2022 FRM Exam Part 2 - Liquitidy and Treasury Risk Measurement and Management [4] 0137686544, 9780137686544

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GARP FRM Financial Risk Manager

Liquidity and Treasury Risk Measurement and Management

Pearson

Copyright © 2022, 2021 by the Global Association of Risk Professionals All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pearson Education, Inc. for this edition only. Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted. Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them:

"Liquidity Risk," by John C. Hull, reprinted from Risk Management and Financial Institutions, 5th Edition (2018), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Liquidity and Leverage" by Allan M. Malz, reprinted from Financial Risk Management: Models, History, and Institutions (2011), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Early Warning Indicators" by Shyam Venkat and Stephen Baird, reprinted from Liquidity Risk Management: A Practitioner's Perspective (2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "The Investment Function in Financial Services Management" and "Liquidity and Reserves Management: Strategies and Policies," by Peter S. Rose and Sylvia C. Hudgins, reprinted from Bank Management & Financial Services, Ninth Edition (2013), by permission of the McGraw Hill Companies, Inc. "Intraday Liquidity Risk Management," by Shyam Venkat and Stephen Baird, reprinted from Liquidity Risk Management: A Practitioner's Perspective (2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Monitoring Liquidity," by Antonio Castagna and Francesco Fede, reprinted from Measuring and Managing Liquidity Risk (2013), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Liquidity Stress Testing" by Shyam Venkat and Stephen Baird, reprinted from Liquidity Risk Management: A Practitioner's Perspective (2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "The Failure Mechanics of Dealer Banks," by Darrell Duffie, reprinted from the Journal o f Economic Perspectives, vol. 24, no. 1, Winter 2010, by permission from Journal of Economic Perspectives. "Liquidity Risk Reporting and Stress Testing," by Moorad Choudhry, reprinted from The Principles o f Banking (2012), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Contingency Funding Planning" by Shyam Venkat and Stephen Baird, reprinted from Liquidity Risk Management: A Practicioner's Perspective (2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Managing and Pricing Deposit Services" and "Managing Nondeposit Liabilities," by Peter S. Rose and Sylvia C. Hudgins, reprinted from Bank Management & Financial Services, Ninth Edition (2013), by permission of the McGraw Hill Companies, Inc. "Repurchase Agreements and Financing," by Bruce Tuckman and Angel Serrat, reprinted from Fixed Income Securities: Tools for Today's Markets,

Pearson

3rd Edition (2011), by permission of John Wiley & Sons, Inc. All rights reserved. Used under license from John Wiley & Sons, Inc. "Liquidity Transfer Pricing: A Guide to Better Practice," Financial Stability Institute Occasional Paper No. 10, by Joel Grant, June 2011, by permission of the Bank for International Settlements. Information retrieved from the Bank for International Settlements is freely available at their website: www.bis.org. "The US Dollar Shortage in Global Banking and the International Policy Response," BIS Working Paper No. 291, by Patrick McGuire and Gotz von Peter, October 2009, by permission of the Bank for International Settlements. Information retrieved from the Bank for International Settlements is freely available at their website: www.bis.org. "Covered Interest Rate Parity Lost: Understanding the Cross-Currency Basis," by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko, BIS Quarterly Review, September 2016, by permission of the Bank for International Settlements. Information retrieved from the Bank for International Settlements is freely available at their website: www.bis.org. "Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques," by Peter S. Rose and Sylvia C. Hudgins, reprinted from Bank Management & Financial Services, Ninth Edition (2013), by permission of the McGraw Hill Companies, Inc. "Illiquid Assets," by Andrew Ang, reprinted from Asset Management: A Systematic Approach to Factor Investing (2014), by permission of Oxford University Press. "Movements in the Effective Federal Funds Rate, Its Target (the Intended Federal Funds) Rate, and the Discount (Primary Credit) Rate for Depository Institutions Seeking Credit from the Federal Reserve Banks," reprinted with permission from the Federal Reserve Bank of St. Louis Monetary Trends, March 2011, p. 3; https://s3.amazonaws.com/files. research.stlouisfed.org/datatrends/pdfs/mt/20110301/mtpub. pdf. Learning Objectives provided by the Global Association of Risk Professionals. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. Pearson Education, Inc., 330 Hudson Street, New York, New York 10013 A Pearson Education Company www.pearsoned.com Printed in the United States of America

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ISBN 10: 0137686544 ISBN 13: 9780137686544

Chapter 1

Liquidity Risk

1.1 Liquidity Trading Risk

1

Chapter 2

Liquidity and Leverage

17

2 2.1 Funding Liquidity Risk

18

1.1.1 The Im portance of Transparency

3

1.1.2 M easuring M arket Liquidity

4

M aturity Transform ation

18

1.1.3 Liquidity-Adjusted VaR

5

Liquidity Transform ation

19

1.1.4 Unwinding a Position O ptim ally

5

Bank Liquidity

20

1.1.5 O ther M easures of M arket Liquidity

6

Structured C redit and O ff-Balance-Sheet Funding

22

Funding Liquidity of O ther Interm ediaries

23

System atic Funding Liquidity Risk

24

1.2 Liquidity Funding Risk

6

1.2.1 Sources of Liquidity

6

1.2.2 Reserve Requirem ents

9

1.2.3 Regulation

9

2.2 Markets for Collateral

26

11

Structure of M arkets for Collateral

26

1.3.1 Positive and N egative Feedback Traders

Economic Function of Markets for Collateral

28

11

Prime Brokerage and Hedge Funds

29

1.3.2 Leveraging and D eleveraging

12

Risks in M arkets for Collateral

29

1.3.3 Irrational Exuberance

13

1.3.4 The Impact of Regulation

14

1.3.5 The Im portance of D iversity

14

1.3 Liquidity Black Holes

2.3 Leverage and Forms of Credit in Contemporary Finance

31

Defining and M easuring Leverage

31

Summary

14

Margin Loans and Leverage

33

Further Reading

15

Short Positions

34

Practice Questions and Problems

15

D erivatives

35

Further Questions

16

Structured C redit

36

A sset Volatility and Leverage

37

in

2.4 Transactions Liquidity Risk Causes of Transactions Liquidity Risk

37

C haracteristics of M arket Liquidity

38

2.5 Liquidity Risk Measurement

38

Measuring Funding Liquidity Risk

38

Measuring Transactions Liquidity Risk

39

2.6 Liquidity and System Risk

41

Funding Liquidity and Solvency

41

Funding and M arket Liquidity

42

System ic Risk and the "Plum bing"

42

"Interconnectedness"

43

Further Reading

Chapter 3

Early Warning Indicators

3.1 Early Warning Indicators: Mechanism to Signal Upcoming Liquidity Crisis

43

45

46

4.3 Popular Money Market Investment Instruments

57

Treasury Bills

57

Short-Term Treasury Notes and Bonds

59

Federal A gency Securities

59

C ertificates of Deposit

59

International Eurocurrency Deposits

59

Bankers' A cceptances

59

Com m ercial Paper

60

Short-Term Municipal O bligations

60

4.4 Popular Capital Market Investment Instruments

60

Treasury N otes and Bonds

60

Municipal Notes and Bonds

60

C orporate Notes and Bonds

61

4.5 Investment Instruments Developed More Recently

61

Structured N otes

61

Securitized A ssets

61

4.6 Investment Securities Held by Banks

63

4.7 Factors Affecting Choice of Investment Securities

64

Introduction: Dashboard and Beyond

46

Regulatory Em phasis in Recent Tim es

46

Key Supervisory Guidelines

46

Expected Rate of Return

65

Risk Identification and EW Is

47

Tax Exposure

65

Fram ew ork Com ponents: M .E.R .I.T .

47

Interest Rate Risk

69

Illustrative EW I List

51

Credit or Default Risk

69

54

Business Risk

70

Liquidity Risk

71

Call Risk

71

Conclusion

Chapter 4

The Investment Function in Financial-Services Management

4.1 Introduction 4.2 Investment Instruments Available to Financial Firms iv

37

■ Contents

55 56 57

Prepaym ent Risk

71

Inflation Risk

72

Pledging Requirem ents

72

4.8 Investment Maturity Strategies

73

4.9 Maturity Management Tools

76

The Yield Curve

76

Duration

77

Summary

78

5.7 Factors in Choosing among the Different Sources of Reserves

110

82

Case Assignment for Chapter 4

5.8 Central Bank Reserve Requirements Around the Globe

111

82

Summary

111

Selected References

85

Key Terms

112

Problems and Projects

113

Internet Exercises

116

Case Assignment for Chapter 5

116

Selected References

118

Key Terms

79

Problems and Projects

80

Internet Exercises

Chapter 5

Liquidity and Reserves Management: Strategies and Policies

87 Chapter 6

5.1 Introduction

88

5.2 The Demand for and Supply of Liquidity

88

5.3 Why Financial Firms Often Face Significant Liquidity Problems

90

5.4 Strategies for Liquidity Managers 91 A sset Liquidity M anagem ent (or A sset Conversion) Strategies Borrowed Liquidity (Liability) M anagem ent Strategies

91

Intraday Liquidity Risk Management 119

6.1 Introduction

120

6.2 Uses and Sources of Intraday Liquidity

121

6.3 Risk Management, Measurement and Monitoring Tools for Financial Institutions

125

G overnance of Intraday LRM

125

Balanced Liquidity Management Strategies 93

M easurem ent of Intraday Liquidity

126

G uidelines for Liquidity M anagers

93

5.5 Estimating Liquidity Needs

94

M easures for Understanding Intraday Flow s

127

92

The Sources and Uses of Funds Approach

94

M easures for Q uantifying and Monitoring Risk Levels

127

The Structure of Funds Approach

97

Role of Stress Testing

128

Liquidity Indicator Approach

100

The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace

101

5.6 Legal Reserves and Money Position Management

103

6.4 Risk Management, Measurement, Monitoring Tools for FMUs

129

O verview of FMU Risk M anagem ent

129

FMU Tools to M anage Intraday Settlem ent Risk

130

Regulations on Calculating Legal Reserve Requirem ents

103

Conclusion

131

Factors Influencing the Money Position

106

Glossary

131 Contents

■ v

Chapter 7

Monitoring Liquidity

133

7.1 A Taxonomy of Cash Flows

134

7.2 Liquidity Options

135

7.3 Liquidity Risk

137

7.4 Quantitative Liquidity Risk Measures

138

7.4.1 The Term Structure of Exp ected Cash Flow s and the Term Structure of Exp ected Cum ulated Cash Flows 138 7.4.2 Liquidity Generation C apacity

141

7.4.3 The Term Structure of Available Assets 143

7.5 The Term Structure of Expected Liquidity 7.6 Cash Flows at Risk and the Term Structure of Liquidity at Risk

Chapter 8

149 150

The Failure Mechanics of Dealer Banks 155

Liquidity Stress Testing

171

9.1 Measuring Contingent Liquidity Requirements

173

9.2 Overview of the Model

174

9.3 Design of the Model

175

O rganizational Scope

175

Planning Horizon

176

9.4 Testing Techniques

176

9.5 Baseline Scenario

177

9.6 Scenario Development

177

Historical Scenarios

177

Hypothetical Scenarios

177

9.7 Development of Assumptions

178

9.8 Outputs of the Model

180

9.9 Governance and Controls

181

9.10 Liquidity Optimization

182

9.11 Funding Optimization

183

9.12 Establishing a Sustainable Infrastructure

183

184

O ver-the-Counter D erivatives

158

9.13 Integration of Liquidity Stress Testing with Related Risk Models

Prime Brokerage and A sset M anagement

160

O ff-Balance-Sheet Financing

160

Conclusion

185

8.2 Failure Mechanisms for Dealer Banks

161

Chapter 10

Liquidity Risk Reporting and i>tress Testing 187

8.1 What Large Dealer Banks Do

157

Securities Dealing, Underwriting, and Trading 158

vi

Chapter 9

The Flight of Short-Term Creditors

161

The Flight of Prime Brokerage Clients

162

W hen D erivatives Counterparties Duck for C over

164

Loss of Cash Settlem ent Privileges

165

8.3 Policy Responses

165

References

167

■ Contents

10.1 Liquidity Risk Reporting

188

Deposit Tracker Report

188

Daily Liquidity Report

188

Funding M aturity G ap ("M ism atch") Report

192

Funding Concentration Report

192

Undrawn Com m itm ent Report

193

Liability Profile

193

W holesale Pricing and Volume

200

Sum m ary and Q ualitative Reports

201

Frequency of Reporting

202

Stress Test Reports

Chapter 11

204

Contingency Funding Planning 209

Chapter 12

Managing and Pricing Deposit Services 221

12.1 Introduction

222

12.2 Types of Deposits Offered by Depository Institutions

222

Transaction (Paym ents or Demand) Deposits

222

Nontransaction (Savings or Thrift) Deposits

224

Retirem ent Savings Deposits

224

12.3 Interest Rates Offered on Different Types of Deposits

225

11.1 Actions in a Liquidity Crisis

210

The Com position of Deposits

225

11.2 Evolving Capabilities and Enhancements

The O w nership of Deposits

226

210

The Cost of Different Deposit Accounts

228

11.3 Design Considerations

210

12.4 Pricing Deposit-Related Services

229 230

I. Align to Business and Risk Profiles

210

II. Integrate with Broader Risk M anagem ent Fram ew orks

211

III. O perational, A ctionable, but Flexible Playbook

12.5 Pricing Deposits at Cost Plus Profit Margin

211

IV. Inclusive of A ppropriate Stakeholder Groups

12.6 New Deposit Insurance RulesInsights and Issues 231

211

V. Supported by a Com m unication Plan

211

11.4 Framework and Building Blocks

211

G overnance and O versight

212

Scenarios and Liquidity Gap Analysis

213

Contingent Actions

214

Monitoring and Escalation

215

Data and Reporting

218

11.5 Additional Considerations

218

Different Types of Institutions

218

O rganizational Structure of the C FP s

218

Liquidity and Capital

219

Conclusion

219

References

219

Sum m ary of Deposit Insurance C overage Provided by the FD IC

12.7 Using Marginal Cost to Set Interest Rates on Deposits Conditional Pricing

231

232 233

12.8 Pricing Based on the Total Customer Relationship and Choosing a Depository

237

The Role That Pricing and O ther Factors Play W hen Custom ers Choose a D epository Institution to Hold Their Accounts

237

12.9 Basic (Lifeline) Banking: Key Services for Low-Income Customers

239

Summary

240

Contents

■ vii

Key Terms

241

Case Assignment for Chapter 13

270

Problems and Projects

242

Selected References

271

Internet Exercises

243

Case Assignment for Chapter 12

244

Selected References

246

Chapter 13

Managing Nondeposit Liabilities

13.1 Introduction

247 248

13.2 Liability Management and the Customer Relationship Doctrine 248 13.3 Alternative Nondeposit Sources of Funds Federal Funds M arket ("Fed Funds")

250

Repurchase A greem ents as a Source of Funds

252

Borrowing from Federal Reserve Banks

255

Advances from Federal Home Loan Banks

256

Developm ent and Sale of Large N egotiable CD s

256

The Eurocurrency Deposit M arket

258

Com m ercial Paper M arket

259

Long-Term N ondeposit Funds Sources

260

13.4 Choosing among Alternative Nondeposit Sources

viii

250

261

Measuring a Financial Firm's Total Need for Nondeposit Funds: The Available Funds Gap

261

N ondeposit Funding Sources: Factors to Consider

262

Summary

267

Key Terms

267

Problems and Projects

268

Internet Exercises

269

■ Contents

Chapter 14

Repurchase Agreements and Financing

14.1 Repurchase Agreements: Structure and Uses

273

274

Repos and Cash M anagem ent

274

Repos and Long Financing

275

Reverse Repos and Short Positions

276

14.2 Repo, Liquidity Management, and the Financial Crisis of 2007-2009 277 Case Study: Repo Financing and the Collapse of Bear Stearns

277

Case Study: JPM organ Chase's Repo Exposure to Lehman Brothers

278

14.3 General and Special Repo Rates

280

Special Spreads in the United States and the Auction Cycle

281

Special Spreads in the United States and the Level of Rates

284

Valuing the Financing A dvantage of a Bond Trading Special in Repo

285

Chapter 15

Liquidity Transfer Pricing: A Guide to Better Practice 287

15.1 Introduction

288

15.1.1 A Sum m ary of the Major Lessons Learned

288

15.1.2 Regulatory Developm ents

289

15.1.3 The Need for More Guidance on LTP

290

15.2 Governing LTP

290

15.2.1 M anagem ent of the LTP Process

291

15.2.2 Liquidity M anagem ent Information System s (LMIS)

292

15.2.3 Remuneration Practices

293

15.3 LTP In Practice: Managing On-Balance Sheet Funding Liquidity Risk

294

Chapter 16

The US Dollar Shortage in Global Banking and the International Policy Response 309

16.1 Introduction

310

16.2 Banks' International Positions: Concepts and Data

311

15.3.1 W hy Banks Need LTP

294

15.3.2 An Exam ple of W hat Can Go W rong with Poor LTP

294

15.3.3 "Z ero " Cost of Funds Approach - Liquidity as a "F re e " Good

294

15.3.4 Pooled "A verag e" Cost of Funds Approach to LTP

295

16.3.2 Balance Sheet Expansion since 2000

316

15.3.5 M atched-M aturity Marginal Cost of Funds Approach to LTP

16.3.3 Cross-Currency Funding Positions

316

297

15.3.6 Exam ples of Pricing Funding Liquidity Risk

16.3.4 M aturity Transform ation across Banks' Balance Sheets

320

298

16.4 The US Dollar Shortage

323

15.3.7 Sum m ary

301

16.5 The International Policy Response

325

16.6 Concluding Remarks

327

Data Appendix

328

15.4 LTP In Practice: Managing Contingent Liquidity Risk

301

15.4.1 Liquidity Cushions: A Principle of Liquidity Risk M anagem ent

301

15.4.2 Extant Guidance Focuses on Size, Com position and M arketability

302

15.4.3 Problem s with Banks Liquidity Cushions Unveiled by the G F C

302

15.4.4 LTP and Liquidity Cushions - Both Principles, Both Treated Separately

302

15.4.5 Poor Attribution of Cost of Carrying a Liquidity Cushion

302

15.4.6 Towards Better M anagem ent of Contingent Liquidity Risk

303

15.4.7 Exam ple of Pricing Contingent Liquidity Risk

304

15.5 Conclusion

305

Appendix: LTP Principles and Recommendations

16.3 The Long and Short of Banks' Global Balance Sheets 313 16.3.1 The Structure of Banks' O perations 313

Reconstructing Banks' Global Balance Sheets 328 The BIS International Banking Statistics

328

Construction of the D ataset

328

Consistency Check and Data Lim itations

329

References

330

Chapter 17

Covered Interest Parity Lost: Understanding the Cross-Currency Basis 333

17.1 A Framework 307

334

Demand for Currency H edges: W hy the Basis O pens Up

337

Contents

■ ix

Limits to A rb itrag e: W hy the Basis Does Not Close

17.2 The Currency Basis in the Cross Section Q uantitative Indicators of Hedging Demand

338

339 339

17.3 The Currency Basis in the Time Series: The Yen/Dollar Case 343 Demand for Currency Hedges and the Basis

343

Tighter Limits to A rb itrage and the Basis

344

Regression Results

345

Conclusions

346

References

347

Chapter 18

Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques 349

18.1 Introduction

350

18.2 Asset-Liability Management Strategies

350

A sset M anagem ent Strategy

350

Liability M anagem ent Strategy

350

Funds M anagem ent Strategy

351

18.3 Interest Rate Risk: One of the Greatest Management Challenges

x

351

The Com ponents of Interest Rates

353

Responses to Interest Rate Risk

355

18.4 One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin

356

Interest-Sensitive Gap M anagem ent as a Risk-M anagement Tool

356

Problem s with Interest-Sensitive G A P M anagem ent

362

18.5 The Concept of Duration as a Risk-Management Tool

365

W hat Is Duration?

365

Price Sensitivity to Changes in Interest Rates and Duration

366

C o nvexity and Duration

366

18.6 Using Duration to Hedge Against Interest Rate Risk

367

18.7 The Limitations of Duration GAP Management

372

Summary

373

Key Terms

374

Problems and Projects

375

Internet Exercises

377

Case Assignment for Chapter 18

378

Selected References

380

Chapter 19

Illiquid Assets

381

19.1 Chapter Summary

382

19.2 Liquidating Harvard

382

19.3 Illiquid Asset Markets

383

Sources of Illiquidity

383

Forces Determ ining Interest Rates

351

C haracteristics of Illiquid M arkets

383

The M easurem ent of Interest Rates

352

Sum m ary

385

■ Contents

19.4 Illiquid Asset Reported Returns Are Not Returns

385

Survivorship Bias

385

Infrequent Trading

386

Unsmoothing Returns

386

Selection Bias

389

Sum m ary

390

19.5 Illiquidity Risk Premiums

390

Illiquidity Risk Premiums across A sset Classes

391

Illiquidity Risk Premiums within A sset Classes

392

M arket Making

393

Rebalancing

395

Sum m ary

395

19.6 Portfolio Choice with Illiquid Assets

395

A sset Allocation with Transactions Costs

395

A sset Allocation with Infrequent Trading

396

Sum m ary

397

19.7 Liquidating Harvard Redux

397

The Case for Illiquid A sset Investing

397

Investm ent A d vice for Endow m ents

398

Liquidate Harvard?

399

Index

401

Contents

■ xi

On behalf of our Board of Trustees, GARP's staff, and particu­ larly its certification and educational programs teams, I would like to thank you for your interest in and support of our Financial Risk Manager (FRM®) program.

The FRM program addresses the financial risks faced by both non-financial firms and those in the highly interconnected and sophisticated financial services industry, because its coverage is not static, but vibrant and forward looking.

The past couple of years have been difficult due to COVID-19. And in that regard, our sincere sympathies go out to anyone who was ill or suffered a loss due to the pandemic.

The FRM curriculum is regularly reviewed by an oversight com­ mittee of highly qualified and experienced risk-management professionals from around the globe. These professionals con­ sist of senior bank and consulting practitioners, government regulators, asset managers, insurance risk professionals, and academics. Their mission is to ensure the FRM program remains current and its content addresses not only standard credit and market risk issues, but also emerging issues and trends, ensur­ ing FRM candidates are aware of what is or is expected to be important in the near future. We're committed to offering a pro­ gram that reflects the dynamic and sophisticated nature of the risk-management profession and those who are making it a career.

The FRM program also experienced many virus-related chal­ lenges. Because we always place candidate safety first, we cancelled the May 2020 FRM exam offering and deferred all can­ didates to October, while reserving an optional date in January 2021 for candidates not able to sit for the examination in October. A change like this has never happened before. Ultimately, we were able to offer the FRM exam to all 2020 registered candidates who wanted to sit for it during the year and were not constrained by COVID-related restrictions, which was most of our registrants. Since its inception in 1997, the FRM program has been the global industry benchmark for risk-management professionals wanting to demonstrate objectively their knowledge of financial risk-management concepts and approaches. Having FRM hold­ ers on staff also tells companies' that their risk-management professionals have achieved a demonstrated and globally adopted level of expertise. In a world where risks are becoming more complex daily due to any number of technological, capital, governmental, geopoliti­ cal, or other factors, companies know that FRM holders possess the skills to understand and adapt to a dynamic and rapidly changing financial environment.

xii

■

Preface

We wish you the very best as you study for the FRM exams, and in your career as a risk-management professional. Yours truly,

Richard Apostolik President & CEO

FRM®

Chairperson Michelle McCarthy Beck Former GARP Board Member

Members Richard Apostolik President and CEO, Global Association of Risk Professionals

Dr. Attilio Meucci, CFA Founder, ARPM

Richard Brandt MD Operational Risk Management, Citigroup

Dr. Victor Ng MD Head of Risk Architecture, Goldman Sachs

Julian Chen, FRM, SVP FRM Program Manager, Global Association of Risk Professionals

Dr. Matthew Pritsker Senior Financial Economist and Policy Advisor / Supervision, Regulation, and Credit, Federal Reserve Bank of Boston

Dr. Christopher Donohue, MD GARP Benchmarking Initiative, Global Association of Risk Professionals

Dr. Samantha Roberts, FRM SVP Balance Sheet Analytics & Modeling, PNC Bank

Donald Edgar, FRM MD Risk & Quantitative Analysis, BlackRock

Dr. Til Schuermann Partner, Oliver Wyman

Herve Geny Former Group Head of Internal Audit, London Stock Exchange Group and former CRO, ICAP

Nick Strange Senior Technical Advisor, Operational Risk & Resilience, Supervisory Risk Specialists, Prudential Regulation Authority, Bank of England

Keith Isaac, FRM VP Capital Markets Risk Management, TD Bank Group William May, SVP

Dr. Sverrir Porvaldsson, FRM Senior Quant, SEB

Global Head of Certifications and Educational Programs, Global Association of Risk Professionals

FRM® Committee

■

xiii

Liquidity Risk Learning Objectives After completing this reading you should be able to: Explain and calculate liquidity trading risk via cost of liqui­ dation and liquidity-adjusted VaR (LVaR).

Evaluate Basel III liquidity risk ratios and BIS principles for sound liquidity risk management.

Identify liquidity funding risk, funding sources, and lessons learned from real cases: Northern Rock, Ashanti Goldfields, and Metallgesellschaft.

Explain liquidity black holes and identify the causes of positive feedback trading.

Excerpt is Chapter 24 of Risk Management and Financial Institutions, 5th Edition, by John C. Hull.

1

The credit crisis that started in the middle of 2007 has empha­ sized the importance of liquidity risk for both financial institu­ tions and their regulators. Some financial institutions that relied on wholesale deposits for their funding experienced problems as investors lost confidence in financial institutions. Moreover, financial institutions found that some instruments for which there had previously been a liquid market could only be sold at fire-sale prices during the crisis.

every day. The quoted price of the shares is very close to the price that the financial institution would be able to sell the shares for. However, not all assets are as readily convertible into cash. For example, a $100 million investment in the bonds of a noninvestment-grade U.S. company might be quite difficult to sell at close to the market price in one day. Shares and debt of companies in emerging markets are likely to be even less easy to sell.

It is important to distinguish solvency from liquidity. Solvency refers to a company having more assets than liabilities, so that the value of its equity is positive. Liquidity refers to the ability of a company to make cash payments as they become due. Finan­ cial institutions that are solvent can—and sometimes do—fail because of liquidity problems. Consider a bank whose assets are mostly illiquid mortgages. Suppose the assets are financed 90% with deposits and 10% with equity. The bank is comfortably solvent. But it could fail if there is a run on deposits with 25% of depositors suddenly deciding to withdraw their funds. In this chapter we will examine how Northern Rock, a British bank spe­ cializing in mortgage lending, failed largely because of liquidity problems of this type.

The price at which a particular asset can be sold depends on

It is clearly important for financial institutions to manage liquid­ ity carefully. Liquidity needs are uncertain. A financial institution should assess a worst-case liquidity scenario and make sure that it can survive that scenario by either converting assets into cash or raising cash in some other way. The new Basel III require­ ments are designed to ensure that banks do this. Liquidity is also an important consideration in trading. A liq­ uid position in an asset is one that can be unwound at short notice. As the market for an asset becomes less liquid, traders are more likely to take losses because they face bigger bidoffer spreads. For an option or other derivative, it is important for there to be a liquid market for the underlying asset so that the trader has no difficulty in doing the daily trades necessary to maintain delta neutrality. This chapter discusses different aspects of liquidity risk. It con­ siders liquidity trading risk and liquidity funding risk. It also looks at what are termed "liquidity black holes." These are situations where a shock to financial markets causes liquidity to almost completely dry up.

1.1 LIQUIDITY TRADING RISK If a financial institution owns 100, 1,000, 10,000, or even 100,000 shares in IBM, liquidity risk is not a concern. Several million IBM shares trade on the New York Stock Exchange

2

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1. The mid-market price of the asset, or an estimate of its value 2. How much of the asset is to be sold 3. How quickly it is to be sold 4. The economic environment When there is a market maker who quotes a bid and offer price for a financial asset, the financial institution can sell the asset at the bid and buy at the offer. However, it is usu­ ally stated (or understood) that a particular quote is good for trades up to a certain size. Above that size, the market maker is likely to increase the bid-offer spread. This is because the market maker knows that, as the size of a trade increases, the difficulty of hedging the exposure created by the trade also increases. When there is no market maker for a financial instrument, there is still an implicit bid-offer spread. If a financial institution approaches another financial institution (or an interdealer bro­ ker) to do a trade, the price depends on which side of the trade it wants to take. The bid-offer spread for an asset can vary from 0.05% of the asset's mid-market price to as much as 5%, or even 10%, of its mid-market price. The general nature of the relationship between bid quotes, offer quotes, and trade size is indicated in Figure 1.1. The bid price tends to decrease and the offer price tends to increase with the size of a trade. For an instrument where there is a market maker, the bids and offers are the same up to the market maker's size limit and then start to diverge. Figure 1.1 describes the market for large deals between sophisticated financial institutions. It is interesting to note that bid-offer spreads in the retail market sometimes show the opposite pattern to that in Figure 1.1. Consider, for example, an individual who approaches a branch of a bank wanting to do a foreign exchange transaction or invest money for 90 days. As the size of the transaction increases, the individual is likely to get a better quote. The price that can be realized for an asset often depends on how quickly it is to be liquidated and the economic

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Metallgesellschaft. In the case of Long-Term Capital Manage­ ment positions were unwound slowly over a period of time under the supervision of the Federal Reserve to avoid preda­ tory trading. Another problem in the market for financial assets is that, when one financial institution finds that it needs to unwind a position, it is often the case that many other financial institutions with similar positions need to do the same thing. The liquid­ ity normally present in the market then evaporates. This is the "liquidity black hole" phenomenon that will be discussed later in this chapter.

1.1.1 The Importance of Transparency Bid and offer prices as a function of Fiaure 1.1 quantity transacted.

environment. Suppose you want to sell your house. Sometimes the real estate market is referred to as a "seller's market." Almost as soon as you put the house on the market, you can expect to get several offers and the house will be sold within a week. In other markets, it may take six months or more to sell the house. In the latter case, if you need to sell the house imme­ diately, you will have to reduce the asking price well below the estimated market value. Financial assets are similar to real assets as far as this is con­ cerned. Sometimes liquidity is tight (e.g., after the Russian default of 1998 and after the subprime crisis of 2007-2008). Liquidating even a relatively small position can then be timeconsuming and is sometimes impossible. On other occasions, there is plenty of liquidity in the market and relatively large posi­ tions can be unwound without difficulty. Liquidating a large position can be affected by what is termed predatory trading. This occurs when a market participant, say Company X, has a large position and other market participants guess that it will have to be unwound in the near future. The other market participants attempt to profit by doing similar trades to those they expect from Company X. For example, if it is expected that Company X will have to sell a large position in a particular stock, they short the stock in anticipation of a price decline. This makes it more difficult than it would otherwise be for Company X to exit from its position at competitive prices. To avoid predatory trading, financial institutions emphasize to employees the importance of keeping their positions and their future trading plans confidential. Predatory trading was an issue for the trader known as the London Whale in 2012 and for

One thing that the market has learned from the credit crisis of 2007 is that transparency is important for liquidity. If the nature of an asset is uncertain, it is not likely to trade in a liquid market for very long. It had become common practice in the years prior to 2007 to form portfolios of subprime mortgages and other assets and to create financial instruments by securitizing, re-securitizing, and re-re-securitizing the credit risk. Many of the financial instru­ ments were even more complicated. Sometimes the ABS CDOs that were created included non-mortgage assets and even tranches from other ABS CDOs. After August 2007, market par­ ticipants realized that they knew very little about the risks in the instruments they had traded. Moreover, it was very difficult for them to find out very much about this. Belatedly, they realized they had been using credit ratings as a substitute for an under­ standing of the instruments. After August 2007, the instruments created from subprime mortgages became illiquid. Financial institutions had no idea how to mark to market investments that they had been scram­ bling to buy a few months earlier. They realized that they had purchased highly complicated credit derivatives and that they did not have the tools to value them. They lacked both the necessary models and solid information about the assets in the portfolios underlying the derivatives. Other well-defined credit derivatives, such as credit default swaps, continued to trade actively during the credit crisis. The lesson from all this is that the market can sometimes get car­ ried away trading complex products that are not transparent, but, when it comes to its senses, liquidity for the products soon disappears. When the products do trade again, prices are likely to be low and bid-offer spreads are likely to be high. In July 2008 Merrill Lynch agreed to sell $30.6 billion of ABS CDO tranches (previously rated AAA) to Lone Star Funds for 22 cents on the dollar.

Chapter 1 Liquidity Risk

■ 3

1.1.2 Measuring Market Liquidity One measure of the market liquidity of an asset is its bid-offer spread. This can be measured either as a dollar amount or as a proportion of the asset price. The dollar bid-offer spread is p = Offer price — Bid price

Cost of liquidation (stressed market)

The proportional bid-offer spread for an asset is defined as Offer price — Bid price s = -------------------------Mid-market price where the mid-market price is halfway between the bid and the offer price. Sometimes it is convenient to work with the dollar bid-offer spread, p, and sometimes with the proportional bid-offer spread, s. The mid-market price can be regarded as the fair price. In liqui­ dating a position in an asset, a financial institution incurs a cost equal to sa/2 where a is the dollar (mid-market) value of the position. This reflects the fact that trades are not done at the mid-market price. A buy trade is done at the offer price and a sell trade is done at the bid price. One measure of the liquidity of a book is how much it would cost to liquidate the book in normal market conditions within a certain time. Suppose that s, is an estimate of the proportional bid-offer spread in normal market conditions for the /th finan­ cial instrument held by a financial institution and a; is the dollar value of the position in the instrument. Then XT' SjQ! j

Cost of liquidation (normal market) = 2 j ~^~ ;= 1

(

1. 1)

2

where n is the number of positions. Note that although diversifi­ cation reduces market risk, it does not necessarily reduce liquid­ ity trading risk. However, as explained earlier, s,- increases with the size of position /. Holding many small positions rather than a few large positions therefore tends to entail less liquidity risk. Setting limits to the size of any one position can therefore be one way of reducing liquidity trading risk.

Example 1.1 Suppose that a financial institution has bought 10 million shares of one company and 50 million ounces of a commodity. The shares are bid $89.5, offer $90.5. The commodity is bid $15, offer $15.1. The mid-market value of the position in the shares is 90 X 10 = $900 million. The mid-market value of the position in the commodity is 15.05 X 50 = $752.50 million. The propor­ tional bid-offer spread for the shares is 1/90 or 0.01111. The proportional bid-offer spread for the commodity is 0.1/15.05 or 0.006645. The cost of liquidation in a normal market is 900 X 0.01111/2 + 752.5 X 0.006645/2 = 7.5 or $7.5 million.

4

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Another measure of liquidity is the cost of liquidation in stressed market conditions within a certain time period. Define lx-, and a-/ as the mean and standard deviation of the propor­ tional bid-offer spread for the /th financial instrument held. Then:

The parameter A gives the required confidence level for the spread. If, for example, we are interested in considering "worst case" spreads that are exceeded only 1% of the time, and if it is assumed that spreads are normally distributed, then A = 2.326.

Example 1.2 Suppose that in Example 1.1 the mean and standard devia­ tion for the bid-offer spread for the shares are $1.0 and $2.0, respectively. Suppose further that the mean and standard deviation for the bid-offer spread for the commodity are both $0.1. The mean and standard deviation for the pro­ portional bid-offer spread for the shares are 0.01111 and 0.02222, respectively. The mean and standard deviation for the proportional bid-offer spread for the commodity are both 0.006645. Assuming the spreads are normally distributed, the cost of liquidation that we are 99% confident will not be exceeded is 0.5 X 900 X (0.01111 + 2.326 X 0.02222) + 0.5 X 752.5 X (0.006645 + 2.326 X 0.006645) = 36.58 or $36.58 million. This is almost five times the cost of liquidation in normal market conditions. In practice, bid-offer spreads are not normally distributed and it may be appropriate to use a value of A that reflects their empiri­ cal distribution. For example, if it is found that the 99 percentile point of the distribution is 3.6 standard deviations above the mean for a particular category of financial instruments, A can be set equal to 3.6 for those instruments. Equation (1.2) assumes that spreads in all instruments are perfectly correlated. This may seem overly conservative, but it is not. When liquidity is tight and bid-offer spreads widen, they tend to do so for all instruments. It makes sense for a financial institution to monitor changes in the liquidity of its book by calculating the measures in equations (1.1) and (1.2) on a regular basis. As we have seen, the bid-offer spread depends on how quickly a position is to be liquidated. The measures in equations (1.1) and (1.2) are therefore likely to be decreasing functions of the time period assumed for the liquidation.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

1.1.3 Liquidity-Adjusted VaR Market value at risk is designed to calculate an estimate of a "worst case" change in the mark-to-market valuation of the trading book. The measures in equations (1.1) and (1.2) are designed to calculate the cost of liquidating a book if market prices do not change. Although VaR and liquidity risk measures deal with different types of risks, some researchers have sug­ gested combining them into a liquidity-adjusted VaR measure. One definition of liquidity-adjusted VaR is regular VaR plus the cost of unwinding positions in a normal market. From equation (1.1) this gives Liquidity-Adjusted VaR = VaR +

/=1 2

(1-3)

Alternatively it can be defined as regular VaR plus the cost of unwinding positions in a stressed market. From equation (1.2) this gives1

Suppose that the mid-market price changes are normally distrib­ uted with a standard deviation of cr per day and trading takes place at the beginning of a day. The variance of the change in the value of the traders position on day / is cr1 2xf. Assuming that price changes on successive days are independent, the vari­ ance of the change in the value of the position applicable to the unwind is therefore

2> 2*f

ADVANTAGES: Helps to meet liquidity needs with short term securities and to achieve earnings goals due to higher potential earnings from the long term portion of the portfolio.

30 A

Half or a substantial percentage of portfolio _x_ r \

U CD 20 (/> u To CD

CD Q_

o 1 0 - 20%

30%

Half or a substantial percentage of portfolio A r \

30%

-

0

20%

1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10yr.

The Rate-Expectations Approach STRATEGY: Change the mix of investment maturities as the interest-rate outlook changes.

Shift toward long-term securities if interest rates are expected to fall ------------------------------------------►

O "O

-2 ro o _ c

(D u CD Q_ O 10

Shift toward short-term securities if interest rates are expected to rise

"fU

-

0 j ----- ----- ----- ----- ----- ----- ----- ------------------

1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.

Exhibit 4.3

Additional maturity strategies for managing investment portfolios.

100 percent of his or her institution's funds not needed for loans or cash reserves in securities three years or less from maturity. This approach stresses using the investment portfolio primarily as a source of liquidity rather than as a source of income.

The Back-End Load Maturity Policy An opposite approach would stress the investment portfolio as a source of incom e. An investing institution following the b a ck­ e n d load approach might decide to invest only in bonds in the 5- to 10-year maturity range. This institution would probably rely heavily on borrowing in the money market to help meet its liquidity requirements.

The Barbell Strategy A combination of the front-end and back-end load approaches, frequently employed by smaller financial firms, is the barbell strategy, in which an investing institution places most of its funds in a short-term portfolio of highly liquid securities at one extreme and in a long-term portfolio of bonds at the other extreme, with minimal investment holdings in intermediate maturities. The short-term portfolio provides liquidity, while the long-term portfolio is designed to generate income.

The Rate Expectations Approach The most aggressive of all maturity strategies, often used by the largest financial firms, is one that continually shifts maturities of securities in line with current forecasts of interest rates and the economy. This total perform ance, or rate expectation, approach calls for shifting investments toward the short end of the maturity spectrum when interest rates are expected to rise and toward the long end when falling interest rates are expected. Such an approach offers the potential for large capital gains, but also raises the specter of substantial losses. It requires in-depth knowl­ edge of market forces, presents greater risk if expectations turn out to be wrong, and carries greater transactions costs because it may require frequent security trading and switching. Banks, for example, often trade some of their unpledged security holdings whenever there is the prospect of significant gains in expected returns or the opportunity to reduce asset risk without significant loss in expected yield. They are particu­ larly aggressive when loan revenues are down and the sale of securities whose market value has risen will boost net income and shareholder returns. However, because losses on security trades reduce before-tax income, portfolio managers do not like to take such losses unless they can demonstrate to the board

Chapter 4 The Investment Function in Financial-Services Management

■ 75

of directors that the loss will be more than made up by higher expected returns on new assets acquired from the proceeds of the security sale. In general, investing institutions are inclined to trade securities if (a) their expected after-tax returns can be raised through effective tax management strategies; (b) higher yields can be locked in at the long-term end of the yield curve when the forecast is for falling interest rates; (c) the trade would contribute to an overall improvement in asset quality that would enable the institution to better weather an economic downturn; or (d) the investment portfolio can be moved toward highergrade securities without an appreciable loss in expected return (especially if problems are developing in the loan portfolio).

4.9 MATURITY M AN AGEM EN T TO O LS In choosing among various maturities of investments to acquire, investments officers need to consider carefully the use of two key maturity management tools—the yield curve and duration. These tools help the investments officer understand more fully the consequences and potential impact upon earnings and risk from any particular maturity mix of securities.

The Yield Curve As we will see in Chapter 18, the yield curve is simply a picture of how market interest rates differ across loans and securities of varying term (time) to maturity. Each yield curve, such as the one drawn in Exhibit 4.2, assumes that all interest rates (or yields) included along the curve are measured at the same time and that all other rate-determining forces are held fixed. While the curve in Exhibit 4.2 slopes upward as we move to the right, yield curves may also slope downward or be horizontal, indicat­ ing that short- and long-term interest rates at that particular moment are about the same.

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Forecasting Interest Rates and the Economy Yield curve shapes have critical implications for the decisions an investments officer must make. For example, the yield curve con­ tains an implicit forecast of future interest rate changes, Positively sloped yield curves reflect the average expectation in the market that future short-term interest rates will be higher than they are today. In this case, investors expect to see an upward interest-rate movement, and they often translate this expectation into action by shifting their investment holdings away from longer-term securities (which will incur greater capital losses when market interest rates do rise). Conversely, a downward-sloping yield curve points to investor expectations of declining short-term interest rates in the period ahead. The investments officer will consider lengthening portfolio maturity because falling interest rates offer the prospect of substantial capital gains income from longer-term investments. Yield curves also provide the investments officer with a clue about overpriced and underpriced securities, Because the pre­ vailing yield curve indicates what the yield to maturity should be for each maturity, a security whose yield lies above the curve represents a tempting buy situation; its yield is temporarily too high (and, therefore, its price is too low). On the other hand, a security whose yield lies below the curve represents a possible sell or "don't buy" situation because its yield is too low for its maturity (and, thus, its price is too high). In the long run, yield curves send signals about what stage of the business cycle the economy presently occupies, They gener­ ally rise in economic expansions and fall in recessions.

Risk-Return Trade-Offs The yield curve is also useful because it tells the investments officer something important about the current trade-offs between greater returns and greater risks. The yield curve's shape determines how much additional yield the investments officer can earn by replacing shorter-term securities with longer-term issues, or vice versa. For example, a steeply sloped positive yield curve that rises 100 basis points between 2-year and 10-year matu­ rity bonds indicates that the investments officer can pick up a full percentage point in extra yield (less broker or dealer com­ missions and any tax liability incurred) by switching from 2-year to 10-year bonds. However, 10-year bonds are generally more volatile in price than 2-year bonds, so the investments officer must be will­ ing to accept greater risk of a capital loss on the 10-year bonds if interest rates

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

rise. Longer-term bonds often have a thinner market in case cash must be raised quickly. The investments officer can mea­ sure along the curve what gain in yield will result from maturity extension and compare that gain against the likelihood a finan­ cial firm will face a liquidity crisis ("cash out") or suffer capital losses if interest rates go in an unexpected direction.

Pursuing the Carry Trade Likewise, yield curves provide the investments officer with a measure of how much might be earned at the moment by pur­ suing the carry trade, The officer can borrow funds at the short­ est end of the curve (such as borrowing short-term money using the safest and most liquid investment securities in the financial firm's portfolio as collateral) and then invest the borrowed funds in income-generating assets farther out along the curve. For example, the officer may borrow funds for 30 days at 4 percent and use that money to invest in five-year government bonds yielding 6 percent. The difference between these two rates of return is called carry income and tends to be greatest when the yield curve has a steep upward slope.

Riding the Yield Curve If the yield curve does have a sufficiently strong positive slope, an investing institution may also be able to score significant gains with a maneuver known as riding the yield curve, The investments officer looks for a situation in which some securi­ ties are soon to approach maturity and their prices have risen significantly while their yields to maturity have fallen. If the yield curve's slope is steep enough to more than cover transactions costs, the investing institution can sell those securities, scoring a capital gain due to the recent rise in their prices, and reinvest the proceeds of that sale in longer-term securities carrying higher rates of return. If the riding maneuver works (i.e., the slope of the yield curve does not fall), the investing institution will reap both higher current income and greater future returns.

Duration While the yield curve presents the investments officer with valu­ able information and occasionally the opportunity for substantial gains, it has several limitations, such as uncertainty over exactly how and why the curve appears the way it does at any particular moment and the possibility of a change in the curve's shape at any time. Moreover, the yield curve counts only clock time, not the timing of cash flows expected from a security. The most critical information for the investments officer is usually not how long any particular security will be around but, rather, when it will generate cash and how much cash will be generated each month, quarter, or year the security is held.

The need for this kind of information gave rise to the concept of duration—a present-value-weighted measure of maturity of an individual security or portfolio of securities. As we will discuss in Chapter 18, duration measures the average amount of time needed for all of the cash flows from a security to reach the investor who holds it. We will see in Chapter 18 (especially from Equation [18.18]) that there is a critical relationship between duration, market interest rates, and investment security prices. Specifically, the percent­ age change in the price of an investment security is equal to the negative of its duration times the change in interest rates divided by one plus the initial interest rate or yield.4 Using this relationship we can see how sensitive an investment security's market price will be to changes in market interest rates and we can decide whether the security we are interested in is too price sensitive, or perhaps not price sensitive enough, to meet our financial firm's investment needs. For example, suppose a Treasury note has a duration of 4.26 years and market interest rates rise from 10.73 percent to 12 percent, or 1.27 percent. The duration relationship we described above tells us that should interest rates rise just over one percentage point, the security in question will experience almost a 5 percent decline in price. The investments officer must decide how much chance there is that market interest rates will rise, whether this degree of price sensitivity is acceptable, and whether other investments would better suit the institution's current investment needs.

Immunization Duration also suggests a way to minimize damage to an invest­ ing institution's earnings that changes in market interest rates may cause. That is, duration gives the investments officer a tool to reduce his or her institution's exposure to interest rate risk. It suggests a formula for minimizing interest rate risk: Duration of an individual _ security or a security portfolio

Length of the investor's planned holding period for a security or a security portfolio*1

^

4 The formula described in this sentence (and presented in Chapter 18) applies if a security pays interest once each year, if interest is paid more than once each year the appropriate formula is this: Percentage change ^ a a = -Duration in price

X

Change in interest rate 1 + (1/m)(lnitial rate)

where m is the number of times during a year that the security pays interest. For example, most bonds pay interest semiannually, in which case m = 2.

Chapter 4 The Investment Function in Financial-Services Management

■ 77

CONCEPT CHECK 4.18. What factors affect a financial-service institution's deci­ sion regarding the different maturities of securities it should hold?

4.19. What maturity strategies do financial firms employ in managing their portfolios?

4.20. Bacone National Bank has structured its investment portfolio, which extends out to four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year, and four-year securities. In contrast, Dunham National Bank and Trust holds $36 million in one- and two-year securities and about $30 million in 8- to 10-year maturities. What maturity strategy is each bank following? Why do

For example, suppose a bank is interested in buying Treasury notes because loan demand currently is weak. However, the investments officer is concerned that he or she may be required to sell those securities at this time next year in order to make profitable loans. Faced with this prospect and deter­ mined to minimize interest rate risk, the officer could choose those notes with a duration of one year. The effect of this step is to engage in portfolio immunization—that is, protecting securities purchased from loss of return, no matter which way interest rates go.5 Duration works to immunize a security or portfolio of securi­ ties against interest rate changes because two key forms of risk— interest rate risk and reinvestment risk—offset each other when duration is set equal to the investing institution's planned holding period. If interest rates rise after the securi­ ties are purchased, their market price will decline, but the investments officer can reinvest the cash flow those securities are generating at higher market rates. Similarly, if interest rates fall, the institution will be forced to reinvest at lower interest rates but, correspondingly, the prices of those securi­ ties will have risen. The net result is to approximately freeze the total return from investment security holdings. Capital gains or losses are counterbalanced by falling or rising rein­ vestment yields when duration matches the investing institu­ tion's planned holding period.

5 See Chapter 18 for additional discussion of portfolio immunization.

78

you believe that each of these banks has adopted the particular strategy it has as reflected in the maturity structure of its portfolio?

4.21. How can the yield curve and duration help an invest­ ments officer choose which securities to acquire or sell?

4.22. A bond currently sells for $950 based on a par value of $1,000 and promises $100 in interest for three years before being retired. Yields to maturity on comparable-quality securities are currently at 12 percent. What is the bond's duration? Suppose interest rates in the market fall to 10 percent. What will be the approximate percent change in the bond's price?

SUMMARY This chapter has focused on investments in the banking and financial-services field. What is involved in making investments and why are they important? • For most financial-service firms, investments refer to the buy­ ing and selling of marketable securities, such as government bonds and notes. • Investments fulfill multiple roles in the management of a financial firm. These roles include (a) supplementing income from loans; (b) supplying extra liquidity when cash is low; (c) serving as collateral for borrowings; (d) reducing tax expo­ sure; (e) offsetting risks inherent in other parts of the balance sheet, such as in the loan portfolio; (f) dressing up the bal­ ance sheet; (g) helping to hedge against interest rate risk; and (h) providing greater flexibility in management of assets and liabilities. • The investments officer must choose what kinds of invest­ ments best contribute to the goals established for each insti­ tution's investment portfolio. In lending-type institutions, the investment portfolio normally plays "second fiddle" and the investments officer is often charged with the responsibility for backstopping loans—providing more income when loan demand is weak and more cash when loan demand is high. • In choosing which investments to hold, investments officers must weigh multiple factors: (a) the goal of the investment portfolio; (b) expected rates of return; (c) tax exposure; (d) risks associated with changing market interest rates, with possible default by security issuers, with the possible need

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

for cash at any time, with the impact of inflation and business cycle upon the demand for financial services, and with the prepayment of loans that can reduce expected returns. • An additional factor that investments officers must consider is the maturity or duration of different investment securities, represented by the yield curve. Yield curves convey informa­ tion about the market's outlook for interest rates and graphi­ cally illustrate the trade-off between risk and return that confronts the investments officer. Duration provides a picture

of the time distribution of expected cash flows from invest­ ments and can be used to help reduce interest rate risk. • Most financial firms appear to have a preferred range of maturities and durations for the investments they make, with depository institutions tending to focus upon comparatively short and midrange maturities or durations, and many of their competitors, such as insurance companies and pension funds, tending to reach heavily into the longest maturities or durations.

