1. Uses of Intraday Liquidity

• Intraday liquidity refers to the funds available to a financial institution throughout the business day to meet its payment obligations. It's crucial for the smooth functioning of payment systems and financial markets.
• The movement of cash out of the bank or its accounts during the business day.

1. Outgoing Wire Transfers

• Significance: This is the most significant use of intraday liquidity. * Details: Includes payments for the bank itself (forecasting lead time of 1-2 days) or for its clients (often unpredictable).

• Control: Must be carefully monitored to stay within intraday credit limits; may be slightly delayed if overdraft is excessive.

2. Settlements at Payment Clearing and Settlement (PCS) Systems

• Details: Funds are often settled once daily (near the end of the day), resulting in a net inflow or outflow.

• Forecasting: Challenging for same-day settlements, but easier for multi-day settlements.

3. Funding of Nostro Accounts

• Details: Correspondent bank accounts held in foreign countries for transactions in that currency.

• Usage: Net outflow occurs depending on daily activity. Forecasting is easier for security settlements than for client activities.

4. Collateral Pledging

• Details: Cash outflow required to pledge collateral for specific client or bank transactions (e.g., margin trading).

• Forecasting: Relies on trading volume and daily price change data.

5. Asset Purchases / Funding

• Details: Funds needed to cover purchases of investment portfolio securities, fixed assets, and client loans (credit line draws, new loans).

• Forecasting: Purchases of securities and fixed assets are easier to forecast than client loan draws.

Practice Questions: Q1

Q1. A new bank treasurer is attempting to obtain a better understanding of the bank’s daily cash inflows and outflows. Which of the following transactions is the most significant use of intraday liquidity?
A. Asset purchases/funding.
B. Funding of nostro accounts.
C. Outgoing wire transfers.
D. Settlements at payment, clearing, and settlement (PCS) systems.

Practice Questions: Q1 Answer

Explanation: C is correct.

Outgoing wire payments (either for customers or for the bank itself) are likely the most significant use of intraday liquidity.

Topic 2. Sources of Intraday Liquidity 

• Financial institutions draw upon various sources to maintain their intraday liquidity. These sources can be broadly categorized into internal and external.

• The movement of cash into the bank or its accounts during the business day.

1. Incoming Funds Flow

• Significance: This is the most significant source of intraday liquidity. * Details: Includes payment inflows and settlements from Financial Market Utilities (FMUs). Inflows can occur instantaneously or in batches.​

​2. Cash Balances

• Details: Amounts held at the central bank and at correspondent banks.

• Forecasting: Easier to forecast balances impacted by the bank’s own operations than those impacted by unpredictable client activities.​

3. Intraday Credit

• Details: Temporary overdraft credit offered by central banks, which must be negated by the end of the business day.

• Cost: May involve interest explicitly charged or the pledging of very high-quality collateral.

4. Liquid Assets

• Details: Near-cash items that can be quickly monetized, such as:

  • Money market instruments

  • Time deposits

  • Government securities (with maturities of one year or less)​

5. Overnight Borrowings / Other Term Funding

• Overnight Borrowings: Paid back the next day. A cost-benefit decision between having surplus vs. insufficient liquidity.

• Other Term Funding: Extension of borrowing for longer periods (e.g., a week or month); typically a supplemental or occasional source.

Topic 3. Summary

• Banks must be able to deal with the large amounts of cash inlows and outflows from many sources within the bank. The overall objective is to adhere to the intraday credit limits.

• However, there are three key problems:

  • Cash flows may be extremely volatile on a daily basis with very sudden inflows
    and/or outflows.

  • Macroeconomic factors such as daily volatility of securities’ prices lead to cash
    outflows to finance sudden margin calls. Or, the direct implementation of monetary policy by the central bank would impact market liquidity and ultimately, the bank’s liquidity in terms of inflows/outflows of intraday funds.

  • Real-time balances are often not available and that makes it difficult to accurately assess how much cash there is at a given moment as well as determining how much cash will be needed for the rest of the day.

Practice Questions: Q2

Q2. A bank treasurer is attempting to minimize liquidity funding costs. Which of the following sources of liquidity is most likely to have the greatest explicit financial cost?
A. Cash balances.
B. Incoming funds flow.
C. Intraday credit.
D. Liquid assets.

