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

• ​Outgoing Wire Transfers

  • Could be made for the bank itself (about one or two days lead time) or for its clients (often unpredictable).

  • The most significant use of intraday liquidity.

  • Payments occur throughout the day with a steady pattern.

  • Outgoing payments must be monitored to ensure intraday overdrafts stay within credit limits, as controls typically prohibit exceptions; payments can be delayed until incoming receipts reduce the overdraft.

• Settlements at Payment Clearing and Settlement (PCS) Systems
  • ​PCS systems often settle once daily (near the end of the business day), with a net inflow or outlow of funds.

  • ​Forecasting amounts is challenging for same-day settlements but is easier for multiday settlements.

• Funding of Nostro Accounts

  • Banks often have correspondent bank accounts in foreign countries (for transactions in that foreign country), known as nostro accounts.

  • Depending on the activity going on in the nostro account for the day, there may be a net inflow or outflow of cash.

  • Forecasting amounts is easier for settlements of securities andmore difficult for client activities.

Topic 1. Uses of Intraday Liquidity

• ​Collateral Pledging
  • Specific client and bank transactions will require collateral to be pledged (e.g.,margin trading).
  • Acquiring that collateral results in a cash outflow.
  • Forecasting amounts relies on trading volume and daily price change data.
• Assets Purchasing/ Funding

  • Banks need funds to cover investment portfolio securities purchases, fixed asset

    purchases, and client loans (e.g., draws on credit lines or new loans).

  • The securities and fixed asset purchases are easier to forecast, but the client loans are

    more challenging.

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 

• ​Cash Balances

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

  • Cash balances impacted by the bank’s operations are easier to forecast than those impacted by client activities.​

• Incoming Funds Flow

  • Banks receive payment inflows and financial market utilities (FMUs) settlements; the most significant source of intraday liquidity.

  • Inflows may occur instantaneously or in batches.

• Intraday Credit

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

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

• ​Liquid Assets
  • Near-cash items include money market instruments, time deposits, and government​ securities with maturities of one year or less.

• Overnight Borrowings
  • ​Overnight borrowings are different from intraday credit as they are paid back only on the next day.

  • Overnight borrowings are a cost-benefit decision between having too much liquidity versus having insufficient liquidity to complete a given day’s transactions.

• Other Term Funding

  • An extension of overnight borrowing for longer periods of time such as a week oreven a month.

  • More of a supplemental/occasional source of funds for intraday liquidity rather than the usual source.​

Topic 2. Sources of Intraday Liquidity 

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.

Topic 3. Summary

• Banks must be able to deal with the large amounts of cash inflows 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: 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. Governance of Intraday Liquidity Risk Management

• A strong governance structure in managing intraday liquidity risk covers the following four key areas: active risk management, integration with risk governance, risk assessment, and risk measurement and monitoring.

• Active Risk Management 
  • ​A proactive approach to minimize intraday liquidity risk is more desirable than passively accepting it as a given.
  • Settlement and systemic risks should be explicitly recognized and classified within the institution's risk appetite framework.
• Integration with Risk Governance
  • Intraday liquidity risk management is integrated into the three lines of defense (treasury, corporate risk management, and internal audit) with focus on organization-wide risk management including funding policies, monitoring, and consolidated reporting.
  • Relevant management personnel actively participate in crucial decisions, with oversight committees balanced by key personnel from areas such as treasury and information technology.

Topic 1. Governance of Intraday Liquidity Risk Management

• A strong governance structure in managing intraday liquidity risk covers the following four key areas: active risk management, integration with risk governance, risk assessment, and risk measurement and monitoring.

• Risk Assessment 
  • ​The focus is on settlement risk review, covering risk identification, measurement, and evaluation.
  • Business unit managers and the risk management team analyze internal controls to determine their effectiveness in reducing or minimizing settlement risk.
• ​Risk Measurement and Monitoring
  • ​Intraday liquidity risk monitoring involves two approaches: (1) dollar value of intraday credit provided to customers, and (2) dollar value of intraday credit used by the firm.
  • For credit provided to customers, enhanced technology enables banks to determine real-time customer cash balances and chargeback intraday overdraft fees from the central bank.
  • For intraday credit use, the goal is to provide a comprehensive view of all intraday credit, though real-time account balances may be unavailable for some accounts (e.g., correspondent banks).
  • Data consolidation into a single location is limited by inconsistent IT investments across different banks.

Practice Questions: Q1

Q1. 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: Q1 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.

Topic 3. Monitoring Risk Levels

• Daily maximum intraday liquidity usage: Calculated by dividing the most negative daily balance by the credit line limit (committed or uncommitted), computed across all cash accounts on a combined basis for accurate total intraday liquidity use assessment.
• Intraday credit relative to Tier 1 capital: The ratio of unsecured and available intraday credit to Tier 1 capital indicates the bank's intraday settlement risk or systemic risk, acknowledging that collateral pledging reduces settlement risk.
• Client intraday credit usage: The ratio of client's highest intraday borrowing to credit line limit, computed on an aggregate basis, indicates required liquidity for client operations and helps identify clients consistently in overdraft positions requiring remedial actions or additional charges.
• Payment throughput: Tracks the proportion and timing of outgoing payments during the day to monitor payment patterns, ensure compliance with FMU payment deadlines, identify peak payment periods, and assess impacts on available intraday liquidity and credit use.
• FMU efficiency measure: Maximum intraday credit use as a percentage of total transaction amounts with an FMU measures how efficiently the FMU uses intraday credit.

Practice Questions: Q2

Q2. 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: Q2 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. Methods for Tracking Intraday Flows

• Total payments: Track all electronic payments with details (amount, time, payer, payee) to monitor total payments sent/received, net settlement positions, and payment volume trends.
• Other cash transactions: Cover intraday and ending settlement positions for all FMUs involved, including periodic account and collateral balances for securities settlement networks.
• Settlement positions: Monitor data on settlement positions across all FMUs to ensure proper intraday liquidity management and systemic risk control, identifying trends linked to macroeconomic factors for earlier liquidity anticipation.
• Time-sensitive obligations: Carefully monitor deadlines for time-sensitive payments to avoid late settlement penalties and potential adverse outcomes.
• Total intraday credit lines to clients and counterparties: Track actual versus potential credit provided to determine maximum exposure and maintain statistics on credit usage patterns including normal and high-use times and levels.
• Total bank intraday credit lines available and usage: Calculate intraday credit used in normal circumstances and compare to maximum available credit (committed and uncommitted) to determine and control the bank's contribution to systemic risk in financial markets.