K E Y TERMS money market instruments, 57 capital market instruments, 57 U.S. Treasury bill, 57 Treasury notes, 59 Treasury bonds, 59 federal agency securities, 59 certificate of deposit (CD), 59 bankers' acceptances, 59 commercial paper, 60 municipal bonds, 60

corporate notes, 61 corporate bonds, 61 securitized assets, 61 mortgage-backed bond, 62 stripped security, 62 yield to maturity (YTM), 65 holding period yield (HPY), 65 tax swap, 67 portfolio shifting, 68 interest rate risk, 69

credit risk, 69 business risk, 70 liquidity risk, 71 call risk, 71 prepayment risk, 71 inflation risk, 72 pledging, 72 yield curve, 76 duration, 77 portfolio immunization, 78

Chapter 4 The Investment Function in Financial-Services Management

■ 79

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

PROBLEM S AND PROJECTS 1. A 20-year U.S. Treasury bond with a par value of $1,000 is currently selling for $1,025 from various securities dealers. The bond carries a 6 percent coupon rate with payments made annually. If purchased today and held to maturity, what is its expected yield to maturity?

2. A municipal bond has a $1,000 face (par) value. Its yield to maturity is 5 percent, and the bond promises its holders $60 per year in interest (paid annually) for the next 10 years before it matures. What is the bond's duration? 3. Calculate the yield to maturity of a 20-year U.S. government bond that is selling for $975 in today's market and carries a 5 percent coupon rate with interest paid semi-annually.

4. A corporate bond being seriously considered for purchase by Old Dominion Financial will mature 20 years from today and promises a 7 percent interest payment once a year. Recent inflation in the economy has driven the yield to maturity on this bond to 10 percent, and it carries a face value of $1,000. Calculate this bond's duration.

5. Forever Savings Bank regularly purchases municipal bonds issued by small rural school districts in its region of the state. At the moment, the bank is considering purchasing an $8 million general obligation issue from the York school district, the only bond issue that district plans this year. The bonds, which mature in 15 years, carry a nominal annual rate of return of 6.75 percent. Forever Savings, which is in the top corporate tax bracket of 35 percent, must pay an average interest rate of 4.25 percent to borrow the funds needed to I purchase the municipals. Would you recommend purchasing these bonds? Calculate the net after-tax return on this bank-qualified municipal security. What is the tax advantage for being a qualified bond? 6 . Forever Savings Bank also purchases municipal bonds issued

by the city of Richmond. Currently the bank is considering a nonqualified general obligation municipal issue. The bonds, which mature in 15 years, provide a nominal annual rate of return of 9.75 percent. Forever Savings Bank has the same cost of funds and tax rate as stated in the previous problem.

a. Calculate the net after-tax return on this nonqualified municipal security.

b. What is the difference in the net after-tax return for this qualified security (Problem 5) versus the nonquali­ fied municipal security?

80

c. Discuss the pros and cons of purchasing the nonquali­ fied rather than the bank-qualified municipal described in the previous problem.

7. Lakeway Thrift Savings and Trust is interested in doing some investment portfolio shifting. This institution has had a good year thus far, with strong loan demand; its loan revenue has increased by 16 percent over last year's level. Lakeway is subject to the 35 percent corporate income tax rate. The investments officer has several options in the form of bonds that have been held for some time in its portfolio:

a. Selling $4 million in 12-year City of Dallas bonds with a coupon rate of 7.5 percent and purchasing $4 million in bonds from Bexar County (also with 12-year maturities) with a coupon of 8 percent and issued at par. The Dallas bonds have a current market value of $3,750,000 but are listed at par on the institu­ tion's books. b. Selling $4 million in 12-year U.S. Treasury bonds that carry a coupon rate of 12 percent and are recorded at par, which was the price when the institution pur­ chased them. The market value of these bonds has risen to $4,330,000. Which of these two portfolio shifts would you recommend? Is there a good reason for not selling these Treasury bonds? What other information is needed to make the best deci­ sion? Please explain. 8 . Current market yields on U.S. government securities are

distributed by maturity as follows: 3-month Treasury bills 6- month Treasury bills 1- year Treasury notes 2- year Treasury notes 3- year Treasury notes 5-year Treasury notes 7- year Treasury notes 10-year Treasury bonds 20-year Treasury bonds 30-year Treasury bonds

1.90 2.10 2.25 2.51 2.82 3.28 3.56 3.98 4.69 5.25

percent percent percent percent percent percent percent percent percent percent

Draw a yield curve for these securities. What shape does the curve have? What significance might this yield curve have for an investing institution with 75 percent of its

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

investment portfolio in 7-year to 30-year U.S. Treasury bonds and 25 percent in U.S. government bills and notes with maturities under one year? What would you recom­ mend to management?

9. A bond possesses a duration of 8.89 years. Suppose that market interest rates on comparable bonds were 7.5 per­ cent this morning, but have now shifted downward to 7.25 percent. What percentage change in the bond's value occurred when interest rates decreased by 25 basis points?

10. The investments officer for Sillistine Savings is concerned about interest rate risk lowering the value of the institu­ tion's bonds. A check of the bond portfolio reveals an aver­ age duration of 4.5 years. How could this bond portfolio be altered in order to minimize interest rate risk within the next year? 11. A bank's economics department has just forecast acceler­ ated growth in the economy, with GDP expected to grow at a 4.5 percent annual growth rate for at least the next two years. What are the implications of this economic forecast for an investments officer? What types of securities should the officer think most seriously about adding to the invest­ ment portfolio? Why? Suppose the bank holds a security portfolio similar to that described in Table 4.3 for all insured U.S. banks. Which types of securities might the investments officer want to think seriously about selling if the projected economic expansion takes place? What losses might occur and how could these losses be minimized? 12. Contrary to the exuberant economic forecast described in Problem 11, suppose a bank's economics department is forecasting a significant recession in economic activity. Output and employment are projected to decline signifi­ cantly over the next 18 months. What are the implications of this forecast for an investment portfolio manager? What is the outlook for interest rates and inflation under the fore­ going assumptions? What types of investment securities

ial. They are not actual FRM exam questions.

would you recommend as good additions to the portfolio during the period covered by the recession forecast and why? What other kinds of information would you like to have about the bank's current balance sheet and earnings report in order to help you make the best quality decisions regarding the investment portfolio?

13. Arrington Hills Savings Bank, a $3.5 billion asset institution, holds the investment portfolio outlined in the following table. This savings bank serves a rapidly growing money center into which substantial numbers of businesses are relocating their corporate headquarters. Suburban areas around the city are also growing rapidly as large numbers of business owners and managers along with retired profes sionals are purchasing new homes. Would you recommend any changes in the makeup of this investment portfolio? Please explain why.

Types of Securities Held

Percent of Total Portfolio

U.S. Treasury securities

38.7%

Federal agency securities

35.2

State and local government obligations

Types of Securities Held

Percent of Total Portfolio

Securities available for sale

45.6%

15.5

Securities with maturities: Under one year

11.3

Domestic debt securities

5.1

One to five years

37.9

Foreign debt securities

4.9

Over five years

50.8

Equities

0.6

Chapter 4 The Investment Function in Financial-Services Management

■ 81

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

Internet Exercises 1. As the investments officer for Bank of America, you have been informed by a member of that bank's board of direc­ tors that the investment policies you have followed over the past year have been substandard relative to your com­ petitors, including Citigroup, Wells Fargo, and JP Morgan Chase. You protest and observe that all financial institutions have faced a tough market and, in your opinion, your bank has done exceptionally well. Challenged, your CEO asks you to prepare a brief memo with comparative investment facts, defending your bank's relative investment perfor­ mance against the other BHCs mentioned. Use the FDIC's Statistics on Depository Institutions at www2.fdic.gov/sdi to develop a reply. What conclusion did you reach after exam­ ining your bank's relative investment performance over the last complete calendar year?

2. A number of websites are available to help in evaluating the merits and demerits of different types of securities that banks are allowed to hold in their investment portfo­ lios. See www.sifma.org and www.investinginbonds.com. Find one additional website on your own and compare and contrast the usefulness of these three websites.

3. If you want a summary of regulations applying to bank and thrift security portfolios, you would turn to the regulators' websites. The Federal Reserve's Trading and CapitalMarkets Activity Manual found at www.federalreserve .gov/boarddocs/supmanual/trading.pdf has a section on "Capital Market Activities." Read and briefly outline the first two pages on "Limitations and Restrictions on Securi­ ties Holdings" that is found in section 3000.1— Investment Securities and End-User Activities.

CA SE ASSIGN M EN T FOR CHAPTER 4 YOUR BANK'S INVESTMENT FUNCTION: AN EXAMINATION OF THE SECURITIES PORTFOLIO Chapter 4 explores how the investments officer manages a financial firm's securities portfolio and describes the portfolio's purpose and composition. A significant portion of the chapter outlines and describes the different types of money market and capital market instruments found in the securities portfolio. Part One of this assignment examines the types of securities in your bank's portfolio and asks you to make some inferences about factors that played a role in the selection of securities for that portfolio. The possible factors are discussed midchapter. Part Two of this assignment examines the maturity structure of your bank's securities portfolio. This topic is covered in the later part of the chapter. Chapter 4's assignment is designed to focus on the issues of importance to investments officers in large com­ mercial banks or similar competing institutions.

Part One: The Composition of Your Bank's Securities Portfolio—Trend and Comparative Analysis A. Data Collection: For this part, you will access data at the FDIC's website located at www2.fdic.gov/sdi for your BHC. Use SDI to create a four-column report of your bank's information and the peer group information across years. In this part of the assignment for Report Selection use the pull­ down menu to select Securities and view this in Percent of Assets. For the size of the securities portfolio relative to total

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assets, see Item 1—the components of the securities portfo­ lio are listed as Items 4-7 and 13-14. Enter the percentage information for these items as an addition to the spread­ sheet for comparisons with the peer group as illustrated using BB&T's 2010 and 2009 year-end data.

B. Compare columns of row 77. How has the relative size of your bank's securities portfolio-to-total assets ratio changed across periods? Does your BHC have more or less liquidity than the group of comparable institutions?

C. Use the Chart function in Excel and the data by columns in rows 78 through 83 to create four pie charts illustrating the profile of securities held by your BHC and its peer group. With these pie charts provide titles, labels, and percent­ ages. If you save these as separate sheets, they do not clut­ ter the spreadsheets that you use most frequently, yet they are available to insert in Word documents. To give you an example, the charts for BB&T and its peer group for 2010 would appear as on the following page.

D. Utilizing the above information, write one or two paragraphs about your BHC's securities portfolio and how it compares to its peers. Use your pie charts as graphics and incorporate them in the discussion. Provide inferences concerning the fac­ tors (e.g., expected rate of return, tax exposure, interest rate risk) affecting the choice of investment securities.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

B

;

File

ial. They are not actual FRM exam questions.

Real Numbers for Real Banks Chapter 10 - Microsoft Excel

Home

h--i

Page Layout

Formulas

Data

in Q [ q) - TSCLGC(t0, t^, . . . , cf1_a(to, tb) - TSECCF(t0, tb) - TSCLGC(t0, tb)}

(7.15)

It is easy to check, by inspecting formulae (7.15) and (7.10), that each element of the TSLaR-|_a is the difference between corre­ sponding elements of the TSL-|_a and the TSLe. We have already mentioned that the curves presented in this section have to be computed by simulating the risk factors affecting all the cash flows at a balance sheet level. Although their use is generally restricted to simulation engines to gener­ ate the TSLe and the TSL-|_a, they can be used at a less general level to:

D

cf(t0, tm; n) = ^ c f(t0/ tm; djt n) j= 1

where {d -1; d2, . . . , c/D} are all the contracts andjor securi­ ties generating cash flows at date tm, included in the TSCF and the TSLGC, under scenario n. 3. At each step m E { 1 , . . . , M}, the maximum and mini­ mum cash flows, at a confidence level of a and 1 — a,

• calculate single metrics of interest, such as the TSAA of a single bond or of a portfolio of bonds, the TSLGC of the liquidity buffer (i.e., the fraction of LGC that relates to BSL); • compute specific measure for one or more securities, such as haircuts and adjustments due to a lack of liquidity in their dealing in the market;

Chapter 7 Monitoring Liquidity

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153

• measure single phenomena such as prepayments, usage of credit lines or the evolution of non-maturing liabilities (e.g., sight deposits); • price the liquidity risk embedded in banking and trading book products. When used independently the information derived by the mod­ els is useful for pricing and risk management, with the caveat that we are getting away from the more general picture where correlation effects play a big role. Thus, results obtained in this

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way should never form the basis for aggregation into a compre­ hensive measure of liquidity risk. We present models that allow the bank to simulate the cash flows of the main items on its balance sheet and to build all the metrics we have described. But before doing so, we have to spend more time considering the liquidity buffer and term structure of funding liquidity and the interrelations existing between them when the bank plans an equilibrium liquidity policy.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The Failure Mechanics of Dealer Banks Learning Objectives After completing this reading you should be able to: Compare and contrast the major lines of business in which dealer banks operate and the risk factors they face in each line of business.

Assess policy measures that can alleviate firm-specific and systemic risks related to large dealer banks.

Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks.

Excerpt is Volume 24, Number 1, Winter 2010, pp. 51 to 72 of Journal of Economic Perspectives, by Darrell Duffie.

155

A bank is conventionally viewed as an intermediary between depositors, who desire short-term liquidity, and borrowers, who seek project financing. Occasionally, perhaps from an unex­ pected surge in the cash withdrawals of depositors or from a shock to the ability of borrowers to repay their loans, depositors may become concerned over the bank's solvency. Depositors may then "run," accelerating or worsening the bank's failure. The standard policy tools for treating the social costs of bank failures include regulatory supervision and risk-based capital requirements to reduce the chance of a solvency threatening loss of capital; deposit insurance to reduce the incentives of individual depositors to trigger cash insolvency by racing each other to withdraw their deposits; and regulatory resolution mechanisms, which give authorities the power to efficiently restructure or liquidate a bank. During the recent financial crisis, major dealer banks—that is, banks that intermediate markets for securities and derivatives— suffered from new forms of bank runs. The most vivid examples are the 2008 failures of Bear Stearns and Lehman Brothers. Dealer banks are often parts of large complex financial organi­ zations whose failures can damage the economy significantly. As a result, they are sometimes considered "too big to fail." The mechanics by which dealer banks can fail and the policies available to treat the systemic risk of their failures differ mark­ edly from the case of conventional commercial bank runs. These failure mechanics are the focus of this article. As an illustration, consider a protagonist dealer bank, whom we shall call Alpha Bank, whose capital position has just been severely weakened by trading losses. The cause need not be a general financial crisis, although that would further reduce Alpha's chances for recovery. Alpha seeks new equity capital to shore up the value of its business, but potential providers of new equity question whether their capital infusions would do much more than improve the position of Alpha's creditors. They also feel too uninformed about the value of Alpha's assets and future busi­ ness opportunities to offer a price for new shares that Alpha, given its own information, is willing to accept. In a rational gamble to signal its strength and to protect its longrun brand reputation and customer network, Alpha uses some of its scarce capital to bail out important clients from the significant losses that they have suffered through investments arranged by Alpha. Alpha's managers understand their bank's vulnerability to the flight of its creditors, clients, and counterparties. As the cracks in Alpha's finances become more apparent, those who deal with Alpha nevertheless begin to draw back. In particular, Alpha has been operating a significant prime bro­ kerage business, offering hedge funds and other major investors

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such services as information technology, trade execution, accounting reports, and—more important to our story—holding the hedge funds' cash and securities. These hedge funds have heard the rumors and have been watching the market prices of Alpha's equity and debt in order to gauge Alpha's prospects. They begin to shift their cash and securities to better capital­ ized prime brokers or, safer yet, custodian banks. Because Alpha had relied in part on its clients' cash and securities to finance its own business, these departures reduce Alpha's financial flexibility. Alpha notices that some of its derivatives counterparties (entities with whom Alpha has entered derivative contracts) have begun to lower their exposures to Alpha. Their transac­ tions are more and more slanted toward trades that drain cash toward the counterparties and away from Alpha. In addi­ tion, other dealer banks are increasingly being asked to enter derivatives trades, called "novations," that have the effect of inserting the other dealers between Alpha and its original derivatives counterparties, insulating those counterparties from Alpha's default risk. As those dealers notice this trend, they begin to refuse novations that would expose them to Alpha's default. This damages Alpha's reputation. Further, the cash collateral placed with Alpha by its derivatives counterparties, which had been an extra source of financing to Alpha, is rapidly dwindling. Alpha's short-term secured creditors see no good reason to renew their loans to Alpha. Potentially, they could get caught up in the administrative mess that would accompany Alpha's default. Most of them fail to renew their loans to Alpha. A large fraction of these short-term secured loans are in the form of repurchase agreements, or "repos." The majority of these repos have a term of one day. Thus, on short notice, Alpha needs to find significant new financing or to conduct costly fire sales of its securities. Alpha's liquidity position is now grave. In the normal course of business, Alpha's clearing bank allows Alpha and other dealers the flexibility of "daylight overdrafts" of cash for the intraday financing of trades. The clearing bank routinely holds Alpha's securities in amounts sufficient to cover these overdrafts. Finally, however, Alpha receives word that its clearing bank has exercised its right to stop processing Alpha's cash and securities transactions given the exposure of the clearing bank to Alpha's overall position. Unable to execute trades or to send cash to meet its obligations, Alpha declares bankruptcy. Alpha Bank is a fictional composite, standing for any of a relatively small group of financial institutions that are significant dealers in securities and over-the-counter derivatives. These firms typify relatively large global financial groups that, in

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

addition to their securities and derivatives businesses, may oper­ ate traditional commercial banks or have significant activities in investment banking, asset management, and prime brokerage. Most of these are among the dealer banks listed in Table 8.1 that were invited by the New York Federal Reserve to a meeting concerning over-the-counter derivatives on April 1, 2009. This list overlaps substantially with the list of primary dealers in U.S. government securities.1 As Table 8.1 suggests, large dealer banks typically operate under the corporate umbrellas of holding companies.

Bank of America, N.A. Barclays Capital BNP Paribas Citigroup Credit Suisse Deutsche Bank AG

This article will first review the main lines of business of large dealer banks, including: (1) securities dealing, underwriting, and trading; (2) over-the-counter derivatives; and (3) prime brokerage and asset management. I will include a brief discussion of sources of financing, including off-balance-sheet structures and short-term secured credit through repurchase agreements. I then examine the key failure mechanisms of dealer banks. As in the story of Alpha Bank, these include the flight of prime-brokerage clients, the sudden disappear­ ance of short-term secured creditors, the defensive reactions of derivatives counterparties, and, finally, the loss of cash and securities settlement privileges at a clearing bank.

Dresdner Kleinwort Goldman, Sachs & Co. HSBC Group JPMorgan Chase Morgan Stanley The Royal Bank of Scotland Group Societe Generale UBS AG Wachovia Bank N.A., A Wells Fargo Company

In the concluding section, I consider potential policy implications. Many of the business activities of the companies that operate large dealer banks are outside of the scope of traditional bank-failure resolution mechanisms, as explained by Bliss and Kaufman (2006). Since the financial crisis, however, all large dealer banks now operate as regulated banks or within regulated bank holding companies. During the financial crisis, dealer banks drew support from traditional and new sources of government and central-bank financing. Concerns remain over the systemic risk that some of these financial institutions could pose to the economy in the future. Although access to government support mitigates the systemic risk associated with catastrophic failures, it also creates a perverse incentive. The common knowledge that large financial institutions will receive support when they are sufficiently distressed—in order to limit disruptions to the economy—provides an incentive to large financial institutions to take inefficient risks, and for their creditors to cooperate by financing them at a lower cost than would be available without the implicit backstop of government support. As the financial crisis has made clear, it is important

1 The primary dealers that are not part of financial groups represented are Cantor Fitzgerald (an inter-dealer broker), Daiwa Securities America Inc., and Mizuho Securities USA Inc. The dealers that are not also primary dealers in U.S. government securities are the Royal Bank of Scotland Group, Societe Generale, and Wachovia Bank (now owned by Wells Fargo).

Dealers Invited to an April 1, 2009, Table 8.1 Meeting on Over-the-Counter Derivatives, Hosted by the New York Federal Reserve Bank

Source: New York Federal Reserve Bank.

to consider alternatives to government and central-bank lastresort financial support. Among the additional mechanisms that might be used to address large dealer-bank failure processes are the central clearing of over-the-counter derivatives; dedicated "utilities" for clearing tri-party repurchase agreements under strict standards; and automatic recapitalization mechanisms, such as mandatory rights offerings of equity or forms of debt that convert to equity contingent on distress triggers.

8.1 WHAT LARGE D EA LER BANKS DO I will tend to simplify by treating large dealer banks as members of a distinct class, although in practice they vary in many respects. I focus here on their most significant lines of business. These include intermediation of the markets for securities, securities lending, repurchase agreements, and derivatives; prime brokerage for hedge funds; and asset management for institutional and wealthy individual investors. Dealer banks also conduct proprietary trading—that is, speculation on their own accounts. As a part of their asset-management businesses, some dealer banks operate "internal hedge funds" and private equity partnerships, of which the bank acts effectively as a general partner with limited-partner clients.

Chapter 8

The Failure Mechanics of Dealer Banks

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157

Dealer banks are typically parts of large financial organizations that operate other financial businesses, although these will not be our focus here. For example, many large dealer-banks have conventional commercial banking operations, including deposit taking as well as lending to corporations and consumers. They may also act as investment banks, which can involve managing and underwriting securities issuances and advising corporate clients on mergers and acquisitions. Investment banking some­ times includes "merchant banking" activities, such as buying and selling oil, forests, foodstuffs, metals, or other raw materials.2 One suspects that some of the risk-management failures discov­ ered during the financial crisis are associated with diseconomies of scope in risk management and corporate governance. In other words, some senior executives and boards simply found it too difficult to comprehend or control some of the risk-taking activities inside their own firms.3

Securities Dealing, Underwriting, and Trading Dealer banks intermediate in the primary market between issuers and investors of securities, and in the secondary mar­ ket among investors. In the primary market, the dealer bank, sometimes acting as an underwriter, effectively buys equities or bonds from an issuer and then sells them over time to inves­ tors. In secondary markets, a dealer stands ready to have its bid prices hit by sellers and its ask prices hit by buyers. Dealer banks dominate the intermediation of over-the-counter securi­ ties markets, covering bonds issued by corporations, munici­ palities, certain national governments, and securitized credit products. Over-the-counter trades are privately negotiated. Trade between dealers in some securities, particularly govern­ ment bonds, can also be intermediated by interdealer brokers and electronic trading platforms (which are essentially "bulletin boards" on which bids or offers can be commonly observed by other dealers). Although public equities are easily traded on exchanges, dealers are also active in secondary markets for equities—for example, dealers often intermediate large block trades. Banks with dealer subsidiaries also engage in speculative

2 The relevant research, for example Boot, Milbourn, and Thakor (1999), does not find a strong case for the net benefits of forming large diversi­ fied financial conglomerates of this type. There may exist economies of scope in information technology, marketing, and financial innovation. For potential synergies between commercial and investment banking, see Kanatas and Qi (2003). 3 For a case example of lapses in risk oversight, see UBS (2008) "Share­ holder Report on UBS's Writedowns," especially Chapter 5: "Risk Management and Risk Control Activities."

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investing, often called proprietary trading, which can be aided in part by the ability to observe flows of capital into and out of certain classes of securities. Securities dealers also intermediate in the market for repur­ chase agreements, or "repos." A repo is in essence a short­ term cash loan collateralized by securities. One counterparty borrows cash from the other, and as collateral against per­ formance on the loan, that counterparty posts government bonds, corporate bonds, securities from government-sponsored enterprises, or other securities such as collateralized debt obli­ gations. For example, a hedge fund that specializes in fixedincome securities can finance the purchase of a large quantity of securities with a small amount of capital by placing purchased securities into repurchase agreements with a dealer, using the cash proceeds of the repo to purchase additional securities. The majority of repurchase agreements are for short terms, typi­ cally overnight. These repurchase agreements are commonly renewed with the same dealer or replaced by new repos with other dealers. The performance risk on a repo is typically miti­ gated by a "haircut" that reflects the risk or liquidity of the secu­ rities. For instance, a haircut of 10 percent allows a cash loan of $90 million to be obtained by posting securities with a market value of $100 million. For settlement of their repo and securities trades, dealers typi­ cally maintain "clearing accounts" with other banks. JPMorgan Chase and the Bank of New York Mellon handle most dealer clearing. Access to clearing bank services is crucial to a dealer's daily operations. Transactions cannot otherwise be executed. In order to mitigate counterparty risk, some repurchase agree­ ments are "tri-party." The third party is usually a clearing bank that holds the collateral and is responsible for returning the cash to the creditor. In principle, this facilitates trade and insulates the lender somewhat from the risk of a borrower's default. In 2007, tri-party repos totaled $2.5 trillion (Geithner, 2008). The same two clearing banks, JPMorgan Chase and the Bank of New York Mellon, are also dominant in tri-party repos. In Europe, tri­ party repos are also arranged through specialized repo clearing services: Clearstream and Euroclear.

Over-the-Counter Derivatives Derivatives are contracts that transfer financial risk from one investor to another. For example, a call option gives an investor the right to buy an asset in the future at a prearranged price, shielding the investor from the risk that the cost of acquiring the asset could rise. Derivatives are traded on exchanges and over the counter. Because over-the-counter derivatives are negoti­ ated privately, they can easily be customized to a client's needs. For most over-the-counter derivatives trades, one of the two

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

counterparties is a dealer. The dealer usually lays off much or all of the risk of its client-initiated derivatives positions by running a "matched book," that is, by aiming for offsetting trades, profit­ ing on the differences between bid and offer terms. As in their securities businesses, dealer banks also conduct proprietary trading in over-the-counter derivatives markets. The notional amount of an over-the-counter derivative contract is typically measured as the market value—or, in the case of bond derivatives, the face value—of the asset whose risk is transferred by the derivative. For example, a call option to buy one million shares of an equity whose price is $50 per share represents a notional position of $50 million dollars. The total notional amount of over-the-counter derivatives outstand­ ing is roughly $600 trillion dollars, according to the Bank of International Settlements. In notional terms, exchange-traded derivatives positions total to approximately $400 trillion. The majority of over-the-counter derivatives are interest-rate swaps, which are commitments to make periodic exchanges of one interest rate, such as the variable London Interbank Offered Rate (LIBOR), for another interest rate, such as a fixed rate, on a stated notional principal until a stipulated maturity date. The largest over-the-counter derivatives dealer by volume is JPMorgan, with a total notional position of approximately $80 trillion, according to the U.S. Office of the Comptroller of the Currency (2009).

Normally, various over-the-counter derivatives trades between a given pair of counterparties are legally combined under a "master swap agreement" between those two counterparties, conforming to standards set by the International Swaps and Derivatives Association (ISDA). Among other provisions, master swap agreements spell out collateral requirements as well as the obligations of the two counterparties in the event that one of them cannot perform. As the market values of the derivatives contracts between two counterparties fluctuate, the collateral required is recalculated, normally on a daily basis, and is netted across the various derivatives held between the two counter­ parties. For example, suppose that A has an exposure to B of $100 million on an oil derivative, while B has an exposure to A of $80 million on an interest-rate derivative. If the master-swap agreement specifies full collateralization of the net exposure, then B posts $20 million of collateral with A. Thus, netting under a master swap agreement lowers exposures and lowers collat­ eral requirements. As the financial crisis that began in 2007 deepened, the range of acceptable forms of collateral taken by dealers from their over-the-counter derivatives counterparties was narrowed. By 2008, over 80 percent of collateral for these agreements was in the form of cash, according to a survey conducted by the Inter­ national Swaps and Derivatives Association (2009). The total amount of collateral demanded also nearly doubled in 2008, from about $2 trillion in 2007 to about $4 trillion in 2008.

It is an accounting identity that the total market value of all derivatives contracts must be zero—that is, the total amount of positive (purchased) positions is equal to the total amount of negative (sold) positions. Contingent on events that may occur over time, derivatives transfer wealth from counterparty to counterparty, but do not directly add to or subtract from the total stock of wealth. Indirectly, however, derivatives can cause net losses through the frictional costs of bankruptcies, such as legal fees, and other costs associated with financial distress. Derivatives markets also serve a social purpose of transfer­ ring risk from those less equipped to bear it to others more equipped to bear it.

Table 8.2 shows the total exposures represented by the overthe-counter derivatives portfolios of major dealers, in each of the major asset classes, as estimated from dealer surveys by the Bank for International Settlements (2009a). At least one of the two counterparties of most over-the-counter derivatives is typi­ cally a dealer. Frequently, both parties are dealers. The final row of Table 8.2 shows a substantial reduction in exposure due to netting.

In addition to the risk associated with the contingent payments promised by a derivatives contract, there is also the risk that the counterparty could fail to meet its promised payments. A use­ ful gauge of counterparty risk in the over-the-counter market is the amount of exposure to default presented by the failure of counterparties to perform their contractual obligations. These exposures can be reduced through collateral. For example, suppose a hedge who has posted $60 million in collateral with a dealer defaults, leaving the dealer with a portfolio of derivatives that would have been worth $100 million had the hedge fund not failed. This leaves the dealer with a net loss of $40 million.

Dealers are especially likely to be counterparties to other deal­ ers in the case of credit default swaps, which are in essence insurance against the default of a named borrower. When a hedge fund decides to reduce a credit default swap position, a typical step is to have its original credit default swap position "novated" to another dealer, which then stands between the hedge fund and the original dealer by entering new back-toback credit default swap positions with each. In this fashion, dealer-to-dealer credit default swap positions grew rapidly. Based on data provided by the Depository Trust and Clearing Corporation (DTCC) in April 2009, of the current aggregate notional of about $28 trillion in credit default swaps whose terms are collected by DTCC's DerivServ Trade Information Warehouse, over $23 trillion were in the form of dealer-to-dealer positions. Since mid-2008, when the total notional size of the

Chapter 8

The Failure Mechanics of Dealer Banks

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Table 8.2 Exposures of Dealers in Over-the-Counter Derivatives Markets by Asset Class, as of June 2009 (net exposures do not include non-U.S. credit default swaps) Asset Class Credit default swap Interest rate Equity linked Foreign exchange

Exposure ($ billions) 2,987 15,478 879 2,470

Commodity

689

Unallocated

2,868 25,372

Total Total after netting

3,744

Source: Bank for International Settlements, November, 2009.

credit default swap market stood at over $60 trillion, the total amount of credit default swaps outstanding has been reduced by over one half through "compression trades," by which redun­ dant or nearly redundant positions among dealers are effectively canceled.

Prime Brokerage and Asset Management Several large dealers are extremely active "prime brokers" to hedge funds and other large investors. A prime broker provides clients a range of services, including management of securities holdings, clearing, cash-management services, securities lend­ ing, financing, and reporting (which may include risk measure­ ment, tax accounting, and various other accounting services). A dealer may frequently serve as a major derivatives counter­ party to its prime-brokerage clients. A dealer often generates additional revenues by lending securities that are placed with it by prime-brokerage clients. As of the end of 2007, according to data from Upper, the majority of prime brokerage services were provided by just three firms: Morgan Stanley, Goldman Sachs, and Bear Stearns, whose prime brokerage business was absorbed by JPMorgan when it acquired Bear Stearns in mid-2008 (Hintz, Montgomery, and Curotto, 2009). Dealer banks often have large asset-management divisions that cater to the investment needs of institutional and wealthy individual clients. The services provided include the holding of client securities, cash management, brokerage, and alternative investment vehicles, such as hedge funds and private-equity partnerships that are often managed by the same bank. Such an "internal hedge fund" may offer contractual terms similar to those of external stand-alone hedge funds and in addition can

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wrap the client's limited-partner position within the scope of general asset-management services for that client. A limited partner in an internal hedge fund may perceive that a large dealer bank is more stable than a stand-alone hedge fund and that the dealer bank might even voluntarily support an internal hedge fund at a time of extreme need. For example, near the end of June 2007, Bear Stearns offered to lend $3.2 billion to one of its failing internal hedge funds, the HighGrade Structured Credit Fund (Barr, 2007b). In August 2007, at a time of extreme market stress and losses to some of its inter­ nal hedge funds, Goldman Sachs (2007) injected a significant amount of capital into one of them, the Global Equity Opportu­ nities Fund. In February 2008, Citigroup provided $500 million in funding to an internal hedge fund known as Falcon (CNBC, 2008). Such actions can be viewed as a rational attempt by dealer banks to protect their reputation and to reassure impor­ tant clients that their financial position is secure.

Off-Balance-Sheet Financing Some large dealer banks have made extensive use of "offbalance-sheet" financing. For example, a bank can originate or purchase residential mortgages and other loans that are financed by selling the loans to a financial corporation or trust that it has set up for this express purpose. Such a "special pur­ pose entity" pays its sponsoring bank for the assets with the proceeds of debt that it issues to third-party investors. The principal and interest payments of the debt issued by the spe­ cial purpose entity are paid from the cash flows that it hopes to receive from the assets that it has purchased from the sponsor­ ing bank. Because the debt obligations of a special purpose entity are usually contractually remote from the sponsoring bank, under certain conditions banks have not been required to treat the assets and debt obligations of such entities as their own, at least for purposes of accounting and of regulatory minimum capital requirements. In this sense, a special purpose entity is "off bal­ ance sheet." Some large dealer banks used special purpose entities to operate much larger loan purchase and origination businesses with a given amount of capital than would have been possible had they held the associated assets on their own bal­ ance sheets. For example, at June 2008, Citigroup, Inc. reported over $800 billion in off-balance-sheet assets held in such "quali­ fied special purpose entities." A particular form of special purpose off-balance-sheet entity that was popular until the financial crisis is the "structured investment vehicle," which finances residential mortgages and other loans with short-term debt sold to investors such as money-market funds. In 2007 and 2008, when home prices fell

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

dramatically in the United States and subprime residential mort­ gage defaults rose, the solvency of many structured investment vehicles was threatened—especially as some short-term credi­ tors to these funds recognized the solvency concerns and failed to renew their loans. Some large dealer banks bailed out investors in some of their structured investment vehicles. For example, in late 2007, HSBC voluntarily committed about $35 billion to bring elements of its structured investment vehicles onto its balance sheet (Goldstein, 2007). Citigroup followed in December 2007 by bringing $49 billion in assets and liabilities of structured investment vehicles onto its own balance sheet (Moyer, 2007). As with the support provided to distressed internal hedge funds, the equity owners and managers of these banks may have feared that the alternative of providing no recourse to their effective clients would have resulted in a loss of market value through a reduction in reputation and market share. Some of these banks, had they been able to foresee the extent of their later losses during the financial crisis, might have preferred to allow their off-balance clients to fend for themselves.

8.2 FAILURE M ECHANISM S FOR D EA LER BANKS The relationships between a dealer bank and its derivatives counterparties, prime-brokerage clients, potential debt and equity investors, clearing bank, and other clients can change rapidly if the solvency of the dealer bank is threatened. The concepts at play are similar to those of a depositor run at a com­ mercial bank. That is, fears over the solvency of the bank lead others to act so as to reduce their potential losses in the event of the bank's default. Unlike insured depositors at a commercial bank, many of those with exposures to dealer banks have no default insurance, or do not wish to bear the frictional costs of involvement in the bank's failure procedures even if they do have insurance. The key mechanisms that lead to the failure of a dealer bank are the flight of short-term creditors, the departures of prime-brokerage clients, various cash-draining actions by derivatives counterparties that are designed to lower their expo­ sures to the dealer bank, and finally and most decisively, the loss of clearing-bank privileges. We will describe each of these types of "run-on-the-bank" behavior in turn and then discuss implications for potential improvements in market infrastructure or regulation.

The Flight of Short-Term Creditors Large dealer banks tend to finance their assets in various ways, including by issuing bonds and commercial paper. Increasingly

over recent years, they have financed the purchase of their secu­ rities inventories with short-term repurchase agreements. The counterparties of these repos are often money-market funds, securities borrowers, and other dealers. Repos with a term of one day, called "overnight repo," are common. Under normal pre-crisis conditions, a dealer bank might have been able to finance most of its holdings of agency securities, Treasuries, cor­ porate bonds, mortgages, and collateralized debt obligations by daily renewal of overnight repos with an average haircut of under 2 percent. The dealer could therefore hold these securi­ ties with little incremental capital. Before their failures, Bear Stearns and Lehman had leverage ratios (the ratio of assets to equity capital) of over 30, with sig­ nificant dependence on short-term repo financing. Although the repo creditors providing cash to a dealer bank have recourse to collateralizing assets, with haircuts that protect them to some degree from fluctuations in the market value of the collateral, they may have little or no incentive to renew repos in the face of concerns over the dealer bank's solvency. Additionally, the repo creditors could be legally required to sell the collateral immedi­ ately4 or could potentially face litigation over allegations of improper disposal of the collateral. The repo creditors can avoid these risks and other unforeseen difficulties simply by reinvest­ ing their cash in new repos with other dealers. If a dealer bank's repo creditors fail to renew their positions en masse, the ability of the dealer to finance its assets with suf­ ficient amounts of new private-sector cash on short notice is doubtful. The dealer may therefore be forced to sell its assets in a hurry to buyers that know it needs to sell quickly. This scenario, called a "fire sale," can easily result in much lower prices for the assets than might be expected in a more orderly sale. The proceeds of an asset fire sale could be insufficient to meet the dealer's cash needs, especially if the dealer's original solvency concerns were prompted by declines in the market values of the collateral assets themselves. A fire sale could also lead to fatal inferences by other market participants of the weakened condition of the dealer. Further, the low prices recorded in a fire sale could lower the market valuation of the securities not sold, and thus reduce the amount of cash that could be raised through repurchase agreements collateralized by those securities, prompting a "death spiral" of further fire sales. For the same reason, fire sales by one large bank could set off fire sales by other banks, causing a systemic risk.

4 In the United States, money market funds, typically operating under Rule 2a-7 of the Securities and Exchange Commission, have restrictions on the types of assets they are permitted to hold and would be required to immediately sell many of the forms of collateral that they could receive in the event that a repo counterparty fails to perform.

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A dealer bank's financing problems could be exacerbated dur­ ing a general financial crisis. For example, haircuts of even investment-grade corporate bonds rose from under 5 percent before the financial crisis to around 20 percent in the weeks fol­ lowing the failure of Lehman Brothers, while repo financing of many forms of collateralized debt obligations and speculatively rated corporate bonds became essentially impossible.5 Peter Fisher (2008) of BlackRock, an investment management firm, wrote: "I would also suggest that the prevalence of repo-based financing helps explain the abruptness and persistence with which the de-levering has been translated into illiquidity and sharp asset price declines." Abate (2009) reported that corpo­ rate bond repo transactions (which include certain mortgagebacked securities not backed by government-sponsored enterprises) fell approximately 60 percent between March 2008 and March 2009. During the week leading up to the failure of Bear Stearns, Cohan (2009) reports on the increasing set of Bear Stearns' normal repo counterparties who told Bear Stearns that they would not be renewing their repo financing to Bear or were applying more onerous haircuts and disputing collateral valuations. A dealer bank can mitigate the risk of a loss of liquidity from a run by short-term creditors in various ways: by establishing lines of bank credit; by dedicating a buffer stock of cash and liquid securities for emergency liquidity needs; and by "laddering" the maturities of its liabilities so that only a small fraction of its debt must be refinanced within a short period of time. Major dealer banks have teams of professionals that manage liquidity risk by controlling the distribution of liability maturities and by manag­ ing the availability of pools of cash and of noncash collateral that is acceptable to secured creditors. A common central-bank response to the systemic risk created by the potential for fire sales is broad and flexible lender-of-lastresort financing to large banks (Tucker, 2009). Such financing buys the time needed to liquidate financial claims in an orderly manner. The U.S. Federal Reserve has always provided secured financing to regulated commercial banks through its discount window. Discount-window financing, however, is available only for a restricted range of high-quality collateral and is also believed to

5 Ewerhart and Tapking (2008) and Hordahl and King (2008) review the behavior of repo markets during the financial crisis. Gorton (April, 2009) provides estimates of the haircuts applied to various classes of securities before and during the financial crisis. In July 2007, corporate bonds and structured credit products of many types, both investment grade and noninvestment grade, had haircuts of 2 percent or less. From the second quarter of 2008, many classes of these securities had haircuts in excess of 20 percent, while a number of classes of securities are shown by Gor­ ton's source to have no financing in the repo market.

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stigmatize banks that are so weak as to need to use it. Dealers that are not regulated as banks do not have access to the dis­ count window. During the financial crisis, special credit facilities were established by Federal Reserve banks, allowing even deal­ ers that did not have access to the discount window to arrange the financing of a wide range of assets or to temporarily exchange relatively less liquid securities for Treasuries.6 Almost immediately after the failure of Lehman, the last two large deal­ ers that had not been regulated as banks, Morgan Stanley and Goldman Sachs, became regulated bank holding companies, giving them access to the discount window, among other sources of government support like government debt guarantees. Other central banks have taken similar steps. The European Central Bank (ECB) provides repo financing to Eurozone banks through regular auctions, by which the ECB accepts a wide range of collateral at moderate haircuts. Cassola, Hortacsu, and Kastl (2008) show that from August 2007, when the range of col­ lateral that was acceptable in the over-the-counter repo market narrowed after a rash of sub-prime mortgage defaults, banks in the Eurozone bid significantly more aggressively for financing in these repo auctions. Tucker (2009) describes a range of new secured financing facilities of the Bank of England. The extent to which a dealer bank is financed by traditional insured bank deposits may lessen its need during a solvency crisis to replace cash that is lost from the exits of repo counter­ parties and other less-stable funding sources. Insured deposits are less likely to run than are many other forms of short-term liabilities. However, under Rule 23A of the Federal Reserve Act, U.S.-regulated banks may not use deposits to fund brokerdealer affiliates of the bank.

The Flight of Prime Brokerage Clients Prime brokerage, as described earlier, is an important source of fee revenue to some dealer banks. Under normal conditions, prime brokers can also finance themselves in part with the cash and securities that clients leave in their prime brokerage accounts. Here's how it works. In the United Kingdom, securities and cash in prime brokerage accounts are generally commingled with the prime broker's own assets and are thus available to the prime

6 These facilities include the Single-Tranche OMO Program, the Term Discount Window Program, the Term Auction Facility, transitional credit extensions announced on September 21,2008, the Primary Dealer Credit Facility, the Term Securities Lending Facility, the Commercial Paper Funding Facility, and the Term Asset-Backed Securities Loan Facility.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

broker for its business purposes, including secured borrowing. Cash in London-based prime brokerage accounts is, for practical purposes, equivalent to uninsured deposits. Prime brokers oper­ ating under United States rules may or may not fully segregate their client's cash, depending on the situation, according to Rule 15c3-2 of the Securities and Exchange Act of 1934. This SEC rule governs the treatment of "free credit balances," the cash that a client has a right to demand on short notice. Under Rule 15c3-3, a U.S.-regulated prime broker must aggregate its clients' free credit balances "in safe areas of the broker or dealer's business related to servicing its customers" or otherwise deposit the funds in a reserve bank account to prevent commin­ gling of customer and firm funds.7 The ability to aggregate cash associated with clients' free credit balances into a single pool, although separate from the prime broker's own funds, provides flexibility to a prime broker in managing the cash needs of its clients. For example, the prime broker can use one client's cash balances to meet the immediate cash demands of another. Suppose that a dealer has two prime brokerage clients. It holds cash belonging to Hedge Fund A of $150 million and has given a cash loan to Hedge Fund B for $100 million. The excess cash of $50 million must be held in a reserve account. But if Hedge Fund A moves its prime broker­ age account to another dealer, then the original prime broker must come up with $100 million of cash from new sources. Prime brokers provide financing to their clients, typically hedge funds, secured by assets of those clients. For U.S. prime bro­ kers, the amounts of such margin loans are limited by regulated "advance rates" that are set according to asset classes. For example, the maximum amount of cash that can be advanced for equities is 50 percent of the market value of the equities. Margin loans for a dealer bank can also be financed using the client's own assets as collateral, through "re-hypothecation." Specifically, the prime broker can obtain the cash that it lends a client, as well as additional cash for its own purposes, by using the client's securities as collateral on a secured loan for itself from a third-party lender. For each $100 of margin cash that it lends to a prime-brokerage client, the dealer is permitted by regulation to finance itself by using up to $140 worth of the client's assets as collateral on new secured loans. Re-hypothecation of securities received from prime brokerage clients is, under normal conditions, a significant source of financ­ ing for the prime broker. When a dealer bank's financial position is weakened, hedge funds may move their prime brokerage accounts elsewhere. A 7 The text of the SEC rules is available on-line at various places, such as the "Securities Lawyer's Deskbook," published by the University of Cin­ cinnati College of Law.

failure to run, as Lehman's London-based clients learned, could leave a client unable to claim ownership of assets that had not been segregated in the client's account and had been re-hypothecated to third parties (for discussions, see Farrell, 2008; Mackintosh, 2008a; Singh and Aitken, 2009). In the United States, ironically, a prime broker's cash liquidity problems can be exacerbated by its prime brokerage business whether or not clients run. Under its contract with its prime broker, a hedge fund could continue to demand cash margin loans from the dealer backed by securities that the hedge fund has left in its prime brokerage account. A prime broker whose solvency is known to be questionable may not itself be able to obtain cash by using those same securities as collateral with other lenders. The dealer's potential secured lenders, as explained earlier, could find it preferable to lend elsewhere. Thus, even the absence of a run by prime brokerage clients could temporarily exacerbate a dealer's liquidity crisis. A dealer could therefore even have an incentive to "fire" a prime broker­ age client to avoid providing cash margin financing to the client! If prime brokerage clients do run, however, the cash that they pull from their free credit balances is no longer available to meet the demands of other clients on short notice, so the prime bro­ ker may be forced to use its own cash to meet these demands.8 The exit of prime brokerage clients whose assets had been used by the prime broker as collateral for securities lending can elimi­ nate a valuable source of liquidity to the prime broker. Even cli­ ents that do not move to another prime broker may, in the face of concerns over their broker's solvency, move some of their securities into accounts that restrict the access of the prime bro­ ker to the securities. Sorkin (2009) discusses the extreme stress on Morgan Stanley's cash liquidity that was caused by the departure of prime bro­ kerage clients during the week of the bankruptcy of Lehman Brothers. Singh and Aitken (2009) calculate that between August 2008 and November 2008, the securities that Morgan Stanley had received from its clients that were available for Morgan Stanley to pledge to others declined by 69 percent, from $832 billion to $294 billion. For Merrill Lynch and Goldman Sachs, the corresponding declines in re-pledgeable client collat­ eral over this short period spanning the default of Lehman were 51 and 30 percent, respectively. The flight of prime-brokerage clients in the face of a dealer bank's financial weakness could also raise concerns over the dealer's long-run profitability among potential providers of emergency capital.

8 Shortfalls are covered, up to limits, by the Securities Investor Protection Corporation (SIPC).

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In the days immediately following Lehman's default, credit default swap rates for Morgan Stanley exceeded 1000 basis points, meaning that the cost of insuring $100 million of senior unsecured Morgan Stanley debt against default losses was above $10 million per year. Some analysts believe that hedge funds are likely to diversify their sources of prime brokerage fur­ ther and in the future place more of their assets with custodian banks rather than with traditional prime brokers (Hintz, Mont­ gomery, and Curotto, 2009).