Practice Questions: Q2 Answer

Explanation: C is correct.

Intraday credit may require collateral pledging (opportunity cost) with no interest charged or it may require interest payments (explicit cost) for using the line of credit during the day.
Cash balances and liquid assets represent assets owned by the bank so if they are used for financing/liquidity purposes, there is no explicit cost, although there may be implicit or opportunity costs, especially with liquid assets (e.g., interest
earned on time deposits or banker’s acceptances). There is no explicit financial cost associated with incoming funds flow.

Practice Questions: Q3

Q3. Which of the following factors is least likely to increase a bank treasurer’s challenge in managing cash in order to stay within its intraday credit limits?
A. Cash flow volatility.
B. Credit quality of assets.

C. Insufficient real-time data.
D. Securities price volatility.

Practice Questions: Q3 Answer

Explanation: B is correct.

The credit quality of a bank’s assets (e.g., cash balances, liquid assets) is very high and therefore, unlikely to have a negative impact on liquidity. Liquid assets include money market instruments, time deposits, and banker’s acceptances, all of which have no or very little default risk. The other three factors explicitly increase the bank treasurer’s challenge in terms of intraday liquidity management.

Module 2. Managing and Measuring Intraday Liquidity Risk

Topic 1. Active Risk Management

• Active risk management in the context of intraday liquidity involves the continuous and proactive identification, measurement, monitoring, and control of risks associated with daily cash flows and funding positions.
• Core Principles:

  • Proactive Stance: Moving beyond reactive responses to actively anticipate and mitigate potential liquidity shortfalls before they materialize.

  • Real-Time Focus: Emphasizing real-time or near real-time data analysis to capture the dynamic nature of intraday exposures.

  • Dynamic Adjustment: The ability to flexibly adjust funding strategies and operational processes in response to changing market conditions or internal needs.

  • Holistic View: Considering all sources and uses of intraday liquidity across the entire institution, including interdependencies between different business lines and entities.

  • Continuous Improvement: Regularly reviewing and enhancing risk management frameworks, tools, and processes based on lessons learned and evolving best practices.

• It's about having the right information at the right time to make informed decisions and take swift action.

Topic 2. Integration With Risk Governance 

• Active risk management for intraday liquidity must be fully embedded within an institution's broader risk governance framework. This ensures consistency, oversight, and accountability.
• Key Aspects of Integration:

  • Board and Senior Management Oversight: The board and senior management are ultimately responsible for setting the risk appetite for intraday liquidity and ensuring that appropriate policies and controls are in place.

  • Clear Roles and Responsibilities: Defining clear roles for front office, risk management, operations, and treasury functions in managing and overseeing intraday liquidity risk.

  • Policy and Procedure Framework: Establishing comprehensive policies and procedures that detail how intraday liquidity risk is identified, measured, monitored, and controlled.

  • Reporting Lines: Ensuring that intraday liquidity risk exposures and breaches are reported promptly to relevant management levels, including escalation procedures.

  • Internal Audit and Review: Regular independent review by internal audit to assess the effectiveness of the intraday liquidity risk management framework.

• Stress Testing and Scenario Analysis: Integrating intraday liquidity into the institution's overall stress testing program to assess resilience under various adverse scenarios.

• Alignment with Other Risk Types: Recognizing the interconnections between intraday liquidity risk and other risk types (e.g., credit risk, operational risk, market risk) and managing them in a coordinated manner.

Practice Questions: Q1

Q1. Which of the following metrics is most appropriate in determining a bank’s systemic risk?
A. Client intraday credit usage.
B. Intraday credit relative to Tier 1 capital.
C. Daily maximum intraday liquidity usage.
D. Total intraday credit lines to clients and counterparties.

Practice Questions: Q1 Answer

Explanation: B is correct.

The ratio of unsecured and available (as opposed to used) intraday credit to Tier 1 capital provides a sense of the bank’s level of intraday settlement risk, or systemic risk. The other metrics are used either to understand intraday cash flows or to monitor risk levels but do not specifically attempt to measure the bank’s systemic risk that it contributes to the overall financial markets.