When Derivatives Counterparties Duck for Cover If a dealer bank is perceived to have some risk of a solvency crisis, an over-the-counter derivatives counterparty would look for opportunities to reduce its exposure to that dealer bank. A variety of mechanisms are possible here. A counterparty could reduce its exposure by borrowing from the dealer. Another strategy is to reduce the exposure by entering new trades with the dealer that cause that dealer to pay out cash for a deriva­ tives position. A counterparty could also seek to harvest cash from any derivatives positions that have swung in its favor over time, and thereby reduce exposure to the dealer. All of these actions reduce the dealer's cash position. If the dealer wants to avoid an adverse signal of its weakness, the dealer cannot afford to refuse its counterparties the opportunity to make these trades at terms prevailing elsewhere in the market. As we have explained, a counterparty to the dealer could also reduce its exposure through novation to another dealer (Inter­ national Swaps and Derivatives Association, 2004). For instance, a hedge fund that had purchased protection from a dealer on a named borrower, using a credit default swap contract, could ask a different dealer for a "novation." The new dealer would thereby offer protection to the hedge fund and buy protection itself from the original dealer, thus insulating the hedge fund from the default of the original dealer. When Bear Stearns' solvency was threatened in mid 2008, some of Bear Stearns' counterparties asked other dealers for novations, by which those dealers would effectively absorb the risk of a failure by Bear Stearns (Burroughs, 2008; Kelly, 2008; Cohan, 2009, p. 27). Although dealers routinely grant such novations because they facilitate normal trading strategies, in this case other dealers began to refuse these Bear Stearns novations. This in turn is likely to have spread alarm over Bear Stearns's difficulties, lead­ ing to actions that are likely to have worsened Bear Stearns's cash position (for further discussion, see Yavorsky, 2008a; Leising, 2009). Based on analysis by Singh (2009), the exposures of over-thecounter derivatives counterparties to Citibank, after netting and

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collateral, fell from $126 billion in March 2008 to $81 billion in March 2009, suggesting that counterparties significantly reduced their exposures to a dealer whose solvency was in question. Over the same period, by comparison, over-the-counter derivatives exposures to comparatively healthy JPMorgan Chase grew from $68 billion to $86 billion. As discussed earlier, over-the-counter derivatives agreements often call for posting collateral. Further, they call for increases in collateral from a counterparty whose credit rating is down­ graded below a stipulated level. For example, in its 10K filing with the Securities and Exchange Commission dated January 1, 2009 (p. 82), Morgan Stanley disclosed: "In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business segment, the Company may be required to provide additional collateral to certain counterparties in the event of a credit ratings down­ grade. As of November 30, 2008, the amount of additional col­ lateral that could be called by counterparties under the terms of collateral agreements in the event of a one-notch downgrade of the Company's long-term credit rating was approximately $498.3 million. An additional amount of approximately $1,456.2 million could be called in the event of a two-notch downgrade." Collateral-on-downgrade triggers were the most proximate cause of the need by the insurance company AIG for a massive U.S. government bailout. Master swap agreements include terms for the early termina­ tion of derivatives in a selection of contingencies, including the default of one of the counterparties. The actual procedures to be followed can be complicated, as appears to be case in the Lehman bankruptcy (Lehman Bankruptcy Docket, 2008a; 2008b). The general thrust of the settlement terms in the event of a default is that the nondefaulting counterparty is entitled to the replacement cost of the contracts it holds. For any con­ tingent claim, including a derivative contract, other dealers offer one price to buy and a higher price to sell. This bid-offer spread implies an effective transaction cost that increases the replacement cost of the derivatives portfolio and thus raises the claim against the defaulting dealer. For example, Citibank had an over-the-counter derivatives portfolio with a total notional size of roughly $30 trillion in the summer of 2009 (according to data from the Office of the Comptroller of the Currency). If the effective average bid-offer spread on this portfolio is, for example, 0.2 percent of the notional position amount, then the effective increase in liability to Citibank associated with a default termination of its derivatives portfolio would be on the order of $60 billion. This termination loss on the derivatives portfolio would be above and beyond any loss associated with the fair market value of the portfolio (which is about halfway between the bid value and the offer value).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Further, most over-the-counter derivatives contracts are exempted by law as "qualifying financial contracts" from the automatic stay at bankruptcy that holds up other creditors of a dealer. The effect of unwinding the dealer's derivatives portfolio is a large post-bankruptcy drain on the defaulting dealer, with priority to derivatives counterparties. This raises the incentive of other creditors to run from their exposures before default or to fail to finance a dealer threatened by a cash liquidity crisis, further accelerating the default. One way to reduce the incentive of counterparties to flee from an apparently weak dealer bank is to have the derivatives con­ tracts guaranteed by a "central clearing counterparty," a special-purpose financial institution whose only business is to stand in between the original buyers and sellers of over-thecounter derivatives (Bank for International Settlements, 2007; Bliss and Steigerwald, 2006; Duffie and Zhu, 2009, Hills, Rule, Parkinson, and Young, 1999; Ledrut and Upper, 2007). A central clearing counterparty collects capital from all members and col­ lateral against derivatives exposures to its members in order to cover any losses associated with defaults. Assuming that the central clearing counterparty has sufficient resources, the origi­ nal counterparties to the dealer are insulated from the default of the dealer. As one example, Global Association of Central Coun­ terparties (2009) describes the performance of central clearing counterparties in processing some of Lehman's derivatives posi­ tions when it defaulted.9 Central clearing counterparties can handle only derivatives with relatively standard terms, however, and therefore would not have been in a position to mitigate the counterparty risks associated with the infamous credit derivatives of AIG Financial Products unit, which were highly customized.

wired to the dealer's counterparty (or that counterparty's own clearing bank) before the necessary cash actually appears in the dealer's clearing account on that day, under the premise that the dealer will receive sufficient cash from other counterparties during the day in the course of settling other transactions. Meanwhile, the dealer holds securities in its clearing account with a market value that is likely to be more than sufficient to cover any potential shortfall.10 Abate (2009) estimates that the intraday peak level of overdrafts typically occurs at about 10 a.m. and "easily exceeds several hundred billion dollars." When a dealer's cash liquidity comes into doubt, however, a clearing bank has a "right of offset," a contractual right to dis­ continue making cash payments that would reduce the account holder's cash balance below zero during the day, after account­ ing for the value of any potential exposures that the clearing bank has to the account holder. In the case of Lehman's default, for instance, it has been reported that Lehman's clearing bank, JPMorgan Chase, invoked this right, refusing to process Lehm­ an's instructions to wire cash needed to settle Lehman's trades with its counterparties (Dey and Fortson, 2008; Teather, 2008; Craig and Sidel, 2008). Lehman was unable to meet its obliga­ tions on that day and entered bankruptcy.

8.3 PO LICY RESPO N SES Policies for the prudential supervision, capital requirements, and failure resolution of traditional commercial banks have been developed over many years and are relatively settled. The financial crisis, however, has brought significant new attention to policies for reducing the risks posed by large systemically impor­ tant financial institutions, particularly dealer banks.

The final step in the collapse of a dealer bank's ability to meet its daily obligations is likely to be the refusal of its clearing bank to process transactions. In the normal course of business, a clearing bank would extend "daylight overdraft privileges" to its creditworthy clearing customers. For example, the cash required to settle a securities trade on behalf of a dealer client could be

The regulatory changes currently envisioned for systemically important financial institutions in both the United States and Europe include higher capital requirements, new supervi­ sory councils, and special powers to resolve these financial institutions as they approach insolvency or illiquidity. Banks sponsoring securitization deals will also be required to hold at least a minimum level of exposure to the securitized cash flows, in an attempt to give them the incentive to lower the risk of

9 Yavorsky (2008b) describes how many firms involved with Lehman— hedge funds, buy-side firms, and other dealers—tried in September 2008 to negotiate offsetting replacement trades that would reduce their exposure to Lehman. These trades would only take place if Lehman declared bankruptcy. Unfortunately, "the close-out session resulted in the replacement of only a relatively limited amount of all the outstand­ ing trades." The practical problems involved the large number of partici­ pants, the large number of outstanding positions, and the difficulties of agreeing on prices at a time of significant volatility in the market.

10 In the U.S. interbank market, cash payments are settled by FedWire electronic transfer of federal funds from one bank's account with the Federal Reserve to another's. As far as the interest earned on its federal funds and its reserve requirements, what matters to a clearing bank on a given day is its federal funds balances as of 6:30 p.m. Eastern. The Fed charges banks a fee of 36 basis points for daylight overdrafts of fed­ eral funds. Clearing banks, in turn, may assess a similar fee to dealer's, although the clearing bank's overdraft in federal funds would typically be smaller than the sum of the overdrafts of its client dealers, given positive and negative dealer balances can be netted.

Loss of Cash Settlement Privileges

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these securitization structures. Capital requirements are likely to be higher for derivatives that are not guaranteed by a central clearing counterparty. Information about derivatives positions will be placed into repositories available to regulators. To this point, however, proposed regulations are unlikely to result in the safe resolution of dealer banks that depend on large amounts of overnight repo financing and have large over-thecounter derivatives portfolios. Most repos and over-the-counter derivatives are qualifying financial contracts that are exempt from automatic stays at bankruptcy (Bliss, 2003; Edwards and Morrison, 2005). Runs by short-term secured lenders and over-the-counter derivatives counterparties may continue to contribute to the failure mechanics of large dealer banks and to systemic risk.

backing. Currently, the majority of over-the-counter derivatives positions are not centrally cleared. There has been modest prog­ ress toward clearing significant quantities of over-the-counter derivatives that are based on equities, commodities, and for­ eign exchange. Although a large quantity of interest-rate swaps are cleared, the majority are not. Even the recently established central clearing counterparties for credit default swaps will not easily treat a large quantity of positions in credit default swaps that are not standard enough to be cleared. The challenge of how to clear a greater share of derivatives and how to deal with the fact that many derivatives are not standard has only been partially addressed through legislative proposals that include higher regulatory capital requirements for uncleared derivatives.

Perhaps the most important source of systemic risk is the poten­ tial impact of dealer-bank fire sales on market prices and inves­ tor portfolios. In the recent financial crisis, the risk of fire sales was significantly mitigated by lender-of-last-resort financing by central banks (Tucker, 2009), and by capital injections into dealer banks, such as those of the Bank of England and the U.S. Treasury Department's Troubled Asset Relief Program (TARP). Some of these facilities are likely to be costly to taxpayers and to increase moral hazard in the risk taking of large dealer banks going forward, absent other measures.

A further set of proposals addresses the pre-failure resolution of dealer banks that are suffering grievous financial distress. Dealer banks could be given regulatory incentives or requirements to issue forms of debt that, contingent on stipulated distress trig­ gers, convert to equity (Flannery, 2005; Squam Lake Working Group on Financial Regulation, 2009). Duffie (2009) proposes that distress-contingent convertible debt be complemented with regulations favoring mandatory rights offerings of equity that, similarly, are automatically triggered by leverage or liquid­ ity thresholds. These two new instruments can be designed to recapitalize a financial institution before a destructive run is likely to commence, and to reduce a financial institution's incen­ tives for socially excessive risk taking.

Another set of policy steps considers the problems of short-term tri-party repos, which are a particularly unstable source of financ­ ing in the face of concerns over a dealer's solvency. Because tri­ party clearing banks have an incentive to limit their exposures to a dealer bank, they are likely to limit the access of a weakened dealer bank to repo financing and to clearing account functions. Bernanke (2008; see also 2009) has pointed to the potential benefits of a tri-party repo "utility," which would have less discretion in rolling over a dealer's repo positions, meet high standards, and suffer from fewer conflicting incentives. Another approach, mentioned by Abate (2009) is central-bank insurance of tri-party repo transactions. Yet another approach under dis­ cussion is an "emergency bank," to be financed by repo market participants, that could manage the orderly unwinds of repo positions of weakened dealers. The emergency bank would have access to discount-window financing from the central bank and would insulate systemically critical clearing banks from losses in the course of the unwinding process. The threat posed by the flight of over-the-counter derivatives counterparties can be lowered by central clearing. Sufficiently extensive and unified clearing can reduce the total exposure of market participants to any given dealer through the multilateral netting of positive against negative exposures (Duffie and Zhu, 2009). Obviously, the financial strength of large central clear­ ing counterparties is crucial, as is their implicit government

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The financial crisis has made clear the need to reconsider the systemic risks posed by the failure of dealer banks and has pro­ vided new insights into the mechanics by which they fail. The task of building new institutional mechanisms to address these failure mechanics is timely and urgent.

I am grateful for impetus from Andrei Shleifer and Jeremy Stein, for research assistance from Ross Darwin, Vojislav Sesum, and Zhipeng Zhang, and for helpful conversations with Joseph Abate, Tobias Adrian, James Aitken, John Berry, Robert Bliss, Lucinda Brickler, Jeremy Bulow, John Coates, Bill Dudley, David Fanger, Alessio Farhadi, Peter Fisher, John Goggins, Jacob Goldfield, Jason Granet, Ken Griffin, Robert E. Hall, Brad Hintz, Henry Hu, Anil Kashyap, Matt King, Matthew Leising, Paul Klemperer, Joseph Langsam, Raghu Rajan, Manmohan Singh, Glen Taksler, Rick Thielke, Till Schuermann, Hyun Shin, Jeremy Stein, Paul Tucker, Andrew White, Alex Wolf, Alex Yavorsky, Haoxiang Zhu, and Tatjana Zidulina. I also thank David Autor, Chad Jones, Ann Norman, and especially Timothy Taylor for guidance from the Journal of Economic Perspectives.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

References

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Abate, Joseph. 2009. "Money Markets: Tri-party Repo Concerns." Technical Report, Barclays Capital, Research, US Economics & Rates, Strategy, March 12, 2009.

Burroughs, Bryan. 2008. "Bringing Down Bear Stearns." Vanity Fair, August.

Bank for International Settlements. 2007. "New Developments in Clearing and Settlement Arrangements for OTC Derivatives." Technical Report, Bank of International Settle­ ments, March.

Cassola, Nuno, Ali Hortacsu, and Jakub Kastl. 2008. "Effects of the Subprime Market Crisis on the Primary Market for Liquidity." Unpublished paper. CNBC. 2008. "Citigroup to Bail Out Internal Hedge Fund." Web news report, CNBC.com, February 23.

Bank for International Settlements. 2009a. "OTC Derivatives Market Activity in the First Half of 2009." Technical Report, BIS Monetary and Economic Department, Basel, November.

Cohan, William D. 2009. House o f Cards: A Tale of Hubris and Wretched Excess on Wall Street. New York: Doubleday.

Bank for International Settlements. 2009b. "The Role of Valua­ tion and Leverage in Procyclicality," April.

Craig, Susanne, and Robin Sidel. 2008. "J.P. Morgan Made Dual Cash Demands." Wall Street Journal, October 8.

Barr, Alistair. 2007a. "Bear Stearns' Credit Hedge Funds Almost Wiped Out: Leveraged Fund Worth Nothing; 'Very Little Value' Left in Larger Fund, Letter Says." MarketWatch, July 18.

Dey, lain, and Danny Fortson. 2008. "JP Morgan Brought Down Lehman Brothers." Technical Report. The Sunday Times, October 5.

Barr, Alistair. 2007b. "Bear to Lend $3.2 Bln to One of its Hedge Funds— But Bank Doesn't Lend Money to Other, More Leveraged, Hedge Fund." MarketWatch, June 22.

Diamond, Douglas W., and Philip H. Dybvig. 1983. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy, 91(3): pp. 401-419.

Bernanke, Ben. 2008. "Reducing Systemic Risk." Speech presented at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming, August 22.

Duffie, Darrell. 2009. "Contractual Methods for Out-of-Court Restructuring of Systemically Important Financial Institutions." Submission Requested by the U.S. Treasury Working Group on Bank Capital, Graduate School of Business, Stanford University, November, 2009. http://www.stanford.edu/~duffie/RestructuringDuffie.pdf. Forthcoming in Ending Government Bailouts as We Know Them, ed. Kenneth Scott, George Shultz, and John Taylor. Hoover Press.

Bernanke, Ben. 2009. "Financial Reform to Address Systemic Risk." Technical Report, Speech at the Council on Foreign Relations, March 10. Bliss, Robert. 2003. "Resolving Large Complex Financial Organizations." In Research in Financial Services: Private and Public Policy, Vol. 15: Market Discipline in Banking: Theory and Evidence, ed. George G. Kaufman, pp. 3-31. Amsterdam: Elsevier Press.

Duffie, Darrell, and Haoxiang Zhu. 2009. "Does a Central Clear­ ing Counterparty Reduce Counterparty Risk?" http://www .stanford.edu/~duffie/DuffieZhu.pdf.

Bliss, Robert, and George G. Kaufman. 2006. "U.S. Corporate and Bank Insolvency Regimes: An Economic Comparison and Evaluation." Working Paper WP-06-01, Federal Reserve Bank of Chicago. Bliss, Robert, and Robert Steigerwald. 2006. "Derivatives Clearing and Settlement: A Comparison of Central Counter­ parties and Alternative Structures." Federal Reserve Bank of Chicago Economic Perspectives, 30 (4, Fourth Quarter): pp. 22-29. Boot, Arnoud, Todd Milbourn, and Anjun Thakor. 1999. "Mega­ mergers and Expanded Scope: Theories of Bank Size and Activ­ ity Diversity." Journal of Banking and Finance, 23(2-4): pp. 195-214.

Edwards, Franklin, and Edward R. Morrison. 2005. "Derivatives and the Bankruptcy Code: Why the Special Treatment?" Yale Journal on Regulation, 22(1): pp. 91-122. Ewerhart, Christian, and Jens Tapking. 2008. "Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis." ECB Working Paper 909, European Central Bank. Farrell, Sean. 2008. "Hedge Funds with Billions Tied up at Lehman Face Months of Uncertainty." The Independent, October 6. Financial Services Authority. 2009. "Strengthening Liquidity Standards." Policy Statement, October, 2009. http://www.fsa .gov.uk/pubs/policy/ps09_16.pdf.

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Fisher, Peter. 2008. Comments on "The Role of Liquidity in Financial Crises," by Franklin Allen and Elena Carletti, Jackson Hole Conference, August.

Ledrut, Elisabeth, and Christian Upper. 2007. "Changing Post­ trading Arrangements for OTC Derivatives." BIS Quarterly Review, December, pp. 83-95.

Flannery, Mark J. 2005. "No Pain, No Gain? Effecting Market Discipline via Reverse Convertible Debentures." Chapter 6 in Capital Adequacy beyond Basel: Banking, Securities, and Insur­ ance, ed. Hal S. Scott. Oxford: Oxford University Press.

Lehman Bankruptcy Docket. 2008a. "Notice of Debtors' Motion for an Order Pursuant to Sections 105 and 365 of the Bank­ ruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivative Contracts Fed Seeks End to Wall Street Lock on OTC Derivatives." Techni­ cal Report, Docket Number 1498, November 13.

Geithner, Timothy. 2008. "Remarks at the Economic Club of New York," New York City, June 9. Global Association of Central Counterparties. 2009. "Central Counterparty Default Management and the Collapse of Lehman Brothers." Technical Report, CCP12, The Global Association of Central Counterparties. Goldman Sachs. 2007. "Goldman Sachs and Various Investors Including C.V. Starr & Co., Inc., Perry Capital LLC and Eli Broad Invest $3 Billion in Global Equity Opportunities Fund." Technical Report, Goldman Sachs Press Release, August 13. Goldstein, Steve. 2007. "HSBC to Provide $35 billion in Funding to SIVs—Citigroup Reportedly under Pressure to Move Securi­ ties onto Its Balance Sheet." MarketWatch, November 27. Gorton, Gary. 2009. "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007+." April, 2009. (May 9 version: http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf.) Forthcoming in Slapped by the Invisible Hand, by Gary Gorton. Oxford University Press. Hills, Bob, David Rule, Sarah Parkinson, and Chris Young. 1999. "Central Counterparty Clearing Houses and Financial Stability." Bank of England Financial Stability Review, June, pp. 122-134. Hintz, Brad, Luke Montgomery, and Vincent Curotto. 2009. "U.S. Securities Industry: Prime Brokerage, A Rapidly Evolving Industry." Technical Report, Bernstein Research, March 13. Hordahl, Peter, and Michael R. King. 2008. "Developments in Repo Markets During the Financial Turmoil." BIS Quarterly Review, December, pp. 37-52. International Swaps and Derivatives Association. 2004. "User's Guide to the 2004 ISDA Novation Definitions." Technical Report, ISDA Technical Document, New York. International Swaps and Derivatives Association. 2009. "ISDA Margin Survey 2009." Technical Report, ISDA Technical Docu­ ment, New York. Kanatas, George, and Jianping Qi. 2003. "Integration of Lend­ ing and Underwriting: Implications of Scope Economies." Jour­ nal of Finance, 58(3): pp. 1167-1191. Kelly, Kate. 2008. "Fear, Rumors Touched Off Fatal Run on Bear Stearns." Technical Report, WSJ.com, May 28.

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Lehman Bankruptcy Docket. 2008b. "Order Pursuant to Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivative Contracts." Docket Number 2257, December 16. Leising, Matthew. 2009. "Fed Seeks End to Wall Street Lock on OTC Derivatives." Bloomberg.com, May 6. Mackintosh, James. 2008a. "Lehman Collapse Puts Prime Broker Model in Question." Financial Times, September 24. Mackintosh, James. 2008b. "Flight from Morgan Stanley Broker­ age." Financial Times, September 25. Moyer, Liz. 2007. "Citigroup Goes It Alone To Rescue SIVs." Forbes.com, December 13. Securities and Exchange Commission. 2004. "Rule 15c3-3: Reserve Requirements for Margin Related to Security Futures Products." Technical Report, 17 CFR Parts 200 and 240 [Release No. 34-50295; File No. S7-34-02] RIN 3235-AI61. August 31. Singh, Manmohan. 2009. "Counterparty Risk Post-Lehman Rela­ tive to pre Bear Sterns." May. Singh, Manmohan, and James Aitken. 2009. "Deleveraging after Lehman— Evidence from Reduced Rehypothecation." IMF Work­ ing Paper 09/42, International Monetary Fund. Sorkin, Andrew Ross. 2009. Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. Viking. Squam Lake Working Group on Financial Regulation. 2009. "An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities." Working Paper, Council on For­ eign Relations, April. Teather, David. 2008. "Banking Crisis: Lehman Brothers: JP Mor­ gan Accused over Bank's Downfall." The Guardian (London), October 6. Tucker, Paul. 2009. "The Repertoire of Official Sector Interven­ tions in the Financial System: Last Resort Lending, MarketMaking, and Capital." Technical Report, Speech Delivered to the "Bank of Japan 2009 International Conference on Financial

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

System and Monetary Policy: Implementation," Bank of Japan, Tokyo, May 27-28. UBS. 2008. "Shareholder Report on UBS's Writedowns." Techni­ cal Report, UBS, April 18, Zurich. U.S. Office of the Comptroller of the Currency. 2009. "OCC's Quarterly Report on Bank Trading and Derivatives Activities: Second Quarter 2009." Technical Report, US Department of the Treasury, Washington, DC. U.S. Treasury Department. 2009. "Resolution Authority for Systemically Significant Financial Companies Act of 2009." Techni­ cal Report, U.S. Treasury Department.

University of Cincinnati College of Law. 2009. "Securities Law­ yer's Deskbook." http://taft.law.uc.edu/CCL/ (accessed Decem­ ber 8, 2009). Yavorsky, Alexander. 2008a. "Credit Default Swaps: Market, Systemic, and Individual Firm Risks." Moody's Finance and Securities, Investor Report, Special Comment, Moody's Investor Services, March. Yavorsky, Alexander. 2008b. "Credit Default Swaps: Market, Sys­ temic, and Individual Firm Risks in Practice." Moody's Finance and Securities, Investor Report, Special Comment, Moody's Investor Services, October.

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Liquidity Stress Testing S te p h e n Baird

Learning Objectives After completing this reading you should be able to: Differentiate between various types of liquidity, including funding, operational, strategic, contingent, and restricted liquidity.

Discuss liquidity stress test design issues such as scope, scenario development, assumptions, outputs, governance, and integration with other risk models.

Estimate contingent liquidity via the liquid asset buffer.

Excerpt is Chapter 3 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.

The global liquidity crisis, which lasted from approximately August 2007 to the end of 2008, ushered in the broader finan­ cial crisis and highlighted the importance of prudent manage­ ment of liquidity risk. Prior to the crisis, liquidity was readily available at low cost, and many banks, though apparently well capitalized, did not have an adequate framework for ensuring ample liquidity to see them through a prolonged dislocation in the financial markets. Believing that the funding of contingent obligations and the inability to roll over existing contractual obligations were highly unlikely, these institutions did not conduct stress tests that adequately reflected the severity and duration of the liquidity crisis that actually occurred during this period. The liquidity stress test provides the critical underpinning to a bank's liquidity risk management framework by determining

the amount of liquidity that must be held in order to ensure the institution can meet financial obligations under stressed condi­ tions. A robust liquidity stress test is based on a projection of cash flows arising from assets, liabilities, and other off-balance sheet items under a variety of systemic and idiosyncratic sce­ narios that can occur over varying time horizons. The results of the liquidity stress test provide the foundation for setting the bank's liquidity risk appetite, establishing appropriate limits and targets, and developing an effective contingency funding plan. In this chapter we will define what is meant by "contingent liquidity" within the context of liquidity risk management and the liquidity stress test in particular. We will review the key components of a liquidity stress test, including (a) the appropri­ ate scope and structure of the liquidity stress test across the

IMAGE IS EVERYTHING: THE COLLAPSE OF WASHINGTON MUTUAL Ignited by a sudden $17 billion run on bank deposits lasting approximately nine days, WaMu, the thrift divi­ sion of Washington Mutual, Inc., was seized by the Office of Thrift Supervision on September 25, 2008—to date, the largest such seizure in U.S. history. Once considered the banking industry's version of Walmart, WaMu filed for bankruptcy protection under Chapter 11 one day after the Office of Thrift Supervision placed its thrift operations into FDIC receivership, thus becoming the second largest such bankruptcy filing in U.S. history—surpassed only by that of Lehman Brothers a week earlier. In a deal brokered chiefly by the FDIC, JP Morgan Chase & Co. purchased WaMu, preventing a potentially devastating insurance payout to WaMu's depositors.

reserves to $50 billion, and shuttered underperforming busi­ ness units. In short, although the bank held a significant sub-prime exposure, it was well positioned to fund opera­ tions through a competitive buyout process and possibly achieve long-term recovery albeit with a smaller scale thrift division. Nonetheless, the crushing blow to WaMu's reputa­ tion resulting from dismal outlook reports left the bank with a widespread public perception of illiquidity and scant options outside of bankruptcy.

The root of the deluge of retail deposits flowing out of WaMu's branches can be traced to market perceptions of the bank's solvency. Two of WaMu's major sources of unsecured funding—commercial paper and federal funds purchased— dried up almost completely. This was interpreted by the rest of the bank's lenders to mean the bank was no longer a viable counterparty and led to the bank's collapse. Yet, rep­ resentatives of WaMu were quick to note that its operations did not depend on the availability of short-term financing. In fact, this position was likely correct. At the time of its demise, WaMu still had one of the country's largest retail branch networks, and only a few months before had received an investment from a private-equity firm, increased its liquidity

Fitzpatrick. The Wall Street Journal; published September 26, 2008

172

References: "WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History" Robin Sidel, David Enrich, Dan

"Saying Yes, WaMu Built Empire on Shaky Loans" Peter S. Goodman and Gretchen Morgenson. The New York Times; published December 28, 2008 "WaMu Slumps as Gimme Credit Cites Liquidity Concern" Ari Levy. Bloomberg Financial News; published July 24, 2008 "WaMu: We have $50 billion in liquidity" Aaron Smith. CNN Money.com; published July 25, 2008.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

enterprise, (b) scenario development, and (c) the development of key assumptions. We will also discuss the broader governance context of the liquidity stress test, including the governance around the liquidity stress testing process, how outputs sup­ port the liquidity risk management regime of the organization, and the controls required within and around the process. Intra­ day liquidity considerations, however, are separately discussed in Chapter 6. While the industry has made significant strides in enhanc­ ing liquidity stress testing capabilities since the dark days of 2007-08, banks and their regulators will be working hard to meet a number of challenges over the next several years in order to realize the goal of establishing a fully robust liquid­ ity stress testing program. In this chapter we will focus on two of these emerging trends. First, the industry should improve the level of integration and consistency between the liquid­ ity stress test, the capital stress test, and, more broadly, risk measurement and monitoring, performance measure­ ment, and regulatory reporting. Second, banks should invest in achieving a sustainable technology infrastructure that ensures liquidity stress testing is performed in an efficient and controlled manner. As was seen during the financial crisis, the perception of a liquidity problem that may arise through an insufficient liquidity risk management framework can be just as problematic for a financial institution as an actual inability to meet financial obliga­ tions. The fall of Washington Mutual Bank (WaMu) provides an instructive example.

9.1 M EASURING CO N TIN GEN T LIQUIDITY REQUIREM EN TS The objective of the liquidity stress test is to measure the amount of liquidity the institution must maintain in order to ensure continuing ability to meet financial obligations under stressed conditions. In order to construct an effective liquidity stress testing framework, it is important to clearly define what is meant by "liquidity" for liquidity stress testing purposes. Within this context, liquidity refers to funding liquidity risk— the risk that the institution will not have adequate capacity to fund its obligations without incurring unacceptable economic losses. Assessing asset liquidity—the risk of incurring losses due to difficulty converting assets into cash—while not the

objective of the liquidity stress test, must also be carefully con­ sidered in the liquidity stress test since it can also impact the amount of funding that can be made available from the sale of assets. As a source of funding liquidity, businesses, including finan­ cial institutions, utilize liquidity for four purposes: operational, restricted, contingent, and strategic. Operational liquidity represents the cash that is needed to fund the business on a daily basis, and it is required to ensure orderly clearing of payment transactions. Depending on the nature of the institution's business, operating cash needs might be quite volatile and, as a result, a cushion is added to account for the unpredictability of daily settlements and the excessive system and management effort that would be required to manage cash to its theoretical minimum. Operational liquidity must be maintained to ensure the institution's operations and is therefore unavailable to meet financial obligations under a liquidity stress test. Restricted liquidity represents liquid assets that are available to be used only for specifically defined purposes. For example, a bank may be required to collateralize certain wholesale borrow­ ings. Restricted liquidity is unavailable to meet general financial obligations under a liquidity stress test, but should be applied to any assumed outflows which they support. Contingent liquidity represents the liquidity that is available to meet general financial obligations under a stress scenario. This liquidity is available in the form of the institution's liquid asset buffer, which comprises access to financial assets that are of very high quality and can be easily converted into cash without any real loss of market value. Measuring required contingent liquid­ ity to cover stressed cash outflows is the principal objective of the liquidity stress test. Strategic liquidity represents the cash that is held by the institution to meet future business needs that may arise outside the course of normal operations, but it is not pri­ marily aimed at supporting the bank during times of stress. For example, strategic liquidity may be held to fund future acquisitions or capital expenditure programs. Strategic liquidity may be redirected to meet contingent liquidity requirement needs. As a pragmatic matter, this will likely be feasible only if such liquidity is present via holdings of highly liquid assets. This liquidity taxonomy is illustrated in Figure 9.1.

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Available funding under stress test

Contingent

s Liquid asset buffer composed of a mixture of liquid investments, liquidity facility availability, and unrestricted deposits s Available to meet general financial obligations under a stress test

s

✓

Operational

Not available for drawdown under stress test

Restricted

Reserved for specifically defined purposes arising from normal operations, e.g. collateralization requirements Attributed to underlying outflows under stress, but not used for general financial obligations Strategic

s Cash used to fund typical business operations and clear payment transactions on a daily basis

s Reserved for strategic business initiatives outside of normal operations, e.g. M&A, capital improvement projects

s Levels of cash reserves vary widely by business and operating environment

s Not intended to fund daily operations under a stress scenario, but high quality asset portion contributes to contingent funding

Short-Term Funding (Operational Requirements)

Figure 9.1

Liquidity taxonomy.

9.2 O VERVIEW O F THE M ODEL If the objective of the liquidity stress test is to measure the amount of required contingent liquidity, then the institution must construct a cash flow model that accurately and precisely measures the following components: Liquid a sse t buffer. The liquid asset buffer represents the contingent liquidity that is currently in place. The liquidity stress test framework must clearly define the market and operational characteristics that securities must meet in order to qualify for inclusion in the liquid asset buffer. In general, requirements should ensure that the liquidity-generating capacity of securities included in the liquid asset buffer remains intact even in periods of severe idiosyncratic and market stress. The fundamental characteristics of liquid asset buffer securities should include low credit and market risk, ease and certainty of valuation, trading in an active and siz­ able market, and low concentration of buyers and sellers. The liquid asset buffer should also meet operational requirements that ensure the liquidity is under the control of the central treasury area of the entity undergoing the stress test. S tre s s e d o u tflo w s. Stressed outflows are those assumed to occur under stress scenarios. Stressed outflows may

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Long-Term Funding (Strategic Planning)

result from the need to prematurely settle non-contractual maturity obligations as well as the inability to refund con­ tractual maturity obligations that under normal circum­ stances could be rolled over. The institution's framework should clearly define the types of outflows to be modeled, which typically fall into the categories of retail deposit outflows, unsecured wholesale funding outflows, secured funding runoff, derivative transaction funding, loss of fund­ ing on asset-backed issuances, and drawdown of credit and liquidity facilities. Stressed inflows are assumed to partially offset the stressed outflows. Inflows may include secured funding transaction maturities, loan repayments from cus­ tomers, and drawdowns on liquidity facilities available to the institution. Depending on the assumptions used in a particu­ lar stress scenario, the level of inflows may be reduced or limited by market conditions. S tre sse d inflow s.

S tre sse d liquid a sse t buffer. The liquid asset buffer, net of stress outflows and stress inflows, indicates the adequacy of the current liquid asset buffer given the stress scenario assumptions.

The components of the liquidity stress test model are depicted in Figure 9.2.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

$60

Normal Liquid A sse t Buffer Contingent liquidity that is currently in place. Should com prise a well diversified portfolio of actively traded a sse ts with an implicit e ase and certainty of valuation. A sse t quality standards should ensure sufficient liquidity generation capacity (investm ent income / proceeds from sale) during periods of high system atic and idiosyncratic stre ss.

Fiqure 9.2

(L e s s ): S tre sse d C a s h Outflow Mixture of contractual and contingent ca sh outflows which are assum ed to occur under stre ss scen ario s. Exam p le s include unplanned (prem ature) non­ contractual obligation settlem ent and inability to roll-over so u rces of funding, resulting in a short to long-term liquidity gap. A well defined stre ss testing fram ework should clearly establish the categories of outflows to be modeled.

P lu s: S tre ssed C a sh Inflows C a sh inflows which are assum ed to partially offset stressed outflows. E xa m p le s include secured funding transaction maturities, loan repaym ents from custom ers and draw downs on liquidity facilities available to the institution. Depending on the assum ptions used in a particular stre ss scenario, the level of inflows m ay be limited by market conditions or a regulatory cap (e.g . not to exceed 7 5 % of outflows under B a se l III L C R .)

Y ie ld s: S tre sse d Liquid A sse t Buffer Total contingent liquidity having been reduced by net ca sh outflows. T h e stressed liquid a sse t buffer is indicative of the ad equacy of the normal liquid a sse t buffer given the stre ss scenario assum ptions. Insufficient liquidity under stre ss m ay point towards contractual maturity m ism atch, insufficient a sse t quality, or an overconcentration of certain so u rce s of funding.

Components of the liquidity stress testing model.

9.3 DESIGN O F THE M ODEL The liquidity stress testing model forms an integral component of an end-to-end process that begins with risk identification and event analysis in order to ensure that the roster of scenarios appropriately captures material liquidity risks (Figure 9.3).

Organizational Scope The consolidated stress test should be the lynchpin of any liquidity risk framework. However, an institution may determine there is a need to conduct stress testing on subsidiary entities within the organization. The organizational levels at which a bank may stress liquidity include the parent, subsidiary legal entities, lines of business, service business units, and shared ser­ vice centers. Each of these cases may be addressed through a separate liquidity stress test, where necessary. For less material entities or those entities where risk is assessed to be manage­ able, less complex entity-level liquidity risk reporting might be sufficient. As a general rule, the institution should consider the organizational level at which (a) liquidity is commingled, and (b) liquidity oversight has management accountability.

Combinations of legal entities and operating units having both of these characteristics will provide the building blocks of the enterprise-level liquidity stress test: Liq u id ity tra n sfe r re strictio n s. Liquidity may be trapped in certain legal entities, potentially creating a distorted view of the consolidated liquidity position of the institution. For example, foreign exchange controls may inhibit the conver­ sion of foreign currency in off-shore legal entities. The bank should assess the impact of such restrictions on enterpriselevel liquidity, considering not only a normal operating environment but stressed conditions as well. Bank holding companies, for example, should assume little or no access to banking subsidiary cash during a crisis due to capital ade­ quacy requirements.

The existence of liquidity transfer restrictions does not nec­ essarily give rise to the need for an additional stress test where it can be demonstrated that a subsidiary would not be required to upstream cash to the parent. For example, an institution may stress the consolidated entity and the holding company but choose not to test individual banking subsidiar­ ies under the assumption that movement of cash from the parent to the subsidiary would be unrestricted.

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C u rre n cy .

While the liquidity stress test should be performed in the currency of the entity being tested (the home country for the consolidated test), careful consideration should be taken for the liquidity impact of currency conversion require­ ments. For example, less established offshore subsidiaries or branches sometimes carry a significant currency mismatch, and the settlement time frame for the home country parent to swap fund an unanticipated outflow may prove problem­ atic in a crisis.

a recovery or resolution process taking place is unrealistic. One circumstance in which the bank may choose to forecast beyond twelve months is the case where a survival horizon is calculated under the stress test. For banks with ample liquid­ ity, the survival horizon may extend well beyond this period; some banks have a survival horizon that may extend as far out as two years, although the extent of the modeled stress will abate beyond the extreme level of severity assumed in the very short term.

R e g u la to ry ju risd ictio n . For institutions operating in mul­ tiple foreign jurisdictions under various regulatory oversight regimes, the need to conduct individual stress tests for foreign subsidiaries or groups may arise. For example, U.S. regulations require certain foreign banking organizations to conduct liquidity stress tests for intermediate holding compa­ nies and branches in order to address concerns that foreign banks operating in the country would otherwise be overreliant on offshore funding.

The frequency of cash flow measurement within the overall time horizon must also be determined. The decision to estimate daily, weekly, or monthly cash flows should balance the benefits of improved precision against the reduced forecasting accu­ racy beyond a certain time frame. Stress models that forecast daily over a short time frame (e.g., one month) and transition to weekly or monthly cash flows for the remaining time horizon are likely to provide the best balance. The need to forecast daily during the initial stage of the stress test is recommended not only as a result of the relatively higher predictability of these cash flows, but also because, as was seen during the financial crisis, the most critical period of stress for the institution may in fact occur during those first few days.

Planning Horizon The objective of the liquidity stress test is to ensure that the institution can maintain adequate contingency fund­ ing through a period of prolonged stress. To meet this goal, the planning horizon of the liquidity stress test should be at least twelve months. The bank may choose to project cash flows beyond twelve months; however, longer-term projec­ tions may be subject to significant forecast error depend­ ing on the time horizon of the baseline balance sheet and income statement budgeting performed as part of the strategic planning process. Moreover, the likelihood of the bank continuing operations indefinitely under stress without

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9.4 TESTING TECH N IQ U ES There are three general approaches to performing a liquidity stress test— historical statistical techniques, deterministic models, and Monte Carlo simulation: such as cash flow at risk (CFaR), model a historical pro forma cash flow based on the observed cash flow volatility of the institution. H istorical statistical te ch n iq u e s,

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

D e te rm in istic m o d e ls, such as the development of hypothet­ ical liquidity stress scenarios, model the liquidity impact of a forward-looking or historical-based scenario that has been developed by the institution.

is a statistical technique that relies on simulation modeling and can be used to assess liquidity risk by stress testing specified variables over a future time frame. M o n te C a rlo sim ulation

Stochastic techniques that rely on observations of historical vola­ tility of cash flow variables, whether using historical statistical models such as CFaR or Monte Carlo simulation techniques that rely on historical observations of volatility, are viewed less favor­ ably in the wake of the financial crisis. By its nature, liquidity stress is an extreme "tail event," and deterministic scenarios, despite their reliance on many assumptions that are derived through expert judgment, are viewed by regulators and most financial institutions as the most effective tool for assessing liquidity risk. An additional challenge of stochastic approaches is their limited ability to accurately predict the management countermeasures that would occur during a liquidity crisis event. The remainder of this chapter will focus on the development of a deterministic liquidity stress test framework.

9.5 BASELIN E SCEN ARIO The starting point for building the liquidity stress test is the baseline balance sheet funding and liquidity plan. As a banking organization builds out its liquidity stress test framework, it is sometimes necessary to enhance the structure of the baseline plan as well to ensure that the base case is consistently struc­ tured and at the same level of detail as the stress scenarios. It is also advisable to house the baseline analysis in the same reporting and analysis platform as the liquidity stress test. The objective is to ensure that the institution can gauge the sever­ ity of each stress scenario by making a valid comparison to the baseline forecast.

9.6 SCEN ARIO D EV ELO PM EN T By its very nature, liquidity failure is a high-impact, lowfrequency event. Fortunately, only a handful of large financial institutions have collapsed due to insufficient liquidity. Unfor­ tunately for this very reason, there is little data upon which to build reliable, predictive models that can accurately estimate the minimum level of liquidity an institution can expect to maintain within a confidence interval. Even in the recent finan­ cial crisis, a combination of government intervention, monetary

stimulus, and customer delevering led to a liquidity buildup that quickly stuffed the cash coffers of all but the shakiest banks. As a result of these limitations and the highly complex, intercon­ nected nature of liquidity behavior, the industry approach to performing a liquidity stress test is to develop a set of discrete, deterministic scenarios. While the menu of liquidity stress test scenarios has become somewhat standardized across the bank­ ing industry since the financial crisis, it is important that each financial institution carefully consider its unique or idiosyncratic material risks when building out its scenario framework. There are two general types of liquidity stress scenarios—historical scenarios and forward-looking (hypothetical) scenarios.

Historical Scenarios Historical scenarios are based on actual liquidity failures and attempt to translate those events to the financial institution performing the stress test. The failures of WaMu and Northern Rock in 2008 are common reference events. The advantage of historical scenarios is that they are empirically based. The disad­ vantage of this approach is that few such failures have actually occurred; and for the ones that have taken place, very limited data are available. Additionally, future business conditions may cause new and unanticipated liquidity events, creating a poten­ tial blind spot for management.

Hypothetical Scenarios Hypothetical scenarios are based on a forward-looking view in which the financial institution experiences severe liquidity stress. Banks typically develop multiple scenarios. Liquidity stress sce­ narios should exhibit the following characteristics: Some liquidity stress impacts are the result of systemic stress, such as a reduction in the market liquidity of securities, while other impacts are the result of bank-only stress, such as a deposit run. See Figure 9.3 for a detailed description of these impacts. Banks should develop at least one scenario for each of the cases of systemic, idiosyncratic, and combined idiosyncratic and systemic in order to capture these varying impacts. D istin g u ish b e tw e e n sy ste m ic and id io sy n cra tic risk.

D istin g u ish b e tw e e n le v e ls of se v e rity . Assuming graduat­ ing levels of severity, for example, by developing adverse and severely adverse variations of the idiosyncratic scenario, enables the institution to broaden its view of liquidity risk and applicable limits.

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The bank must establish a spe­ cific, detailed description of the business and market events associated with each scenario in order to provide the foun­ dation for assumption development as well as linking stress testing to early warning indicators in contingency funding plans. In developing and documenting each stress scenario, the bank should ensure the level of detail is sufficient to pro­ vide a comprehensive view into the specific conditions the institution is experiencing. Scenario descriptions typically include, at a minimum: C le a rly d e fin e th e sce n a rio s.

• The general level of stress (e.g., high) of market, eco­ nomic, and credit conditions • Conditions of wholesale secured and unsecured funding markets • Changes in counterparty haircut requirements by collateral type • Liquidity impacts on securities in the liquidity buffer and other assets in the event of sale • Details of credit grade downgrades • Deposit runoff assumptions by product and customer type, and with consideration to other factors such as insur­ ance coverage • Description of impacts on specific counterparty relationships • Rating trigger impacts on derivative margin and collateral calls • Impact of regulatory actions or limit breaches in foreign jurisdictions • Assumed drawdowns on unfunded credit and liquidity facilities • Assumed debt calls and buybacks C o n s id e r m ore h o listic a p p ro a c h e s to sce n a rio

Standard industry liquidity stress test scenarios, including those required by regulators under the Basel III liquidity coverage ratio (LCR), are highly prescrip­ tive. This philosophy is in sharp contrast to the approach taken for capital stress testing, where a set of high-level macroeconomic developments are assumed and then care­ fully assessed to link their impacts to the bank's financial performance and capital position. In addition to the liquidityspecific scenarios described here, the institution should also consider scenarios based on broader economic and business impacts. Doing so will ensure the bank is considering sys­ temic, interdependent risk behavior rather than simply devel­ oping isolated liquidity assumptions. d e v e lo p m e n t.

In addition to assumption-based hypothetical scenarios, the bank may also perform a reverse liquidity stress test. The

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objective of a reverse liquidity stress test is to determine which conditions would need to exist, given the bank's current liquidity level, to cause its current business plan to become unviable. To construct such a scenario will require determina­ tion of which factors will have the most significant impact on liquidity and stressing these assumptions to the institution's destruction. Developing such a reverse stress test scenario, while simple in theory, presents a number of problems as there are a large number of factors which could combine to destroy the institution. It can also be difficult to develop a destruction scenario if the bank is highly liquid without making fantastic, apocalyptic assumptions. As a result, reverse stress testing is not a universally performed exercise among financial institu­ tions; however, the FRB's SR Letter 12-7 does provide guidance on reverse stress testing, which is applicable to institutions above $10 billion in consolidated assets. In this context, the failure considerations (which most banks qualify as a liquidity driven event) under recovery and resolution planning might be viewed as constituting a reverse stress test. Nevertheless, it is advisable to at least think through a reverse stress test in devel­ oping traditional stress test scenarios as a way of facilitating an understanding of the priority risks the institution should be testing (Table 9.1).

9.7 D EVELO PM EN T O F ASSUMPTIONS *1 Liquidity stress testing is built on hypothetical and historical scenarios, and as a result is highly dependent on the validity of assumptions in generating meaningful results. For many key assumptions there is limited historical or market data to draw upon in building a fact base. Nevertheless, applying segmen­ tation frameworks that enable differentiation of assumptions across varying levels of cash flow risk enhances the rigor of the liquidity stress test. In addition to developing internal views of stressed liquidity behavior, the institution should reference the Basel III (including as implemented in local jurisdictions) liquidity coverage ratio cash flow rates. Generally, in developing liquidity stress testing assumptions the institution should do the following: 1. Qualitatively assess the expected liquidity behavior for each type of cash flow to determine where there is significant liquidity risk. 2. Determine the appropriate level of segmentation for each

type of risk based on an assessment of behavioral differ­ ences, bearing in mind any limitations in ongoing data availability.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 9.1

Key Liquidity Stress Impact Factors

Category

Key Liquidity Stress Impacts

Deposit runoff

Depositors accelerate demand deposit withdrawals

Deposit runoff

Term depositors exercise early withdrawal rights

Loss of wholesale funding

Inability to roll over short-term, maturing unsecured wholesale funding

Loss of wholesale funding

Early termination of unsecured wholesale funding credit lines and/or early redemption of wholesale fundings

Loss of secured funding

Loss of willing counterparties for secured funding

Loss of secured funding

Limitation of security types available for secured funding and/or increased collateral haircuts

Loss of secured funding

Loss of access to asset-backed funding facilities due to lack of funding, embedded options, or lack of eligible assets

Reduced investment portfolio liquidity

Increased liquidity haircuts and/or reduced valuations of liquidity portfolio securities

Derivative cash flows

Increased derivative margin/collateral calls due to increased market volatility of under­ lying position

Derivative cash flows

Increased collateral calls due to reduction in collateral value

Ratings downgrades

Collateral or other liquidity impacts due to ratings triggers

Credit/liquidity facilities

Accelerated drawdown of credit and liquidity facilities by customers/counterparties

3. Qualitatively assess and order by rank varying levels of liquidity risk for each segmentation factor, potentially utiliz­ ing a scoring system. 4. Develop quantitative modeling assumptions based on any historical data available, such as experiences during the financial crisis, or available from other sources such as peer benchmarking. 5. Develop matrices of relative modeling assumptions based on scored risk levels and baseline historical data.

6. Adjust assumption matrices as appropriate for each stress scenario, for example, reflecting differences in relative overall severity or assumptions concerning idiosyncratic or systemic risk. The following assumptions can have an outsized impact on the results of the stress test, and should be considered carefully in developing the model: In vestm en t p o rtfo lio haircuts. The ability to obtain liquid­ ity through pledging, funding through a repo transaction, or outright sale of investment portfolio securities will have a critical impact on available liquidity under stress. For sys­ temic stress scenarios, it is assumed that haircuts will widen on securities as was observed during the crisis. The model should include varying haircut assumptions for each security type where liquidity characteristics differ, for example, dif­ ferentiating between agency mortgage-backed securities and

non-agency mortgage-backed securities. The model should also include expected haircut differences between secured financing channels used by the institution, for example, Federal Home Loan Bank funding, and repo facilities. Developing a scoring system that orders by rank the relative liquidity along these various segmentation dimensions can be a useful framework for this purpose. The institution can then assign specific haircuts to each type of security and funding channel based on the assessed liquidity risk. The starting point for developing liquidity haircuts is a review of current market conditions (assuming such conditions are normal), and comparing these advance rates to what the bank expe­ rienced during the financial crisis. If the bank does not have such data available, it will need to be obtained through peer comparisons where possible. Deposit runoff is, for most institutions, the most significant threat to liquidity and the most important behavioral dynamic to model. For the typical, heavily depositfunded bank, liquidity stress test models built on simplistic assumptions concerning deposit behavior will most likely yield meaningless results, even if other aspects of the model have been calibrated rigorously. D e p o sit o u tflo w s.

Unfortunately, there is a scarcity of historical data to rely upon in developing deposit runoff assumptions. While the runs that occurred during the crisis, particularly those at WaMu and Northern Rock, provide useful reference

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Table 9.2

Deposit Behavioral Characteristics

Typical Behavioral Assessment Factors Consumer

Small Business

Commercial and Institutional

• • • • • • •

• • • • • •

• • • • • • • •

Relationship tenure Checking product usage ATM usage frequency Rate paid Internet usage FDIC coverage Direct control vs. escrow

Relationship tenure Value-added product usage Credit usage Branch usage frequency FDIC coverage Rate paid

points, the institution should build a set of detailed deposit runoff assumptions based on a behavioral segmentation framework that captures differences in stressed deposit behavior. Table 9.2 summarizes behavioral differences typically observed in deposit portfolios. The institution should care­ fully analyze the historical behavior of its deposit portfolio— preferably at the account rather than portfolio level—to develop an appropriate internal segmentation framework. Empirical analysis is unlikely to yield a perfect experiment indicative of behavior during a hypothetical crisis. However, such an analysis is suggestive of customer "stickiness" and provides a more rigorous foundation than high-level, qualita­ tive assumptions. U n se cu re d w h o le sa le fu n d in g . Availability of unsecured wholesale funding is generally assumed to be heavily reduced in a stress scenario, particularly under idiosyncratic stress. The bank should review each funding channel to dif­ ferentiate by key liquidity factors, most significantly overnight versus term funding. There is likely to be little historical data available assuming the institution has not experienced a significant stress event. Banks typically apply highly conserva­ tive assumptions when reflecting on the drastic impact that a stress event is likely to have on wholesale funding availability, particularly term funding.

Collateral requirements should be expected to increase during a stress scenario as a result of both valuation impacts on existing collateral as well as increased collateral levels required as a result of changes in derivative positions. How the institution develops assump­ tions for collateral call levels (as opposed to collateral valu­ ation impacts, which should align to unsecured wholesale funding models) will depend on the level of detail required. The institution may choose to review its historical collateral call levels, particularly during times of stress, and select the most significant liquidity requirement experienced during C o lla te ra l re q u ire m e n ts.