Topic 3. Risk Assessment

• Risk assessment for intraday liquidity involves systematically identifying and evaluating potential threats to an institution's ability to meet its daily payment obligations.
• Key Steps in Risk Assessment:

  • Identification of Liquidity Drivers: Understanding the key business activities and payment flows that generate both inflows and outflows of funds throughout the day (e.g., customer deposits/withdrawals, securities settlements, derivatives clearing).

  • Analysis of Payment Timing and Volatility: Assessing the timing and predictability of large payments and receipts. Identifying periods of peak demand or potential bottlenecks.

  • Counterparty Risk Assessment: Evaluating the creditworthiness and operational reliability of key counterparties (e.g., payment systems, correspondent banks) that could impact expected inflows.

  • Operational Risk Assessment: Identifying potential operational failures (e.g., system outages, processing errors) that could disrupt payment flows or access to funding.

  • Market Risk Assessment: Analyzing how market movements (e.g., interest rate changes, collateral value fluctuations) could affect the cost or availability of intraday funding.

  • Contingency Funding Planning: Developing and regularly reviewing plans for accessing alternative funding sources in times of stress.

Topic 4. Risk Measurement and Monitoring

• Monitoring intraday liquidity risk is tracked using two primary dollar values:

  • Dollar Value of Intraday Credit Provided to Customers

    • Goal: Enhance technology to determine customers' real-time cash balances.

    • Benefit: Allows the bank to accurately charge back customers for any intraday overdraft charges incurred from the central bank.

  • Dollar Value of Intraday Credit Used by the Firm

    • Goal: Provide a consolidated, big-picture view of all intraday credit use.

    • Limitation: Challenges arise from the lack of:

      • Real-time balances from all cash accounts (e.g., correspondent banks).

      • Consistency in IT systems needed to consolidate data across different banks.

Topic 5. Tracking Intraday Flows and Monitoring Risk Levels

• Methods for Tracking Intraday Flows: Tracking is essential for anticipating liquidity needs and adhering to deadlines.

  • Total Payments: Track all electronic payments (amount, time, payer, payee) to monitor total sent/received, net settlement positions, and payment volume trends.
  • Other Cash Transactions: Record intraday and end-of-day settlement positions across FMUs, including securities settlement networks, with account and collateral balances.
  • Settlement Positions: Monitor positions with FMUs to manage intraday liquidity, systemic risk, and identify trends linked to macro factors for early liquidity planning.
  • Time-Sensitive Obligations: Closely track deadlines for settlements; delays can lead to penalties and adverse outcomes.
  • Intraday Credit Lines to Clients/Counterparties: Track actual vs. potential credit provided; maintain usage statistics (normal vs. peak).
  • Bank’s Intraday Credit Lines: Measure available vs. used credit to monitor and control the bank’s contribution to systemic risk.

• Monitoring Risk Levels

  • Daily Maximum Intraday Liquidity Usage: Most negative balance of the day ÷ Credit Line Limit. Measures peak usage; does not require real-time information. Should be viewed on a combined basis for all cash accounts.
  • Intraday Credit Relative to Tier 1 Capital: Unsecured and available intraday credit ÷ Tier 1 Capital. Systemic Risk Indicator: Comparing unsecured/available credit to Tier 1 capital provides a sense of the bank's level of intraday settlement/systemic risk.

  • Client Intraday Credit Usage: Client's highest intraday borrowing amount ÷ Credit Line Limit (Aggregated or Individual). Indicates how much liquidity the bank must provide to finance client operations. Identifies clients consistently in overdraft for potential remedial action.

  • Payment Throughput: Proportion of outgoing payments and when they occur during the day. Monitors payment patterns to avoid late payments and ensure compliance with FMU stipulations (e.g., making a certain percentage of payments within a deadline).

Practice Questions: Q2

Q2. In the context of characteristics of an effective governance structure in controlling intraday liquidity within a bank, there is emphasis on expertise in which line of defense?
A. Treasury.
B. Internal audit.
C. Information technology.
D. Corporate risk management.

Practice Questions: Q2 Answer

Explanation: D is correct.

Ideally, the intraday liquidity risk management framework adopts the standard three lines of defense with emphasis on expertise in the second line of defense, namely corporate risk management. The other two lines of defense are treasury and internal audit. Information technology is not a line of defense, per se.