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Relationship tenure Credit usage Treasury and trade usage Balance level Net borrowing position Industry segment Company size Rate paid

a historical period. A more detailed approach would be to model each position independently. The model should address each material source of contingent liquidity outflow, including drawdowns of customer credit lines, liquidity facilities, letters of credit, trade financing arrangements, securitization facility runoff, and other contractual arrangements. Where possible, the institution should review the behavior of such contingent liabilities during the financial crisis. If historical data is not available, conservative assumptions are appropriate. O th e r co n tin g e n t lia b ilitie s.

Non-contractual commitments must also be incorporated into the model. Particularly for lower stress scenarios, the institution will still seek to maintain reputational strength and avoid damage to business franchise value. Achieving these objectives may require voluntary financing transactions such as completion of underwriting pipeline deals and repurchase of securities issued in order to protect counterparties from mark-to-market losses. Quantitative assumptions for these requirements can be developed using the projected level of activity as appropriate. The liquidity stress test should incorporate a set of realistic assumptions concerning the institution's abil­ ity to reduce liquidity-draining business activities such as new loan origination. These assumptions should be developed through discussions with business unit management, who will have a view into the level of reduced funding activity that can occur without causing significant reputational problems. B u sin ess dial back.

9.8 OUTPUTS O F THE M ODEL The outcome of liquidity stress testing, along with the other components of the institution's liquidity risk measurement framework, provide the foundation for assessing tactical and structural liquidity relative to internally established limits and regulatory expectations. In particular, the liquidity stress test

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

forms an integral part of an institution's liquidity risk escalation process. The bank's liquidity limit structure, and in particular the contingency funding plan, should be tied directly to the results of the liquidity stress test. These linkages may exist through, for example, survival horizon metric minimums, minimum available liquidity limits, and stressed liquidity metric limits. The liquidity stress test should enable the production of a regu­ lar reporting package that contains the following for each of the entities being tested: Key assumptions include (1) overall stress level represented by the scenario; (2) indica­ tion of whether the scenario is systemic, idiosyncratic, or both systemic and idiosyncratic; (3) documentation of the overall macroeconomic, market, and company-specific events lead­ ing to the stress scenario; and (4) description of the cash flow impacts of the scenario. S tre ss te stin g assu m p tio n s.

Liq u id ity p o sitio n m etrics. The principal measurement out­ come of the liquidity stress test is the level of available liquid­ ity relative to net cash outflows under each scenario. The exact form of this metric varies across institutions but may be expressed as a percentage of net outflows or as a dollar value relative to a policy minimum. Some institutions distin­ guish between tactical and structural liquidity in measuring the results of the liquidity stress test. The Basel III LCR, for example, provides a thirty day view into available liquidity under stress. To measure the longer-term or structural liquid­ ity position, the institution may calculate a survival horizon relative to a limit. For example, the bank's policy may be to maintain available liquidity to support twelve months of net outflow under a specific stress scenario.

In addition to measur­ ing the current liquidity position, the bank should measure the prospective liquidity profile of the bank over the stress horizon. Key indicators of liquidity risk include prospective available liquidity, ratios indicative of wholesale funding dependence (e.g., net non-core funding dependence), and metrics indicative of potential overconcentration in specific funding channels (e.g., percentage of funding from brokered deposits). When monitoring prospective liquidity, it is impor­ tant to highlight any specific stress points along the horizon where survival would require potentially problematic debt issu­ ances, intercompany funding transactions, or capital actions. The institution may choose to establish limits for prospective liquidity in addition to current liquidity, for example, maintain­ ing a certain survival horizon throughout the stress test. P ro sp ectiv e liquidity position m etrics.

In addition to capturing the liquidity impact of the stress test, it is also important to measure the balance sheet more holistically. For example, C a p ita l and p e rfo rm a n ce m etrics.

assessing the economic impact of the investment portfolio by measuring yield net of a regulatory or economic capital charge enables the institution to assess the tradeoff between low-yielding, low-haircut instruments and higher performance, less liquid ones. Monitoring key capital metrics for each entity ensures that the model captures the impact of any capital actions required to support liquidity during the stress period. The frequency with which the liquidity stress test is performed will vary and typically depends upon the cadence of manage­ ment oversight and operational and technological capabilities of the institution. At a minimum, the liquidity stress test should be performed quarterly in order to support review by the asset liability management committee. More advanced banking organizations have made significant investments in building the ability to perform liquidity stress tests more frequently, in some cases even daily.

9.9 G O V ER N A N CE AND CON TROLS As an integral part of the institution's liquidity risk governance framework, the liquidity stress test should be the subject of, while at the same time supporting, effective oversight in order to help ensure the liquidity risk profile is aligned to the bank's risk appe­ tite and capacity. The specific roles should consist of the following: The ALCO, consistent with its board, management risk committee, and executive management delegated oversight of managing liquidity risk, typically has overall responsibility for the liquidity stress test­ ing framework. Specifically, the ALCO should be responsible for the following:

A sset-liab ility co m m itte e (A L C O ).

• Ensuring the establishment, review, and approval of a liquidity stress testing policy. The liquidity stress testing policy should detail the scenarios to be run, key assump­ tions, roles and responsibilities, reporting requirements, and limits. The specific structure of liquidity stress testing documentation may be tailored to the policy structure of the bank. Many institutions include this policy as an appendix or supporting standard to the overall liquidity risk management policy or as a component of the con­ tingency funding plan. The liquidity stress testing policy should be renewed at least annually. • Suggesting and approving liquidity risk scenarios, including major changes to liquidity scenarios and/or assumptions. • Setting liquidity risk policy limits dependent on stress test outcomes and escalating exceptions. For certain limit tiers, escalation may be required to the board of directors.

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Treasury. The treasury unit, as the first line of defense, typically has ownership of the liquidity stress test modeling process. Treasury should be responsible for the following: • Maintenance of liquidity stress testing procedures. • Recommending stress test scenarios. • Reviewing and monitoring the liquidity characteristics of the institution's assets and liabilities and making rec­ ommendations to the ALCO concerning stress testing assumptions. Treasury should work with other functions within the organization, in particular business line manage­ ment, in developing assumptions for customer assets and liabilities. A formal requirement should be established in the liquidity stress testing policy that management reviews the key analytical assumptions of the liquidity stress test at least quarterly. • Producing stress test-based liquidity risk reporting. It is recommended that the liquidity stress test baseline balance sheet data (i.e., the current positions and contractual maturities) be fed from, or at least reconciled to, reporting prepared by a group independent of treasury, such as financial control, independent risk management, or middle office. Within large, complex banking organizations, it is expected that multiple treasury units will perform liquidity stress tests for their respective entities. In such cases the corporate trea­ sury group should ensure that the global liquidity stress test­ ing policy establishes a consistent framework of scenarios, assumptions, and model design across the enterprise. Risk management. The independent risk management func­ tion, as the second line of defense, is responsible for provid­ ing independent oversight of liquidity stress testing along with the other components of the liquidity risk management program. Specifically, risk management is responsible for the following: • Administering the liquidity risk stress testing policy • Reviewing and providing effective challenge of the sce­ nario design and assumptions • Ensuring the institution's approach to liquidity stress test­ ing is in line with acceptable industry practices and regula­ tory rules and guidance • Reviewing and approving the liquidity stress test-based limits • Monitoring of liquidity stress test-based limits • Ensuring the institution's ALCO, executive management, and board are kept well-informed of the bank's liquidity risk profile as indicated by the stress testing results

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Where multiple risk units within the institution are oversee­ ing liquidity stress testing, the independent risk management function should be responsible for coordinating globally with regional and business unit risk management teams to ensure enterprise-wide consistency. Internal au d it. Internal audit, as the third line of defense, should periodically review the liquidity stress testing frame­ work, procedures, and controls to ensure compliance with policy, regulatory, and control requirements. M o d el risk m a n a g e m e n t: Model risk management is respon­ sible for providing independent validation and changing management governance of the liquidity stress testing model in line with the institution's model risk management policy. Practices vary among institutions in defining and evaluat­ ing models for oversight. It is assumed, however, that the liquidity stress testing model will be assessed as highly criti­ cal given its foundational role in monitoring the bank's risk profile.

9.10 LIQUIDITY OPTIMIZATION The primary goal of the liquidity stress test is to determine the appropriate size of the liquidity buffer. However, the liquidity stress test should also be referenced in developing the composi­ tion of the buffer, with the objective of maximizing the efficiency of the liquidity portfolio. Given a target level of contingent liquidity required to support risk limits and regulatory require­ ments, Treasury will be able to choose between portfolio alter­ natives that vary in terms of both yield and capital requirements. This choice gives rise to an optimization opportunity: Liq u id ity v e rsu s y ie ld : Typically, higher yielding instruments will have less favorable liquidity characteristics and/or add duration to the investment portfolio. Maximizing the yield and/or duration of the portfolio (even under the usual strict investment policy constraints) is likely to be suboptimal for the institution's return on asset performance as a whole. This yield maximizing portfolio will be inefficient due to the addi­ tional balance level required to offset stress test haircuts and the mismatch between the portfolio's inflows and the stress test outflows. For example, taking the simplified stress test­ ing example represented by the Basel III LCR, maximizing the size of the Level 2A portfolio (e.g., by investing in agency mortgage-backed securities) that require a 15% haircut, may reduce overall return on assets relative to investing slightly lower yielding treasury securities that require no haircut.

Conversely, maximizing the liquidity profile of the portfolio at the expense of yield may be equally inefficient. Armed

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

with a robust liquidity stress testing model, treasury should avoid constructing a needlessly conservative liquidity portfolio when the pattern of stressed net outflows dem­ onstrates that the institution can comfortably stretch the duration and risk profile of its investments. Depending upon the institution's eco­ nomic and regulatory capital framework, a similar trade-off exists for incorporating the capital impact of various port­ folio alternatives. Continuing with the example of Level 2A agency mortgage-backed securities, maximizing the invest­ ment allocation of these instruments may be suboptimal given the additional regulatory and potentially economic capital requirements associated with these instruments. For banks whose capital position is such that any additional asset amount gives rise to an additional equity capital requirement under leverage ratio limits, the additional haircut required for higher-risk instruments will also be problematic. Liq u id ity vs. cap ital.

9.11 FUNDING OPTIMIZATION An important insight provided by the liquidity stress test model is the impact of varying funding sources with differing liquidity characteristics. In fact, a key objective of the focus on enhancing liquidity stress testing since the financial crisis has been to cre­ ate an incentive for financial institutions to favor "sticky" funding sources such as retail branch deposits at the expense of "hot" money sourced from wholesale channels. By explicitly model­ ing the liquidity impact of these funding alternatives, treasury can and should develop a target funding profile that balances liquidity and cost. For example, the superior liquidity profile of commercial deposits linked to treasury management services should serve to bolster the business case for investing in target industry segments with more intensive working capital require­ ments. Building this linkage requires a funds transfer pricing (FTP) framework that accurately incorporates the stressed liquid­ ity profile of various business segments across the enterprise.

9.12 ESTABLISHING A SUSTAINABLE INFRASTRUCTURE The strongest liquidity stress testing analytical framework will have little value without a data management infrastructure to support it. In order to support efficient and controlled ongo­ ing stress testing and reporting, the institution should maintain an information technology infrastructure that performs auto­ mated data collection, aggregation, capturing of market data, report generation, and analytics. The challenge for many large,

complex financial institutions has been that developing such an infrastructure for liquidity stress data has required signifi­ cant modifications to existing data warehouse capabilities built largely on general ledger and transactional customer data. In building an infrastructure that supports liquidity stress testing, the institution should ensure that several critical requirements are met. These include: Position d ata co llectio n and a g g re g a tio n . A data manage­ ment model must be established to ensure that required liquidity position data are captured in an automated fashion. The specific architecture employed by an institution will vary, but could include the use of standardized templates or data hub structures. Required liquidity attributes may need to be associated to each position to enable automated develop­ ment of model inputs. The position data will also need to conform to the required organizational granularity. For large, internationally active banking organizations, this is likely to require data across numerous legal entity, business line, and jurisdictional dimensions. In addition to capture current positions, the institution should retain historic data in the data hub for historical analysis-based model calibration. The objective is to ensure that liquidity data is housed in a single location and forms a single source of truth. R e g u la to ry re p o rt g e n e ra tio n . Building on this automated position capture should be the ability to generate regulatory reports (e.g., the Basel III LCR) with a minimum of manual intervention. Solutions may include functional replicas of offi­ cial regulatory reports—or customized proprietary versions if official templates are not available—that are populated with associated validations and regulatory adjustments, requiring minimal user manipulation. Such solutions may be developed as proprietary applications or included within the reporting functionality of third party treasury platforms.

The liquidity stress test model should contain the features and functions that management would expect in any robust analysis tool. These would include, for example, the ability to perform sensitivity analysis on stress test assumptions, the ability to save scenarios, and the ability to easily generate various legal entity views. In addition to such flexible forecasting functionality, leading practice is to include analytic functionality that, for example, assesses the economic capital impact of various liquidity portfolio allocations. A n a ly tics.

Liq u id ity d a sh b o a rd . Key risk indicators and performance drivers should be tracked on a predefined basis and dis­ tributed to risk managers. Liquidity stress test results may be included in an existing risk dashboard or circulated separately.

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9.13 INTEGRATION O F LIQUIDITY STRESS TESTING WITH RELATED RISK M ODELS Liquidity stress testing should not be performed in a silo with­ out consideration of other related risk frameworks, such as asset liability management (for interest rate risk), capital stress testing, and recovery and resolution planning. These models may employ related assumptions concerning the balance sheet behavior of certain accounts, and developing these assump­ tions independently is likely to lead to an inconsistent overall risk management framework. More importantly, it is imperative that a banking organization consider the correlations between risk types that are likely to surface in a systemic or idiosyncratic stress scenario. For example, in a capital-stressed environment, an institution may be required to take a capital action requiring the raising of liquidity at the holding company level. If raising such liquidity requires incurring losses on investment portfolio liquidation (all the more likely in a stressed environment), addi­ tional capital pressures may occur. In theory, the institution should maintain a holistic risk model that assesses the impact on liquidity, capital, and balance sheet structure under a common set of scenarios. In prac­ tice, such an approach can be problematic due not only to the modeling complexity involved, but also as a result of the need to develop unique stress scenarios for each risk type. For example, a bank may stress capital based on a recession­ ary scenario that adversely affects credit performance but is also associated with falling interest rates (as expected during a recession) and a less severe impact on liquidity than what would be typically assumed under an idiosyncratic "run on the bank" liquidity stress test scenario. Nevertheless, the bank should carefully consider the interdependencies and connec­ tion points between the liquidity stress model and other risk models: Linking capital and liquidity stress testing requires, first, ensuring that the liquidity stress test incorporates any required capital infu­ sions of subsidiary entities. For each liquidity stress test sce­ nario, capital impact assumptions must be developed based on the overall market and idiosyncratic conditions assumed to occur under the scenario. The level of detail in developing these assumptions may vary from a high-level capital infusion assumption for affected subsidiaries to detailed credit loss and pre-provision net revenue modeling. Liq u id ity stre ss te stin g and cap ital stre ss te stin g .

Second, the capital stress testing framework should include a liquidity stress evaluation to assess the impact of any required liquidity impacts on capital adequacy. In conjunction

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with performing the capital stress test, the institution should perform a liquidity impact analysis to determine whether additional capital impacts may occur through investment portfolio and required funding actions that would cause fur­ ther deterioration in capital adequacy. Liq u id ity stre ss te stin g and a s s e t liab ility m a n a g e m e n t.

Interest rate risk models are designed to assess the interest expense and economic value of equity impacts of severe movements in interest rates. Such a stress event could have a significant impact on capital but is less likely to have a direct impact on the bank's short-term liquidity profile. As a result, a liquidity impact analysis is typically not run concur­ rently with interest rate risk stress testing analogous to what must be performed for capital stress testing. Nevertheless, a consistent behavioral framework should be applied to both the interest rate and liquidity stress testing models. For example, if the liquidity stress test model assumes that certain operational deposits do not run off in a stress event, the interest rate risk model should segment these deposits and assume that they would have duration at least as long as non-operational deposits. When it comes to the liquidity stress model, however, it is important to consider interest rate impacts. In particular, the liquidity stress test scenario framework, liquidity risk dash­ boards, and liquidity risk early warning indicators should not neglect to include the possibility of an interest rate shock and the potential impact such an event would have on inde­ terminate liabilities. For example, in an environment where rates are historically low and there is significant risk of a yield curve steepening (i.e., the current environment), the institu­ tion must carefully consider the impact of deposit disinter­ mediation due to interest rate increases. A significant yield curve steepening could present significant liquidity risk to the institution, even in the absence of any safety and soundness concerns, as depositors seek the higher yields available in longer-duration investments. Liq u id ity stre ss te stin g and fu n d s tra n sfe r p ricin g. The FTP framework, while not a risk model, is a strategically impor­ tant tool for driving business decision making. One of the key objectives of any FTP framework is proper pricing of liquidity, whether provided by the treasury center for lend­ ing purposes or credited to liability-generating activities. The FTP framework should leverage and be consistent with the contingent liquidity requirement for assets and liabilities measured by the liquidity stress test model. For example, if it is determined that a 25% cash buffer is required to support a wholesale operational deposit (to borrow a Basel III LCR assumption), the cost of carrying this buffer should be passed through within the FTP framework.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

CON CLUSION The liquidity stress test is a core component of the bank's liquidity risk framework, and following the financial crisis has become an increased area of scrutiny and expectation among regulators and other stakeholders. While nearly all financial institutions of significant size have a basic liquidity stress testing process in place, there are typically a number of areas of potential improvement. As banks continue to refine and improve their liquidity stress capabilities, they should focus on four areas: •

nevertheless make a diligent attempt to build the most robust set of assumptions possible. Increasing the level of granularity—such as by enhancing the level of segmentation for deposit behavioural analysis—typically yields beneficial results. •

m o d e ls. Longer term, the industry will continue to evolve toward unifying what is currently a set of relatively isolated frameworks in addressing liquidity risk, capital, asset liability management, and performance measurement. Developing better linkage between stress testing and performance man­ agement and across risk categories will create the necessity to holistically assess risk-based performance results in busi­ ness and treasury banking activities.

En su rin g th e a p p ro p ria te sc o p e and stru ctu re o f th e liq u id ­

While stress testing the consolidated entity is a common practice, it is important to carefully review juris­ diction, legal entity, charter, and foreign exchange liquidity restrictions to ensure testing is performed with each appro­ priate view. ity stre ss te s t.

•

While there is unlikely to be a perfect historical experiment upon which to base stress scenario assumptions, the bank should Building th e m o del on ro b u st assu m p tio n s.

Im proving in te g ratio n w ith re la te d risk and p e rfo rm a n ce

•

Creating a sustainable liquidity risk infrastructure is a necessary foundation for improved analyt­ ics and more frequent monitoring. For most institutions, this will require establishing and maintaining a tailored data hub, an automated data model, and robust analytics and reporting capabilities.

A u to m a tin g th e p ro ce ss.

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Learning Objectives After completing this reading you should be able to: Identify best practices for the reporting of a bank's liquidity position. Compare and interpret different types of liquidity risk reports.

Excerpt is Chapter 14 of The Principles of Banking, by Moorad Choudhry.

Explain the process of reporting a liquidity stress test and interpret a liquidity stress test report.

Elsewhere I have highlighted the nature of liquidity risk exposure measurement. We press on further with a look at benchmark liquidity risk reporting, and stress testing report­ ing output. We look at a range of quantitative and qualitative liquidity reports, as part of our approach to a general under­ standing of liquidity risk management at the aggregate over­ view level. We begin with an illustration using examples of baseline liquidity reports. This is followed with a description of additional liquid­ ity reports, together with a summary of the reporting frequency required by UK regulated banks. This regulatory reporting requirement is similar in most other jurisdictions. The second part of the chapter looks at the presentation of liquidity stress testing results. A number of the reports shown here are available as template spreadsheets on the Wiley website supplementary material.

10.1 LIQUIDITY RISK REPORTING A bank will produce a number of liquidity reports in the normal course of business, on a daily, weekly, monthly and quarterly basis. It is important that the format of liquidity Ml is both trans­ parent and accessible. We illustrate a sample of reports that provide a benchmark framework for reporting.

Deposit Tracker Report The deposit tracker is a simple report of the current size of deposits, together with a forecast of what the level of deposits are expected to be going forward. This report is tracked weekly and monthly because it provides an idea of the LTD ratio in the immediate short term. The LTD is a key management liquidity ratio. Table 10.1 A shows the first part of a typical deposit tracker report for a medium-sized commercial bank, as at month-end May 2009. We see that the report provides the following:

We see that this bank is required to meet a Board-approved LTD ratio limit of 85%, which it is just exceeding as at the date of this report, but the forecast for year-end is within this. Table 10.1 B is the second part of the deposit tracker, it shows how much liabilities will need to increase, or assets reduce, all else being equal, for the bank to meet a particular LTD ratio. Figure 10.1 is a graphical presentation of the deposit tracker report. Figure 10.2A from the report shows the customer deposits by account type and tenor, while Figure 10.2B shows the deposits' maturity profile. This illustration assists the Treasury department to gauge the trend of the deposit balances over time. For example, from Figure 10.2A it is clear that a large percentage of the retail bank deposits are current accounts and rolling deposits, with very little fixed-term deposits. For regulatory purposes, these funds will be treated as short-term liabilities and will not assist the bank's regulatory liquidity metrics (which emphasises long-term funds), even though the local regulator may allow the bank to treat overnight balances as longer term if they can be shown to be acting as such in "behavioural" terms. In this case, it is worthwhile for the bank to undertake a marketing exercise to determine if customers may be interested in moving their deposits into fixed-term or notice accounts. Any increase in the size of the latter will improve the firm's liquidity metrics. The forecast element of this report is based essentially on objective judgement. The historical trend up to the current date will assist in making the forecast; otherwise, it is a case of making as best an estimate as possible, with inputs from the relationship managers who look after the various cus­ tomer accounts.

Daily Liquidity Report

• the aggregate customer assets and hence, the LTD ratio;

The daily liquidity report is a straightforward spreadsheet detailing the bank's liquid and marketable assets, together with liabilities, up to 1-year maturity and beyond. It provides an end-of-day of the bank's liquidity position for the Treasury and Finance departments. Each branch and subsidiary will complete one, although a bank that has only a branch structure (and no subsidiaries) may aggregate the report.

• a forecast of the position for the month-end for each month to the end of the year.

We provide an example of a daily liquidity report for a com­ mercial bank at Figure 10.3. This uses inputs from the bank's

• the month-end actuals for deposits by customer type; • the change from each month-end

188

■

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 10.1 A Deposit Tracker

Deposit Tracker Report, Month-End Actuals and Year-End Forecast Month End Actuals

Forecasts

31/12/2008 31/01/2009 28/02/2009 31/03/2009 30/04/2009 28/05/2009 30/06/2009

31/07/2009

30/08/2009

30/09/2009

31/10/2009

30/11/2009

31/12/2009

Eligible Correspon­ dent Banks

482,236

431,166

485,302

507,193

536,907

493,930

515,753

520,753

520,753

520,753

525,753

530,753

535,753

Corporate Client Deposits

449,871

375,849

248,677

263,267

243,710

280,248

273,893

273,893

273,893

273,893

273,893

273,893

273,893

14,168

23,334

18,990

102,174

102,582

99,119

99,123

99,123

99,123

124,123

124,123

124,123

124,123

196,624

195,814

192,100

226,622

267,001

325,016

333,287

343,287

348,287

373,287

393,287

413,287

433,287

1,234,799

1,318,219

1,323,738

1,264,323

1,293,918

1,258,133

1,264,025

1,264,025

1,264,025

1,264,025

1,264,025

1,264,025

1,264,025

24,864

37,456

38,358

37,196

37,388

35,512

35,529

35,529

35,529

35,529

35,529

35,529

35,529

Private Bank Client Deposits Local Authority Deposits Retail Bank Deposits Eligible Private Bank Correspon­ dent Banks Treasury Sales

5,775

5,198

4,477

3,846

822

770

763

763

763

763

763

763

763

2,408,337

2,387,036

2,311,642

2,404,621

2,482,328

2,492,728

2,522,373

2,537,373

2,542,373

2,592,373

2,617,373

2,642,373

2,667,373

-21,301

-75,394

92,979

77,707

10,400

29,645

15,000

5,000

50,000

25,000

25,000

25,000

Drawdown-Month ahead

76,374

8,526

4,479

5,298

2,911

3,136

5,570

Repayment-Frorm loans schedules

37,888

11,920

4,429

2,326

25,800

7,965

20,863

Forecast Monthly loan +/—

38,486

-3,394

50

2,972

-22,889

-4,829

-15,293

Total Customer Deposits: M/M +/W/W +/ Mend +/-

Total Customer Loans: Loan-to-deposit %

oo o

2,305,766

2,266,004

2,223,145

2,166,076

2,194,016

2,145,648

2,184,134

2,180,740

2,180,790

2,183,762

2,160,873

2,156,044

2,140,751

95.74

94.93

96.17

90.08

88.39

86.08

86.59

85.94

85.78

84.24

82.56

81.59

80.26

o

o

Table 10.1B

Deposit Tracker, LTD Ratio Required Cash Flow Changes Forecasts

LTD Required:

ratio

Liabilities increase

85

278,851

303,823

84

310,588

83

343,089

82

Assets reduce

31/01/2009

28/02/2009

31/03/2009

30/04/2009

28/05/2009

30/06/2009

47,196

31/07/2009

28,203

30/08/2009

23,262

30/09/2009

31/10/2009

143,704

98,867

31,564

334,959

174,041

129,596

61,615

77,786

58,746

366,846

205,109

161,065

92,390

109,113

90,025

376,384

399,510

236,935

193,301

123,916

141,205

122,066

81

410,500

432,981

269,547

226,334

156,220

174,088

80

445,469

467,289

302,974

260,192

189,332

85

-237,023

-258,249

-122,148

-84,037

-26,829

84

-260,894

-281,366

-146,194

-108,860

-51,756

-65,340

-49,347

83

-284,764

-304,482

-170,241

-133,684

-76,684

-90,564

-74,720

82

-308,634

-327,599

-194,287

-158,507

-101,611

-115,788

-100,094

-96,044

-58,016

81

-332,505

-350,715

-218,333

-183,330

-126,538

-141,012

-125,468

-121,468

-83,940

80

-356,375

-373,831

-242,379

-208,154

-151,466

-166,235

-150,842

-146,891

-109,864

-66,975

30/11/2009

31/12/2009

-23,241

-75,169

-105,851

-148,842

53,805

7,344

-44,905

-75,654

-118,860

85,085

38,666

-13,911

-44,730

-88,155

117,127

70,752

17,838

-13,051

-56,701

154,899

149,960

103,630

50,372

19,409

-24,470

207,794

188,552

183,614

137,330

83,718

52,682

8,566

-40,117

-23,973

-19,773

19,755

63,894

89,973

126,516

-45,196

-6,169

37,720

63,550

99,842

-70,620

-32,093

11,547

37,126

73,168

-14,627

10,702

46,495

-40,801

-15,722

19,821

-42,145

-6,853

100.00 95.00 90.00 85.00 80.00 75.00 70.00

Figure 10.1

Deposit tracker, graphical illustration.

balance sheet accounting system to provide a summary of liquid assets, liabilities by tenor, and a cumulative liquidity report. Figure 10.3 is the summary of liquid securities; in this case these consist of government bonds, central bank eligible

and non-eligible bank CDs. The value of securities deemed instantly liquid will be input to the liquidity ratio calculation report. Table 10.2A is the summary of assets and liabilities, and Table 10.2B is the cumulative liquidity report and liquidity

Customer deposits / Accounts by maturity

300

1200

250 -

t*

-

1000

- 800

200 -

LU

U)

_Q

LU

- 600

150 -

03

_o

ro

O 100 Q_ O u

- 400

-

50 -

0

-

Current accounts

■ &

Rolling deposits

Up to 1 week

1 month

3 months 6 months 12 months

12 months +

Correspondent banks

22.74

0

44.13

273.68

183.40

26.00

0.00

0.00

Corporate banking

78.89

51.94

55.78

25.32

61.08

7.27

0.17

0.00

0

0

29.60

74.24

127.63

71.64

29.18

1.00

13.76

95.35

0.00

0.00

0.00

0.00

0.00

0.00

112.98

1036.85

0.59

7.49

28.73

69.35

9.65

2.14

Local authority deposits Private banking -a- Retail banking

Figure 10.2A

U)

*03 -M

CD

200

0

Deposit tracker, deposit type and tenor.

Chapter 10 Liquidity Risk Reporting and Stress Testing

■

191

Custom er deposits / A ccounts m aturity profile

LU

CD •c—» c

_Q CD

+-»

*03

Cl)

risk factor calculation. The "counterbalancing capacity" in Table 10.2B is the sum of available securities to cover for sud­ den cash outflows. This spreadsheet is available on the Wiley website supplemen­ tary material accompanying this book.

Funding Maturity Gap ("Mismatch") Report The funding gap report shows the maturity gap (also known as the maturity mismatch) per time bucket, for all assets and liabilities, with an adjustment for liquid securities. It includes the cumulative liquidity cash flow of the previous report just described, and indeed the two reports can be combined. An extract is shown at Table 10.3. Figure 10.4 shows the maturity mismatch in graphical form. The key indicates the cash flow for each type of product. The same report is used to generate the cash flow survival horizon report. This is shown at Figure 10.5. We observe that

192

■

the bank in this example has a survival horizon of only seven days under normal circumstances; when the cash flow value of liquid securities and other adjustments is included, we see that the survival period is extended to 27 days. This is still below the Basel III requirement, and so on the strength of this report the bank will need to take action to address the liquidity shortage. The full report spreadsheets, with breakdown by product type and incorporating cell formulae, are available on the Wiley website.

Funding Concentration Report Funding source concentration reports are key Ml for senior Treasury and relationship managers. A central principle of liquidity management is funding diversity, and its empha­ sis that a bank should not become over-reliant on a single source, or sector, of funds. This includes reliance on intra­ group funds.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

SECURITIES AND CDs 00s In p u t data

Classification Marketable

Securities

CDs

Bank CDs: non-ECB eligible, liquid at maturity date (breakdown below)

231,645

Bank CDs: ECB eligible, liquid same day

0

ECB eligible securities, liquid in 1 week tender

649,967

Non-ECB eligible securities, can be sold over 4 weeks

277,589

Government securities

9,640

TOTAL MARKETABLE SECURITIES AND CDs

937,196

231,645

Non-marketable Non-ECB eligible CD summary Average remaining tenor

Amount

1 day 2 days 1 week 2 weeks

6,645

1 month

25,000

2 months

50,000

3 months

35,000

6 months

115,000

12 months

Figure 10.3

List of liquid securities: input to daily liquidity report.

Table 10.4 is an example of a Large Depositor Concentration Report for a banking group. In this case "large" is defined as someone that deposits USD 50 million or more; however, a bank may define it in percentage of total liability terms rather than absolute amounts. Generally speaking, a deposit of 5% of total liabilities should be treated as large by ALCO. In the illustration shown, the largest depositor ("CBS") exceeds the internal single-source concentration limit of 10% by a consid­ erable margin. Assuming that this is a close customer relation­ ship, the bank will need to increase its liabilities base to bring the share down to limit, or otherwise risk damaging the relation­ ship by asking the depositor to remove some of the funds.

stress points for a bank's funding requirement. In a stress situa­ tion a bank can expect un-utilised liquidity and funding lines to be drawn down, as customers experience funding difficulties of their own. The existence of undrawn commitments can exacer­ bate funding shortages at exactly the wrong time, which is why liquidity metrics include such undrawn commitments. It is also a reason to report them separately. Figure 10.6A is an example of an undrawn commitments report, showing trend over time, while Figure 10.6B shows the trend for both drawn and undrawn committed facilities. These are aggregate-level reports, the bank will also produce detailed breakdowns per customer.

Undrawn Commitment Report

Liability Profile

Off-balance sheet products such as liquidity lines, revolving credit facilities, letters of credit and guarantees are potential

This is a simple breakdown of the share of each type of liability at the bank. An example is shown at Figure 10.7. In this case,

Chapter 10 Liquidity Risk Reporting and Stress Testing

■

193

194

Table 10.2 A

Asset and Liability Cash Flows Input Data

■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

ASSETS

000s

1 Day

2 Days

1 Week

2 Weeks

1 Month

2 Months

3 Months

6 Months

< 1 Year

>1 Year

Total

Non-marketable Securities & CDs

0

Retail call a/c Retail time deposit

6,754

0

0

0

0

0

0

0

0

0

6,754

432

3,533

0

4

4

4,529

9

1,619

420

23,749

34,299

Inter-Group call

4,725

0

0

0

0

0

0

0

0

0

4,725

Inter-Group time

19,199

89,848

281,434

90,150

135,378

73,895

60,768

21,379

5,912

244

778,207

Other bank call

56,568

0

0

0

0

0

0

0

0

0

56,568

Other bank time

5,465

148,347

188,620

7,833

89,500

30,020

0

25,319

128

83,985

579,217

Corporate call

30,658

0

0

0

0

0

0

0

0

0

30,658

Corporate time

13,936

112,975

35,335

53,432

10,923

159,894

133,718

63,182

116,551

1,365,637

2,065,583

Government bonds

161,011

0

19,361

35

335

303

9

868

678

84,857

267,457

Total Assets

298,748

354,703

524,750

151,454

236,140

268,641

194,504

112,367

123,689

1,558,472

3,823,468

2 Weeks

1 Month

2 Months

3 Months

6 Months

>1 Year

Total

Average remaining duration of assets

44.59 Months

Input Data Liabilities

000s

1 Day

1 Week

2 Days

0 o

Table 10.3

Extract from Maturity Gap Report

Data as of 2 June 2010. All figures in EUR thousands unless otherwise noted. Liquidity Management - Maturity Mismatch No behavioural or stress adjustments applied Inflows

Sight

Two - Eight Days

Nine Days - One Month

TOTAL INFLOWS Outflows

(908,203,354)

(188,005,661)

(705,398,674)

Sight

Two - Eight Days

Nine Days One Month

TOTAL OUTFLOWS

893,940,981

397,283,377

1,379,620,964

1,251,323,695

One - Three Months

Three - Six Months

Six Months - One Year

One - Three Years

Three - Five Years

Five Years and on

(376,131,077)

(86,328,844)

(97,212,696)

One - Three Months

Three - Six Months

Six Months One Year

(481,473,198)

(444,603,252)

(734,632,172)

(4,021,988,928)

One - Three Years

Three - Five Years

Five Years and on

Total

328,027,956

105,751,557

3,219,569

0

0

4,359,168,099

Behavioural Adjustments/Stress

Total

OK

Net Mismatch per Bucket

(14,262,374)

209,277,716

674,222,290

Adjustments

Sight

Sight - 8 Days

TOTAL ADJUSTMENTS

(1,256,876,281)

Cumulative Mismatch

Sight

875,192,618

241,699,112

8,538,861

(478,253,629)

(444,603,252)

(734,632,172)

337,179,171

Sight - 1 Month Sight - Three Months

Sight - Six Months

Sight - One Year

Sight - Three Years

Sight - Five Years

Sight - Five Years

Total

(1,256,876,281)

(1,256,876,281)

(1,256,876,281)

(1,256,876,281)

(1,256,876,281)

(1,256,876,281)

(1,256,876,281)

(11,311,886,530)

Sight - 8 Days

Sight - 1 Month Sight - Three Months

Sight - Six Months

Sight - One Year

Sight - Three Years

Sight - Five Years

Sight - Five Years

(1,256,876,281)

(1,271,138,655)

(1,061,860,938)

(387,638,649)

487,553,969

729,253,082

737,791,943

259,538,314

(185,064,938)

(919,697,110)

Liquidity Ratio

29.16%

24.36%

8.89%

-11.18%

-16.73%

-16.93%

-5.95%

4.25%

21.10%

Behavioural Adjustments/Stress Variance

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

Internal Limit

0.00%

3.00%

-3.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

-5.00%

FSA Limit Notes: "Outflow" are LIABILITIES. "Inflow" are ASSETS.

10,000,000,000 □ 3 0 - F iscal L iab ilities

□ □ □ □ B □

8,000,000,( 6,000,000.
UMIa £ 4IUM-

•

# 0

. G

• •

• •

1

•

•

* .

• •

•

•

0 0

# • 0

0

•

•

:

• • •

•

•

0

*

;

1 0 § •

0 • •

0 •

•

• • •

i • i

• • •

•

•

•

• • 0 0 • 1 •

• • 0 •

•

*

0

i n 1

* 0 1

-

II 1

I N

1 i

1 ■

• n

• .*

- i! t ,v " - ..!

* -r *

» ••

U41MC0)-.

11*

t• ♦•

‘‘TOSSUiSSSB |C

— K«l

• G r a p h s s h o w d a ily c a s h flo w m o v e m e n t s o v e r a 6 m o n th p e rio d fro m 2 3 rd F e b 2 0 1 0

• S h o w s t h e P o s t - F S A s t r e s s e d C u m u la t iv e C a s h flo w F o r e c a s t t a k in g In to a c c o u n t th e im m e d ia te s a le / r e p o o f

• T h e C a s h f lo w i s a r r iv e d a t a fte r f a c t o r in g in s a le / r e p o o f m a r k e t a b le s e c u r it ie s ( b o n d s , F R N s , C D s ) . “ O v e r n ig h t ” d a ta

M a rk e ta b le s e c u r it ie s

I s u n a d ju s t e d .

• T h e fo llo w in g F S A s t r e s s e d h a v e b e e n a p p lie d : W h o le s a le F u n d in g , R e ta il L iq u id ity , In tra d a y liq u id it y - 3 & 5 d a y

• T h e C u m u la t iv e c a s h f lo w i s b a s e d o n c o n t r a c t u a l c a s h f lo w s a n d n o a d ju s t m e n t h a s b e e n m a d e fo r a s s e t / lia b ilit y

s t r e s s e s , C r a s s C u r r e n c y L iq u id ity , In t ra - G r o u p L iq u id ity , O ff B a l a n c e S h e e t L iq u id ity , M a rk e ta b le A s s e t s , N o n -

b e h a v io u r o r “ s t i c k i n e s s ” .

M a rk e ta b le A s s e t s , F u n d in g C o n c e n t r a t io n .

• D a ta fe e d in g g r a p h u s e s s a m e b a s e lin e d a ta a s s e e n in B L A S T . A d d itio n a l d e a ls h a v e b e e n a d d e d to t h is d a ta fo r F X

• O B F ( s t ic k in e s s ) a p p lie d : N o n L ia b ilit ie s (1 0 0 % e v e r y 3 d a y s ) , C u r r e n t A c c o u n t s ( - 5 .6 6 % e v e r y 3 6 d a y s ) , R e ta il T im e

s w a p p o s it io n s .

d e p o s it s ( - 0 .4 1 % e v e r y 3 4 4 d a y s ) , C a p it a l (1 0 0 % e v e r y 3 d a y s ) , C a s h & E q u iv a le n t s (1 0 0 % e v e r y 3 d a y s ) , F is c a l L ia b ilit ie s (1 0 0 % e v e r y 3 d a y s ) , R e p o L ia b ilit ie s (c u r r e n t ly n o r e p o s ) , O t h e r tim e d e p o s it s ( - 0 .0 3 % e v e r y 4 7 d a y s ) , F X

T h e “c u m u la t iv e c a s h f lo w " s u r v iv a l h o r iz o n i s 4 2 d a y s . M arketable S e c u ritie s

Haircut Value

€ 1 ,2 7 9 ,2 0 0 ,2 2 6 € 1 5 0 ,1 1 6 ,4 2 3

(1 0 0 % e v e r y 3 0 d a y s ) • O B F n o t a p p lie d : C o r p D e p o s it s , G o v t t im e d e p o s it s , In tra g ro u p tim e d e p o s it s , In t e r b a n k tim e d e p o s it s , O t h e r L ia b ilit ie s • F o r e c a s t e d C u m u la t iv e C a s h flo w s u r v iv a l h o r iz o n i s b e y o n d t h a t o f th e 6 m o n t h s b e in g a n a ly s e d fo r t h is re p o rt

Marketable Securities stressed

Fiqure 10.13

€ 1 ,1 2 9 ,0 8 3 ,8 0 3

o n c e O B F a n d t h e F S A s t r e s s e s h a v e b e e n a p p lie d .

Senior management summary report, 1-slide PowerPoint.

money for regulatory purposes, although certain regulatory authorities will allow a "behavioural" adjustment of retail depos­ its where it can be shown that these remain fairly stable over time. For example, 50% of such deposits may be allowed to be treated as longer term funds. Generally, however, such funds do not improve a bank's liquidity metrics, because they are viewed as 1-day funds by regulators. For off-balance sheet items, the UK FSA treatment is as follows: • Derivatives values/notionals are not included in the liquidity ratio calculation; however, coupons receivable or payable will be included on their pay dates.

Bank liquidity models commonly apply the following treatment: • Derivatives are included to the extent that collateral is pay­ able or receivable under an ISDA/CSA agreement; coupons receivable or payable will also be included on their pay dates. • Commitments: all committed but undrawn lending is included as an outflow of cash (at sight) and included in liquidity calculations. In general, a conservative approach to treatment of expected cash outflows, whether as derivative collateral or undrawn com­ mitments, is recommended business bestpractice.

• Commitments: 10% (specified by FSA) committed but undrawn lending is included as an outflow of cash (at sight) and included in the ratio calculations.

Chapter 10 Liquidity Risk Reporting and Stress Testing

205

206 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 10.6

Liquidity Management: Individual Stress Test Results Report

Stress Tests - Individual Shocks

Sight - 8 Day

Sight - 1 Month

Probability

Impact

Reduction in Liquid Assets Change in repo criteria

Mark-to-market reduction in value of assets

Light

Rating category 1 notch downgrade

8.46%

1.35%

50%

30

Moderate

Rating category 2 notch downgrade

2.34%

0.12%

20%

70

Severe

Rating category 3 notch downgrade

-15.2%

-18.2%

1%

90

8.46%

1.35%

60%

20 30

Light Moderate Severe

Increased haircut on assets

Light Moderate Severe

Unavailability of repo facilities

2.34%

0.12%

40%

-15.2%

-18.2%

5%

70

8.46%

1.35%

70%

25 45

2.34%

0.12%

30%

-15.2%

-18.2%

8%

80

-15.2%

-18.2%

5%

100

Severe

Treat all marketable securities as illiquid (i.e., allocate to final legal maturity time buckets)

Light

Reduce customer deposits by 5%, replace with o/night funding

8.46%

1.35%

70%

20

Moderate

Reduce customer deposits by 10%, replace with o/night funding

2.34%

0.12%

15%

30

Severe

Reduce customer deposits by 15%, replace with o/night funding

-15.2%

-18.2%

5%

40

Light

Reduce Local Authority deposits by 25%, other deposits by 10%, replace with overnight funding

8.46%

1.35%

5%

20

Moderate

Reduce Local Authority deposits by 50%, other Corporate Banking deposits by 35%, replace with overnight funding

2.34%

0.12%

2%

70

Severe

Reduce Local Authority deposits by 100%, other Corporate Banking deposits by 70%, replace with overnight funding

-15.2%

-18.2%

1%

100

Light

Reduce net group liability to EUR500 mm, replace with overnight funding

8.46%

1.35%

100%

5

Decrease in Liabilities Withdrawal of customer deposits

Withdrawal of corporate deposits

Withdrawal of intragroup deposits

Table 10.6

C ontinued

Stress Tests - Individual Shocks

Withdrawal of inter-bank deposits

Sight - 8 Day

Sight - 1 Month

Probability

Impact

Chapter 10 Liquidity Risk Reporting and Stress Testing

2.34%

0.12%

70%

20

-15.2%

-18.2%

30%

50

Reduce deposits from "relationship banks" (correspondent banks) by 5%, other inter-bank deposits by 25%, replace with o/night funding

8.46%

1.35%

80%

20

Moderate

Reduce deposits from"relationship banks" (cor­ respondent banks) by 25%, other inter-bank deposits by 50%, replace with o/night funding

2.34%

0.12%

30%

60

Severe

Reduce deposits from "relationship banks" (cor­ respondent banks) by 50%, other inter-bank deposits by 100%, replace with o/night funding

-15.2%

-18.2%

10%

90

Light

Stress GBP and USD FX rates by 15%

8.46%

1.35%

90%

20

Moderate

Stress GBP and USD FX rates by 15%

2.34%

0,12%

40%

40

Severe

Stress GBP and USD FX rates by 25%

-15.2%

-18.2%

20%

90

Light

Withdrawal of less liquid swap markets

8.46%

1.35%

30%

15

Moderate

Withdraws of swap markets (excl. USD, EUR, GBR)

2.34%

0.12%

7%

40

Severe

Withdrawal of all swap markets

-15.2%

-18.2%

2%

50

Moderate

Reduce net group liability to EUR250 mm, replace with overnight funding

Severe

Reduce net group liability to nil, replace with overnight funding

Light

FX Markets FX rate changes

Withdraw of FX swap markets

Stress Tests-Combined Shocks

Sight - 8 day

Sight - 1 month

Slow-bum liquidity crunch

Detailed description of balance sheet shocks

-25.5%

-26.7%

Probability 2%

Impact 85

Severe reputational damage

Detailed description of balance sheetshocks

-42.4%

-51.2%

0.50%

100

■ 207

Contingency Funding Planning Chi Lai and Richard Tuosto

Learning Objectives After completing this reading you should be able to: Discuss the relationship between contingency funding planning and liquidity stress testing. Evaluate the key design considerations of a sound contin­ gency funding plan.

Assess the key components of a contingency funding plan (governance and oversight, scenarios and liquidity gap analysis, contingent actions, monitoring and escalation, and data and reporting).

Excerpt is Chapter 7 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.

11.1 ACTION S IN A LIQUIDITY CRISIS

set out the company's strategies for addressing liquidity needs during liquidity stress events.

A contingency funding plan (CFP) serves as a logical connection to its companion, the liquidity stress testing framework, by link­ ing the stress test results and other related information as inputs to the CFP governance, menu of contingent liquidity actions, and decision framework.

As part of this guidance, supervisors have indicated that CFPs should have defined policies and procedures that address the governance, roles and responsibilities, liquidity measures and triggers, menu of contingent actions, and communication pro­ tocols. Further, an institution's CFP, or collective set of CFPs, should be tailored to the specific business and risk profiles of the institution, covering the different set of businesses, subsid­ iaries, legal entities, products/asset classes, and geographic and foreign exchange (FX) coverage in which the institution oper­ ates. Finally, institutions should also regularly test their CFPs to ensure operational effectiveness.

Contingent liquidity events can be categorized by their level of estimated adverse impact and probability. Institutions man­ age one end of the spectrum—the low-impact, high-probability events—as part of their business-as-usual (BAU) funding and liquidity risk management activities but use CFPs to address the other end of the spectrum associated with high-impact low-probability events. CFPs provide a structured approach for developing and implementing the institution's financial and oper­ ational strategies for effectively managing such contingent liquid­ ity events during periods of severe market and financial stress. This chapter provides a brief overview of the CFP's evolution and recent changes, design framework and key considerations, and implementation considerations.

11.2 EVOLVING CAPABILITIES AND EN H AN CEM EN TS Formalized CFPs have gained greater traction and importance over the past decade as market disruptions have become more common and concerns for the survival of institutions in crisis have drawn sharpened attention. Progress has been made in formalizing and standardizing CFPs; however, there remain notable differences among institutions with respect to the level of coverage and detail. In general, smaller institutions have typically included their CFPs as part of their broader business continuity plans, while larger institutions have established more formalized CFPs. Larger, more complex firms may also have several CFPs to address the specific challenges and options for different subsidiaries and legal entities. The European Banking Commission's 2008 report, "EU Bank's Liquidity Stress Testing and Contingency Funding Plans," which highlighted the practices of 84 surveyed institutions, noted rec­ ommendations on areas for enhancements, and provided guid­ ance to supervisors and central banks on areas of focus for their evaluation of the institutions' CFPs. Since that time, supervisors have released additional guidance pertaining to CFP design and implementation requirements. More recently, the Federal Reserve, in its "Enhanced Prudential Standards for Bank Hold­ ing Companies and Foreign Banking Organizations" guidance, required that banking organizations operating in the U.S. with $50 billion or more in assets establish and maintain a CFP to

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In addition to the specific guidance on CFPs, other supervisory guidance on capital management, liquidity risk management, and recovery and resolution planning have impacted how insti­ tutions design their CFPs. In particular, the Federal Reserve's Comprehensive Liquidity Assessment and Review (CLAR) and the daily liquidity regulatory reporting requirements have link­ ages to the CFPs' governance and liquidity measures. Addi­ tionally, CFPs are often referenced as part of and aligned to an institution's recovery and resolution planning activities, as liquidity risk is often one of the key drivers of the potential institution's failure and a critical resource needed to effectively support the execution of the institutions' resolution strategies'. In this capacity, the CFP serves as an important bridge between the institution's BAU liquidity risk management practices and the recovery and resolution planning activities, where specific parts of the institution must be resolved.

11.3 DESIGN CONSIDERATIONS While no universal CFP exists that can cover all types of institu­ tions and situations, there are several CFP key design consider­ ations that firms should be mindful of in designing or refreshing their CFPs. These considerations include the following: I. Aligned to business and risk profiles

II. Integrated with broader risk management frameworks III. Operational and actionable, but flexible playbook IV. Inclusive of appropriate stakeholder groups V. Supported by a communication plan

I. Align to Business and Risk Profiles CFPs should be considered in the context of the institu­ tion's specific business and risk profiles, including the scope of business activities, products/asset classes, geographic and

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

FX coverage, and legal entity structures. Institutions should ensure consistency by aligning their risk appetite statement to the CFP framework, through quantifiable early warning indica­ tors, limits, and escalation levels. A CFP should be refreshed accordingly as the institution's business and risk profile changes over time; both internally as corporate and business strategies change, new products and services are introduced, as well as externally, as the macroeconomic and market environments evolve. In addition to the periodic updates to the CFP, leading institutions are taking a more proactive stance on the development of the CFP by incor­ porating it as part of, or in parallel with, their strategic planning exercises, thereby positioning the CFP to be more forwardlooking and flexible.

II. Integrate with Broader Risk Management Frameworks The CFP is not a stand-alone tool, but rather, an integrated part of the institution's liquidity risk management and firm-wide risk management frame-works, including enterprise risk manage­ ment (ERM), capital management, and business continuity and crisis management. This integration of the CFP to other compo­ nents of the ERM disciplines increases the CFP's effectiveness and consistency by enabling it to leverage and reference estab­ lished controls and processes. The CFP should be explicitly linked to the liquidity risk mea­ surement framework and the liquidity stress test, in particular through its limit structure and escalation levels. For example, the liquidity risk measures used in the institution's BAU risk manage­ ment activities serve as a foundation from which the CFP defines its early warning indicators (EWIs). Additionally, linkages to the business continuity and crisis management frameworks will reinforce key operational and communication protocols during times of crisis.

III. Operational, Actionable, but Flexible Playbook As a playbook, the effectiveness of the CFP lies in its opera­ tional readiness. In a crisis, the ability to convene management and start to develop contingent strategies and a plan of action would likely prove highly challenging without prior planning. As such, it is important for the CFP to include a menu of possible contingency actions that management can undertake in differ­ ent stress scenarios and at graduated levels of severity. These graduated stress levels should be aligned to EWIs, triggers, and contingency actions. Through this process, the institution will have a structured roadmap, outlining potential liquidity risks and

associated management actions that can be calibrated for differ­ ent stages of the liquidity crisis. By virtue of the fact that the CFP cannot anticipate all possible situations that may lead to a liquidity crisis, effective CFPs strike a balance between specifying recommended contingency actions while enabling management sufficient flexibility and discretion to make informed decisions as the crisis evolves over time.

IV. Inclusive of Appropriate Stakeholder Groups Developing operational readiness in a CFP requires a thorough understanding of both strategic and tactical aspects of the institution. This assessment begins with scenario design, contin­ gency planning, and communication strategies, and continues through execution, where timely coordination and communica­ tion are critical to ensuring that internal and external stakehold­ ers remain confident in the institution's financial strength. For these reasons, the involvement of appropriate stakeholder groups, including various management committees (e.g., assetliability committee (ALCO), risk and capital committee, invest­ ment committee), business units, finance, corporate treasury, risk, operations and technology, is needed to capture the appropriate elements of the CFP as part of the design and to ensure successful coordination from an execution standpoint. In practice, involvement of the various stakeholder groups pro­ vides a strong forum in which potential issues or challenges can be openly discussed and addressed.

V. Supported by a Communication Plan As in any crisis, the coordinated and timely communication of information to stakeholders is critical—a key lesson that resur­ faced in the recent financial crisis. In addition to the need for the institution to be internally coordinated, external communication to clients, analysts, counterparties, and regulators with timely and accurate information is critical as it helps to reinforce confidence in the institution and mitigate potential risk that rumors and fears do not further precipitate and adversely impact the institution.

11.4 FRAM EW O RK AND BUILDING BLOCKS With these key design considerations in mind, institutions can develop their CFPs using an integrated framework that addresses the people, process, data, and reporting dimensions, keeping in mind that the CFP framework should be tailored to its business and risk profiles, including the scope and scale of its

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business activities, products/asset classes, geographic and FX coverage, subsidiaries, and/or legal entities. Key components of a CFP framework include the following: 1. Governance and oversight 2. Scenarios and liquidity gap analysis 3. Contingent actions

4. Monitoring and escalation 5. Data and reporting

Governance and Oversight An effective CFP requires both well-defined roles and responsi­ bilities and a strong communication strategy that ensures timely coordination and communication among internal and external stakeholders. Both the organizational roles and communications plan need to be supported by well-defined policies and proce­ dures, and reinforced through CFP periodic testing and simula­ tion exercises.

Stakeholder Involvement, Roles, and Responsibilities A well-designed CFP requires representation from a variety of stakeholder groups across the institution. Front office and busi­ ness groups can provide insights into how their businesses per­ form under different business environments and stress scenarios; corporate finance, treasury and risk management groups can provide perspectives on how funding and liquidity risk profiles are managed, both in BAU and in crisis situations, and the tools afforded as the liquidity crisis escalates; and operations can describe the collateral and cash management processes and how they manage the inflows and outflows of liquidity. While the specific CFP roles and responsibilities of different groups may vary across different institutions, there are several groups that play a pivotal role in the CFP design and implementation, including corporate treasury, the liquidity crisis team, management com­ mittee, and board of directors. The following descriptions should serve as a starting point for institutions in defining specific CFP roles and responsibilities. Institutions should be mindful that these roles should be tailored to address institution-specific organiza­ tional structure, capabilities, and coverage/responsibilities:

Corporate treasury. As part of its BAU activities, corporate treasury monitors the ongoing business, risk, funding, and liquidity profile of the institution. The treasurer, in consulta­ tion with the CFO and others, may invoke the CFP and con­ vene the liquidity crisis team (LCT) based on a review of the markets, industry, institution-specific conditions, and liquidity stress testing results.

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Liquidity crisis team. The LCT serves as the central point of contact and is responsible for the continuous monitoring of the institution's liquidity profile. The LCT will also provide recommendations on CFP actions, working closely with cor­ porate treasury and the management committee. In perform­ ing this function, the LCT helps ensure effective coordination and communication across the organization as well as with external stakeholders. The LCT should be composed of senior members of the institution's business and supporting functions, including C-level executives, and heads of business segments, geographies, and legal entities. Generally, the LCT is responsible for designing the CFP and submitting it to the senior management group for review and approval. Management committee. During a crisis, the senior manage­ ment of an institution provides oversight of the LCT and con­ sults with the board of directors, monitoring the institution's liquidity risk profile and reviewing specific recommendations for and coordination of CFP actions. Board of directors. The board of directors should be actively engaged, in coordination with the management committee and LCT teams, during the crisis and serve as an advisor and counsel to them. A strong understanding of the contents of the CFP will enable board members to be actively engaged with the management committee in evaluating CFP actions being considered, particularly if the institution's liquidity position continues to worsen, and strategic actions, such as large asset and/or subsidiary sales, need to be taken. For institutions that have complex business models that include multiple business segments, geographies, and/or legal entities, it is important that the overall organizational structure be well defined at the parent level and the operat­ ing subsidiaries. This helps ensure a proper chain of com­ mand where decisions are well coordinated and aligned across the institution as a whole.

Communication and Coordination CFPs should include a communications strategy and plan to ensure proper notification, coordination, issue reporting and escalation. The different groups across the institution must work in concert, relying on each other to ensure information is avail­ able on a timely basis to support management decision-making. Additionally, an effective communication strategy and plan pro­ motes confidence. Confidence is critical, as demonstrated time and again in financial services industry, most recently during the financial crisis of 2007-08. In any crisis situation, clear and timely communication helps the institution demonstrate a sense of control and confidence that

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

management understands the challenges ahead and has a plan of action. This is important to both internal and external stakehold­ ers, including employees, clients, counterparties, shareholders, rat­ ings agencies, and regulators, as the loss of confidence can quickly spiral downward when rumors start to take over news headlines— whether such headlines are grounded on reality or not. Communications with respect to messaging and content should be centrally managed. Everyone should be working off the same page. However, the bidirectional communication and coordina­ tion with the stakeholders should reside with those executive and management teams that have existing working relation­ ships. For example: • Business units—clients, counterparties • Corporate treasury— regulators and supervisors, rating agencies, clearing banks • Investor relations—investors, analyst community, public media • Legal and compliance— regulators and supervisors These coordination points may differ across institutions, depending on their size, complexity, and organization structure. Additionally, institutions may already have existing communi­ cation plans, as part of their BAU and/or business continuity activities. As such, institutions should look to leverage existing practices as part of their CFP design and make appropriate enhancements, where appropriate.

Policies and Procedures Institutions should document their CFPs and ensure alignment with other risk management, business continuity, and recov­ ery planning-related policies and procedures. Documentation should include all aspects of the CFP, including the governance structure, processes, data, and reporting activities. An illustra­ tive example of a CFP policy outline is as follows: • Introduction • Overview and purpose of the CFP • Related policies including CFPs across business segments, geographies and legal entities, resolution and recovery planning, and business continuity policies • Governance • Roles and responsibilities

• Inputs, outputs, and calculations • Key assumptions • Data control • Model validation • Monitoring and escalation • Regular monitoring and risk management • Liquidity gap analysis • Contingent actions • Reporting • Reporting frequency • Briefing decks and reports The CFP policy should be consistently applied, whether it is a sin­ gle CFP or multiple CFPs, and should be reviewed and updated periodically to ensure continued alignment to the institutions current and forecasted business activities and risks exposures.

Testing and Readiness Assessment On a periodic basis, institutions should evaluate their CFP oper­ ational readiness and test targeted elements of their CFPs to ensure relevance and execution effectiveness in times of stress, particularly given changing market dynamics and the institution's business and risk profiles. While certain contingent activities, such as business divestitures, large asset sales, and use of Fed­ eral Reserve borrowing, may be impractical or unavailable for testing, there are some market activities such as debt issuances, brokered deposits issuances, and limited securities sale of the investment portfolio to generate additional liquidity that may be appropriate to test. Additionally, institutions should evaluate the CFP's opera­ tional effectiveness: Such activities should include the CFP's governance, escalation process, communication, coordi­ nation, and reporting. Leading institutions that perform frequent exercises that best simulate the potential liquidity crisis environment will improve the CFP's operational effec­ tiveness and response times, aspects that are critical during a crisis. Further, the test simulations may also identify potential gaps and/or improvement opportunities that would otherwise be undetected if the CFP were left purely as a theoretical design exercise.

• Review and approval • Periodic review • Stress testing and scenarios overview (likely covered in detail in separate document) • Methodology • Scenario design

Scenarios and Liquidity Gap Analysis Institutions should align their CFP stress scenarios to those in its liquidity stress testing framework, as well as to other frameworks such as the recovery and resolution plans. The liquidity stress testing scenarios will cover both systemic (general market) and

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idiosyncratic (institution-specific) risks and address both mar­ ket (asset) liquidity and funding liquidity, over short-term and prolonged stress periods. The liquidity stress testing framework should ensure that effects of these stresses on the institution's liquidity profile is appropriately measured and monitored. The CFP in turn should provide a tactical mechanism for escalating a developing crisis to management's attention and ensuring actionable responses are available.

• Securitizing retail assets (e.g., mortgages, credit card receiv­ ables, loans, auto leases)

In addition to incorporating the outcomes of the institution's liquidity stress testing, the CFP itself may contain additional liquidity-related stress scenarios. These additional scenarios, while outside the institution's broader liquidity risk monitor­ ing and limit structure (as contained within the liquidity stress test), ensure effective contingency plans are in place in the event of certain events that could potentially impact liquid­ ity. For example, the CFP might include scenarios in which its intraday debit cap with Fedwire is exceeded, specific coun­ terparties fail, or Federal Home Loan Bank funding becomes unavailable.

• Reducing asset growth through reduced balance transfers

Contingent Actions Based on the liquidity gap analysis, institutions can develop contingent actions/capital recovery actions, including a spec­ trum of business scoping activities, pricing initiatives, disposi­ tion actions, and potential expense control actions, that will help strengthen the institution's liquidity position. In general, the applicability and appropriateness of such contingent actions should be considered in the context of the nature and severity (amount) of capital shortfall, associated timing and pattern of the expected capital shortfall, estimated capital relief from the contingent action, and the institution's ability to execute internal or external/market activities associated with such contingent actions. Examples of contingent actions include, but not are limited to the following: • Maintaining lines of credit that allow borrowing without major restrictions on use and reasonable rates • Increasing underwriting standards and dialing back lending • Adjusting pricing strategies to increase premiums paid on deposit products in order to entice investors to place depos­ its with the institution • Changing investment strategy to roll off reinvestment of securities at maturity • Shifting allocation from short-term funding to longer-term funding sources • Increasing issuance of brokered CDs or direct to consumer deposits

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• Pledging of assets through the Federal Reserve discount window • Selling liquid assets/investments • Drawing down on securitization conduits • Issuing subordinated debt • Issuing at-call loans (which can be recalled to provide cash when needed) • Selling consumer loans and/or credit card receivables • Selling business or business units • Raising equity funds through asset sales or issuance • Reducing capital distributions • Curtailing discretionary spending and expenses The availability and potential impact of these contingent actions is dependent on the systemic and/or idiosyncratic nature and severity of the stress events. For example, a general freeze-up or withdrawal of credit in the financial markets could prevent access to existing lines of credit for rolling over short-term obli­ gations. Lenders may restrict or outright refuse to extend credit based on perceptions of the institution's financial strength and exposures to risks. Asset liquidity may decrease precipitously, leaving the institution challenged to fund certain business activi­ ties and commitments. In general, a number of market factors can impact the institu­ tion's ability to take contingent actions including, but not limited to the following: • Shutdown of securitization markets • Restricted access to repo funding due to solvency issues, credit downgrades, or reputation damage • Ratings downgrade and subsequent increase in collateral/ margin requirements • Predatory margin and collateral practices by counterparties • Increased cash deposit requirements with custodian banks • Increased cost-of-funding (i.e., debt yields) • Deposit runoff • Collapse of interbank market and wholesale funding concentration • Counterparties not willing to roll over funding Management should try to anticipate these challenges as well as the implications they may have on its liquidity responses. Where possible, the CFP should document mitigating actions that man­ agement would consider taking to address such challenges.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Market Signals and Reputational Impact In the early stages when an institution experiences liquidity stress, it may elect to curtail certain businesses activities, tighten its credit and lending standards, and/or limit its exposure to higher risk counterparties to strengthen its liquidity profile and resources. While these responses will provide some measure of improved liquidity, such actions may send inadvertent signals to the market and thereby impact the external perception of the institution's financial strength and reputation, adversely limiting the availability and/or effectiveness of future contingent actions as the crisis evolves. For example, borrowers who believe that the institution has spurned their business will likely look to other lenders. Coun­ terparties, such as hedge funds, which rely on credit from prime brokers or trading counterparties, could cease their relation­ ship with the institution and seek other trading partners or intermediaries. Certain debt holders that have strong business relationships with the institution could "force" a debt buyback, and the institution in agreeing to such buyback will likely reduce its liquidity; however, refusing to do so could raise questions regarding the institution's viability. A change in the market's perception of an institution's viability could have rapid and severe impacts on its liquidity. For this reason, certain actions could cause more harm than benefit depending on the severity of the stress and the institution's financial strength, as already noted. At various stages of liquidity stress, management must consider the signals that its actions convey to the markets, its lenders, clients, and counterparties. Depending on the specific timing, certain contingent actions, while they may provide short-term liquidity, may ultimately leave the institution worse off, depend­ ing on the reactions of its external stakeholders. For example, attempts to access a sovereign lending facility or other emer­ gency source of funds may lead counterparties and lenders to immediately withdraw existing credit out of concern that the institution will fail. The sale of certain businesses or a suspen­ sion of activities, such as reverse repo or other customer funding operations, could be perceived as signs of distress. These con­ tingent actions may be necessary during the later stages of the crisis; however, at earlier stages, perceived signals of weakness may actually precipitate a liquidity crunch for the institution.

Monitoring and Escalation The CFP should leverage the institution's liquidity risk monitor­ ing and measurement framework. This framework should include a portfolio of measures to monitor both the current liquidity profile and the anticipated effects of potential liquidity events.

These measures can be organized as market and business mea­ sures (external and internal) and liquidity health measures (inter­ nal), and represent factors that affect—directly or indirectly—the institution's liquidity position. Collectively, these measures form a set of key risk indicators or Early Warning Indicators (EWIs) that provide advance signaling of potential liquidity problems on the horizon, enabling management to evaluate and take measured steps as the crisis escalates.

Early Warning Indicators Market and business measures reflect the market environment and institution-specific business strategy and activities. These indicators, such as significant changes in levels and volatility of the equity markets, severe drop in institution's stock price, and dramatic changes in the business' revenues from a certain geographic area, can prompt management to evaluate how changing market conditions and institution's business strat­ egy may be adversely impacted and thereby proactively take actions in advance of oncoming market disruptions. Liquidity health measures serve as indicators of the institution's liquidity base and strength. While the market and business risk measures should be evaluated within a broader context, the liquidity health measures, such as short-term funding as a proportion of total funding, deposits-to-loan for depository businesses, and the firm's credit rating, are more targeted in that deterioration in these metrics reflect a direct and adverse impact on the institution's current and/or projected liquidity profile and strength. Both types of measures are important for informing manage­ ment of the potential effects of different liquidity stress sce­ narios. Internal and external EWIs should be selected in concert so that the institution can identify emerging liquidity risks and the nature of these risks as idiosyncratic, systemic, or some combination of the two. The combination of EWIs and escala­ tion levels enable the institution to anticipate and manage the liquidity crisis as it unfolds over time.

Market and Business Factors Institutions will need to define EWIs using external and internal information in order to monitor trends in the market as well as among the institution's peer group. Such information can include a combination of macroeconomic measures, industry measures, and institution-specific measures. Macro-environment factors may not directly correspond to indi­ vidual liquidity challenges that an institution may face; however, they can provide insight into general market distress and a sys­ temic withdrawal of liquidity, similar to the freezing of the repo markets during the financial crisis. Macro-environment measures

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should focus on risks that are specific to the financial system and its general liquidity. Examples may include repo spreads, asset haircut trends, and movements in credit default swap (CDS) spreads. Industry factors include trends in the profitability of the financial sector, recent rating agency action, banking industry capital adequacy, S&P financial institution sector movement, and other factors. Competitor analysis can also be applied to evaluate the trends in the industry to detect potential performance problems in an institution's peer group.

Such EWIs are generally most useful before or at the onset of the liquidity crisis, and during the early stages of the CFP escalation levels; however, their usefulness and applicability are aligned to the specific stress scenario and the institution's spe­ cific business and risk profiles.

Liquidity Health Measures

Institution-specific measures help management to assess the market's perception of the institution's financial strength and the likelihood of a liquidity crisis through external information. Inter­ nal measures provide greater insight into the operations of the institution and their potential impact on its liquidity position.

While the review of macro-economic and industry measures provide advance signaling of a potential pending liquidity crisis, institutions should also monitor a suite of liquidity health ratios to help quantify the impact of the liquidity risks and to support decision making on CFP actions being considered. These met­ rics will typically be detailed in the institution's liquidity risk man­ agement policy and referenced by the CFP. Key liquidity health measures include, but are not limited to, the following:

Examples of EWIs encompassing market and business factors include:

• Projected net funding requirements to current unused funding capacity. Measures the funding and borrowing

• Significant and unexpected drop in stock market indices • Downgrade of U.S. Treasury or other sovereign debt rates • Spike in market volatility (e.g., VIX) • Unexpected catastrophic events (e.g., September 11, 2001, earthquakes) • Rapid asset growth funded by potentially volatile liabilities • Real or perceived negative publicity • A decline in asset quality • A decline in earnings performance or projections • Downgrades or announcements of potential downgrades of the institution's credit rating by rating agencies • Cancellation of loan commitments and/or not renewing maturing loans • Wider secondary spreads on the institution's senior and sub­ ordinated debt, rising CDS spreads and increased trading of the bank's debt • Increased collateral requirements or demand collateral for accepting credit exposure to the institution from counterparties • Counterparties and brokers unwilling to deal in unsecured or longer-term transactions • Requests from depositors for early withdrawal of their funds, or the bank has to repurchase its paper in the market • Calls by debt holders for the institution to buy back its debt or CD issuance • Volatility in foreign exchange markets, particularly in the currencies in which the institutions has exposure to and/or requires as part of its liquidity risk management

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needed to finance the institution's increased lending activities and banking activities, and provides an approach to assess the institution's future lending obligations in proportion to the total funds available at the institution.

• Non-core funding to long-term assets. Measures the proportion of longterm funding needs that are supported by less stable sources of funding. A higher non-core fund­ ing dependency ratio is indicative of a high dependence on volatile funding sources that, during times of financial stress, may have limited availability or may only be available at a much higher cost.

• Overnight borrowings to total assets. Measures the reli­ ance on overnight funding to fund the institution's assets as the use of this volatile source of funding can expose the institution to increased liquidity risk.

• Short-term liabilities to total assets. Measures the funding levels that will need to be rolled over within a predetermined short-term time period (e.g., under 30 days, 60 days, 90 days) to support the institution's assets.

• Funding sources concentration. The concentration of fund­ ing sources for an institution is an important measure for understanding which counterparties are most likely to cease providing liquidity during a stress event. Liquidity provid­ ers that comprise a substantial proportion of an institution's funding needs could cause serious harm to liquidity during times of stress, should they decide that their exposure to the institution is too large and decrease that exposure. Managing concentration and establishing a variety of liquidity providers will likely lessen the impact of the loss of any single provider and give the institution additional sources of liquidity to tap in the case of a shortfall.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

• Funding maturity profile. In addition to managing the con­ centration of funding sources, institutions should also evalu­ ate the concentration of maturities for their funding. Large concentrations in funding maturities can threaten an institu­ tion's liquidity position, particularly when a concentration in maturity is accompanied by a reliance on short-term fund­ ing. Institutions should assess the maturity horizon of their funding sources in tandem with the concentration of funding sources and with significant consideration to the institution's reliance on short-term funding.

• Used capacity to total borrowing capacity. Measures the borrowing capacity available to the institution, based on the used capacity relative to the total borrowing capacity, where the used capacity represents the amount of funding currently being utilized across all funding channels (core funding, inter­ bank markets, and funds generated by institutional sales).

• Liquid assets to volatile liabilities. Measures the basic surplus or cushion that liquid assets provide over required funding needs and can be used to monitor the level of liquid assets available to offset volatile funding.

• Unpledged eligible collateral to total assets. Measures the institution's ability to sell assets or use assets as collateral to obtain funding to meet future requirements. The ability to quickly identify and understand the liquidity of unencum­ bered assets will help it optimize its management of the collateral, particularly during periods of market stress.

• Loans to commitments. Measures the exposure to credit facilities that may be required at some point in the future. As these commitments are drawn down, utilization increases, prompting further need for funding to meet the obligations. For institutions with more advanced liquidity risk management capabilities, these liquidity health measures will also include daily liquidity position reporting, the Basel III Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) measures. These liquidity health measures should be monitored continu­ ously over the course of the crisis; however, their importance is related to their associated limits. As these liquidity health measures start to reach predefined limits, management should start to evaluate what contingent actions are appropriate. Simi­ lar to the market and business measures, the usefulness and applicability of liquidity health measures are dependent on the institution's scope and complexity of business activities.

Escalation Levels In designing their CFPs, institutions establish a series of esca­ lation levels properly aligned to the scenarios, contingency actions, and liquidity measures, including EWIs and health mea­ sures. While there are no specific guidelines in the number of

escalation levels required in CFPs, three to five escalation levels are common industry practice. For illustrative purposes, here are descriptions of the different escalation levels, using three levels:

• Level 1. This is the initial escalation level and represents ele­ vated monitoring over market conditions and the impact to the institution's business segments and performance. Level 1 could be triggered by stress test results indicating a greater decline in liquidity than the institution's risk appetite targets and/or a shift in the market's perception of the institution. The convening of the LCT prompts closer coordination and communications among the various stakeholders internally and a communication plan is executed to keep external stake­ holder properly informed and aware of the institution-specific issues and challenges, and actions being contemplated. Monitoring should remain focused on forward-looking mea­ sures of the institution's liquidity health and the general market perception. Business activities that are expected to impact the business and risk profile of the institution will likely be closely monitored with increased frequency and scrutiny.

• Level 2. At this escalation level, the institution has experi­ enced noticeable markets and/or idiosyncratic events that are adversely impacting its business and liquidity risk profile. The institution should monitor indicators of its current liquidity position and any causes of deterioration more closely, with a focus on how the institution's peers and counterparties react to the changing market dynamics. As the crisis continues to worsen, management's attention is on recovery while sustaining business and financial perfor­ mance; however, the focus is more attuned to the immediate and short-term horizon. The LCT and management commit­ tee activities are taken to actively enhance the institution's liquidity position, likely curtailing business activities, and lim­ iting the extension of additional and new credit facilities. In addition, the institution may take steps to improve its liquidity through strategic sales of less liquid portfolio invest­ ments and assets, in addition to evaluating the feasibility of significant CFP contingent actions, such as larger asset sales, business divestitures, and discontinuing certain business activities, given the evolving market conditions.

• Level 3. At the later stages of the crisis, the institution would have taken dramatic steps to stabilize its liquidity position, potentially including significant curtailing of liquidity intensive business activities or disposition/sales of businesses. At this point, the institution's focus is primarily on survival. In this situation, the market environment, state of the institution, and potential CFP actions show similarities to the circumstances contemplated as part of the institution's recovery and resolution planning activities.

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Events that trigger the status of the escalation level should be analyzed to understand the cause of the trigger event(s) and the association to capital adequacy; findings should be summa­ rized and communicated, along with specific recommendations. The movement from one escalation level to another—whether up or down—should be explicitly considered and approved by the LCT. While the CFP provides a structured outline for the expected levels and trend of EWIs and liquidity risk measures, the importance of management's expert judgment and ability to put together the mosaic of the different challenges and decide on a proper course of action should not be understated. At each escalation level, notification, review and approval requirements should be defined to ensure appropriate com­ munications and reporting, in alignment and concert with the defined CFP governance structure, roles and responsibilities. For example, the Level 1 escalation level, which represents height­ ened management monitoring, may require only notification and periodic update to senior management, CFO, CRO, etc.; contingent actions taken at this level may require ALCO and/or the Treasurer. At the Level 2 or 3 escalation levels, where contin­ gency actions typically involve more severe actions, notification as well as approvals for certain contingent actions will inevitably involve senior management and/or the Board. Additional information on EWIs can be found in Chapter 3— Early Warning Indicators.

Data and Reporting When ensuring that the institution's liquidity risk monitoring and measuring framework adequately supports the objec­ tives of the CFP, one should consider the frequency with which various measurements utilized to monitor and manage liquid­ ity risk are generated, assessed, and reported. While daily reporting of the liquidity profile to the treasury function and the funding desks is prevalent at many institutions, there are a number of institutions that could benefit from increasing the frequency of liquidity management reporting, especially to other areas of the institution (such as senior management group, ALCO and other risk committees, and the board). This broader reporting of liquidity management should have the contextual information and qualitative guidance to support senior management in its approach to understanding the insti­ tution's liquidity profile. Reports should convey the methods used to determine liquidity coverage for upcoming liabilities and funding needs and elabo­ rate on the level of coverage predicted by these measures. In addition, institutions should ensure that existing reports capture intraday liquidity positions, track exposure to contingent liabili­ ties, and monitor capacity usage in funding sources.

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Consideration should be given to the dissemination of liquidity risk reports within the institutions, how these reports are used by management and the board in making decisions, and the appropriateness of the information contained within the reports, given their audience.

11.5 ADDITIONAL CONSIDERATIONS Different Types of Institutions As noted earlier, the scope and depth of the CFP will be dependent on the type of institution. Depository institutions will primarily focus on their deposit base and potential runoff, while institutions that rely more on wholesale funding will look to lines of credit and funding markets. Insurance companies primarily derive their funding from the liabilities of their poli­ cies and have historically focused on cash flow matching more than banking institutions. These unique characteristics should be reflected in the CFP's design, monitoring tools, and menu of contingent actions. Institutions must also recognize the risks inherent in their busi­ ness practices. Lending institutions that specialize in revolv­ ers and other open commitment loans should incorporate the potential liquidity drain from obligors drawing down on unfunded commitments. Prime brokers and broker dealers can experience a decline in the funding coverage of their assets as clients withdraw their accounts from the institution. Counterpar­ ties may also make collateral calls, where they previously did not, on positions that have moved in their favor or refuse to post collateral. Institutions that rely on wholesale funding may also experience higher margin requirements and collateral haircuts as their creditworthiness comes under question.

Organizational Structure of the CFPs An effective CFP properly addresses the institution's suite of businesses, geographies, and legal entities. However, it is unlikely that a single CFP document can properly cover all these elements in a clear and concise manner. More practically, institutions have developed a portfolio of CFPs. This portfolio of CFPs consists of individual CFPs that address businessspecific segment, products/asset classes, geographic and FX coverage, and legal entities. In aggregate, the portfolio of CFPs provides a comprehensive view and coverage of the institution's business activities. Depending on the nature and scope of the institution, separate CFPs may be necessary to address regulatory requirements. For example, ring-fenced entities that are supervised by a different

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

regulator than that of the institution's regulator at the holding company have separate CFPs. Some industry participants have taken the opportunity to align CFP coverage to also include legal entities classifications associated with their recovery and resolution planning strategies. Other institutions that have large FX business and coverage may develop a currency CFP that ana­ lyzes the currency exposures across its legal entities.

review their CFPs to ensure that the key elements that consti­ tute an effective CFP include the following attributes: • Strong management involvement and participation from the enterprise • Alignment to other capital and risk management frameworks • Evaluation of a wide range of possible scenarios • Clearly documented management action plan

Liquidity and Capital The advancement of capital and liquidity practices, guided both by enhanced expectations from supervisors as well as internallydriven initiatives, has been notable; however, there is still work to be done. Historically, capital and liquidity management practices have been highly siloed; however, most recently, insti­ tutions have started to bring a more integrated approach and view to these areas. This integrated approach will help bring a common set of EWIs, a more comprehensive view of the impact of liquidity specific stress test results, and proposed response actions on capital positions and vice versa. Further, it should strengthen the alignment of the integrated liquidity and capital stress testing and contingency plans to other enterprise-wide applications, including recovery and resolution plans, capital management, enterprise risk management, and other related capabilities of the institution.

CON CLUSION While institutions have made measureable progress in their CFPs, there are nevertheless opportunities for improvement. Regulatory focus will likely remain elevated in the area of liquid­ ity risk management, and expectations will likely only increase. Consequently, institutions need to demonstrate their CFPs are well designed, aligned with the institution's target business and risk profiles, and are actionable. As such, institutions should

• Communication plan with coordination to internal and exter­ nal stake-holders Institutions should be mindful that the CFP is a playbook—and as such, it requires updating on a regular basis. Strong CFPs will not only provide a menu of options during a time of crisis, but also enhance the overall strategic, business, and risk man­ agement capabilities of the institution, ultimately helping to establish further credibility and confidence from the institution's external stakeholders.

References European Central Bank. 2008. "EU Bank's Liquidity Stress Test­ ing and Contingency Funding Plans," European Central Bank SR 10-6. "Interagency Policy Statement on Funding and Liquid­ ity Risk Management," 2010. OCC, FRB, FDIC, OTS, NCUA Basel Committee on Banking Supervision, 2008. "Principles for Sound Liquidity Risk Management and Supervision, Bank for International Settlement— Basel Committee on Banking Supervision" Office of the Comptroller of the Currency. 2012. Comptroller's Handbook, "Safety and Soundness— Liquidity," June 2012, Office of the Comptroller of the Currency R. Bryant. "Contingency Funding Plan: Banking Busywork or Essential Management Tool?" Federal Reserve Bank of Atlanta

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Managing and Pricing Deposit Services Learning Objectives After completing this reading you should be able to: Differentiate between the various transaction and non-transaction deposit types. Compare the different methods used to determine the pricing of deposits and calculate the price of a deposit account using cost-plus, marginal cost, and conditional pricing formulas.

Explain challenges faced by banks that offer deposit accounts, including deposit insurance, disclosures, overdraft protection, and basic (lifeline) banking.

Excerpt is Chapter 12 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

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K EY TOPICS IN THIS CHAPTER • Types of Deposit Accounts Offered • The Changing Mix of Deposits and Deposit Costs • Pricing Deposit Services • Conditional Deposit Pricing • Rules for Deposit Insurance Coverage • Disclosure of Deposit Terms • Lifeline Banking

12.1 INTRODUCTION Barney Kilgore, one of the most famous presidents in the history of Dow Jones & Company and publisher of The Wall S tre e t Journal, once cautioned his staff: "Don't write banking stories for bankers. Write for the bank's customers. There are a hell of a lot more depositors than bankers." Kilgore was a wise man, indeed. For every banker in this world there are thousands upon thousands of depositors. Deposit accounts are the number one source of funds at most banks. Deposits are a key element in defining what a banking firm really does and what critical roles it really plays in the economy. The ability of management and staff to attract transaction (checkable) and savings deposits from businesses and consum­ ers is an important measure of a depository institution's accep­ tance by the public. Moreover, deposits provide much of the raw material for making loans and, thus, may represent the ulti­ mate source of profits and growth for a depository institution. Important indicators of management's effectiveness are whether or not funds deposited by the public have been raised at the lowest possible cost and whether sufficient deposits are avail­ able to fund all those loans and projects management wishes to pursue.1 This last point highlights two key issues every depository institution must deal with in managing the public's deposits: (1) Where can funds be raised at lowest possible cost? and (2) How can management ensure that the institution always has enough deposits to support lending and other services the public demands? Neither question is easy to answer, especially in today's competitive marketplace. Both the cost and amount of deposits that depository institutions sell to the public are heavily influenced by the pricing schedules

1Portions of this chapter are based on an article by Peter S. Rose in The Canadian Banker [3] and are used with permission of the publisher.

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and competitive maneuverings of other financial institutions offering similar services, such as share accounts in money market mutual funds and credit unions, cash management accounts offered by brokerage firms and insurance companies, and interest-bearing investment accounts offered by many securities firms. So challenging has it become today to attract significant new deposits that many financial firms have created a new executive position— c h ie f d e p o sit officer. Innovation in the form of new types of deposits, new service delivery methods (increasingly electronic in design), and new pricing schemes is accelerating today. Financial-service managers who fail to stay abreast of changes in their competitors' deposit pricing and marketing programs stand to lose both customers and profits. In this chap­ ter we explore the types of deposits that depository institutions sell to the public. We also examine how deposits are priced, the methods for determining their cost to the offering institu­ tion, and the impact of government regulation on the deposit function.

12.2 TYPES O F DEPOSITS O FFER ED BY DEPOSITORY INSTITUTIONS The number and range of deposit services offered by deposi­ tory institutions are impressive indeed and often confusing for customers. Like a Baskin-Robbins ice cream store, deposit plans designed to attract customer funds today come in 31 flavors and more, each plan having features intended to closely match business and household needs for saving money and making payments for goods and services.

Transaction (Payments or Demand) Deposits One of the oldest services offered by depository institutions has centered on making paym ents on behalf of customers. This transaction, or dem and, deposit service requires financialservice providers to honor immediately any withdrawals made either in person by the customer or by a third party designated by the customer to be the recipient of funds withdrawn. Trans­ action deposits include regular noninterest-bearing dem and d e p o sits that do not earn an explicit interest payment but pro­ vide the customer with payment services, safekeeping of funds, and recordkeeping for any transactions carried out by check, card, or via an electronic network, and interest-bearing dem and d e p o sits that provide all of the foregoing services and pay inter­ est to the depositor as well.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Two other important interest-bearing transaction accounts were created in the United States in 1982 with passage of the Garn-St Germain Depository Institutions Act. Banks and thrift institutions could offer deposits competitive with the share accounts offered by money market funds that carried higher, unregulated interest rates and are normally backed by a pool of high-quality securi­ ties. The result was the appearance of money market deposit accounts (MMDAs) and Super NOWs (SNOWs), offering flexible money market interest rates but accessible via check or preau­ thorized draft to pay for goods and services.

Factoid In 2003 for the first time in the history of the United States payments made by checks written against transaction deposit accounts were smaller in number than electronic payments, due principally to the explosive growth of debit cards and computer terminals which promise to expand sharply in the new century.

MMDAs are short-maturity deposits that may have a term of only a few days, weeks, or months, and the offering institution

Noninterest-Bearing Transaction (Demand) Deposits Interest payments have been prohibited on regular check­ ing accounts in the United States since passage of the GlassSteagall Act of 1933. Congress feared at the time that paying interest on immediately withdrawable deposits endangered bank safety—a proposition that researchers have subsequently found to have little support. However, demand (transaction) deposits are among the most volatile and least predictable of a depository institution's sources of funds, with the shortest potential maturity, because they can be withdrawn without prior notice. Most noninterest-bearing demand deposits are held by business firms. In 2009 the U.S. Congress passed the Wall Street Reform and Consumer Protection Act, allowing banks offering demand deposits to corporations to pay interest on these accounts.

Interest-Bearing Transaction Deposits Many consumers today have moved their funds into other types of transaction deposits that pay at least some interest return. Beginning in New England during the 1970s, hybrid checking-savings deposits began to appear in the form of negotiable order of withdrawal (NOW) accounts. NOWs are interest-bearing savings deposits that give the offering deposi­ tory institution the right to insist on prior notice before the cus­ tomer withdraws funds. Because this notice requirement is rarely exercised, the NOW can be used just like a checking (transac­ tion) account to pay for purchases of goods and services. NOWs were permitted nationwide beginning in 1981 as a result of pas­ sage of the Depository Institutions Deregulation Act of 1980. However, they could be held only by individuals and nonprofit institutions. When NOWs became legal nationwide, the U.S. Congress also sanctioned the offering of automatic transfers (ATS), which permit the customer to preauthorize a depository institution to move funds from a savings account to a transaction account in order to cover overdrafts. The net effect was to pay interest on transaction balances roughly equal to the interest earned on a savings account.

can pay any interest rate competitive enough to attract and hold the customer's deposit. Up to six preauthorized drafts per month are allowed, but only three withdrawals may be made by writing checks. There is no limit to the personal withdrawals the customer may make (though service providers reserve the right to set maximum amounts and frequencies for personal with­ drawals). Unlike NOWs, MMDAs can be held by businesses as well as individuals. Super NOWs were authorized at about the same time as MMDAs, but could be held only by individuals and nonprofit institutions. The number of checks the depositor may write is not limited by regulation. However, offering institutions post lower yields on SNOWs than on MMDAs because the former can be drafted more frequently by customers. Incidentally, fed­ eral regulatory authorities classify MMDAs today not as trans­ action (payments) deposits, but as savings deposits. They are included in this section on transaction accounts because they carry limited check-writing privileges.

Mobile Apps— Impact on Transaction Deposits and Potential Customers Finally, the hottest item in the transaction deposit field today appears to be the mobile check deposit. Designed principally for customers on the move, carrying camera-equipped smart phones (such as iPhone or BlackBerry), users take pictures of the front and back of endorsed checks, upload this information into their deposit account, regardless of their location, and receive instant confirmation of the posted deposit. Protection can be provided by such security measures as two-factor login authen­ tication; recent deposits may be visible where the participating depository institution allows this visibility, and photo clarity may be corrected and improved. This mobile-deposit innovation has centered initially in the industry's leaders, such as JP Morgan Chase, USAA, and Bank of America. However, this service will likely soon be offered by a host of smaller depository institutions, both banks and credit

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unions, advertising the capability to make deposits from homes, businesses, shopping centers, and thousands of other, more convenient locations. K ey q u estio n s for the future: • With mobile-phone digital services who will want to write checks? • What will be the use of building or operating branch offices and automated teller machines (ATMs)? • With phone delivery what is the compelling reason to actually visit a depository institution? • What opportunities for attracting new deposits and new sources of revenue does mobile-phone banking present to the industry? • How many more phone users, compared to deposit holders, are there as prospective customers around the globe? Increasingly electronic payment services (such as PayPal) are capturing the consumer's money in place of banks and other depository institutions. Banking's share of "swipe fees" at store registers generally have declined as electronic transactions have taken over.

Nontransaction (Savings or Thrift) Deposits Savings or thrift deposits are designed to attract funds from customers who wish to set aside money in anticipation of future expenditures or for financial emergencies. These deposits nor­ mally pay significantly higher interest rates than transaction deposits do. While their interest cost is higher, thrift deposits are generally less costly to process and manage on the part of offering institutions. Just as depository institutions for decades offered only one basic transaction deposit—the regular checking account—so it was with savings plans. Passbook savings deposits were sold to household customers in small denominations (frequently a passbook deposit could be opened for as little as $5), and withdrawal privileges were unlimited. While legally a depository institution could insist on receiving prior notice of a planned withdrawal from a passbook savings deposit, few institutions insisted on this technicality because of the low interest rate paid on these accounts and because passbook deposits tend to be stable anyway, with little sensitivity to changes in interest rates. Individuals, nonprofit organizations, and governments can hold savings deposits, as can business firms, but in the United States businesses could not place more than $150,000 in such a deposit. Some institutions offer sta tem en t savings d e p o sits, evidenced only by computer entry. The customer can get monthly printouts

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or electronic statements, showing deposits, withdrawals, interest earned, and the balance in the account. Many depository institu­ tions, however, still offer the more traditional passbook savings deposit, where the customer is given a booklet or electronic message, showing the account's balance, interest earnings, deposits, and withdrawals, as well as the many rules that bind depository institution and depositor. For many years, wealthier individuals and businesses have been offered time deposits, which carry fixed maturity dates (often covering 30, 60, 90,180 or 360 days and 1 through 5 years or more) with fixed and sometimes fluctuating interest rates. More recently, time deposits have been issued with interest rates adjusted periodically (such as every 90 days, known as a leg or roll period ). Time deposits must carry a minimum maturity of seven days and normally cannot be withdrawn before that. Time deposits come in a wide variety of types and terms. How­ ever, the most popular of all time deposits are CD s— certificates o f d e p o sit. CDs may be issued in n eg o tia b le form—the $100,000-plus instruments purchased principally by corpora­ tions and wealthy individuals that may be bought and sold any number of times prior to reaching their maturity—or in nonneg o tia b le form—smaller denomination accounts that cannot be traded prior to maturity and are usually acquired by individuals. Innovation has entered the CD marketplace recently with the development of bum p-up CD s (allowing a depositor to switch to a higher interest rate if market interest rates rise); step-u p CD s (permitting periodic upward adjustments in promised interest rates); liquid CD s (allowing the depositor to withdraw some of his or her funds without a withdrawal penalty); and index CD s (linking returns on these certificates to stock market perfor­ mance, such as returns on the Standard and Poor's 500 stock index).

Retirement Savings Deposits In 1981, with passage of the Economic Recovery Tax Act, the U.S. Congress opened the door to yet another deposit instrument— retirem ent savings accounts. Wage earners and salaried individuals were granted the right to make limited con­ tributions each year, tax free, to an individual retirem ent account (IRA), offered by depository institutions, brokerage firms, insur­ ance companies, and mutual funds, or by employers with quali­ fied pension or profit-sharing plans. There was ample precedent for the creation of IRAs; in 1962, Congress had authorized finan­ cial institutions to sell K eogh plan retirement accounts, available to self-employed persons. In 1997 the Congress, in an effort to encourage more saving for retirement, purchases of new homes, and childrens' education, modified the rules for IRA accounts, allowing individuals with

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

higher incomes to make annual tax-deductible contributions to their retirement accounts and families to set up new education savings accounts that could grow tax-free until needed to cover college tuition and other qualified educational expenses. At the same time the Tax Relief Act of 1997 created the Roth IRA, which allows individuals to make non-tax-deductible contribu­ tions to a savings fund that can grow tax free but pay no tax on their investment earnings when withdrawn. Concern by Congress over the fact that few workers still appeared to be saving for retirement led to passage of the Pen­ sion Protection Act of 2006. This law makes it easier for employ­ ers to automatically enroll their employees in retirement plans through payroll deductions. In some cases workplace retirement plans periodically reallocate a worker's payroll savings into dif­ ferent retirement assets as circumstances change, even if the worker herself doesn't do so (known as a "default option"). These employer-engineered decisions regarding employees' retirement accounts are subject to the proviso that the manager running the retirement plan act not recklessly but as a "prudent person" would. Today depository institutions in the United States hold about a quarter of all IRA and Keogh retirement accounts outstanding, ranking second only to mutual funds. The great appeal for the managers of depository institutions is the high degree of stabil­ ity of IRA and Keogh deposits—financial managers can generally rely on having these funds around for several years. Moreover, many IRAs and Keoghs carry fixed interest rates—an advantage if market interest rates are rising—allowing depository institu­ tions to earn higher returns on their loans and investments that more than cover the interest costs associated with IRAs and Keoghs. (These retirement accounts were made more attractive to the public recently when the U.S. Congress voted to increase FDIC insurance coverage to $250,000 for qualified deposits.) Overall, however, Keogh and IRA retirement accounts repre­ sented less than 5 percent of the total deposits of U.S. FDICinsured banks.

12.3 INTEREST RATES O FFER ED ON D IFFER EN T TYPES O F DEPOSITS Each of the different types of deposits we have discussed typi­ cally carries a different rate of interest. In general, the longer the maturity of a deposit, the greater the yield that must be offered to depositors because of the time value of money and the frequent upward slope of the yield curve. For example, NOW accounts and savings deposits are subject to immediate with­ drawal by the customer; accordingly, their offer rate to custom­ ers is among the lowest of all deposits. In contrast, negotiable

CDs and deposits of a year or longer to maturity often carry the highest interest rates that depositories offer. The size and perceived risk exposure of offering institutions also play an important role in shaping deposit interest rates. For example, banks in New York and London, due to their greater size and strength, typically are able to offer deposits at the low­ est average interest rates, while deposit rates posted by other institutions are generally scaled upward from that level. Other key factors are the marketing philosophy and goals of the offer­ ing institution. Depository institutions that choose to compete for deposits aggressively will post higher offer rates to bid deposits away from their competitors.

F a cto id Virtual (Web-centered) banks generally offer higher deposit interest rates than do traditional brick-and-mortar banks. Why?

Answer: This is probably due to the somewhat greater perceived risk of the Web-based banks and their frequent lack of a complete menu of services.

Film to id What Christmastime ritual finds James Stewart playing the manager of a small-town thrift with funding problems so severe that core depositors are lined up to withdraw all their money?

Answer: It's a Wonderful Life.

The Composition of Deposits The largest of all depository institutions are commercial banks, whose $9.3 trillion in deposits in 2010 exceeded the deposits held by all nonbank depository institutions (including thrifts and credit unions) by a ratio of more than four to one. By examining recent trends in bank deposits we can get a pretty good idea of recent changes in the mix of deposits at all types of depository institutions in recent years. In recent years, banks have been most able to sell time and savings deposits—interest-bearing thrift accounts—to the public. As Table 12.1 shows, time and savings deposits repre­ sented more than four-fifths of the total deposits held by all U.S.-insured commercial banks by 2010. Not surprisingly, then, interest-bearing deposits and nontransaction deposits, both of which include time and savings deposits, have captured the majority share of all deposit accounts. In contrast, regular demand deposits, which generally pay little or no interest and

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Table 12.1

The Changing Composition of Deposits in the United States Percentages for All U.S. FDIC-lnsured Banks

Deposit Type or Category

1983

1987

1993

1998

2001

2007

2010*

Noninterest-bearing deposits Interest-bearing deposits Total deposits

37.9% 62.1 100.0%

20.5% 79.5 100.0%

20.8% 79.2 100.0%

19.5% 80.5 100.0%

19.9% 80.1 100.0%

16.4% 83.6 100.0%

18.2% 81.8 100.0%

Transaction deposits Nontransaction deposits Total domestic office deposits

31.9% 68.1 100.0%

32.3% 67.7 100.0%

33.4% 66.6 100.0%

24.3% 75.7 100.0%

21.2% 78.8 100.0%

12.5% 87.5 100.0%

12.3 87.7 100.0%

Demand deposits Savings deposits** Time deposits Total domestic office deposits

25.4% 30.2 44.4 100.0%

22.9% 36.2 40.9 100.0%

20.2% 41.2 38.6 100.0%

18.9% 43.5 37.6 100.0%

19.0% 48.0 33.0 100.0%

8.8% 55.1 36.1 100.0%

8.7 64.3 27.0 100.0%

*Figures based on data for September 30, 2010. **The savings deposit figures include money market deposit accounts (MMDAs). Source: Federal Deposit Insurance Corporation.

make up the majority of transaction and noninterest-bearing deposits, have declined significantly to less than 10 percent of total deposits inside the United States. Indeed, as Gerdes et al. [1 ] observed, the volume of checks paid in the United States fell from close to 50 billion in 1995 to only about 40 billion most recently due mainly to the rise of electronic payments media, including credit and debit cards, Web-based payments systems, and electronic wire transfers. However, most authorities argue that checks written against demand (transaction) deposits will continue to be important in the American payments system, though in parts of Europe (par­ ticularly in Finland, Germany, and the Netherlands) electronic payments are rapidly moving upward. Bankers, if left to decide for themselves about the best mix of deposits, would generally prefer a high proportion of transac­ tion deposits (including regular checking or demand accounts) and low-yielding time and savings deposits. These accounts are among the least expensive of all sources of funds and often include a substantial percentage of core deposits—a stable base of deposited funds that is not highly sensitive to market interest rates (i.e., bears a low interest-rate elasticity) and tends to remain with a depository institution. While many core deposits (such as small savings accounts) can be withdrawn immediately, they have an effective maturity often spanning years. Thus, the availability of a large block of core deposits increases the duration of a depository institution's liabilities and makes that institution less vulnerable to swings in interest rates. The presence of substantial amounts of core deposits in smaller banks helps explain why large banks in recent years have acquired so many smaller banking firms—to gain access to a

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more stable, less-expensive deposit base. In 2010, according to the FDIC, core deposits (principally small savings and checkable accounts) represented 80 percent of total deposits at the small­ est (under $100 million in assets) U.S. banks compared to about 70 percent at the largest ($1 billion in assets plus) U.S. banking firms. However, the combination of inflation, government dereg­ ulation, stiff competition, and better-educated customers has resulted in a dramatic shift in the mix of deposits that depository institutions are able to sell, including a decline in core accounts. Operating costs for institutions offering deposit services have soared in recent years. For example, interest payments on deposits (both foreign and domestic) for all insured U.S. com­ mercial banks amounted to about $10 billion in 1970, but had jumped to more than $200 billion in 2010. At the same time new, higher-yielding deposits proved to be more interest sensi­ tive than older, less-expensive deposits, thus putting pressure on management to pay competitive interest rates on their deposits. Depository institutions that didn't keep up with market interest rates had to be prepared for extra liquidity demands— substantial deposit withdrawals and fluctuating deposit levels. Faced with substantial interest cost pressures, many financial managers have pushed hard to reduce their institution's nonin­ terest expenses (e.g., by automating their operations and reduc­ ing the number of employees on the payroll).

The Ownership of Deposits The dominant holder of bank deposits inside the United States is the private sector—individuals, partnerships, and corpora­ tions (IPC)—accounting for three-quarters of all U.S. deposits.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The next largest deposit owner is state and local governments (about 4 percent of the total), representing the funds accumu­ lated by counties, cities, and other local units of government. These deposits are often highly volatile, rising sharply when tax collections roll in or bonds are sold, and falling precipitously when local government payrolls must be met or construction begins on a new public building. Many depository institutions accept state and local deposits as a service to their commu­ nities even though these deposits frequently are not highly profitable.

Factoid The more rapid the turnover of population in a given market area, the more intensive tends to be competition among depository institutions in the sale of deposit services and the more favorable loan and deposit interest rates tend to be, unless the relocation of depositors doesn't require a change of depository institution.

Banks also hold comparatively small amounts of U.S. govern­ ment deposits. In fact, the U.S. Treasury keeps most of its oper­ ating funds in domestic banking institutions in Treasury tax and loan (TT&L) accounts. When taxes are collected from the public

or Treasury securities are sold to investors, the government usually directs these funds into TT&L deposits first, in order to minimize the impact of government operations on the financial system. The Treasury then makes periodic withdrawals (directing the money into its accounts at the Federal Reserve banks) when it needs to make expenditures. Today the Treasury pays fees to depository institutions to help lower the cost of handling gov­ ernment deposits and receives interest on many of the balances held with depository institutions. Another deposit category of substantial size is deposits held by foreign governments, businesses, and individuals, many of which are received in offshore offices. Foreign-owned deposits rose rapidly during the 1960s and 1970s, climbing to nearly one-fifth of total U.S. bank deposits in 1980, reflecting the rapid growth in world trade and investments by U.S. businesses abroad. However, foreign-owned deposits then declined as a propor­ tion of U.S. bank funds as domestic interest rates proved to be significantly cheaper. Moreover, international crises, the tragedy of 9/11, and recent economic fluctuations encouraged American banks to scale down their overseas expansion plans. However, as the 21st century unfolded, foreign deposits began to grow again due to the availability of higher-yielding foreign invest­ ments, the continued expansion of several foreign economies (especially in Asia), and a deep business recession in Europe and the United States.

E-BANKING AND E-COMMERCE CHECK CLEARING FOR THE 21ST CENTURY ACT (CHECK 21) Paper checks are being processed much faster these days and more businesses and consumers are going electronic. In past years depositors used to count on "float" time between the moment they wrote a check and the time funds were actually removed from their checking account. With float the check writer could often beat the check back to his bank and deposit more money just in time. Today, however, funds often get moved out of one account into another the same day. Increasingly financial firms are capturing the float that used to benefit depositors. At the heart of the newly emerging check system is a process known as electro n ic ch eck conversion, which takes informa­ tion from the check you have written and electronically deb­ its your account, often on the spot. Your check is not sent through the normal clearing process used in the past. Indeed, some merchants will stamp "void" on your check and give it right back to you once they have electronically transferred the data it contains. Moreover, more depository institutions are neither returning checks to their deposit customers nor sending original checks to other depository institutions.

In 2004, the Check 21 Act became law, permitting depository institutions to electronically transfer ch eck im ages instead of checks themselves, replacing originals with su bstitu te checks. These are photographed copies of the front and back of the original check that can be processed as though they were originals. The front will say: "This is a legal copy of your check. You can use it in the same way you would use the original check." Thus, substitute checks provide proof that you paid a bill just as would be the case if you had the origi­ nal check. Check 21 carries a number of benefits for both depositors and depository institutions. It protects depositors against loss from substitute checks. The depositor can contact his or her deposit institution to request a refund when the use of substitute checks has led to an error that cost the deposi­ tor money. Check 21 also benefits depository institutions by sharply reducing the cost of check clearing, especially in doing away with the necessity of shipping bundles of checks around the country. However, from the customer's point of view more bounced checks and overdraft charges are likely. (For further information about Check 21 and the rights and obligations of depositors and institutions, see, especially, www.federalreserve.gov/check21.)

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The final major deposit ownership category is deposits of other banks, which include co rre sp o n d e n t d e p o sits, representing funds that depository institutions hold with each other to pay for correspondent services. For example, large metropolitan banks provide data processing and computerized recordkeeping, investment counseling, participations in loans, and the clearing and collection of checks and other drafts for smaller urban and outlying depository institutions. An institution that holds depos­ its received from other depositories will record them as a liability on its balance sheet under the label d e p o sits due to banks and o th er d e p o sito ry institutions. The institution that owns such deposits will record them as assets under the label d e p o sits due from banks and o th er d e p o sito ry institutions.

The Cost of Different Deposit Accounts Other factors held constant, the managers of depository insti­ tutions would prefer to raise funds by selling those types of deposits that cost the least amount of money or, when revenues generated by the use of deposited funds are considered, gen­ erate the greatest net revenue after expenses. If a depository institution can raise all of its funds from sales of the cheapest deposits and then turn around and purchase the highestyielding assets, it will maximize its spread and, possibly, its net

income. But what are the cheapest deposits? And which depos­ its generate the highest net revenues? Research based upon cost-accounting techniques suggests that checkable (demand or transaction) d e p o sits —including regular checking accounts, special checkbook deposits (which often pay no interest), and interest-bearing checking accounts—are typically among the lowest-cost deposits that depositories sell. While check processing and account maintenance are major expense items, the absence of interest payments on many demand (transaction) deposit accounts help keep their cost down relative to other sources of funds. Moreover, check­ processing costs should move substantially lower in the period ahead as ch eck im aging becomes more widely used. Paper checks are rapidly being supplanted by electronic images, per­ mitting greater storage capacity and faster retrieval, cutting costs and improving service. Especially popular in the new century have been autom atic bill­ paying services, including online bill payment services offered

by depository institutions and direct electronic debits that you authorize out of your bank account and are carried out by a credit card company or other merchant to whom you owe money. Increasingly it is becoming possible to pay almost every bill without cutting a check or visiting a list of websites. Funds

REAL BANKS, REAL DECISIONS

WHO OFFERS THE HIGHEST DEPOSIT INTEREST RATES, AND WHY? Customers interested in purchasing the highest-yielding interest-bearing deposits and the managers of depository institutions interested in discovering what deposit interest yields their competitors are offering can consult newspapers or go online to key websites—for example, www.banx.com or www.Bankrate.com. Among the key types of deposit rate information available are these: • The average yields (APY) offered on CDs purchased through security brokers who search the marketplace every day for the highest yields available on large deposits (usually close to $100,000 in size). • A list of those depository institutions offering the highest yields (APYs) on retail deposits (typically $500 to $25,000 minimum denomination) and jumbo CDs (usually carrying an opening balance of about $100,000 or even larger). Among the depository institutions offering the highest deposit yields are usually leading credit card and household lenders, such as Discover Bank, Ally Bank (formerly GMAC Bank), and E* Trade Bank.

228

Why are the foregoing institutions generally among the leaders in offering deposit interest rates? One reason is they expect to earn relatively high returns on their consumer and credit card loans, giving them an ample margin over deposit costs. In the case of Internet-based banking institutions these unique electronic firms must attract the public away from more traditional institutions and often provide few services, so they must offer exceptional deposit rates to attract the funds they need. Moreover, virtual banks typically have relatively low fixed (overhead) costs, allowing these firms to bid higher for the public's deposits. On the negative side, however, many virtual banks have not been as successful in attracting customers as have traditional depository institutions in recent years. Indeed, the most successful firms at attracting customer deposits recently have been m ultichannel d e p o sito ry institutions —offering both traditional and online services through the same institution— indicating that many customers are more likely to use online services of financial firms that also are accessible in person through traditional branch offices and automated teller machines.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

are simply automatically "yanked out" of your account on the same day each month. In fact, so significant has been the recent decline in paper check volume that the Federal Reserve System announced recently that it was reducing the number of check processing regions in the United States. This trend has gotten a favorable reception from financial institutions hoping to reduce operating costs. However, check writing has generated substantial fee income for most offering institutions—a key source of revenue that will have to be replaced with new revenue sources as the global financial system goes more and more electronic. Thrift deposits—particularly money market accounts, time deposits, and savings accounts—generally rank second to demand deposits as the least costly deposits. Savings depos­ its are relatively cheap because of the low interest rate they tend to carry—one of the lowest annual interest yields (APY) offered—and, in many cases, the absence of monthly statements for depositors. However, many passbook savings accounts have substantial deposit and withdrawal activity as some savers attempt to use them as checking (transaction) accounts. While demand (checking or transaction) deposits have about the same gross expenses per dollar of deposit as time (thrift) deposits do, the higher service fees levied against transaction account customers help to lower the net cost of checkable deposits (after service revenues are netted out) below the net cost of most time (thrift) accounts. This factor plus new govern­ ment regulations help explain why depository institutions today are more aggressively pricing their checkable deposits, asking depositors to pay a bigger share of the activity costs they cre­ ate when they write checks and transfer funds electronically. When we give each type of deposit credit for the earnings it generates through the making of loans and investments, check­ able (demand) deposits appear to be substantially more profit­ able than time deposits for the average depository institution. Moreover, interest expense per dollar of time deposits averages about triple the interest expense associated with each dollar of demand (transaction) deposits. Business transaction accounts, generally speaking, are consid­ erably more profitable than personal checking accounts. One reason is the lower interest expense generally associated with commercial deposits. Moreover, the average size of a personal transaction account normally is less than one-third the average size of a commercial account, so a depository institution receives substantially more investable funds from commercial demand deposits. However, competition posed by foreign financialservice firms for commercial transaction accounts has become so intense that profit margins on these accounts often are razor thin in today's market.

While the managers of depository institutions would prefer to sell only the cheapest deposits to the public, it is predominantly public preference that determines which types of deposits will be created. Depository institutions that do not wish to conform to customer preferences will simply be outbid for deposits by those who do. At the same time, recent deregulation of the financial markets has made it possible for more kinds of financial service firms to respond to the public's deposit preferences.

CO N CEPT C H EC K 12.1. What are the major types of deposit plans that depository institutions offer today?

12.2. What are core deposits, and why are they so impor­ tant today?

12.3. How has the composition of deposits changed in recent years?

12.4. What are the consequences for the management and performance of depository institutions resulting from recent changes in deposit composition?

12.5. Which deposits are the least costly for depository institutions? The most costly?

12.4 PRICING DEPOSIT-RELATED SERVICES We have examined the different types of deposit plans offered today and how the composition of deposits has been chang­ ing over time. An equally important issue remains: How should depository institutions price their deposit services in order to attract new funds and make a profit? In pricing deposit services, management is caught on the horns of an old dilemma. It needs to pay a high enough interest return to attract and hold customer funds, but must avoid paying an interest rate so costly it erodes any potential profit margin. In fact, in a financial marketplace that approaches perfect competi­ tion, the individual depository institution has little control over its prices. It is the marketplace, not the individual financial firm, that ultimately sets prices. Financial institutions, like most other businesses, are price takers, not price makers. In such a mar­ ketplace, management must decide if it wishes to attract more deposits and hold all those it currently has by offering deposi­ tors at least the market-determined price, or whether it is willing to lose funds.

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Factoid Several deposit-related fees charged by depository institu­ tions have increased faster than inflation in recent years. These more rapidly rising bank fees include charges for checks returned for insufficient funds, stop-payment orders, ATM-usage fees, and overdraft fees.

12.5 PRICING DEPOSITS AT CO ST PLUS PROFIT MARGIN The idea of charging the customer for the full cost of deposit-related services is relatively new. In fact, until a few decades ago the notion that customers should receive most deposit-related services fre e o f ch a rg e was hailed as a wise innovation—one that responded to the growing chal­ lenge posed by other financial intermediaries that were invading traditional deposit markets. Many managers soon found reason to question the wisdom of this marketing strategy, however, because they were flooded with numer­ ous low-balance, high-activity accounts that ballooned their operating costs. The development of interest-bearing checkable deposits (par­ ticularly NOWs) offered financial managers the opportunity to reconsider the pricing of deposit services. Unfortunately, many of the early entrants into this new market moved aggressively to capture a major share of the customers through b elo w -co st p ric­ ing. Customer charges were set below operating and overhead costs associated with providing deposit services. The result was a substantially increased rate of return to the customer, known as the im plicit in terest rate —the difference between the true cost of supplying fund-raising services and the service fees actu­ ally assessed the customer. In the United States, variations in the implicit interest rate paid to the customer were the principal way most banks competed for deposits over the 50 years stretching from the Great Depression to the beginning of the 1980s. This was due to the presence of regulatory ceilings on deposit interest rates, beginning in 1933 with passage of the GlassSteagall Act. These legal interest rate ceilings (Regulation Q) were designed to protect depository institutions from "excessive" interest rate competition for deposits, which could allegedly cause them to fail. Prevented from offering higher explicit interest rates, U.S. depositories competed instead by offering free bank-by-mail services, gifts ranging from teddy bears to toasters, and convenient neighborhood branch offices.

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Unfortunately, such forms of n o n p rice co m p etitio n tended to distort the allocation of scarce resources in the financial sector. Congress finally responded to these problems with passage of the Depository Institutions Deregulation Act of 1980, a federal law that called for a gradual phaseout of fed­ eral limits on the interest rates depositories could offer their customers. Today, the responsibility for setting deposit prices has been transferred largely from public regulators to private decision makers—that is, to depository institutions and their customers.

Factoid Which type of depository institution—small banks versus large banks, interstate banks versus single-state banks—tend to charge the highest fees for deposit-related services? As noted by Hannan [9], larger banks and interstate banks tend to levy higher deposit-related fees, especially; low-balance, insufficient funds, and stop-payment fees.

Deregulation has brought more frequent use of unbundled service pricing as greater competition has raised the average real cost of a deposit for deposit-service providers. This means that deposits are usually priced separately from other services. And each deposit service may be priced high enough to recover all or most of the cost of providing that service, using the follow­ ing cost-plus pricing formula: Estimated Unit price overhead Planned charged the Operating expense profit customer = expense + allocated to + margin for each per unit the depositfrom each deposit of deposit service service service service function unit sold

(12.1)

Tying deposit pricing to the cost of deposit-service pro­ duction, as Equation (12.1) does, has encouraged deposit providers to match prices and costs more closely and eliminate many formerly free services. In the United States, for example, more depositories are now levying fees for excessive withdrawals, customer balance inquiries, bounced checks, stop-payment orders, and ATM usages, as well as raising required minimum deposit balances. The results of these trends have generally been favorable to depository institutions, with increases in service fee income generally outstripping losses from angry customers closing their accounts.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

12.6 NEW DEPOSIT INSURANCE RULES-INSIGHTS AND ISSUES Summary of Deposit Insurance Coverage Provided by the FDIC A major reason depository institutions are able to sell deposits at relatively low rates of interest compared to interest rates offered on other financial instruments is because of governmentsupplied deposit insurance. The Federal Deposit Insurance Corporation (FDIC) was established in 1934 to insure depos­ its and protect the U.S. money supply in those cases where depository institutions having FDIC membership failed. Insured depository institutions must display an official sign at each teller station, indicating they hold an FDIC membership certificate. FDIC insurance covers only those deposits made in the United States, though the depositor does not have to be a U.S. resident to receive FDIC protection. All types of deposits normally are covered up to at least $250,000 for each single account holder. As the table below illustrates FDIC insurance coverage has increased substantially in recent years in an effort to promote public confidence in the banking system and deal with inflation, among other factors. FD IC Insurance Coverage Limits:

Year

Standard Coverage Limit

Year

Standard Coverage Limit

1934

$2,500

1968-73

$20,000

1934-49

5,000

1974-79

40,000

1950-65

10,000

1980-2007

100,000

1966-68

15,000

2008

250,000

Deposits placed in separate financial institutions are insured separately, each eligible for full coverage. However, deposits held in more than one branch office of the same depository institution are added together to determine the total amount of insurance protection available. If two formerly independent institutions merge, for example, and a depositor holds $250,000 in each of these two merging institutions, the total protection afforded this depositor would then be a maximum of $250,000, not $500,000, as it would have been before the merger. How­ ever, the FDIC normally allows a grace period so that, for a short time, a depositor with large deposits in two institutions that merge can receive expanded coverage up to at least $500,000 until arrangements can be made to transfer some of the deposi­ tor's funds to other institutions. Insurance coverage may also be increased at a single institution by placing funds under different categories of legal ownership. For example, a depositor with $250,000 in a savings deposit and another $250,000 in a time deposit might achieve greater insurance coverage by making one of these two accounts a joint ownership account with his or her spouse. Also, if a family is composed of husband and wife plus one child, for example, each family member could own an account and each pair of family members could also hold joint accounts, resulting in insur­ ance coverage up to $1,500,000 in total. Only natural persons, not corporations or partnerships, can set up insurance-eligible joint accounts. Each co-owner of a joint account is assumed to have equal right of withdrawal and is also assumed to own an equal share of a joint account unless otherwise stated in the account record. No one person's total insured interest in all joint accounts at the same insured depository institution can exceed $250,000. For example, suppose Mr. Jones has a joint account with Mrs. Jones amount­ ing to $700,000. Then each is presumed to have a $350,000 share and each would have maximum FDIC insurance coverage of $250,000 unless the deposit record shows that, for example, Mrs. Jones owns $500,000 of the $700,000 deposit and Mr. Jones would be covered, therefore, for a maximum of only $200,000.

Note: *Coverage of up to $250,000 was temporary in 2008 and 2009 and made permanent in 2010 with passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Savings deposits, checking accounts, NOW accounts, Christmas Club accounts, time deposits, cashiers' checks, money orders, officers' checks, and any outstanding drafts normally are protected by federal insurance. Certified checks, letters of credit, and traveler's checks for which an insured depository institution is primarily liable also are insured if these are issued in exchange for money or in return for a charge against a deposit. On the other hand, U.S. government secu­ rities, shares in mutual funds, safe deposit boxes, and funds stolen from an insured depository institution are not covered by FDIC insurance. Depository institutions generally carry private insurance for these items.

IRA and Keogh retirement deposits also became fully insured up to $250,000 with the passage of recent legislation. Deposits belonging to pension and profit-sharing plans receive "pass­ through insurance" provided the individual participants' ben­ eficial interests are ascertainable and the depository institution involved is at least "adequately capitalized." Funds deposited by a corporation, partnership, or unincorporated business or association are insured up to the maximum allowed by law and are insured separately from the personal accounts of the company's stockholders, partners, or members. Funds deposited by a sole proprietor are considered to be personal funds, however,

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and are added to any other single-owner accounts the individual business owner has and are protected at least up to $250,000. The amount of insurance premiums each FDIC-insured deposi­ tory institution must pay is determined by the volume of deposits it receives from the public and by the insurance rate category in which each institution falls. Under the current risk-based deposit insurance system more risky depository institutions must pay higher insurance premiums. The degree of risk exposure is determined by the interplay of two factors: (1) the adequacy of capital maintained by each depository institution and (2) the risk class in which the institution is judged to be according to its regulatory supervisors. Well-capitalized, A-rated depositories pay the lowest deposit insur­ ance fee per each $100 of deposit they hold, while undercapital­ ized, C-rated institutions pay the greatest insurance fees. Twice each year the board of directors of the FDIC must decide what insurance rates to assess insured institutions. If the federal insurance fund falls below $1.25 in reserves per $100 in covered deposits (known as the Designated Reserve Ratio [DRR]), the FDIC will raise its insurance fees. When the amount of reserves exceeds the $1.25 per $100 standard, insurance fees may be lowered or eliminated. The boards of the FDIC and the National Credit Union Administra­ tion are authorized to increase the insurance limit every five years in order to protect against inflation, provided this seems warranted. Moreover, the 1.25 percent required DRR mentioned above— sometimes referred to as the "hard" target—may be altered at the FDIC's discretion to form a "soft" target—that is, the FDIC has the authority to allow the DRR to range between 1.15 and 1.50 percent of all insured deposits. Thus, the FDIC now has more flexibility in deciding when it needs to change insurance fees and the amount of depositor insurance protection that it provides. So u rce: Federal Deposit Insurance Corporation.

12.7 USING M ARGINAL CO ST TO SET INTEREST RATES ON DEPOSITS Many financial analysts argue that, whenever possible, marginal co st —the added cost of bringing in new funds—and not histori­ cal average cost, which looks at the past, should be used to help price funds sources for a financial-service institution. The reason is that frequent changes in interest rates will make historical average cost a treacherous standard for pricing. For example, if interest rates are declining, the added (marginal) cost of rais­ ing new money may fall well below the historical average cost over all funds raised. Some loans and investments that looked unprofitable when compared to historical cost will now look profitable when measured against the lower marginal interest

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cost we must pay today. Conversely, if interest rates are on the rise, the marginal cost of today's new money may substantially exceed the historical cost of funds. If management books new assets based on historical cost, they may turn out to be unprofit­ able when measured against the higher marginal cost of raising new funds in today's market. Economist James E. McNulty [8] has suggested a way to use the marginal, or new money, cost idea to help a depository institu­ tion set the interest rates it will offer on new deposit accounts. To understand this marginal cost pricing method, suppose a bank expects to raise $25 million in new deposits by offering its depositors an interest rate of 7 percent. Management estimates that if the bank offers a 7.50 percent interest rate, it can raise $50 million in new deposit money. At 8 percent, $75 million is expected to flow in, while a posted deposit rate of 8.5 percent will bring in a projected $100 million. Finally, if the bank prom­ ises an estimated 9 percent yield, management projects that $125 million in new funds will result from both new and existing deposits that customers will keep in the bank to take advantage of the higher rates offered. Let's assume as well that manage­ ment believes it can invest the new deposit money at a yield of 10 percent. This investment yield represents marginal revenue, the added operating revenue the bank will generate by making new investments from new deposits. Given these facts, what deposit interest rate should the bank offer its customers? As Table 12.2 shows, we need to know at least two crucial items to answer this question: the marginal c o st of moving the deposit rate from one level to another and the marginal co st rate, expressed as a percentage of the volume of additional funds coming into the bank. Once we know the marginal cost rate, we can compare it to the expected additional revenue (mar­ ginal revenue) the bank expects to earn from investing its new deposits. The items we need are: Marginal cost = Change in total cost = New interest rate X Total funds raised at new rate - Old interest rate (12.2) X Total funds raised at old rate and Marginal cost rate =

Change in total cost ---- —--- ;----;--- Additional funds raised

(12.3)

For example, if the bank raises its offer rate on new deposits from 7 percent to 7.5 percent, Table 12.2 shows the marginal cost of this change: Change in total cost = $50 million X 7.5 percent — $25 million X 7 percent = $3.75 million — $1.75 million = $2.00 million. The marginal cost rate, then, is the change in total cost divided by the additional funds raised, or $2 million $25 million = 8 preSent

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 12.2

Using Marginal Cost to Choose the Interest Rate to Offer Customers on Deposits

Example of a Bank Attempting to Raise New Deposit Funds Expected Amounts of New Deposits That Will Flow In $25

Average Interest the Bank Will Pay on New Funds 7.0%

Total Interest Cost of New Funds Raised

Marginal Cost of New Deposit Money

Marginal Cost as a Percentage of New Funds Attracted (marginal cost rate)

Expected Marginal Revenue (return) from Investing the New Funds

Difference between Marginal Revenue and Marginal Cost Rate

Total Profits Earned (after interest cost)

10.0%

+3%

$0.75

$1.75

$1.75

7.0%

50

7.5

3.75

2.00

8.0

10.0

+2%

1.25

75

8.0

6.00

2.25

9.0

10.0

+ 1%

1.50

100

8.5

8.50

2.50

10.0

10.0

+0

1.50

125

9.0

11.25

2.75

11.0

10.0

-1 %

1.25

Note: Figures in millions except percentages.

F a c to id By 2010 total estimated FDIC-insured deposits reached a record $6.2 trillion compared to only $4.3 trillion three years before."

Notice that the marginal cost rate at 8 percent is substantially above the average deposit cost of 7.5 percent. This happens because the bank must not only pay a rate of 7.5 percent to attract the second $25 million, but it must also pay out the same 7.5 percent rate to those depositors who were willing to contrib­ ute the first $25 million at only 7 percent. Because the bank expects to earn 10 percent on these new funds, marginal revenue exceeds marginal cost by 2 percent at a deposit interest cost of 8 percent. Clearly, the new deposits will add more to revenue than they will to cost. The bank is justified (assuming its projections are right) in offering a deposit rate at least as high as 7.5 percent. Its total profit will equal the difference between total revenue ($50 million X 10 percent = $5 million) and total cost ($50 million X 7.5 percent = $3.75 million), for a profit of $1.25 million. Scanning down Table 12.2, we note that the bank continues to improve its total profits, with marginal revenue exceeding mar­ ginal cost, up to a deposit interest rate of 8.5 percent. At that rate the bank raises an estimated $100 million in new money at a marginal cost rate of 10 percent, matching its expected mar­ ginal revenue of 10 percent. There, total profit tops out at $1.5 million. It would not pay the bank to go beyond this point, however. For example, if it offers

a deposit rate of 9 percent, the marginal cost rate balloons upward to 11 percent, which exceeds marginal revenue by a full percentage point. Attracting new deposits at a 9 percent offer rate adds more to cost than to revenue. Note, too, that total profits at a 9 percent deposit rate fall back to $1.25 million. The 8.5 percent deposit rate is clearly the best choice, given all the assumptions and forecasts made. The marginal cost approach provides valuable information to the managers of depository institutions, not only about setting deposit interest rates, but also about deciding just how far the institution should go in expanding its deposit base before the added cost of deposit growth catches up with additional rev­ enues, and total profits begin to decline. When profits start to fall, management needs either to find new sources of funding with lower marginal costs, or to identify new assets promising greater marginal revenues, or both.

Conditional Pricing The appearance of interest-bearing checking accounts in the New England states during the 1970s led to fierce competi­ tion for customer transaction deposits among depository institutions across the United States. Out of that boiling competitive cauldron came widespread use of conditional pricing, where a depository sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below that minimum. Thus, the customer pays a price conditional on how he or she uses a deposit account.

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Conditional pricing techniques vary deposit prices based on one or more of these factors: 1. The number of transactions passing through the account (e.g., number of checks written, deposits made, wire transfers, stoppayment orders, or notices of insufficient funds issued). 2. The average balance held in the account over a designated period (usually per month). 3. The maturity of the deposit in days, weeks, months, or years. The customer selects the deposit plan that results in the lowest fees possible and/or the maximum yields, given the number of checks he or she plans to write, or charges planned to be made,

the number of deposits and withdrawals expected, and the planned average balance. Of course, the depository institution must also be acceptable to the customer from the standpoint of safety, convenience, and service availability. Economist Constance Dunham [7] has classified checking account conditional price schedules into three broad catego­ ries: (1) flat-rate pricing, (2) free pricing, and (3) condition­ ally free pricing. In flat-rate pricing, the depositor's cost is a fixed charge per check, per time period, or both. Thus, there may be a monthly account maintenance fee of $2, and each check written or charge drawn against that account may cost the customer 10 cents, regardless of the level of account activity.

INSIGHTS AND ISSUES THE TRUTH IN SAVINGS ACT In November 1991, the U.S. Congress passed the Truth in Savings Act, which requires depository institutions to make

greater disclosure of the terms attached to the deposits they sell the public. On September 14, 1992, the Federal Reserve Board issued Regulation DD to spell out the rules that depos­ itories must follow to conform with this law. The Fed's regulation stipulates that consumers must be fully informed of the terms on deposit plans before they open a new account. A depository institution must disclose the minimum balance required to open the account, how much must be kept on deposit to avoid paying fees or obtain the promised yield, how the balance in each account is figured, when interest actually begins to accrue, any penalties for early withdrawal, options available at maturity, reinvestment and disbursement options, advance notice of the approaching end of the depos­ it's term if it has a fixed maturity, and any bonuses available. When a consumer asks for the current interest rate the offering institution must provide that customer with the rate offered within the most recent seven calendar days and also provide a telephone number so consumers can get the latest offered rate if interest rates have changed. On fixed-rate accounts offering institutions must disclose to customers what period of time the fixed rate will be in effect. On variable-rate depos­ its institutions must warn consumers that interest rates can change, how frequently they can change, how a variable inter­ est rate is determined, and specify if there are limits on how far deposit rates can move over time. For all interest-bearing accounts the depository must disclose the frequency with which interest is compounded and credited. If a customer decides to renew a deposit that would not be automatically renewed on its own, the renewed deposit is considered a new account, requiring full disclosure of terms. Customers must also be told if their account is automatically renewed and, if not, what will happen to their funds (e.g.,

234

will they be placed in a noninterest-bearing account?) if the customer does not remember to renew his or her deposit. (Generally, customers must receive at least 10 days' advance notice of the approaching maturity date for deposits over one year to maturity that are not automatically renewed.) If a change is made in terms that could reduce a depositor's yield, a 30-day advance notice must be sent to the depositor. Depository institutions must send to their customers the amount of interest earnings received, along with the annual percentage yield earned. The annual percentage yield (or APY) must be calculated using: APY earned = 100 [(1 + Interest earned/Average account balance)(365/Daysinperiod) - 1] where the account balance is the average daily balance kept in the deposit for the period covered by each account state­ ment. Customers must be informed of the impact of early withdrawals on their expected APY. For example, suppose a depositor had $1,500 in an interest bearing account for the first 15 days and $500 in the account for the remaining 15 days. The average daily balance in this case is $1,000, or [($1,500 X 15 days + $500 X 15 days)/ 30 days]. Suppose the account has been credited with $5.25 in interest for the latest 30-day period. Then the APY earned is: APY = 100 [(1 + 5.25/1000)365/3° - 1] = 6.58 percent In determining the balance on which interest earnings are figured, the depository institution must use the full amount of the principal in the deposit for each day, rather than count­ ing only the minimum balance that was in the account on one day during the statement period. Methods that do not pay interest on the full principal balance are prohibited. Deposit plans covered by the Truth in Savings Act are confined to those accounts held by individuals for a personal, family, or household purpose.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

INSIGHTS AND ISSUES HOW U.S. DEPOSITORY INSTITUTIONS SHOULD DISCLOSE THE TERMS ON THEIR DEPOSIT SERVICES TO CUSTOMERS

after the maturity date to withdraw the funds without being charged a penalty.

In order to help institutions selling deposit services in the United States conform to the Truth in Savings Act, the Fed­ eral Reserve Board provides managers with examples of proper disclosure forms to use to inform customers of the terms being quoted on their deposits. For example, the Fed has provided an example of a proper disclosure form for cer­ tificates of deposit as shown below.

Sample Disclosure Form for XYZ Savings Bank One-Year Certificate of Deposit Rate Information The interest rate for your account is

5.20% with an annual percentage yield of 5.34%. You will be paid this rate until the maturity date of the certificate. Your certificate will mature on September 30, 2017. The annual percentage yield assumes interest remains on deposit until maturity. A withdrawal will reduce earnings. Interest will be compounded daily and credited to your account on the last day of each month. Interest begins to accrue on the business day you deposit any noncash item (for example, checks).

Minimum Balance Requirements You must deposit $1,000

to open this account. You must maintain a minimum balance of $1,000 in your account every day to obtain the annual percentage yield listed above.

Balance Computation Method We use the daily bal­

ance method to calculate the interest on your account. This method applies a daily periodic rate to the principal in the account each day.

Transaction Limitations After the account is opened, you

may not make deposits into or withdrawals from the account until the maturity date.

Early Withdrawal Penalty If you withdraw any principal

before the maturity date, a penalty equal to three months' interest will be charged to your account.

Renewal Policy This account will be automatically renewed at maturity. You have a grace period often (10) calendar days

Free pricing, on the other hand, refers to the absence of a monthly account maintenance fee or per-transaction charge. Of course, the word free can be misleading. Even if a deposit-service provider does not charge an explicit fee for deposit services, the customer may incur an implicit fee in the form of lost income (opportunity cost) because the

Both the Truth in Savings Act and the Federal Reserve's Regulation DD stipulate that advertising of deposit terms may not be misleading. If interest rates are quoted in an advertisement, the institution must tell the public what the other relevant terms of the deposit are, such as the minimum balance needed to earn the advertised yield and whether any fees charged could reduce the depositor's overall yield. The Federal Reserve has recently developed sample adver­ tisements to guide managers in making sure that advertising contains all the essential information the consumer needs. For example, the sample advertisement form for CDs shown below was developed recently by the Federal Reserve Board. The sample advertisement illustrates the basic require­ ments for legitimate advertising of deposits under the Truth in Savings Act: (a) deposit rates must be quoted as annual percentage yields (APY), (b) the dates and minimum balance required must be explicit, and (c) the depositor must be warned of penalties or fees that could reduce the yield.

Bank XYZ Always Offers You Competitive CD Rates!! Certificate of Deposit

Annual Percentage Yield (APY)

5-year

6.31%

4-year

6.07%

3-year

5.72%

2-year

5.25%

1-year

4.54%

6-month

4.34%

90-day

4.21% APYs are offered on accounts from 2010 through 2017.

The minimum balance to open an account and obtain the APY is $1,000. A penalty may be imposed for early withdrawal. For more information call: (202) 123-1234.

effective interest rate paid may be less than the going rate on investments of comparable risk. Many depository institutions have found free pricing decidedly unprofitable because it tends to attract many small, active deposits that earn positive returns for the offering institution only when market interest rates are high.

Chapter 12 Managing and Pricing Deposit Services

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Factoid Who cares most about the location of a depository institution—high-income or low-income consumers? Recent research suggests that low-income consumers care more about location in choosing an institution to hold their deposit, while high-income customers appear to be more influenced by the size of the financial firm holding their account.

Conditionally free deposits have come to replace both flatrate and free deposit pricing systems in many financial-service markets. Conditionally free pricing favors large-denomination deposits because services are free if the account balance stays above some minimum figure. One of the advantages of this pricing method is that the customer, not the offering institution, chooses which deposit plan is preferable. This self-selection process is a form of m arket signaling that can give the deposi­ tory institution valuable data on the behavior and cost of its deposits. Conditionally free pricing also allows the offering insti­ tution to divide its deposit market into high-balance, low-activity accounts and low-balance, high-activity accounts.

As an example of the use of conditional pricing techniques for deposits, the fees for regular checking accounts and savings accounts posted by two banks are given in Exhibit 12.1.

We note that Bank A in Exhibit 12.1 appears to favor highbalance, low-activity checking deposits, while Bank B is more lenient toward smaller checking accounts. For example, Bank A begins assessing a checking-account service fee when the cus­ tomer's balance falls below $600, while Bank B charges no fees for checking-account services until the customer's account bal­ ance drops below $500. Moreover, Bank A assesses significantly higher service fees on low-balance checking accounts than does Bank B—$5 to $10 per month versus $3.50 per month. On the other hand, Bank A allows unlimited check writing from its regular accounts, while B assesses a fee if more than 10 checks or withdrawals occur in any month. Similarly, Bank A assesses a $3 per month service fee if a customer's savings account dips below $200, while Bank B charges only a $2 fee if the customer's savings balance drops below $100. These price differences reflect differences in the philoso­ phy of management and owners of these two banks and the types of customers each bank is seeking to attract. Bank A is located in an affluent neighborhood of homes and offices and is patronized primarily by high-income individuals and busi­ nesses who usually keep high deposit balances, but also make many charges and write many checks. Bank B, on the other hand, is located across the street from a large university and actively solicits student deposits, which tend to have relatively low balances. Bank B's pricing schedules are set up to accept

Bank A

Bank B

Regular checking account:

Regular checking account:

Minimum opening balance

$100

If minimum daily balance is

Minimum opening balance

$100

If minimum daily balance is

$600 or more

No fee

$500 or more

No fee

$300 to $599

$5.00 per mo.

Less than $500

$3.50 per mo.

Less than $300

$10.00 per mo.

If the depositor's collected monthly balance averages $1,500, there is no fee No limit on number of checks written Regular savings account:

Minimum opening balance

If checks written or ATM transactions (debits) exceed 10 per month and balance is below $500

$0.15 per debit

Regular savings account:

$100

Service fees:

Minimum opening balance

$100

Service fees:

If balance falls below $200

$3.00 per mo.

If balance falls below $100

$2.00 per mo.

Balance of $200 or more

No fee

Balance above $100

No fee

Fee for more than two withdrawals per month

Exhibit 12.1

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Fee for more than three $2.00

withdrawals per month

$2.00

Example of the use of conditional deposit pricing by two banks serving the same market area.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

low-balance deposits, but the bank also recognizes that it needs to discourage excessive charges and check writing by numerous small depositors, which would run up costs. It does so by charging higher per-check fees than Bank A. In these two instances we can see that deposit pricing policy is sensitive to at least two factors:

1. The typ es o f cu stom ers each d e p o sito ry institution plans to serve —each institution establishes price schedules that appeal to the needs of individuals and businesses repre­ senting a significant portion of its market area.

2. The co st that sew in g d ifferen t typ es o f d e p o sito rs will p re s­ en t to the offering institution —most institutions today price deposit plans in such a way as to cover all or at least a sig­ nificant portion of anticipated service costs.

12.8 PRICING BASED ON THE TOTAL CUSTOM ER RELATIONSHIP AND CHOOSIN G A DEPOSITORY Related to the idea of targeting the best customers for special treatment is the notion of pricing deposits according to the n u m ber o f se rv ice s the cu sto m e r uses. Customers who pur­ chase two or more services may be granted lower deposit fees compared to the fees charged customers having only a limited relationship to the offering institution. The idea is that selling a customer multiple services increases the customer's depen­ dence on the institution and makes it harder for that customer to go elsewhere. In theory at least, relationship pricing pro­ motes greater customer loyalty and makes the customer less sensitive to the prices posted on services offered by compet­ ing financial firms.

The Role That Pricing and Other Factors Play When Customers Choose a Depository Institution to Hold Their Accounts To be sure, deposit pricing is important to financial firms offer­ ing this service. But how important is it to the customer? Are interest rates and fees the most critical factors a customer con­ siders when choosing an institution to hold his or her deposit account? The correct answer appears to be no. Households and businesses consider multiple factors, not just price, in deciding where to place their deposits, recent stud­ ies conducted at the Federal Reserve Board, the University of Michigan, and elsewhere suggest. As shown in Table 12.3, these studies contend that households generally rank co n ven ien ce , service availability, and sa fety above price in choosing which financial firm will hold their transaction account. Moreover, famil­ iarity, which may represent not only name recognition but also safety, ranks above the interest rate paid as an important factor in how individuals and families choose a depository institution to hold their savings account.

F a cto id There is research evidence today that the interest rates banks pay on deposits and the account fees they charge for deposit services do influence which depository institu­ tion a customer chooses to hold his or her account. Inter­ estingly, rural financial-service markets appear to be more responsive to interest rates and fees than do urban markets, on average.

Table 12.3 Factors in Household and Business Customers' Choice of a Financial Firm for Their Deposit Accounts (ranked from most important to least important) In Choosing a Financial Firm to Hold Their Checking (Transaction) Accounts, Households Consider

1. Convenient location. 2. Availability of many other services. 3. Safety

4. Low fees and low minimum balance. 5. High deposit interest rates.

In Choosing a Financial Firm to Hold Their Savings Deposits, Households Consider

1. Familiarity. 2. Interest rate paid,

3. Transactional convenience (not location). 4. Location. 5. Availability of payroll deduction. 6. Fees charged.

In Choosing a Financial Firm to Supply Their Deposits and Other Services, Business Firms Consider

1. Financial health of lending institution. 2. Whether bank will be a reliable

source of credit in the future. 3. Quality of bank officers. 4. Whether loans are competitively priced. 5. Quality of financial advice given. 6. Whether cash management and operations services are provided.

Source: Based on studies by the Federal Reserve Board, Survey of Consumer Finances.

Chapter 12 Managing and Pricing Deposit Services

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237

CONCEPT CHECK 12.6. Describe the essential differences between the follow­ ing deposit pricing methods in use today: cost-plus pricing, conditional pricing, and relationship pricing.

12.7. A bank determines from an analysis of its cost­ accounting figures that for each $500 minimum-balance checking account it sells, account processing and other operating costs will average $4.87 per month and over­ head expenses will run an average of $1.21 per month. The bank hopes to achieve a profit margin over these particular costs of 10 percent of total monthly costs. What monthly fee should it charge a customer who opens one of these checking accounts?

12.8. To price deposits successfully, service providers must know their costs. How are these costs deter­ mined using the historical average cost approach? The marginal cost of funds approach? What are the advantages and disadvantages of each approach?

12.9. How can the historical average cost and marginal cost of funds approaches be used to help select assets, (such as loans) that a depository institution might wish to acquire?

12.10. What factors do household depositors rank most highly in choosing a financial firm for their checking account? Their savings account? What about business firms?

12.11. What does the 1991 Truth in Savings Act require financial firms selling deposits inside the United States to tell their customers?

12.12. Use the APY formula required by the Truth in Sav­ ings Act for the following calculation. Suppose that a customer holds a savings deposit in a savings bank for a year. The balance in the account stood at $2,000 for 180 days and $100 for the remaining days in the year. If the savings bank paid this depositor $8.50 in interest earnings for the year, what APY did this customer receive?

ETHICS IN BANKING AND FINANCIAL SERVICES THE CONTROVERSY OVER DEPOSIT OVERDRAFT PROTECTION Financial managers, customers, and government regulators have weighed in recently on one of the most controversial ser­ vices financial institutions offer today. That service is overdraft protection (sometimes called "bounce protection"). If you acci­ dentally overdraw your deposit account, this service is designed to make sure your incoming checks and drafts are paid and that you avoid excessive NSF (not sufficient funds) fees. There are a variety of these deposit protection plans, but most commonly your bank will set you up with a line of credit (say, $1,000) in return for an annual fee (perhaps $25 to $50 per year). Another type of overdraft plan calls for you to maintain a second account from which the financial-service provider will transfer enough money to pay any overdrafts. What's so controversial about that? After all, as long as you don't write checks or drafts that are too large and go beyond your credit limit the financial-service provider pays all your overdrafts and saves you from insuf­ ficient funds charges both from the service provider and from the merchants who received your bad checks. Sometimes just one bad check can run up $50 or more in fees, never mind the hassle of contacting the merchant who received your bad check and straightening things out. Priced correctly, deposit overdraft protection can bring in substantial revenues for the financial firm. You pay a fee just

238

to get signed up even before you use the service. Then, if the lender has to cover your bad checks, you will have to pay off the loan the lender extended to you (normally within 30 days) plus pay a substantial contract interest rate (say, 18 percent). The combined charges plus short-term nature of the overdraft loan may force you to pay an actual interest rate (measured by the APR) of 200 percent or more. To some observers these loans resemble predatory lending, especially for low-income individuals who may need short-term credit just to get by each month. Moreover, customers, knowing they will be covered if they spend too much, may tend to run repeated overdrafts, wind­ ing up paying large amounts of interest instead of preparing for the possibility of overdrafts by building up their savings. Moreover, feeling they are safe, people may tend to avoid balancing their account statement each month, making more frequent overdrafts likely. Faced with adverse public and regulators' comments some financial firms have reduced or eliminated their overdraft fees. Still, this is a service that has remained popular, especially in recent years when most NSF fees have been sharply on the rise at a pace faster than the rate of inflation. Customers seem to like the convenience, particularly in making sure their most important bills (e.g., home mortgage payment and util­ ity bills) get paid on time. For the financial-service provider it is an important source of fee income that flows through to the bottom line and increases profits.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Indeed, surveys indicate that household customers tend to be extremely loyal to their depository institutions—about a third reported never changing their principal bank of deposit. When an institutional affiliation is changed, it appears to be due mainly to customer relocation, though once a move occurs many cus­ tomers seem to pay greater attention to competing institutions and the relative advantages and disadvantages they offer as well as pricing. Three-quarters of the households surveyed recently by the University of Michigan's Survey Research Center cited location as the primary reason for staying with the financial firm they first chose.

Factoid Recent research suggests that at least half of all households and small businesses hold their primary checking account at a depository institution situated within three miles of their location.

Business firms, on the other hand, prefer to leave their deposits with financial institutions that will be reliable sources of credit and, relatedly, are in good financial shape. They also rate highly the quality of officers and the quality of advice they receive from financial-service managers. Recent research suggests that financial-service providers need to do a better job of letting their customers know about the cost pressures they face today and why they need to charge fully and fairly for any services customers use.

12.9 BASIC (LIFELINE) BANKING: K EY SERVICES FOR LOW -INCOME CUSTOM ERS Our overview in this chapter would not be complete without a brief look at a controversial social issue— basic (or lifeline) banking. Should every adult citizen be guaranteed access to certain basic financial services, such as a checking account or personal loan? Is there a minimum level of financial service to which everyone is entitled? Can an individual today really function—secure adequate shelter, food, education, a job, and health care—without access to certain financial services? Some authorities refer to this issue as lifeline banking because it originated in the controversy surrounding electric, gas, and telephone services. Many people believe these services are so essential for health and comfort they should be provided at reduced prices to those who could not otherwise afford them. The basic, or lifeline, banking issue catapulted to nationwide

attention during the 1980s and 1990s when several consumer groups, such as the Consumers Union and AARP, first studied the problem and campaigned actively for resolution of the issue. Some depositories have been picketed and formal complaints have been lodged with federal and state regulatory agencies. The dimensions of the lifeline banking issue have been hinted at in several recent consumer surveys (see, for example, Good [4]). During the 1990s inquiries by the Federal Reserve indicated that about 12 percent of Americans had neither checking nor savings accounts and about 15 percent had no transaction deposits. A more up-to-date FDIC population survey (12), carried out in 2010 in conjunction with the U.S. Census, found that a substan­ tial segment of the U.S. population is either (1) "unbanked" (i.e., with no deposits or loans of any kind), about 8 percent or 9 million households; or (2) "underbanked" (i.e., having access to some critical services but not others), amounting to about 18 percent or 21 million households. Among the "under­ banked" are those families relying on expensive payday loans, check cashing firms, pawnshops, and money order services to pay their bills. Racial and ethnic minorities are substantially more likely than the general population to be "underbanked." Moreover, most families in this situation report the lowest incomes, little formal education, and often represent single-parent households that do not have trust in the banking system. Yet, only a minority of banks seem concerned about this issue. Many members of the unbanked population represent poten­ tially profitable customers for traditional financial-service providers. Among the financial services most in demand are wire transfers or remittances of money sent to loved ones elsewhere. For example, thousands of documented and undocumented workers regularly wire billions of dollars annu­ ally from the United States to families and friends in Latin America. It has been estimated that the wire-transfer mar­ ket generates well over $100 billion in business annually for participating financial firms. One of the most serious problems individuals outside the finan­ cial mainstream face is lack of access to a deposit account. Many of these potential deposit customers do not have Social Security numbers or other acceptable ID required to open an account under current U.S. law (especially the USA Patriot Act). Others who can submit acceptable ID find most conventional deposit plans too expensive to meet their needs. Without a checking or savings account, few people can get approval for credit because most lending institutions prefer to make loans to those customers who keep deposits with them. Yet access to credit is essential for most families to secure adequate housing, medical care, and other important services.

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Several depository institutions have responded to this problem with basic deposit plans that allow users to cash some checks (such as Social Security checks), make a limited number of per­ sonal withdrawals or write a small number of checks (such as 10 free checks or charges per month), or earn interest on even the smallest balances. As yet, few laws compel financial institutions to offer basic services, except in selected states—for example, Illinois, Massachusetts, Minnesota, Pennsylvania, and Rhode Island—though many states have debated such legislation. Another component was added to this dilemma when the U.S. Congress passed the Debt Collection Improvement Act in 1996 and when the U.S. Treasury launched its Electronic Funds Transfer program in 1999. Both events require that government payments, such as paychecks and Social Security checks, eventu­ ally be delivered via electronic means. This, of course, implies that some sort of deposit account be available in the recipient's name in which these funds can be placed. What, if anything, should government do? Even if new legisla­ tion is not forthcoming, do financial institutions have a responsi­ bility to serve all customers within their communities? These are not easy questions to answer. Most financial-service providers are privately owned corporations responsible to their stockhold­ ers to earn competitive returns. Providing financial services at prices so low they do not cover production costs interferes with that important goal. However, the issue of lifeline banking may not be that simple because many financial firms are not treated in public policy like other private firms. For example, entry into the banking industry is regulated, with federal and state regulatory agencies compelled by law to consider "public convenience and needs" in permitting new banks to be established. Moreover, the Com­ munity Reinvestment Act of 1977 requires regulatory agencies to consider whether a covered financial organization applying to set up new branch offices or merge with another institution has really made an "affirmative effort" to serve all segments of the communities in which it operates. This most recent legal requirement to fully serve the local com­ munity may include the responsibility to offer lifeline financial services. Moreover, depository institutions receive important aid from the government that grants them a competitive advantage over other financial institutions. One of the most important of these aids is deposit insurance, in which the government guar­ antees most of the deposits these institutions sell. If depository institutions benefit from insurance backed ultimately by the public's taxes, do they have a public responsibility to offer some services that are accessible to all? If yes, how should they decide which customers should have access to low-price services? Should they insist on imposing a means test on customers?

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Someone must bear the cost of producing services. Who should bear the cost of lifeline services? Answers to these questions are not readily apparent, but one thing is certain: These issues are not likely to go away.

CONCEPT CHECK 12.13. What is lifeline banking? What pressures does it impose on the managers of banks and other financial institutions? 12.14. Should lifeline banking be offered to low-income customers? Why or why not?

SUMMARY Deposits are the vital input for banks and their closest competi­ tors, the thrift institutions—the principal source of financial capital to fund loans and security investments and help gener­ ate profits. The most important points this chapter has brought forward include: • In managing their deposits financial firms must grapple with two key questions centered upon costand volume. Which types of deposits will help minimize the cost of fund-raising? How can a depository institution raise sufficient deposits to meet its fund-raising needs? • The principal types of deposits offered by depository institutions today include (1) transaction (or payments) accounts, which customers use primarily to pay for purchases of goods and services; and (2) nontransaction (savings or thrift) deposits, which are held primarily as savings to prepare for future emergencies and for the expected yield they prom­ ise. Transaction deposits include regular checking accounts, which often bear no interest return, and interest-bearing transaction deposits (such as NOWs), which usually pay a low yield and, in some cases, limit the number of checks or other drafts that can be written against the account. Nontransac­ tion deposits include certificates of deposit (CDs), savings accounts, and money market accounts. • Transaction deposits often are among the most profitable deposit services because of their nonexistent or low interest rates and the higher service fees these accounts usually carry. In contrast, nontransaction, or thrift, deposits generally have the advantage of a more stable funding base that allows a depository institution to reach for longer-term and higheryielding assets. • The most popular deposit-pricing methods today is condi­ tional pricing. In this case the interest rate the customer may

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

earn and the fees he or she may be asked to pay are condi­ tional on the intensity of use of deposit services and the bal­ ance in the account. In contrast, the cost-plus pricing method calls for estimating all operating and overhead costs incurred in providing each service and adds a margin for profit. Under marginal cost pricing, the offering institution will set its price at a level just sufficient to attract new funds and still earn a profit on the last dollar of new funds raised. Finally, relation­ ship pricing calls for assessing lower fees or promising more generous yields to those customers who are the most loyal. • Recently new rules have entered the deposit market. The Truth in Savings Act requires banks and thrift institutions to make full and timely disclosure of the terms under which each deposit service is offered. This includes information on

minimum-balance requirements, how deposit balances are determined, what yield is promised, what the depositor must do to earn the promised return, and any penalties or fees that might be assessed. • Finally, one of the most controversial issues in modern banking— lifeline banking—continues to be debated in the deposit-services industry. Depository institutions have been asked in several states to offer low-cost financial services, especially deposits and loans, for those customers unable to afford conventional services. Some institutions have responded positively with limited-service, low-cost accounts, while others argue that most financial firms are profit-making corporations that must pay close attention to profitability and cost of each new service.

K E Y TERMS transaction deposit, 222 NOW accounts, 223 money market deposit accounts, 223 Super NOWs, 223 thrift deposits, 224

passbook savings deposits, 224 time deposits, 224 core deposits, 226 cost-plus pricing, 230 Federal Deposit Insurance Corporation (FDIC), 231

conditional pricing, 233 Truth in Savings Act, 234 relationship pricing, 237 basic (lifeline) banking, 239

Chapter 12 Managing and Pricing Deposit Services

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The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

PROBLEM S AND PROJECTS 1. Rhinestone National Bank reports the following figures in its current Report of Condition:

Liabilities and Equity (millions)

Assets (millions) Cash and interbank deposits

$ 50

Short-term security investments

15

Core deposits

$ 50

Large negotiable CDs

150

Total loans, gross

400

Deposits placed by brokers

65

Long-term securities

150

Other deposits

45

10

Money market liabilities

195

Other liabilities

65

Equity capital

55

Other assets Total assets

$625

Total liabilities and equity capital

$625

a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by Rhinestone. Given the mix of its assets, do you see any potential problems? What changes would you like to see management of this bank make? Why? b.

Suppose market interest rates are projected to rise significantly. Does Rhinestone appear to face signifi­ cant losses due to liquidity risk? Due to interest rate risk? Please be as specific as possible.

2. Kalewood Savings Bank has experienced recent changes in the composition of its deposits (see the following table; all figures in millions of dollars). What changes have recently occurred in Kalewood's deposit mix? Do these changes suggest possible problems for manage­ ment in trying to increase profitability and stabilize earnings?

Types of Deposits Held

This Year

One Year Ago

Two Years Ago

Three Years Ago

Regular and special checking accounts

$235

$294

$337

$378

Interest-bearing check­ ing accounts

392

358

329

287

242

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Regular (passbook) savings deposits

501

596

646

709

Money market deposit accounts

863

812

749

725

Retirement deposits

650

603

542

498

CDs under $100,000

327

298

261

244

CDs $100,000 and over

606

587

522

495

3. First Metrocentre Bank posts the following schedule of fees for its household and small-business transaction accounts: • For average monthly account balances over $1,500, there is no monthly maintenance fee and no charge per check or other draft. • For average monthly account balances of $1,000 to $1,500, a $2 monthly maintenance fee is assessed and there is a 10c charge per check or charge cleared. • For average monthly account balances of less than $1,000, a $4 monthly maintenance fee is assessed and there is a 15c per check or per charge fee. What form of deposit pricing is this? What is First Metrocentre trying to accomplish with its pricing schedule? Can you foresee any problems with this pricing plan? 4. Fine-Tuned Savings Association finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing CDs at the interest rates indicated below:

Expected Volume of New Deposits $10 million

Rate of Interest Offered Depositors 2.00%

15 million

2.25

20 million

2.50

24 million

2.75

26 million

3.00

Management anticipates being able to invest any new deposits raised in loans yielding 5.50 percent. How far should this thrift institution go in raising its deposit inter­ est rate in order to maximize total profits (excluding interest costs)? 5. New Day Bank plans to launch a new deposit campaign next week in hopes of bringing in from $100 million to

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

$600 million in new deposit money, which it expects to invest at a 4.25 percent yield. Management believes that an offer rate on new deposits of 2 percent would attract $100 million in new deposits and rollover funds. To attract $200 million, the bank would prob­ ably be forced to offer 2.25 percent. New Day's fore­ cast suggests that $300 million might be available at 2.50 percent, $400 million at 2.75 percent, $500 million at 3.00 percent, and $600 million at 3.25 percent. What volume of deposits should the institution try to attract to ensure that marginal cost does not exceed marginal revenue? 6 . R&R Savings Bank finds that its basic transaction account,

which requires a $1000 minimum balance, costs this savings bank an average of $3.25 per month in servic­ ing costs (including labor and computer time) and $1.25 per month in overhead expenses. The savings bank also tries to build in a $0.50 per month profit margin on these accounts. What monthly fee should the bank charge each customer? Further analysis of customer accounts reveals that for each $100 above the $1,000 minimum in average bal­ ance maintained in its transaction accounts, R&R Sav­ ings saves about 5 percent in operating expenses with each account. (Note: If the bank saves about 5 percent in operating expenses for each $100 held in balances above the $1,000 minimum, then a customer maintaining an average monthly balance of $1,500 should save the bank 25 percent in operating costs.) For a customer who consistently maintains an average balance of $1,200 per month, how much should the bank charge in order to protect its profit margin? 7. Lucy Lane maintains a savings deposit with Monarch Credit Union. This past year Lucy received $10.75 in interest earnings from her savings account. Her savings deposit had the following average balance each month: January

$450

July

$450

February

350

August

425

March

300

September

550

April

550

October

600

May

225

November

625

June

400

December

500

What was the annual percentage yield (APY) earned on Lucy's savings account?

ial. They are not actual FRM exam questions.

8 . The National Bank of Mayville quotes an APY of 2.75 per­

cent on a one-year money market CD sold to one of the small businesses in town. The firm posted a balance of $2,500 for the first 90 days of the year, $3,000 over the next 180 days, and $3,700 for the remainder of the year. How much in total interest earnings did this small busi­ ness customer receive for the year?

Internet Exercises 1. Your education has paid off. You have stepped five years into the future and are reviewing your bank accounts. The money has just piled up. You have a joint account with your fiancee containing $265,000 to be used for your first home. You have a joint account with your mother containing $255,000, and you have an account in your own name with $155,000 for the necessities of life. All three accounts are at the Monarch National Bank. Go to the following FDIC website www2.fdic.gov/edie and have Edie determine the insurance coverage. How much is uninsured? Can you describe the rules determining coverage? 2. How has the composition of deposits changed at your favorite local depository institution over the past 10 years? You can find this deposit information for banks and savings institutions at the FDIC's website. Utilize the Statistics on Depository Institutions link at www2.fdic .gov/sdi. Using the points made in this chapter, explain why your local institution's mix of deposits is changing the way it is. How can depository institution managers influence the trends occurring in the composition of their deposits? 3. Which depository institutions currently quote the highest interest rates on checking accounts? Savings accounts? Money market deposits? Three- and six-months CDs? Visit www.fisn.com,banked.com and www.banx.com for the answers. 4. Compare your local depository institution's interest rates on six-month and one-year certificates of deposit (check newspaper ads, call its customer service line, or visit its website) with the best rates on these same savings instruments offered by depository institutions quoting the highest deposit interest rates in the United States, (See websites listed in Exercise 3.) Why do you think there are such large interest-rate differences between your local institution and those posting the highest interest rates?

Chapter 12 Managing and Pricing Deposit Services

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243

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

CA SE ASSIGN M EN T FOR CHAPTER 12 YOUR BANK'S DEPOSITS: VOLATILITY AND COST

to select Total Deposits and view this in Percentages of Total Assets. To assess the overall importance of deposits as a source of funding, focus on total deposits to total assets. From the Total Deposits report you will collect information to break down deposits in several ways: (1) total deposits into domestic deposits versus foreign; (2) total deposits into interest-bearing deposits versus noninterest-bearing depos­

Chapter 12 examines the major source of funds for depository institutions—deposits. The importance of attracting and maintain­ ing deposits as a stable and low-cost source of funds cannot be overstated. This chapter begins by describing the different types of deposits, then explains why a depository institution's manage­ ment is concerned with cost, volatility (risk of withdrawals), and the trade-off between the two. In this assignment, you will be comparing the character of your bank's deposits across time and with its peer group of banks to glean information concerning the cost and stability of this source of funds. Chapter 12's assignment is designed to develop your deposit-related vocabulary and to emphasize the importance of being able to attract funds in the form of deposits, which is unique to banks and thrift institutions.

its; and (3) domestic deposits into their basic types. All the data for rows 109-123 are available from the Total Deposits report; however, you will have to derive NOW accounts in row 120 by subtracting demand deposits from transaction deposits. Finally, we will go to the Interest Expense report and gather information on the proportion of interest paid for foreign and domestic deposits to total assets. Enter the percentage information for these items as an addition to the spreadsheet for comparisons with the peer group as follows:

The Character and Cost of Your Bank's Deposits— Trend and Comparative Analysis

B. Having collected all the data for rows 109-125, you will

A. Data Collection: Once again the FDIC's website located at

calculate the entries for rows 126 and 127. For example, the entry for cell B126 is created using the formula func­ tion B124/B113.

www2.fdic.gov/sdi/ will provide access to the data needed for your analysis. Use Statistics on Depository Institutions (SDI) to create a four-column report of your bank's informa­ tion and peer group information across years. In this part of the assignment, for Report Selection use the pulldown menu

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107 D eposits 108 Date

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BB&T

P e e r Group

BB&T

P e e r Group

31-12-2010

31-12-2010 31-12-2009

70.13%

68.22%

71.23%

68.20%

110 D eposits held in d o m estic offices

67.04%

52.48%

69.47%

52.12%

111 D eposits held in foreign o ffice

3.09%

15.74%

1.77%

16.08%

112 Total D eposits

70.13%

68.22%

71.23%

68.20%

113 Interest-b earing dep osits (dom estic)

53.54%

38.70%

57.71%

39.20%

114 Interest-b earing dep osits (foreign) 115 N o ninterest-bearing dep so its (dom estic) 116 N o ninterest-b earing dep so its (foreign)

2.96%

14.69%

1.67%

15.40%

13.50%

13.77%

11.76%

12.92%

0.13%

0.86%

0.10%

BB&T

117

67.04%

118 Total d o m estic deposits 119 Dem and deposits

3.89%

P e e r Group 52.48% 5.22%

BB&T 69.47%

1

J

K

L

M

N

O

P

Q

R

0.68% 52.12%

3.19% 4.98+%

2.64%

1.34%

2.11%

1.37%

39.83%

26.50%

35.92%

26.60%

122 O ther savings dep osits (exclud ing MMDAs)

2.76%

8.42%

2.32%

7.06%

25.92%

12.11%

123 Total tim e deposits

H

P e e r Group

121 M oney m arkest d ep o sits accounts (MMDAs)

120 NOW accounts

F ____

31-12-2009

109 Total D eposits

17.92%

9.00%

124 D om estic o ffice dep osits (in te re st exp en se)

0.60%

0.28%

0.84%

0.44%

125 Foreign o ffice dep osits (in te re st exp en se)

0.00%

0.09%

0.01%

0.10%

1.12%

0.72%

1.46%

1.12%

127 bearing dep osits

0.00%

0.60%

0.60%

0.65%

128 Transaction accounts

6.53%

6.56%

5.30%

6.35%

A verage in te re st cost in dom estic o ffice interes126 bearing dep osits A verage in te re st cost in foreign o ffice interes-

129 130 Year-to-Year Comparisons

Com parisons w ith Peer Group

©

▼

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

S

T

The following questions are intended to help candidates understand the

your bank relied more or less on depositors than the aver­ age bank in the peer group? D. Use the chart function in Excel and the data by columns in rows 113 through 116 to create a group of four bar charts illustrating the reliance on deposits as a source of funds and drawing attention to the breakdown of foreign versus domestic and interest-bearing versus noninterest-bearing deposits. You will be able to select the block and create the chart with just a few clicks of the mouse, saving it as a separate sheet to insert into your document. Remember to provide titles, labels, and percentages; otherwise, we have something reminiscent of abstract art. Write one or two paragraphs for your BHC summarizing the breakdown of deposits. Paragraphs describing deposits at BB&T in 2010 and 2009 illustrate how to write your financial data. Deposits provide a significant portion of the funding for bank holding companies. In 2010 more than 70 percent of BB&T's assets were funded by deposits and in 2009 more than 71 percent of their assets were funded by depos­ its. These ratios may be compared to 68.22 percent of deposits-to-total assets for the peer group of institutions in 2010 and 68.20 percent of deposits-to-total assets for the peer group of institutions in 2009. This indicates that BB&T is more reliant on deposits than its peer group, as illustrated by the associated column chart. In the above exhibit, we see that BB&T receives a greater pro­ portion of funds from domestic deposits than the Peer Group of Institutions in both 2010 and 2009 and a smaller propor­ tion of funds from foreign deposits than the Peer Group of Institutions in both years. In aggregate, BB&T has a greater

I---- ------ ---- 1---- ------ ---- 1---- ------ -12/31/2010 Peer Group

12/31/2009 BB&T

proportion of interest-bearing deposits than the peer group and a comparable proportion of noninterest-bearing depos­ its. The average interest cost on domestic interest-bearing deposits for BB&T for 2010 is 1.12 percent, which is 40 basis points above the peer group average of 0.72 percent. However, for foreign interest-bearing deposits the average interest cost for BB&T in 2010 was 0 percent—a whopping 60 basis points lower than the peer group's average interest cost. For domestic interest-bearing deposits in 2009, BB&T paid 32 basis points above the peer group's average interest cost of 1.12 percent These changes in pricing deposits help to explain how BB&T maintained their deposit base. In fact the proportion of domestic deposits-to-total assets for BB&T declined only slightly from 69.47 percent to 67.04 percent. E. Once again use the chart function in Excel and the data by columns in rows 119 through 123 to create a group of four columns charts illustrating the types of domestic deposits supporting assets for your BHC and its peer group. This time we will utilize the column charts that sum to 100 percent to focus on composition by types of domestic deposits, rather than the contribution to funding sources as illustrated in Part D. By choosing different types of charts we can focus our discussions on particular issues, emphasiz­ ing what we view to be most important. The above column chart illustrates BB&T's deposit composition relative to its peer group for 2010 and 2009. Using your column chart as a supportive graphic, write one or two paragraphs describing your BHC's domestic deposit com­ position with inferences concerning interest costs and deposit volatility (withdrawal risk). Domestic Deposits Composition: A Comparison of BB&T with Peers

Breakdown of Deposits-to-Total Asset

12/31/2010 BB&T

ial. They are not actual FRM exam questions.

12/31/2010 BB&T

12/31/2009 Peer Group

12/31/2010 Peer Group

12/31/2009 BB&T

■ N oninterest-bearing deposits (foreign)

□ N oninterest-bearing dep osits (dom estic)

□ Total tim e deposits

□ Interest-bearing dep osits (foreign)

■ Interest-bearing deposits (dom estic)

□ O th e r savings dep osits (excluding M M D As)

□ N O W accounts

■ D em and deposits

12/31/2009 Peer Group

□ M oney m arkets deposits accounts (M M D As)

Chapter 12 Managing and Pricing Deposit Services

■

245

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

Selected References For a discussion of recent trends in deposit services, see these sources: 1. Gerdes, Geoffrey R,; Jack K. Walton II; May X. Liu; and Darrel W. Parke. "Trends in the Use of Payment Instruments in the United States." Federal Reserve Bulletin, Spring 2005, p p .180-201. 2. Santomero, Anthony M. "The Changing Patterns of Payments in the United States." Business Review, Federal Reserve Bank of Philadelphia, Third Quarter 2005, pp. 1-8. 3. Rose, Peter S. "Pricing Deposits in an Era of Competi­ tion and Change." The Canadian Banker, vol. 93, no. 1 (February 1986), pp. 44-51. For a discussion of the controversy over lifeline banking services, see: 4. Good, Barbara A. "Bringing the Unbanked Aboard." Economic Commentary, Federal Reserve Bank of Cleveland, January 15, 1999. For a discussion of the role of depositors in disciplining bank risk taking and bank behavior, see especially: 5. Vaughan, Mark D.; and David C. Wheelock. "Deposit Insur­ ance Reform: Is It Deja Vu All Over Again?" The Regional Economist, Federal Reserve Bank of St. Louis, October 2002, pp. 5-9. 6 . Federal Deposit Insurance Corporation. "Privatizing

Deposit Insurance: Results of the 2006 FDIC Study." FDIC Quarterly 1, no. 2 (2007), pp. 23-32. For a discussion of deposit pricing techniques, see these studies:

8 . McNulty, James E. "Do You Know the True Cost of Your

Deposits?" Review, Federal Home Loan Bank of Atlanta, October 1986, pp. 1-6. For a discussion of recent trends in deposit service availability and service fees, see: 9. Hannan, Timothy H. "Retail Fees of Depository Institutions, 1994-99." Federal Reserve Bulletin, January 2001, pp. 1-11. For a discussion of the impact of the Truth in Savings Act on the cost of bank regulatory compliance, see: 10. Elliehausen, Gregory, and Barbara R. Lowrey. The Cost of Implementing Consumer Financial Regulation; An Analysis of the Experience with the Truth in Savings Act. Staff Study No. 170, Board of Governors of the Federal Reserve System, December 1997. For an international view of reaching out to unbanked custom­ ers, see, for example: 11. Skelton, Edward C, "Reaching Mexico's Unbanked, "Economic Letter, Federal Reserve Bank of Dallas, vol, 5, no. 7 (July 2008), pp. 1-8. For a close view of the Federal Deposit Insurance Corporation's most recent study of unbanked and underbanked customers see in particular: 12. Federal Deposit Insurance Corporation. "Findings from the FDIC Survey of Bank Efforts to Serve the Unbanked and Underbanked," FDIC Quarterly, vol. 3, no. 2 (First Quarter 2009), pp. 39-47.

7. Dunham, Constance. 'Unraveling the Complexity of NOW Account Pricing." New England Economic Review, Federal Reserve Bank of Boston, May/June 1983, pp. 30-45.

246

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Managing Nondeposit Liabilities Learning Objectives After completing this reading you should be able to: Distinguish between the various sources of non-deposit liabilities at a bank.

Calculate overall cost of funds using both the historical average cost approach and the pooled-funds approach.

Describe and calculate the available funds gap. Discuss factors affecting the choice of non-deposit funding sources.

Excerpt is Chapter 13 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

247

K EY TOPICS IN THIS CHAPTER • Liability Management • Customer Relationship Doctrine • Alternative Nondeposit Funds Sources

a loan request—even when deposits and other cash flows are inadequate—usually brings in both new deposits and the demand for other services as well. And the benefits may reach far beyond the borrowing customer alone. For example, a loan made to a business firm often brings in personal accounts from the firm's owners and employees.

• Measuring the Funds Gap • Choosing among Different Funds Sources • Determining the Overall Cost of Funds

13.1 INTRODUCTION The traditional source of funds for most depository institutions is the deposit account—both checking and savings deposits sold to individuals, businesses, and governments. The public's demand for deposits supplies much of the raw material for lending and investing and, ultimately, for the profits these insti­ tutions earn. But what does management do to find new money when deposit volume is inadequate to support all loans and investments these institutions would like to make? In Chapter 9 we found part of the answer to this question is that services like standby credit letters and credit guarantees may be sold to bring in customer fees and loans may be securitized or sold outright to attract new funds in order to make new loans. Chapter 4 provides another part of the answer—when depos­ its don't bring in enough money some security investments, previously acquired, may be sold to generate more cash. In the present chapter we explore yet another important nonde­ posit source of funding—selling lOUs in the money and capital markets for periods of time that may stretch from overnight to several years.

13.2 LIABILITY M AN AGEM EN T AND THE CUSTOM ER RELATIONSHIP D O CTRIN E1 Managers of lending institutions learned over the years that turning down a profitable loan request with the usual excuse— "We don't have enough deposits or other funds sources to support the loan"—is not well received by their customers. Denial of a credit request often means the immediate loss of a customer account and perhaps the loss of any future business from the disappointed customer. On the other hand, granting

1 Portions of this chapter are based on an article by Peter S. Rose in The Canadian Banker [4] and are used with permission.

248

■

F ilm to id What 2003 drama casts Philip Seymour Hoffman as an assis­ tant bank manager with authority over sources and uses of funds at the bank whose love of Atlantic City gets him into trouble? Answer: Owning Mahowny.

The financial community learned long ago the importance of the customer relationship doctrine, which proclaims that the first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings. Thus, lending decisions often precede funding deci­ sions; all loans and investments whose returns exceed their cost and whose quality meets the lending institution's credit stan­ dards should be made. If enough deposits are not immediately available to cover these loans and investments, then manage­ ment should seek out the lowest-cost source of borrowed funds available to meet its customers' credit needs. Of course, the customer relationship doctrine has its limitations. Sometimes it results in scores of poor-quality loans. For example, during the collapse of the subprime mortgage market in the 2007-2009 business recession regulators found that many mort­ gage lenders went overboard in approving loans, falling well below normal industry standards and made in haste with little or no docu­ mentation. Moreover, this wild lending spree was amply supported by cheap money with money market borrowing rates at historic lows. Subsequently, the volume of home foreclosures rose rapidly and many mortgage lenders appeared to abandon positive cus­ tomer relationship strategies in favor of a concentrated effort simply to recover at least some of their funds from beleaguered borrowers. During the 1960s and 1970s, the customer relationship doctrine spawned the liquidity management strategy known as liability management as discussed in Chapters 5 and 18. Liability man­ agement consists of buying funds, mainly from other financial institutions, in order to cover good-quality credit requests and satisfy any legal reserve requirements on deposits and other borrowings that law or regulation may require. A lending institu­ tion may acquire funds by borrowing short term, such as in the domestic Federal funds market, or borrowing abroad through the Eurocurrency market.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 13.1

Sample Use of Nondeposit Funds Sources to Supplement Deposits and Make Loans

First National Bank and Trust Company Balance Sheet (Report of Condition) Assets

Liabilities and Equity

Loans: New loans to be made, $100,000,000

Funding sources found to support the new loans: Newly deposited funds expected today

$50,000,000

Nondeposit funds sources: Federal funds purchased

19,000,000

Borrowings of Eurodollars abroad

20,000,000

Securities sold under agreements to repurchase (RPs)

3,000,000

Borrowings from a nonbank subsidiary of the bank's holding company that sold commercial paper in the money market Total new deposit and nondeposit funds raised to cover the new loans

Table 13.1 illustrates the basic idea behind liability manage­ ment. In this instance, one of a lender's business custom­ ers has requested a new loan amounting to $100 million. However, the deposit division reports that only $50 million in new deposits are expected today. If management wishes to fully meet the loan request of $100 million, it must find another $50 million from nondeposit sources. Some quick work by the lender's money market division, which contacted

+8,000,000 $100,000,000

correspondent banks in New York and London and negoti­ ated with nonbank institutions with temporary cash surpluses, resulted in raising the entire $50 million by borrowing domes­ tic Federal funds, borrowing from a subsidiary part of the same holding company that sold notes (commercial paper) in the open market, selling investment securities under a security repurchase agreement, and borrowing Eurocurrencies from branch offices abroad.

INSIGHTS AND ISSUES Is This Really the Time to Borrow So Much Money Short Term? We note in the example of liability management in Table 13.1 that nondeposit borrowings are most often short term rather than long term. Why would the liability manager rely so heav­ ily upon short-term debt, especially overnight loans? Hasn't she heard about interest rate risk and the danger that the lender may be forced to borrow short term over and over again at higher and higher interest rates to fund a loan? Yes, but there are good reasons for "going short" in most nondeposit borrowings. For one thing, the borrowing cus­ tomer likely is standing there waiting for his loan. Today there may not be enough time to find and negotiate long-term debt contracts; tomorrow may be another story and longer term deposits may soon roll in. Second, in the example in Table 13.1 we are dealing with funding just one loan. A glance at the lender's whole loan

portfolio may reveal a better overall balance between shortand long-term debt. Third, financial firms have gotten much better at managing interest rate risk than used to be the case. As we saw in Parts Two and Three, they now have a lot of risk-management tools to work with. Moreover, many assets institutions hold are also short term, including some overnight and intraday loans. Financialservice managers have learned to keep a rough balance between their shorter-term assets and shorter-term liabilities in order to protect against liquidity crises. Finally, should the current interest-rate forecast call for declining market interest rates, perhaps this liability manager is in a good position after all. With falling interest rates, tomor­ row's borrowing costs should be lower than today's costs. Much depends on the reliability of the outlook for interest rates and market conditions.

Chapter 13 Managing Nondeposit Liabilities

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249

Unfortunately, the money market division cannot rest on its laurels. They know that a substantial portion of the $50 million just raised will be available only until tomorrow when many of the borrowed funds must be returned to their owners. These departing funds will need to be replaced quickly to continue to support the new loan. Customers who receive loans spend their funds quickly (otherwise, why get a loan?) by writing checks and wiring funds to other financial institutions. This lender, there­ fore, must find sufficient new funds to honor all those outgoing checks and wire transfers that its borrowing customers initiate. Clearly, liability management is an essential tool lenders need to sustain the growth of their lending programs. However, it also poses real challenges for financial-service managers, who must keep abreast of the market every day to make sure their institution is fully funded. Moreover, liability management is an interest-sensitive approach to raising funds. If interest rates rise and the lender is unwilling to pay those higher rates, funds bor­ rowed from the money market will be gone in minutes. Money market suppliers of funds typically have a highly elastic response to changes in market interest rates. Yet, viewed from another perspective, funds raised by liability management techniques are flexible: the borrower can decide exactly how much he or she needs and for how long and usu­ ally find a source of funds that meets those requirements. In contrast, when deposits are sold to raise funds, it is the deposi­ tor who decides how much and how long funds will be left with each financial firm. With liability management institutions in need of more funds to cover expanding loan commitments or deficiencies in cash reserves can simply raise their offer rate in order to reduce their volume of money market borrowing.

13.3 ALTERNATIVE N ON DEPOSIT SO U RCES O F FUNDS As Table 13.2 suggests, the usage of nondeposit sources of funds has fluctuated in recent years, but generally has risen to provide a bigger share of funds for depository institutions. While smaller banks and thrift institutions usually rely most heavily on deposits for their funding needs, leading depository institutions around the globe have come to regard the nondeposit funds market as a key source of short-term money to meet both loan demand and unexpected cash emergencies. Table 13.3 shows the relationship between the size of banks and their affinity for non-deposit borrowing. Clearly, the smallest-size banks (each under $100 million in assets) sup­ port only a small share (about 4 percent) of their assets by nondeposit borrowings. Among the largest institutions (over $1 billion in assets), however, nondeposit borrowings covered

250

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about four times as much among large commercial bank assets (or 16 percent). Overall, nondeposit borrowings have often outstripped the growth of traditional deposits, as Table 13.2 suggests, in part because of the greater flexibility of nondeposit borrowings, which are less regulated, and the loss of some deposits in recent years to competing financial institutions, such as mutual funds, insurance companies, hedge funds, and pension funds, that are competing aggressively today to attract the public's savings. In the sections that follow we examine the most popular nonde­ posit funds sources that financial firms use today.

Federal Funds Market ("Fed Funds") The most popular domestic source of borrowed reserves among depository institutions is the Federal funds market. Originally, Fed funds consisted exclusively of deposits held at the Federal Reserve banks. These deposits are owned by depository institu­ tions at the Fed primarily to satisfy legal reserve requirements, clear checks, and pay for purchases of government securities. These Federal Reserve balances can be transferred from one institution to another in seconds through the Fed's wire transfer network (Fedwire), linking all Federal Reserve banks. Today, however, deposits that depository institutions hold with each other also can be moved around the banking system the same day a request is made. The same is true of large collected demand deposit balances that securities dealers and govern­ ments own. All these types of deposits make up the raw mate­ rial traded in the market for Federal funds. In technical terms, Fed funds are simply short-term borrowings of immediately available money. Financial institutions needed little time to realize the potential source of profits inherent in these same-day monies. Because reserves deposited with the Federal Reserve banks and many demand deposits held by business firms pay little or no inter­ est, bank and nonbank firms have a strong economic incentive to lend excess reserves or any demand deposit balances not needed to cover immediate cash needs. Moreover, there are no legal reserve requirements on Fed funds borrowings currently and few regulatory controls—features that have stimulated the growth of the market and helped keep the cost of borrowing down. Financial firms in need of immediate funds can negotiate a loan with a holder of surplus interbank deposits or reserves at the Fed, promising to return the borrowed funds the next day if need be. The main use of the Fed funds market today is still the tradi­ tional one: a mechanism that allows depository institutions short of reserves to meet their legal reserve requirements or to satisfy loan demand by tapping immediately usable funds from other

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 13.2

Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-lnsured Banks and Thrifts Billions of Dollars at Year-End

Nondeposit Sources of Borrowed Funds

1990

1992

1994

1996

1998

2000

2002

Money market negotiable (jumbo) CDs ($100,000+)

2004

2007

$431.8

$366.5

$344.9

$476.9

$671.4

$821.3

$814.0

$1,505.1

$2,382.2

Eurodollar borrowings from own foreign offices

168.0

160.4

185.9

177.3

148.8

194.3

231.5

382.6

154.5

201.8***

Federal funds borrowings and security RPs

180.1

149.9

221.1

199.8

206.1

235.5

476.8

727.4

838.5

760.7

Commercial paper issued**

420.8

406.5

443.7

601.2

936.2

1,275.8

1,194.0

1,395.0

1,788.1

1,020.0

0.3

0.1

0.5

0.2

0.1

0.2

0.1

0.0

48.6

0.7

Total nondeposit funds raised by U.S.insured banks and thrifts

$1,201.0

$1,083.4

$1,196.1

$1,455.4

$1,962.5

$2,527.1

$2,716.4

$4,010.1

$5,211.9

$3,791.2

Total deposits of FDIC-insured depository institutions

$3,637.3

$3,527.1

$3,611.6

$3,925.2

$4,386.1

$4,914.8

$5,568.7

$5,026.0

$6,590.7

$7,513.7

33%

31%

33%

37%

45%

51%

49%

80%

79%

50%

Borrowings from the Federal Reserve banks

Ratio of nondeposit funds to total deposits for all FDIC-insured banks and thrifts

2010*

$1,800.0

Notes: *Figures for money market CDs, Eurodollar borrowings, and repurchase agreements (RPs) are for second quarter 2010. **lncludes all financecompany paper issued directly to investors by banks and other financial-service providers. *** Figures for Eurodollar commitments to foreign affili­ ates fourth quarter of 2009. Sources: Federal Reserve Board and Federal Deposit Insurance Corporation.

Table 13.3 The Relationship between the Size of Banks and Their Use of Nondeposit Borrowings (2007 figures for FDIC insured banks) Size Group end Type of Depository Institution

Percent of Assets Supported by Nondeposit Borrowings

The largest U.S. commercial banks (over $1 billion in assets each) The smallest U.S. commercial banks (under $100 million in assets each)

16%

4

Note: Thrift institutions include savings and loan associations and sav­ ings banks insured by the Federal Deposit Insurance Corporation. Source: Federal Deposit Insurance Corporation.

institutions possessing temporarily idle funds. Fed funds are also used to supplement deposit growth and give lenders a relatively safe outlet for temporary cash surpluses on which interest can be earned (even for a loan lasting only a few hours). Moreover, the Fed funds market serves as a conduit for the policy initia­ tives of the Federal Reserve System designed to control the growth of money and credit and stabilize the economy. By performing all of these functions, the Fed funds market effi­ ciently distributes reserves throughout the financial system to areas of greatest need. To help suppliers and demanders of Fed funds find each other, funds brokers soon appeared to trade Fed funds in return for commissions. Large, accommodating banks, play a role similar to that of funds brokers for smaller depository institutions in their region. An accommodating bank buys and sells Fed funds simultaneously in order to make a

Chapter 13 Managing Nondeposit Liabilities

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market for the reserves of its customer institutions, even though the accommodating bank itself may have no need for extra funds at the moment.

automatically investing the smaller institution's deposits held with it in Fed funds loans until told to do otherwise.

The procedure for borrowing and lending Fed funds is a simple one. Borrowing and lending institutions communicate either directly with each other or indirectly through a correspondent bank or funds broker. Once borrowing and lending institutions agree on the terms of a Fed funds loan, the lending institution arranges to transfer reserves from a deposit it holds, either at a Federal Reserve bank or with an accommodating bank into a deposit controlled by the borrowing institution. This may be accomplished by wiring Fed funds if the borrowing and lending institutions are in different regions. If lender and borrower hold reserve deposits with the same Federal Reserve bank or with the same correspondent bank, the lending institution simply asks that bank to transfer funds from its reserve account to the borrower's reserve account—a series of bookkeeping entries accomplished in seconds via computer. When the loan comes due, the funds are automatically transferred back to the lending institution's reserve account. (See Table 13.4 for a description of the accounting entries involved.) The interest owed may also be transferred at this time, or the borrower may simply send a check to the lender to cover any interest owed.

Repurchase Agreements as a Source of Funds

The interest rate on a Fed funds loan is subject to negotiation between borrowing and lending institutions. While the interest rate attached to each Fed funds loan may differ from the rate on any other loan, most of these loans use the effective interest rate prevailing each day—a rate of interest posted by Fed funds brokers and major accommodating banks operating at the cen­ ter of the funds marketplace. In recent years, tiered Fed funds rates (i.e., interest-rate schedules) have appeared at various times, with borrowing institutions in trouble paying higher inter­ est rates or simply being shut out of this market completely. The Fed funds market typically uses one of three types of loan agreements: (1) overnight loans, (2) term loans, or (3) continuing contracts. Overnight loans are unwritten agreements, negoti­ ated via wire or telephone, with the borrowed funds returned the next day. Normally these loans are not secured by specific collateral, though where borrower and lender do not know each other well or there is doubt about the borrower's credit standing, the borrower may be required to place selected government securities in a custody account in the name of the lender until the loan is repaid. Term loans are longer-term Fed funds contracts lasting several days, weeks, or months, often accompanied by a written contract. Continuing contracts are automatically renewed each day unless either borrower or lender decides to end this agreement. Most continuing contracts are made between smaller respondent institutions and their larger correspondents, with the correspondent

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Less popular than Fed funds and more complex are repur­ chase agreements (RPs), often viewed as collateralized Fed funds transactions. In an ordinary Fed funds transaction, the seller (lender) is exposed to credit risk because the borrowing institution may not have the funds to repay. If the purchaser of Fed funds were to provide collateral in the form of marketable securities, however, credit risk would be reduced. This is what happens in a repurchase agreement, or RP. Most domestic RPs are transacted across the Fed Wire system, just as are Fed funds transactions. RPs may take a bit longer to transact then a Fed funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of securi­ ties provided as collateral.2 RPs get their name from the process involved—the institution purchasing funds (the borrower) is temporarily exchanging secu­ rities for cash. They involve the temporary sale of high-quality, easily liquidated assets (the "starting leg"), such as Treasury bills, accompanied by an agreement to buy back those assets on a specific future date at a predetermined price (the "closing leg"). (See Table 13.5.) An RP transaction is often for overnight funds; however, it may be extended for days, weeks, or even months. The interest cost for both Fed funds and repurchase agreements can be calculated from the following equation: Interest cost of RP

Number of days Amount Current in RP borrowing ■ ix x ---------- ;------ - (13.1) borrowed RP rate 360 days

For example, suppose a bank borrows $50 million through an RP transaction collateralized by government bonds for three days and the current RP rate in the market is 6 percent. Then this bank's total interest cost would be: Interest 3 r = $50,000,000 x 0.06 X — = $24,995 cost of RP 360 A major innovation occurred in the RP market with the inven­ tion of General Collateral Finance (GCF) RPs in 1998, under the

2As a result of losses on RPs associated with the collapse of two gov­ ernment securities dealers in 1985, Congress passed the Government Securities Act, which requires dealers in U.S. government securities to report their activities and requires borrowers and lenders to put their RP contracts in writing, specifying the nature and location of collateral.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 13.4

The Mechanics of Borrowing and Lending Federal Funds First Way to Lend Fed Funds Step 1. Lending Reserve Balances Held at the Federal Reserve Banks to a Borrowing institution Lender's Balance Sheet Borrower's Balance Sheet Liabilities and Net Worth

Assets Federal funds sold (loaned) Lender's reserves on deposit at the Fed

Liabilities and Net Worth

Assets Borrower's reserves on deposit at the Fed

+ 100 -100

+100

Federal funds purchased (borrowed) to support loans and investments

+ 100

Step 2. Repaying the Loan of Fed Funds through the Federal Reserve Banks Lender's Balance Sheet Liabilities and Net Worth

Assets Lender's reserves on deposit at the Fed Federal funds sold (loaned)

Borrower's Balance Sheet Liabilities and Net Worth

Assets Borrower's reserves on deposit at the Fed

+ 100 -100

-100

Federal funds purchased (borrowed) to support loans and investments

-100

Second Way to Lend Fed Funds Step 1. Lending Fed Funds by a Respondent (usually smaller) Depository Institution to a Correspondent (usually larger) Depository Institution Who May Loan Those Funds to Another Institution (usually located in a major money center where credit demands are often heavy) Lender's (respondent's) Balance Sheet Liabilities and Net Worth

Assets Lender's deposits held with correspondent Federal funds sold (loaned)

Borrower's (correspondent's) Balance Sheet Assets

Liabilities and Net Worth Federal funds purchased (borrowed) to support loans and investments Respondent's bank deposit

-100 + 100

+ 100 -100

Step 2. Correspondent Repaying the Loan to the Respondent Depository Institution Respondent Institution Liabilities and Net Worth

Assets Lender's deposits held with correspondent Federal funds sold (loaned)

+ 100 -100

leadership of the Bank of New York, JP Morgan Chase, and the Fixed Income Clearing Corporation (FICC). What is a GCF RP? How does it differ from the traditional RP? Conventional (fixed-collateral) repurchase agreements desig­ nate specific securities to serve as collateral for a loan, with the

Correspondent Institution Assets

Liabilities and Net Worth Federal funds purchased (borrowed) to support loans and investments Respondent's bank deposit

-100 + 100

lender taking possession of those particular instruments until the loan matures. In contrast, the general-collateral GCF RP has been used for low-cost collateral substitution. Borrower and lender can agree upon a variety of securities, any of which may serve as loan collateral. This agreed-upon array of eligible

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Table 13.5

Raising Loanable Funds through a Repurchase Agreement Involving the Borrower's Securities Step 1. Bank Sells Some of Its Securities under an RP Agreement Commercial Bank Liabilities and Net Worth

Assets Securities sold Seller's reserve balances at the Fed

Temporary Buyer of the Bank's Securities

Securities purchased Cash account

-100 + 100

Liabilities and Net Worth

Assets + 100 -100

Step 2. The RP Agreement Ends and the Securities Are Returned Commercial Bank Temporary Buyer of the Bank's Securities Liabilities and Net Worth

Assets Securities repurchased Seller's reserve balances at the Fed

+ 100 -100

Liabilities and Net Worth

Assets Securities returned Cash account

-100 + 100

REAL BANKS, REAL DECISIONS Charging U.S. Depository Institutions a "Lombard Rate"? What's That? The Federal Reserve's recent changes in the rules (Regula­ tion A) governing its discount window loans bring this aspect of U.S. central banking much closer to what central banks in Europe do. Before 2003 the Federal Reserve's discount rate was fre­ quently the lowest interest rate in the money market and often below the Fed funds interest rate. With the discount rate so low, many depository institutions were tempted to borrow from the Fed and relend the money in the Fed funds market. Some did! Today the U.S. primary-credit discount rate is now set slightly higher than the Fed funds interest rate on overnight loans, which the Federal Reserve is using as a target to stabilize the economy. Setting the Fed's discount rate above market

collateral might include, for example, any obligation of the Trea­ sury or a federal agency. Thus, the same securities pledged at the beginning do not have to be delivered at the end of a loan. Moreover, GCF RPs may be settled on the books of the FICC, which allows netting of obligations between lenders, borrowers, and brokers so that less money and securities must be trans­ ferred. Finally, GCF RPs can be reversed early in the morning and settled late each day, giving borrowers greater flexibility

254

mirrors the "Lombard" credit facilities used by several European central banks. (Incidentally, the term Lombard owes its origin to a German word for collateralized loan. One of the earliest users of above-market loan rates for banks in need of funds was the Bundesbank, Germany's central bank.) Lom­ bard loan rates have been employed by the European Central Bank (ECB) and the central banks of Austria, Belgium, France, Germany, Italy, and Sweden. Similar lending rules were adopted recently by the Bank of Canada and Bank of Japan. With the discount or Lombard rate set above market levels for similar loans, central banks are less inclined to restrict borrowing from the discount window and less concerned about what borrowers do with the money. Moreover, recent evidence suggests that an above-market Lombard rate tends to act as a ceiling on overnight borrowing rates and may serve as an effective ceiling for the U.S. Fed funds interest rate.

during daylight hours in deciding what to do with collateral securities. GCF RPs can make more efficient use of collateral, lower transactions cost, and help make the RP market somewhat more liquid. (For further discussion of this RP innovation, see especially Fleming and Garbade [1].) Overall, however, the RP market has contracted somewhat recently, especially during the 2007-2009 credit crisis, due to concern over the quality and market value of securities being

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

CONCEPT CHECK 13.1. What is liability management?

13.2. What advantages and risks does the pursuit of liability management bring to a borrowing institution?

13.3. What is the customer relationship doctrine, and what are its implications for fund-raising by lending institutions?

13.4. For what kinds of funding situations are Federal funds best suited?

13.5. Chequers State Bank loans $50 million from its reserve account at the Federal Reserve Bank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's district, for 24 hours, with the funds returned the next day. Can you show the

pledged as collateral for these loans. Moreover, one of the fac­ tors that contributed significantly to the well-publicized troubles of Bear Stearns and Lehman Brothers, leading investment banks, was their inability to find adequate support from the RP market.

Borrowing from Federal Reserve Banks For a depository institution with immediate reserve needs, a via­ ble alternative to Fed funds and RPs is negotiating a loan from a central bank for a short period of time. For example, depository

Table 13.6

correct accounting entries for making this loan and for the return of the loaned funds?

13.6. Hillside Savings Association has an excess balance of $35 million in a deposit at its principal correspondent, Sterling City Bank, and instructs the latter institution to loan the funds today to another institution, returning them to its correspondent deposit the next business day. Sterling loans the $35 million to Imperial Security National Bank for 24 hours. Can you show the proper accounting entries for the extension of this loan and for the recovery of the loaned funds by Hillside Savings?

13.7. Compare and contrast Fed funds transactions with RPs. 13.8. What are the principal advantages to the borrower of funds under an RP agreement?

institutions operating in the United States may be eligible for loans granted by the Federal Reserve Bank in their particular region. The Fed will make the loan through its discount window by crediting die borrowing institution's reserve account. (See Table 13.6 for an overview of the typical accounting entries associated with a discount window loan.) Each loan made by the Federal Reserve banks must be backed by collateral acceptable to the Fed. Most depository institutions keep U.S. government securities in the vaults of the Federal Reserve banks for this purpose. The Fed will also accept certain

Borrowing Reserves from the Federal Reserve Bank in the District Securing a Loan from a Federal Reserve Bank Borrowing Depository Institution Liabilities and Net Worth

Assets Reserves on deposit at the Federal Reserve Bank

Notes payable

+100

Federal Reserve Bank Liabilities and Net Worth

Assets Loan and advances

+100

Bank reserve accounts

+ 100

+ 100 Repaying a Loan from a Federal Reserve Bank

Borrowing Depository Institution Liabilities and Net Worth

Assets Reserves on deposit at the Federal Reserve Bank

Notes payable

—100

Federal Reserve Bank Liabilities and Net Worth

Assets Loan and advances

—100

Bank reserve accounts

-100

-100

Chapter 13 Managing Nondeposit Liabilities

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federal agency securities, high-grade commercial paper, and other assets judged satisfactory. Several types of loans are available from the Fed's discount window: 1. P rim ary cre d it —loans

available for short terms (usually overnight but occasionally extending out to 90 days) to depository institutions in sound financial condition. Primary credit normally carries an interest rate slightly above the Federal Reserve's target Fed funds interest rate. Users of primary credit do not have to show (as they did in the past) that they have exhausted other sources of funds before ask­ ing the Fed for a loan. Moreover, the borrowing institution is no longer prohibited from borrowing from the Fed and then loaning that money to other depository institutions in the Fed funds market.

2. S e c o n d a ry cre d it —loans

available at a higher interest rate to depository institutions not qualifying for primary

credit. These loans are subject to monitoring by the Federal Reserve banks to make sure the borrower is not taking on excessive risk. The interest rate on secondary credit may be about 50 basis points above the primary credit rate and 150 basis points above the Fed funds rate. Such a loan can be used to help resolve financial problems, to strengthen the borrowing institution's ability to find additional funds from private-market sources, and to reduce its debt to the Fed. However, secondary credit is not supposed to be used to fund the expansion of a borrowing institution's assets. 3. S e a so n a l c re d it —loans

covering longer periods than pri­ mary credit for small and medium-sized depository insti­ tutions experiencing seasonal (intrayear) swings in their deposits and loans (such as those swings experienced by farm banks during planting and harvesting time). The sea­ sonal credit interest rate is set at the average level of the effective Fed funds rate and the secondary market rate on 90-day certificates of deposit.

Thus, each type of discount window loan carries its own loan rate, with secondary credit generally posting the highest interest rate and seasonal credit the lowest. In 1991 the U.S. Congress passed the FDIC Improvement Act, which places limits on how far the Federal Reserve banks can go in supporting a troubled depository institution with loans. Gen­ erally speaking, undercapitalized institutions cannot be granted discount window loans for more than 60 days in each 120-day period. Long-term Fed support is only permissible if the borrow­ ing institution is a "viable entity." If the Fed exceeds these limi­ tations, it can be held liable to the FDIC for any losses incurred by the insurance fund should the troubled institution ultimately fail. Overall, the Fed's discount window is not a particularly

256

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popular source of funding due to regulations, collateral require­ ments, and cost, though the credit crisis of 2007-2009 increased the popularity of the Fed's "window" as a source of borrowed funds for a wide range of troubled firms.

Advances from Federal Home Loan Banks Recently another government agency—the Federal Home Loan Bank (FHLB) System—has been lending huge amounts of money to scores of home mortgage lenders. The FHLB System, com­ posed of 12 regional banks, was created by federal charter in 1932 in order to extend cash advances to depository institutions experiencing runs by anxious depositors. By allowing these trou­ bled institutions to use the home mortgages they held in their portfolios as collateral for emergency loans, the FHLB improved the liquidity of home mortgages and encouraged more lenders to provide credit to the housing market. In recent years the number of financial institutions eligible to borrow from the FHLB has increased dramatically, especially among smaller community banks and thrift institutions. A recent study (Maloney and Thomson [3]) found that close to 6,000 com­ mercial banks, more than 1,300 thrift institutions, over 700 credit unions, and close to 80 insurance companies had FHLB loans, amounting collectively to more than $500 billion. Managers of mortgage-lending institutions have been attracted to FHLB loans because they represent a stable source of fund­ ing at below-market interest rates. Fully collateralized by home mortgages the maturities of FHLB loans range from overnight to more than 20 years, bearing either fixed or variable interest rates. The system's federal charter enables it to borrow money cheaply and pass those savings along to member institutions who also hold FHLB stock and receive dividends on that stock. Should a borrowing institution fail, the FHLB, legally, is first in line (even ahead of the FDIC) in recovering its funds. In general, this can be a popular funds source due to lower costs and flex­ ibility in the maturity of loans permitted.

Development and Sale of Large Negotiable CDs The concept of liability management and short-term borrow­ ing to supplement deposit growth was given a significant boost early in the 1960s with the development of a new kind of deposit, the negotiable CD. This funding source is really a hybrid account: legally, it is a deposit, but, in practical terms, the negotiable CD is just another form of IOU issued to tap tem­ porary surplus funds held by large corporations, wealthy indi­ viduals, and governments. A CD is an interest-bearing receipt evidencing the deposit of funds in the accepting depository

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

ISSUES AND INSIGHTS The Fed's Term Auction and Securities Lending Facilities as Sources of Medium-Term Credit The turmoil in the financial marketplace during 2007-2009 gave rise to a "credit crunch" among lending institutions worldwide. In particular, the demand for loans bearing oneto six-month maturities— longer than normal Federal funds loans, RPs, and discount window loans—soared as financial managers desperately searched for medium-term money. In December 2007, concerned that its current monetary policy tools were not adequate to provide liquidity to sup­ port the collapsing subprime mortgage market, the Federal Reserve System launched a new source of temporary credit known as the Term Auction Facility (TAF). The Fed began announcing how much it would be willing to loan deposi­ tory institutions for 28-day periods at interest rates below its conventional discount rate. The Fed set up an auction system for these medium-term loans very much like the way Treasury bills are sold, using a single-price auction with sealed bids. Auctions of 28-day loans were held biweekly as 2008 began. Then in March 2008, with several key financial markets (including mortgages, auto loans, credit card receivables, and student loans) imperiled by a deepening shortage of liquid­ ity, the Fed set up a Term Securities Lending Facility (TSLF) to put a floor of liquidity under these troubled markets. Pri­ mary security dealers (who work regularly with the Federal Reserve) were invited to borrow from the Fed, pledging as collateral qualified triple-A-rated securities backed by home mortgages, student loans, and auto and credit card loans. For its part the Fed promised to temporarily swap some of

institution for a specified time period at a specified interest rate or specified formula for calculating the interest rate. There are four main types of negotiable CDs today. Domestic CDs are issued by U.S. institutions inside the territory of the United States. Dollar-denominated CDs issued by banks outside the United States are known as EuroCDs. The largest foreign banks active in the United States (such as Deutsche Bank and HSBC) sell CDs through their U.S. branches, called Yankee CDs. Finally, nonbank savings institutions sell thrift CDs. During the 1960s, faced with slow growth in checkbook depos­ its held by their largest customers because these customers had found other higher-yielding outlets for their cash surpluses, money center banks began to search the market for new sources of funds. First National City Bank of New York (now Citibank), one of the more innovative financial firms in the world, was the first to develop the large ($100,000+) negotiable CD. Citigroup designed this marketable deposit to compete for funds with other well-known money market instruments. It was made large

the Treasury securities it holds in exchange for the dealers' triple-A-rated securities for a period of up to 28 days. This move seemed to help stabilize markets the Fed had targeted, at least for a time. Later in 2011 the Fed supplemented its weapons with a policy called "twist", buying long-term bonds and selling short-term financial instruments to stimulate long­ term investment. Actually the Fed has broad power to provide emergency credit in "unusual" and "exigent" circumstances. For exam­ ple, Section 13, Paragraph 3, of the Federal Reserve Act allows the Fed to lend money to "any individual, partner­ ship, or corporation" on the affirmative vote of at least five members of the Federal Reserve Board. The Fed first made a substantial volume of these Section 13 loans to nonbank enti­ ties during the Great Depression of the 1930s and continued to do so for almost 20 years, especially during World War II to increase production. Most recently in 2008 the New York Fed loaned $29 billion to help support the buyout of trou­ bled security dealer Bear Stearns by JP Morgan Chase. Some authorities in the field have suggested that the Fed's new credit facilities should be retained in the central bank's arsenal of policy weapons, giving the Fed new tools to deal with liquidity crises and avoid direct pressure on key inter­ est rates. Other experts, however, have contended that the Fed's recent, unprecedented actions have simply gone too far, encouraging inflation and failing to invoke the discipline of the marketplace on those individuals and institutions who were, in effect, gambling in the housing and credit markets and threatening the stability of the entire financial system.

enough—generally sold in multiples of $1 million—to appeal to major corporations. Negotiable CDs would be confined to short maturities, ranging from seven days to one or two years in most cases, but concentrated mainly in the one- to six-month maturity range for the convenience of CD buyers. And the new instrument would be negotiable—able to be sold in the secondary market any number of times before reaching maturity—in order to pro­ vide corporate customers with liquidity. To make the sale of nego­ tiable CDs in advance of their maturity easier, they were issued in bearer form. Moreover, several dealers agreed to make a regular market in negotiable CDs carrying maturities of six months or less. The negotiable CD was an almost instant success. Largedenomination CDs grew from almost zero in the early 1960s to nearly $2 trillion as recently as 2011. As with all liability manage­ ment instruments, management can control the quantity of CDs outstanding simply by varying the yield offered to CD customers. Interest rates on fixed-rate CDs, which represent the major­ ity of all large negotiable CDs issued, are quoted on an

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interest-bearing basis, and the rate is computed assuming a 360-day year. For example, suppose a depository institution promises an 8 percent annual interest rate to the buyer of a $100,000 six-month (180-day) CD. The depositor will have the following at the end of six months: Amount due CD customer

Days to maturity Annual rate Principal + Principal X ----,----------X 360 days of interest = $100,000 + $100,000 X

180 X 0.08 360

(13.2)

= $104,000 CDs that have maturities over one year normally pay interest to the depositor every six months. Variable-rate CDs have their interest rates reset after a designated period of time (called a leg or roll period). The new rate is based on a mutually accepted reference interest rate, such as the London Interbank Offer Rate (LIBOR) attached to borrowings of Eurodollar deposits or the average interest rate prevailing on prime-quality CDs traded in the secondary market. The net result of CD sales to customers is often a simple transfer of funds from one deposit to another within the same deposi­ tory institution, particularly from checkable deposits into CDs. The selling institution gains loanable funds even from this simple transfer because, in the United States at least, legal reserve requirements are currently zero for CDs, while checking accounts at the largest depository institutions carry a reserve requirement of 10 percent. Also, deposit stability is likely to be greater for the receiving depository institution because the CD normally will not be withdrawn until maturity. In contrast, check­ able (demand) deposits can be withdrawn at any time. However, the sensitive interest rates attached to the largest negotiable CDs mean that depository institutions must work harder to com­ bat volatile earnings and make aggressive use of rate-hedging techniques. Nevertheless, this is a popular borrowing medium due to its modest cost, large volume of funds available, and flexibility.

The Eurocurrency Deposit Market The development of the U.S. negotiable CD market came on the heels of another deposit market that began in Europe during the 1950s—the Eurocurrency deposit market. Eurocurrency depos­ its were developed originally in Western Europe to provide liq­ uid funds that could be swapped among multinational banks or loaned to the banks' largest customers. Most such international borrowing and lending has occurred in the Eurodollar market. Eurodollars are dollar-denominated deposits placed in bank offices outside the United States. Because they are denomi­ nated on the receiving banks' books in dollars rather than in the

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currency of the home country and consist of accounting entries in the form of time deposits, they are not spendable on the street like currency.3 The banks accepting these deposits may be foreign branches of U.S. banks overseas, or international banking facilities (IBFs) set up on U.S. soil but devoted to foreign transactions on behalf of a par­ ent U.S. bank. The heart of the worldwide Eurodollar market is in London, where British banks compete with scores of American and other foreign banks for these deposits. The Eurocurrency market is the largest unregulated financial market-place in the world. A domestic financial firm can tap the Euromarket for funds by contacting one of the major international banks that borrow and lend Eurocurrencies every day. The largest U.S. banks also use their own overseas branches to tap this market. When one of these branches lends a Eurodeposit to its home office in the United States, the home office records the deposit in an account labeled liabilities to foreign branches. When a U.S. financial firm borrows Eurodeposits from a bank operating overseas, the transaction takes place through the correspondent banking sys­ tem. The lending bank will instruct a U.S. correspondent bank where it has a deposit to transfer funds in the amount of the Eurocurrency loan to the correspondent account of the borrow­ ing institution. These borrowed funds will be quickly loaned to qualified borrowers or, perhaps, used to meet a reserve deficit. Later, when the loan falls due, the entries on the books of cor­ respondent banks are reversed. This process of borrowing and lending Eurodollars is traced out in Table 13.7. Most Eurodollar deposits are fixed-rate time deposits. Begin­ ning in the 1970s, however, floating-rate CDs (FRCDs) and floating-rate notes (FRNs) were introduced in an effort to pro­ tect banks and their Eurodepositors from the risk of fluctuating interest rates. FRCDs and FRNs tend to be medium to long term, stretching from 1 year to as long as 20 years. The offer rates on these longer-term negotiable deposits are adjusted, usually every three to six months, based upon interest rate movements in the interbank Euromarket. The majority of Euro­ deposits mature within six months; however, some are as short as overnight. Most are interbank liabilities whose interest yield is tied closely to LIBOR—the interest rate money center banks quote each other for the loan of short-term Eurodeposits. Largedenomination Euro CDs issued in the interbank market are called tap CDs, while smaller-denomination Euro CDs sold to a wide range of investors are called tranche CDs. As with domes­ tic CDs, there is an active resale market for these deposits.

3ln general, whenever a deposit is accepted by a bank denominated in the units of a currency other than the home currency, that deposit is known as a Eurocurrency deposit. While the Eurocurrency market began in Europe (hence the prefix Euro), it reaches worldwide today.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 13.7

U.S. Bank Borrowing Eurodollars from Foreign Banks

Step 1. Loan Is Made to a U.S. Bank from a Foreign Bank in the Eurodollar Market U.S. Bank Serving U.S. Bank as Correspondent Foreign Bank Borrowing Eurodollars to a Foreign Bank Lending Eurodollars Assets Deposits held at other banks

Liabilities

+ 100

Deposits due to foreign bank +100 (Eurodollars borrowed)

U.S. Bank Borrowing Eurodollars Assets Deposits held at other banks

Assets

Deposits due to foreign bank

Deposits of U.S. correspondent bank doing the borrowing (Eurodollars borrowed)

Assets —100

Deposits due to foreign bank —100 (Eurodollars borrowed)

Assets

Liabilities Deposits due to foreign bank

Deposits of U.S. correspondent bank doing the borrowing (Eurodollars borrowed)

Major banks and their large corporate customers practice arbitrage between the Euro and American CD markets. For example, if domestic CD rates were to drop significantly below Euro interest rates on deposits of comparable maturity, a bank or its corporate customers could borrow in the domestic CD market and lend those funds offshore in the Euromarket. Similarly, an interest rate spread in the opposite direction might well lead to increased Euroborrowings with the proceeds flowing into CD markets inside the United States.

Commercial Paper Market During the 1960s and 1990s large banks and finance companies faced with intense demand for loans found a new source of loanable funds—the commercial paper market. Commercial paper consists of short-term notes, with maturities normally ranging from three or four days to nine months, issued by well-known companies to raise working capital. The notes are

Liabilities

Deposits at U.S. correspondent bank

—100

Eurodollar loan to U.S. bank

+100

+100

Step 2. Loan Is Repaid by the Borrowing U.S. Bank U.S. Bank Serving as Correspondent to a Foreign Bank

Liabilities

—100

Liabilities

Foreign Bank Lending Eurodollars Assets

+100

Liabilities

Deposits at U.S. correspondent bank

+ 100

Eurodollar loan to U.S. bank

-100

—100

generally sold at a discount from face value through security dealers or through direct contact with the issuing company. A substantial portion of this paper—often called industrial paper—is designed to finance the purchase of inventories of goods or raw materials and to meet other immediate cash needs of nonfinancial companies. Another form of commercial paper—usually called finance paper—is issued mainly by finance companies (such as GE Capital Corporation) and the affiliates of financial holding companies (such as HSBC Finance Corpo­ ration). The proceeds from issuing finance paper can be used to purchase loans off the books of other financial firms in the same organization, giving these institutions additional funds to make new loans. Table 13.8 summarizes the process of indirect borrowing through commercial paper issued by affiliated firms. This funds source tends to be high in volume and moderate in cost but also volatile in available capacity and subject to credit risk. Recently foreign banks, such as Barclays Capital, have

Chapter 13 Managing Nondeposit Liabilities

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Table 13.8

Commercial Paper Borrowing by a Holding Company That Channels the Borrowed Funds to One of Its Affiliated Lending Institutions Step 1. Commercial Paper Is Sold by an Affiliated Corporation in the Money Market Lending Institution Affiliated Corporation Assets

Liabilities and Net Worth

Liabilities and Net Worth

Assets Cash account

+100

Commercial paper

+100

Step 2. The Affiliated Corporation Purchases Loans from Lenders That Are Part of the Same Organization Lending Institution Affiliated Corporation Assets

Liabilities and Net Worth

Liabilities and Net Worth

Assets

Loans

—100

Cash account

—100

Reserves

+100

Loans purchased from lending institution

+100

accelerated their mining of both European and American paper markets despite the pressures of the Great Recession.

Long-Term Nondeposit Funds Sources The nondeposit sources of funds discussed to this point are mainly short-term borrowings. The loans involved usually range from hours to days, occasionally stretching into weeks or months. However, many financial firms also tap longer-term nondeposit funds stretching well beyond one year. Examples include mort­ gages issued to fund the construction of buildings and capital notes and debentures, which usually range from 5 to 12 years in maturity and are used to supplement equity (owners') capital. These longer-term nondeposit funds sources have remained relatively modest over the years due to regulatory restrictions and the augmented risks associated with long-term borrowing.

Also, because most assets and liabilities held by depository insti­ tutions are short- to medium-term, issuing long-term indebted­ ness creates a significant maturity mismatch. Nevertheless, the favorable leveraging effects of such debt have made it attractive to larger financial firms in recent years. Because of the long-term nature of these funding sources, they tend to be a sensitive barometer of the perceived risk exposure (particularly the risk of default) of their issuing insti­ tutions. In 1990, for example, when there were fears of major bank defaults, the capital notes of troubled Southeast Banking Corp. and the Bank of Boston carried annual yields of close to 20 percent, while notes issued by the Bank of New England were trading at a discount equal to only about one-fifth of their face value. By 2010 nearly $150 billion in capital notes and debentures (subordinated to the claims of depositors) had been issued by U.S. insured depository institutions.

CONCEPT CHECK 13.9.

What are the advantages of borrowing from the Fed­ eral Reserve banks or other central banks? Are there any disadvantages? What is the difference between primary, secondary, and seasonal credit? What is a Lombard rate, and why might such a rate be useful in achieving monetary policy goals?

13.10. How is a discount window loan from the Federal Reserve secured? Is collateral really necessary for these kinds of loans?

260

13.11. Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank of Cleveland. Can you show the correct entries for granting and repaying this loan? 13.12. Which institutions are allowed to borrow from the Federal Home Loan Banks? Why is this source so popular for many institutions?

13.13. Why were negotiable CDs developed?

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

13.14. What are the advantages and disadvantages of CDs as a funding source?

13.15. Suppose a customer purchases a $1 million 90-day CD, carrying a promised 6 percent annualized yield. How much in interest income will the customer earn when this 90-day instrument matures? What total vol­ ume of funds will be available to the depositor at the end of 90 days?

13.16. Where do Eurodollars come from? 13.17. How does a bank gain access to funds from the Euro­ currency markets?

13.18. Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from Barclays Bank in London and loans the borrowed funds for a week to a

13.4 CHOOSING AM ONG ALTERNATIVE N ONDEPOSIT SO URCES With so many different nondeposit funds sources to draw upon, managers of financial firms must make choices among them. In using nondeposit funds, funds managers must answer the fol­ lowing key questions: 1. How much in total must be borrowed from these sources to meet funding needs?

2. Which nondeposit sources are best, given the borrowing institution's goals, at any moment in time?

Measuring a Financial Firm's Total Need for Nondeposit Funds: The Available Funds Gap The demand for nondeposit funds is determined basically by the size of the gap between the institution's total credit demands and its deposits and other available monies. Managers respon­ sible for the asset side of the institution's balance sheet must choose which of a wide variety of customer credit requests they will meet by adding direct loans and investment securities to the institution's asset portfolio. Management must be prepared to meet, not only today's credit requests, but all those it can reasonably anticipate in the future. This means that projections of current and anticipated credit demands must be based on knowledge of the current and probable future funding needs of each institution's customers, especially its largest borrowers. Such projections should not be wild guesses; they should be based on

security dealer, and then returns the borrowed funds. Can you trace through the resulting accounting entries? 13.19. What is commercial paper? What types of organiza­ tions issue such paper?

13.20. Suppose that the finance company affiliate of Citi­ group issues $325 million in 90-day commercial paper to interested investors and uses the proceeds to pur­ chase loans from Citibank. What accounting entries should be made on the balance sheets of Citibank and Citigroup's finance company affiliate?

13.21. What long-term nondeposit funds sources do banks and some of their closest competitors draw upon today? How do these interest costs differ from those costs associated with most money market borrowings?

information gathered from frequent contacts between the finan­ cial firm's officers and both existing and potential customers. The second decision that must be made is how much in deposits and other available funds is likely to be attracted in order to finance the desired volume of loans and security investments. Projections must be made of customer deposits and withdrawals, with special attention to the largest customers. Deposit projections must take into account current and future economic conditions, interest rates, and the cash flow requirements of the largest customers. The difference between current and projected outflows and inflows of funds yields an estimate of each institution's available funds gap. Thus, Available funds gap (AFG)

=

Current and projected loans and investments the lending institution desires to make — Current and (13.3) expected deposit inflows and other available funds

For example, suppose a commercial bank has new loan requests that meet its quality standards of $150 million; it wishes to pur­ chase $75 million in new Treasury securities being issued this week and expects drawings on credit lines from its best corpo­ rate customers of $135 million. Deposits and other customer funds received today total $185 million, and those expected in the coming week will bring in another $100 million. This bank's estimated available funds gap (AFG) for the coming week will be as follows (in millions of dollars): AFG = ($150 + $75 + $135) - ($185 + $100) = $306 - $285 = $75

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Most institutions will add a small amount to this available funds gap estimate to cover unexpected credit demands or unantici­ pated shortfalls in deposits and other inflowing funds. Various nondeposit funds sources then may be tapped to cover the esti­ mated funds gap.

3. The length of time (maturity or term) for which funds are needed.

A sample of interest rates on money market borrowings, aver­ aged over selected years, is shown in Table 13.9. Note that the various funds sources vary significantly in price—the interest rate the borrowing institution must pay for use of the money. Among the cheapest short-term borrowed funds source is usu­ ally the prevailing effective interest rate on Federal funds loaned overnight to borrowing institutions. In most cases the interest rates attached to domestic CDs and Eurocurrency deposits are slightly higher than the Fed funds rate. Commercial paper (short-term unsecured notes) normally may be issued at inter­ est rates slightly above the Fed funds and CD rates, depend­ ing upon maturity and time of issue. Today the discount rate attached to loans from the Federal Reserve banks (known as the primary credit rate) is generally among the highest short-term borrowing rates because this form of Federal Reserve credit is generally priced above the central bank's target for the Fed funds rate.

4. The size o f the institution that requires more funds.

Although low compared to most other borrowing rates, the

Nondeposit Funding Sources: Factors to Consider Which nondeposit sources will management use to cover a projected available funds gap? The answer to that question depends largely upon five factors: 1. The relative costs of raising funds from each source. 2. The risk (volatility and dependability) of each funding source.

5. Regulations limiting the use of alternative funds sources.

Relative Costs Managers of financial institutions practicing liability manage­ ment must constantly be aware of the going market interest rates attached to different sources of borrowed funds. Major lenders post daily interest rates at which they are willing to com­ mit funds to other financial firms in need of additional reserves. In general, managers would prefer to borrow from the cheapest sources of funds, although other factors do play a role.

Table 13.9

effective Fed funds rate prevailing in the marketplace tends to be volatile, fluctuating around the central bank's target (intended) Fed funds rate. The key advantage of Fed funds is their ready availability through a simple phone call or online computer request. Moreover, their maturities often are flex­ ible and may be as short as a few hours or last as long as several months. The key disadvantage of Fed funds is their volatile market interest rate—its often wide fluctuations (espe­ cially during the settlement day that depository institutions are trying to meet their legal reserve requirements) that make planning difficult.

Money Market Interest Rates Attached to Nondeposit Borrowings and Large ($100,000 + ) CDs Interest Rate Averages Quoted for the Years

Sources of Borrowed Funds

1994

1996

1998

2000

2002

2004

2005

2007

2010*

Federal funds borrowings

4.47%

5.30%

5.35%

6.24%

1.34%

1.35%

3.22%

5.02%

0.17%

Borrowings from the Federal Reserve banks**

3.76

5.00

4.98

5.50

1.25

2.34

4.19

5.86

0.72

Selling commercial paper (1-month, directly placed)

4.65

5.43

n.a.

6.27

1.68

1.41

3.27

5.07

0.20

Issuing negotiable CDs (secondary market, 1-month)

4.60

5.35

5.49

6.35

1.39

1.45

3.34

5.23

0.26

Selling Eurodollar deposits (3-month maturities)

4.80

5.38

5.44

6.45

1.39

1.55

3.51

5.32

0.39

Notes: *Selected figures based on year-end interest rates. **Posted by the Federal Reserve banks. Beginning in 2003 the quoted discount rate on loans from the Federal Reserve banks is the primary credit rate, initially set at 100 basis points above the Fed's target for the Federal funds rate, but then changed more recently to a range around 50 basis points above the Federal funds interest rate target. Source: Board of Governors of the Federal Reserve System.

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Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Factoids What interest rate attached to nondeposit borrowings tends to be among the lowest?

Answer: The effective Federal funds rate is often among the lowest borrowing rate for depository institutions. Is the Fed funds interest rate usually the absolute lowest in the money market?

Answer: No, the interest rate on the shortest-term U.S. Trea­ sury bills is often slightly lower than the Fed funds rate. In contrast, market interest rates on CDs and commercial paper are usually somewhat more stable, but generally hover close to and slightly above the Fed funds rate due to their longer average maturity and because of the marketing costs spent in finding buyers for these instruments. CDs and commercial paper usually are less popular in the short run than Fed funds and borrowings from the central bank's discount window when a depository institution needs money right away. In contrast, CD and commercial paper borrowings are usually better for longerterm funding needs that stretch over several days or weeks. The rate of interest is usually the principal expense in borrowing nondeposit funds. However, noninterest costs cannot be ignored in calculating the true cost of borrowing nondeposit funds, includ­ ing the time spent by management and staff to find the best funds sources each time new money is needed. A good formula for doing cost comparisons among alternative sources of funds is: Effective cost rate on deposit and nondeposit sources of funds

Noninterest costs Current interest incurred cost on amounts + borrowed to access these funds Net investable funds raised from this source (13.4)

where Current interest cost on amounts borrowed

Noninterest costs to access funds

Prevailing interest Amount of funds rate in the money X borrowed market (13.5) Estimated cost rate representing Amount of funds X staff time, facilities, borrowed and transaction costs (13.6)

Total amount borrowed less legal reserve Net investable funds _ requirements (if any), deposit insurance raised assessments (if any), and funds placed in nonearning assets (13.7)

Note that the cost associated with attracting each funds source is compared to the net amount of funds raised after deductions are made for reserve requirements (if any), insurance fees, and that portion of borrowed funds diverted into such nonearn­ ing assets as excess cash reserves or fixed assets. We use net investable funds as the borrowing base because we wish to compare the dollar cost that must be paid out to attract bor­ rowed funds relative to the dollar amount of those funds that can actually be used to acquire earning assets and cover the cost of fund-raising. Let's see how the above formulas might be used to estimate the real cost of borrowing funds. Suppose that Fed funds are currently trading at an interest rate of 6.0 percent. Moreover, management estimates that the marginal noninterest cost, in the form of personnel expenses and transactions fees, from raising additional monies in the Fed funds market is 0.25 percent. Sup­ pose that a depository institution will need $25 million to fund the loans it plans to make today, of which only $24 million can be fully invested due to other immediate cash demands. Then the effective annualized cost rate for Fed funds would be calcu­ lated as follows: Current interest cost = 0.06 X $25 million = $1.5 million on Federal funds Noninterest cost to = 0.0025 X $25 million = $0,063 million access Federal funds Net investable — $25 million — $1 million — $24 million funds raised Therefore, the effective annualized Fed funds cost rate is $1.5 million + $0,063 million = 0.0651 or 6.51 percent $24 million The depository institution in the above example would have to earn a net annualized return of at least 6.51 percent on the loans and investments it plans to make with these borrowed Fed funds just to break even. Suppose management decides to consider borrowing funds by issuing negotiable CDs that carry a current interest rate of 7.00 percent. Moreover, raising CD money costs 0.75 percent in noninterest costs. Then the annualized cost rate incurred from selling CDs would be as follows: Effective CD _ (0.07 X $25 million + $0.0075 X $25 million) cost rate $24 million _ $1.75 million + $0.1875 million $24 million = 0.0807 or 8.07 percent An additional expense associated with selling CDs to raise money is the deposit insurance fee. In the United States this fee

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263

varies with the risk and capitalization of each depository institu­ tion whose deposits are insured by the Federal Deposit Insur­ ance Corporation (FDIC). To illustrate how the FDIC insurance fee works assume the current insurance rate is $0.0027 per dollar of deposits—a fee sometimes charged the riskiest insured depository insti­ tutions. (We should note as well that the FDIC requires an insured depository institution to pay this insurance fee not just on the actual insured portion of a customer's deposit account but on the full face amount (beyond the insured amount) of each deposit received from the public.) Thus, the total insurance cost for the riskiest depository institutions on the $25 million we are talking about raising through selling CDs would be Total deposits , . . Insurance tee received from X . . . per dollar the public

$25 million X 0.0027 (13.8) $67,500 or $0.0675 million

If we deduct this fee from the new amount of CDs actually avail­ able for use, we get: Effective CD cost rate

$1.9375 million $24 million — $0.0675 million $1.9375 million $23,925 million

0.0810 or 8.10 percent

Clearly, issuing CDs would be more expensive in the above example than borrowing Fed funds. However, CDs have the advantage of being available for several days, weeks, months, or years, whereas Fed funds loans must often be repaid in 24 hours. Nondeposit sources of funds generally are moderate in cost compared to other funding sources. Nondeposit funds tend to be more expensive than checkable deposits but less expensive than thrift (time and savings) deposits. We must add a note of caution here, however, because the costs and the profits associ­ ated with nondeposit funds tend to be more volatile from year to year than the cost and profitability of deposits. Nondeposit funds do have the advantage of quick availability compared to

FIGURING THE OVERALL COST OF FUNDS In our discussion of determining how much each source of borrowed funds costs, we looked at each funding source separately. However, borrowing institutions draw simultaneously on not one, but many different funds sources, including deposits, nonde­ posit borrowings, and owner's equity capital. Can we find a method for determining the cost of funding that brings together all the sources of funding normally in use? The answer is yes. Here we examine two of the most popular overall funds cost methods—the historical average cost approach and the pooled-funds approach.

The Historical Average Cost Approach This approach for determining how much funds cost looks at he past. It asks what funds the financial firm has raised to date and what they cost.

Sources of Funds Drawn Upon Noninterest-bearing demand deposits

Average Amount of Funds Raised (millions)

Average Rate of Interest Incurred

Total Interest Paid for Each Funds Source (millions)

$100

0%

$0

Interest-bearing transaction deposits

200

7%

14

Savings accounts

100

5%

5

Time deposits

500

8%

40

Money market borrowings

100

6%

6

Total funds raised = $1,000

All interest costs = $65

Then the average interest cost of deposits and money market borrowings is: Weighted All interest paid average interest = Total funds raised expense

264

$65 = 6.5 percent $ 1,000

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

But other operating costs, such as salaries and overhead, must also be covered. If these are an estimated $10 million, we have Break-even cost rate on borrowed funds invested in earning assets

Interest + Other operating costs All earning assets

$65 + 10 = 10 percent $750

This cost rate is called break-even because the borrowing institution must earn at least this rate on its earning assets (primarily loans and securities) just to meet the total operating costs of raising borrowed funds. But what about the bor­ rowing institution's stockholders and their required rate of return (assumed hereto be 12 percent after taxes)? Weighted average overall cost of capital

Break-even cost on borrowed funds

Break-even cost

Before-tax cost of the stockholders' investment in the borrowing institution After-tax cost of stockholders' investment (1 — Tax rate)

12 percent 100 = 10 percent + —— — ^ X — — M (1 - 0.35) 750

Stockholders' investment Earning assets 10 percent + 2.5 percent

= 12.5 percent Thus, 12.5 percent is the lowest rate of return over all fund-raising costs the borrowing institution can afford to earn on its assets if its equity shareholders invest $100 million in the institution.

The Pooled-Funds Approach This method of costing borrowed funds looks at the future: What minimum rate of return must be earned on any future loans and investments just to cover the cost of all new funds raised? Suppose our estimate for future funding sources and costs is as follows:

Dollars of New Deposit and Nondeposit Borrowings (millions)

Portion of New Borrowings That Will Be Placed in New Earning Assets

Dollar Amount That Can Be Placed in Earning Assets (millions)

Interest Expense and Other Operating Expenses of Borrowing Relative to Amounts Raised

$100

50%

$50

8%

$8

Time deposits

100

60%

60

9%

9

New stockholders' investment in the institution

100

90%

90

13%

13

Profitable New Deposits and Nondeposit Borrowings Interest-bearing transaction deposits

Total

$300

$200

All Operating Expenses Incurred (millions)

$30 (Continued)

Chapter 13 Managing Nondeposit Liabilities

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The overall cost of new deposits and other borrowing sources must be Pooled All expected deposit and operating expenses nondeposit = All new funds funds expected expense

$30 million = 10 percent $300 million

But because only two-thirds of these expected new funds ($200 million out of $300 million raised) will actually be available to acquire earning assets, Hurdle All expected rate of return _ operating costs overall Dollars available earning assets to place in earning assets

$30 million $200 million = 15 perC6nt

Thus, the borrowing financial firm in the example above must earn at least 15 percent (before taxes), on average, on all the new funds it invests to fully meet its expected fund-raising costs.

most types of deposits, but they are clearly not as stable a fund­ ing source for most institutions as time and savings deposits.

The Risk Factor The managers of financial institutions must consider at least two types of risk when selecting among different nondeposit sources. The first is interest rate risk—the volatility of credit costs. All the interest rates shown in Table 13.9, except most central banks' discount rates, are determined by demand and supply forces in the open market and therefore are subject to erratic fluctuations. The shorter the term of the loan, the more volatile the prevailing market interest rate tends to be. Thus, most Fed funds loans are overnight and, not surprisingly, this market interest rate tends to be the most volatile of all. Management must also consider credit availability risk. There is no guarantee in any credit market that lenders will be willing and able to accommodate every borrower. When general credit conditions are tight, lenders may have limited funds to loan and may ration credit, confining loans only to their soundest and most loyal customers. Sometimes a financial firm may appear so risky to money market lenders they will deny credit or make the price so high that its earnings will suffer. Experience has shown that the negotiable CD, Eurodollar, and commercial paper mar­ kets arc especially sensitive to credit availability risks. Funds managers must be prepared to switch to alternative sources of credit and, if necessary, pay more for any funds they receive.

The Length of Time Funds Are Needed As we have seen, some funds sources may be difficult to access immediately (such as commercial paper and long-term debt capital). A manager in need of loanable funds this afternoon

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would be inclined to borrow in the Fed funds market. However, if funds are not needed for a few days, selling longer-term debt becomes a more viable option. Thus, the term, or maturity, of the funds need plays a key role as well.

The Size of the Borrowing Institution The standard trading unit for most money market loans is $1 million—a denomination that may exceed the borrowing requirements of the smallest financial institutions. For example, Eurodollar borrowings are in multiples of $1 million and usually are available only to money-center financial firms with the high­ est credit ratings. Large negotiable CDs from the largest deposi­ tory institutions are preferred by most investors because there is an active secondary market for prime-rated CDs. Smaller depos­ itory institutions may not have the credit standing to be able to sell the largest negotiable CDs. The same is true of commercial paper. In contrast, the central bank's discount window and the Fed funds market can make relatively small denomination loans that are suitable for smaller depository institutions.

Regulations Federal and state regulations may limit the amount, frequency, and use of borrowed funds. For example, in the United States CDs must be issued with maturities of at least seven days. The Federal Reserve banks may limit borrowings from the discount window, particularly by depository institutions that appear to display sig­ nificant risk of failure. Other forms of borrowing may be subjected to legal reserve requirements by action of the central bank. For example, during the late 1960s and early 1970s, when the Fed­ eral Reserve was attempting to fight inflation with tight-money policies, it imposed legal reserve requirements for a time on Fed

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

CONCEPT CHECK 13.22. What is the available funds gap? 13.23. Suppose JP Morgan Chase Bank of New York discovers that projected new loan demand next week should total $325 million and customers holding confirmed credit lines plan to draw down $510 million in funds to cover their cash needs next week, while new deposits next week are pro­ jected to equal $680 million. The bank also plans to acquire $420 million in corporate and govern­ ment bonds next week. What is the bank's pro­ jected available funds gap? 13.24. What factors must the manager of a financial insti­ tution weigh in choosing among the various non­ deposit sources of funding available today?

funds borrowing, repurchase agreements, and commercial paper issued to purchase assets from affiliated lending institutions. While these particular requirements are not currently in force, it seems clear that in times of national emergency, government policymak­ ers would move swiftly to impose new controls, affecting both the costs and risks associated with nondeposit borrowings.

SUMMARY Although the principal funding source for many financial institu­ tions is deposits, nearly all depository institutions today supple­ ment the funds they attract through sales of deposits with nondeposit borrowings in the money and capital markets. In this chapter we explore the most important nondeposit funds sources and the factors that bear on the managerial decision about which sources of funds to draw upon. The key points in the chapter include: • Today's heavy use of nondeposit borrowings by depository insti­ tutions arose with the development of liability management, which calls upon managers of financial institutions to actively manage their liabilities as Well as their assets on the balance sheet and to use market interest rates as the control lever.

The use of nondeposit borrowings as a key source of funds was given a boost by the emergence of the customer relationship doctrine. This managerial strategy calls for put­ ting the goal of satisfying the credit requests of all quality customers at the top of management's list. If deposits are inadequate to fund all quality loan requests, other sources of funds, including borrowings in the money and capital mar­ kets, should be used. Thus, the lending decision comes first, followed by the funding decision. One of the key sources of nondeposit funds today is the Federal funds market, where immediately available reserves are traded between financial institutions and usually returned within 24 hours. Borrowing from selected government agencies—in the United States, the discount windows of the Federal Reserve banks and advances from die Federal Home Loan banks—has also grown rapidly in recent years. Other key funds sources include selling negotiable jumbo ($100,000+) CDs, borrowing Eurocurrency deposits from international firms offshore, issuing commercial paper in the open market through affiliated corporations, executing repur­ chase agreements where loans collateralized by top-quality assets are made available for a few hours or days, or pursuing longer-term borrowings in the capital markets through the issuance of longer-term debt. Before tapping nondeposit borrowings, however, the managers of financial firms must estimate their funding requirements. One such estimate for a depository institution comes from the available funds gap, the spread between the current and expected volume of loans and investments and the current and expected volume of funds sources. The particular nondeposit funds source(s) chosen by man­ agement will rest upon such factors as (1) the relative cost of each source; (2) the risk or dependability of each funds source; (3) the length of time funds will be needed; (4) the size of the borrowing institution and its funding needs; and (5) the content of government regulations affecting fund-raising. Among the most important government regulations bearing on the use of nondeposit funds are legal reserve require­ ments imposed by central banks around the world and rules dictating the content of contractual agreements when funds are loaned by one financial institution to another.

K E Y TERMS customer relationship doctrine, 248 liability management, 248 Federal funds market, 250 repurchase agreements (RPs), 252

discount window, 255 negotiable CD, 256 Eurocurrency deposit, 258 commercial paper market, 259

available funds gap, 261 interest rate risk, 266 credit availability risk, 266

Chapter 13 Managing Nondeposit Liabilities

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The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

PROBLEM S AND PROJECTS 1. Robertson State Bank decides to loan a portion of its reserves in the amount of $70 million held at the Fed­ eral Reserve Bank to Tenison National Security Bank for 24 hours. For its part, Tenison plans to make a 24-hour loan to a security dealer before it must return the funds to Robertson State Bank. Please show the proper accounting entries for these transactions. 2. Masoner Savings, headquartered in a small community, holds most of its correspondent deposits with Flagg Metrocenter Bank, a money center institution. When Masoner has a cash surplus in its correspondent deposit, Flagg automat­ ically invests the surplus in Fed funds loans to other money center banks. A check of Masoner's records this morning reveals a temporary surplus of $11 million for 48 hours. Flagg will loan this surplus for two business days to Secoro Central City Bank, which is in need of additional reserves. Please show the correct balance sheet entries to carry out this loan and to pay off the loan when its term ends. 3. Relgade National Bank secures primary credit from the Federal Reserve Bank of San Francisco in the amount of $32 million for a term of seven days. Please show the proper entries for granting this loan and then paying off the loan. 4. Shad Corporation purchases a 60-day negotiable CD with a $5 million denomination from Bait Bank and Trust, bearing a 2.95 percent annual yield. How much in interest will the bank have to pay when this CD matures? What amount in total will the bank have to pay back to Shad at the end of 60 days? 5. Deep Valley Bank borrows $125 million overnight through a repurchase agreement (RP) collateralized by Treasury bills. The current RP rate is 2.50 percent. How much will the bank pay in interest cost due to this borrowing? 6 . Thyme Bank of New York expects new deposit inflows next

month of $265 million and deposit withdrawals of $425 mil­ lion. The bank's economics department has projected that new loan demand will reach $400 million and customers with approved credit lines will need $175 million in cash. The bank will sell $450 million in securities, but plans to add $60 million in new securities to its portfolio. What is its projected available funds gap? 7. Wells Fargo Bank borrowed $150 million in Fed funds from JP Morgan Chase Bank in New York City for 24 hours to fund a 30-day loan. The prevailing Fed funds rate on loans

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of this maturity stood at 2.25 percent when these two insti­ tutions agreed on the loan. The funds loaned by Morgan were in the reserve deposit that the bank keeps at the Federal Reserve Bank of New York. When the loan to Wells Fargo was repaid the next day, JP Morgan used $50 million of the returned funds to cover its own reserve needs and loaned $100 million in Fed funds to Bank of America, Char­ lotte, for a two-day period at the prevailing Fed funds rate of 2.40 percent. With respect to these transactions, (a) con­ struct T-account entries similar to those you encountered in this chapter, showing the original Fed funds loan and its repayment on the books of JP Morgan, Wells Fargo, and Bank of America and (b) calculate the total interest income earned by JP Morgan on both Fed funds loans. 8 . Blue Skies Bank of Florida issues a three-month (90-day)

negotiable CD in the amount of $20 million to ABC Insur­ ance Company at a negotiated annual interest rate of 2.75 percent (360-day basis). Calculate the value of this CD account on the day it matures and the amount of interest income ABC will earn. What interest return will ABC Insur­ ance earn in a 365-day year? 9. Banks and other lending affiliates within the holding com­ pany of Best-of-Times Financial are reporting heavy loan demand this week from companies in the southeastern United States that are planning a significant expansion of inventories and facilities before the beginning of the fall season. The holding company plans to raise $775 million in short-term funds this week, of which about $700 million will be used to meet these new loan requests. Fed funds are currently trading at 2.25 percent, negotiable CDs are trad­ ing in New York at 2.40 percent, and Eurodollar borrowings are available in London at all maturities under one year at 2.30 percent. One-month maturities of directly placed com­ mercial paper carry market rates of 2.35 percent, while the primary credit discount rate of the Federal Reserve Bank of Richmond is currently set at 2.75 percent—a source that Best-of-Times has used in each of the past two weeks. Noninterest costs are estimated at 0.25 percent for Fed funds, discount window borrowings, and CDs; 0.35 percent for Eurodollar borrowings; and 0.50 percent for commercial paper. Calculate the effective cost rate of each of these sources of funds for Best-of-Times and make a manage­ ment decision on what sources to use. Be prepared to defend your decision.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

10. Surfs-Up Security Savings is considering the problem of try­ ing to raise $80 million in money market funds to cover a loan request from one of its largest corporate customers, which needs a six-week loan. Assume that market interest rates are at the levels indicated below: Federal funds, average for week just concluded

1.98%

Discount window of the Federal Reserve Bank CDs (prime rated, secondary market):

2.25

One month

2.52

Three months

2.80

Six months

3.18

Eurodollar deposits (three months)

3.00

Commercial paper (directly placed): One month

2.33

Three months

2.70

Unfortunately, Surfs-Up's economics department is forecast­ ing a substantial rise in money market interest rates over the next six weeks. What would you recommend to its funds management department regarding how and where to raise the money needed? Be sure to consider such cost factors as legal reserve requirements, regulations, and what happens to the relative attractiveness of each funding source if interest rates rise continually over the period of the proposed loan. Alternative scenario: What if Surfs-Up's economists are wrong and money mar­ ket rates decline significantly over the next six weeks? How would your recommendation to the funds management department change on how and where to raise the funds needed?

11. J une Bug Bank and Trust has received $750 million in total funding, consisting of $200 million in checkable deposit accounts, $400 million in time and savings deposits, $100 million in money market borrowings, and $50 million in stockholders' equity. Interest costs on time and savings deposits are 2.50 percent, on average, while noninterest costs of raising these particular deposits equal approxi­ mately 0.50 percent of their dollar volume. Interest costs on checkable deposits average only 0.75 percent because many of these deposits pay no interest, but noninterest costs of raising checkable accounts are about 2 percent of their dollar total Money market borrowings cost June Bug an average of 2.75 percent in interest costs and

ial. They are not actual FRM exam questions.

0.25 percent in noninterest costs. Management estimates the cost of stockholders' equity capital at 12 percent before taxes. (The bank is currently in the 35-percent corporate tax bracket.) When reserve requirements are added in, along with uncollected dollar balances, these factors are estimated to contribute another 0.75 percent to the cost of securing checkable deposits and 0.50 percent to, the cost of acquir­ ing time and savings deposits. Reserve requirements (on Eurodeposits only) and collection delays add an estimated 0.25 percent to the cost of the money market borrowings. a. Calculate June Bug's weighted average interest cost on total funds raised, figured on a before-tax basis. b. If the bank's earning assets total $700 million, what is its break-even cost rate? c. What is June Bug's overall historical weighted average cost of capital?

12. Inspiration Savings Association is considering funding a package of new loans in the amount of $400 million. Inspi­ ration has projected that it must raise $450 million in order to have $400 million available to make new loans. It expects to raise $325 million of the total by selling time deposits at an average interest rate of 1.75 percent. Noninterest costs from selling time deposits will add an estimated 0.45 per­ cent in operating expenses. Inspiration expects another $125 million to come from noninterest-bearing transac­ tion deposits, whose noninterest costs are expected to be 2.00 percent of the total amount of these deposits. What is the Association's projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets?

Internet Exercises 1. In terms of size, which banks in the U.S. financial system seem to rely most heavily on deposits as a source of fund­ ing and which on nondeposit borrowings and liability man­ agement? To provide an example for the numbers reported in Table 13.3, go to the FDIC's Institution Directory at http://www2.fdic.gov/idasp/ and search by city and state to find a small bank holding company (BHC) located in your hometown or somewhere you enjoy visiting. Write down the BHC ID of your selected bank. Then go to www2 .fdic.gov/sdi/ to compare your small BHC with two larger BHCs— Bank of America (BHC ID 1073757) and JP Morgan Chase (BHC ID 1039502). Compare and contrast Deposits/ Total Assets and Liabilities/Total Assets for the three BHCs to illustrate your point.

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The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

If you need some help maneuvering around this site to create a report, read on. The process to create a report requires that you "Select the Number of Columns." You want to select "3" to develop the format to collect data for the most recent report. This provides three pull-down menus, each labeled Select One. In the columns select Bank Holding Company from the menu and go on to type in the BHC ID #. After defining the three columns click on Next. At this point, you focus on Report Selection, choos­ ing to View and to do calculations in Percentages. Then you get to identify the information you want to collect before creating the report by clicking Next. You will find deposit and liability information in the Assets and Liabilities report.

3. As a home mortgage lender, you are interested in borrow­ ing from a Federal Home Loan Bank. First determine which district you are in and then go to the bank in that district and find the interest rates on FHLB advances. The following site will get you started: www.fhlbanks.com. 4. In this chapter you have been introduced to a number of instruments used for liability management. Repurchase agreements are always a challenge. To learn a little more about these instruments go to http://www.ny.frb.org/ cfcbsweb/Fleming.Bk_w.pdf. Who are the major partici­ pants in the RP market? 5. You have been introduced to the Eurodollar market. To learn more about this market go to http://www .richmondfed.org/publications/special_reports/ instruments_of_the_money_market/pdf/chapter_05.pdf. For market participants, what are the three basic sources of risk associated with holding Eurodollars?

2. You are interested in borrowing from the discount window of the Federal Reserve Bank in your area. Go to www .frbdiscountwindow.org/ and find out the current interest rates at your FRB. What are they?

CASE ASSIGNMENT FOR CHAPTER 13 Your Bank's Use of Liability Management: A Step Beyond Deposits Liability management was first mentioned in Chapters 5 and 18 and further developed with the focus on sources of funds in Chapter 13. After deposits, where do bank managers go for funding? To the financial markets or, in the United States, to the Federal Reserve banks and Federal Home Loan banks. These types of nondeposit borrowing are described in detail in this chapter. We will look at liabilities to see what they reveal about our BHC's composition of sources of funds.

the nondeposit sources of funds. We add negotiable CDs and Eurodollar deposits to the nondeposit sources and we have the materials most often used in liability management. We will once again visit the FDIC's SDI website located at www2.fdic .gov/sdi/to collect two items from the Memoranda section of the Assets and Liabilities report that may provide further insights for your particular BHC and the peer group of large banks (more than $10 billion in assets). You will create the four-column report for your bank and the peer group across the two years. Access the Assets and Liabilities report using the pull-down menus and collect the percentage information for the two items listed below. Once again, you will enter the percentages as illustrated using BB&T as an example.

Part One: Collecting the Data We have already collected most of the data available to examine nondeposit sources of funds. In the spreadsheet used for comparisons with the peer group, rows 21-25 are B

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Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

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Part Two: Analyzing the Data for Interpretation A. Volatile liabilities include large-denomination time depos­ its, foreign-office deposits, Federal funds purchased, securities sold under agreements to repurchase, and other borrowings. These are the risk-sensitive sources used in liability management You can compare the col­ umns of row 131 to get a sense of the proper answers to the following questions; (1) Is your BHC increasing its reliance on liability management? (2) Is your bank using liability management more than its peers?

ial. They are not actual FRM exam questions.

B. Once you have looked at the big picture using the aggregated measure of volatile liabilities to total assets, observe the comparative and trend differences of its components, especially FHLB advances, Federal funds purchased, and securities sold under agreements to repurchase as a proportion of total assets, C. Write one or two paragraphs discussing your BHC's use of liability management from year to year and in com­ parison to its contemporaries.

Selected References For a fuller explanation of recent developments in nondeposit funding see: 1. Fleming, Michael J.; and Kenneth D. Garbade. "The Repur­ chase Agreement Refined—The GCF Repo," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 9, No. 6 (June 2003), pp. 1-7. 2. Fleming, Michael J.; and Kenneth D. Garbade. "Repurchase Agreements with Negative Interest Rates," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 10, no. 5 (April 2004), pp. 1-7. 3. Maloney, Daniel K.; and James B. Thomson. "The Evolv­ ing Role of the Federal Home Loan Banks in Mortgage Markets," Economic Commentary, Federal Reserve Bank of Cleveland, June 2003, pp. 1-4.

4. Rose, Peter S. "The Quest for New Funds: New Dimensions in a New Market," The Canadian Banker, vol. 94, no. 5 (September/October 1987), pp. 436-455. 5. Stevens, Ed. "The New Discount Window," Economic Commentary, Federal Reserve Bank of Cleveland, May 15, 2003, pp. 1-4. To examine the Federal Reserve System's recent addition to its sources of borrowed funds for troubled depository institutions in need—the TAF or Term Auction Facility—see especially the parallel auction procedure recently used for Treasury bills: 6. Rose, Peter S.; and Milton H. Marquis. Financial Institutions and Markets, E-book, 11th edition, New York: McGraw-Hill/ Irwin, 2011, Chapters 10-13.

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Learning Objectives After completing this reading you should be able to: Describe the mechanics of repurchase agreements (repos) and calculate the settlement for a repo transaction.

Compare the use of general and special collateral in repo transactions.

Discuss common motivations for entering into repos, including their use in cash management and liquidity management.

Identify the characteristics of special spreads and explain the typical behavior of US Treasury special spreads over an auction cycle.

Discuss how counterparty risk and liquidity risk can arise through the use of repo transactions.

Calculate the financing advantage of a bond trading spe­ cial when used in a repo transaction.

# Assess the role of repo transactions in the collapses of Lehman Brothers and Bear Stearns during the 2007-2009 financial crisis.

Excerpt is Chapter 12 of Fixed Income Securities: Tools for Today's Markets, Third Edition, by Bruce Tuckman and Angel Serrat.

This chapter is about repurchase agreements or repos. Repos are short-term contracts that are used to lend money on the security of usually high-grade collateral, to finance the purchase of bonds, and to borrow bonds to be sold short. Financial institutions have traditionally relied on repos to finance some portion of fixed income inven­ tory. Repo financing, as secured, short-term borrow­ ing, is typically a relatively inexpensive way to borrow money. The practice can leave firms in a perilous situation, however, should lenders of cash through repos, in times of trouble, fail to renew their loans. This turned out to be an issue in the financial crisis of 2007-2009, which is illustrated in this chapter by two cases, one about liquidity management at Bear Stearns and one about the financing relationship between Lehman Brothers and JPMorgan Chase. The last part of the chapter focuses on repo rates and, in particular, on the specials market in the United States, where market participants lend money at relatively low rates predominantly in order to borrow the most recently issued and most liquid U.S. Treasury bonds. The behavior of these rates is examined in some detail and linked empirically to the auction cycle of U.S. government bonds.

€ 100mm Face of DBR 4s of 1/4/2037 * Counterparty A €111,772,000

Fiqure 14.1

Counterparty A €111,837,697.10

Fiqure 14.2

At initiation of the repo, depicted in Figure 14.1, counterparty A sells €100 million face amount of the DBR 4s of January 4, 2037, to counterparty B, for settlement on May 31, 2010, at an invoice price of €111.772 million. At the same time, counterparty A agrees to repurchase that €100 million face amount three months later, for settlement on August 31, 2010, at a purchase price equal to the original invoice price plus interest at a repo rate of .23%. Using the actual/360 convention of most money market instruments, and noting that there are 92 days between May 31, 2010, and August 31, 2010, the repurchase price is / \ .23% x 92 = €111,837,697.10 €111,772,000 1+ 360 v /

The unwinding of a repo trade. Hence, at the termination or unwind of the repo, depicted in Figure 14.2, counterparty A repurchases the €100 million face amount of the bund from counterparty B for about €111.838 million. (Bund is another name for a DBR.)

A repurchase agreement or repo is a contract in which a security is traded at some initial price with the understanding that the trade will be reversed at some future date at some fixed price. Repos are used by several different types of market participants for different purposes; Figures 14.1 and 14.2 begin the discussion by illustrating a simplified trade between generic counterparties.

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The initiation of a repo trade

€ 100mm Face of DBR 4s of 1/4/2037

14.1 REPURCHASE A G REEM EN TS: STRUCTURE AND USES

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Counterparty B

(14.1)

The next three subsections describe the three reasons to do repo: to lend funds short-term on a secured basis, to finance a long position in a security, and to borrow a security in order to sell it short.

Repos and Cash Management Investors holding cash for liquidity or safekeeping purposes often find investing in repo to be an ideal solution. The most significant example of this is the money market mutual fund industry, which invests on behalf of investors willing to accept relatively low returns in exchange for liquidity and safety. In terms of Figures 14.1 and 14.2, a money market fund would be in the position of counterparty B, lending money while taking collateral and then, at maturity, collecting the loan plus inter­ est and returning the collateral. Holding collateral makes the lender less vulnerable to the creditworthiness of a counterparty because, in the event of a default by counterparty A, counter­ party B, in this case the money market fund, can sell the repo collateral to recover any amounts owed. In summary, relative to super-safe and liquid non-interest-bearing bank deposits,

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

repo investments pay a short-term rate without sacrificing much liquidity or incurring significant default risk. Municipalities constitute another significant category of repo investors. As the timing of tax receipts has little to do with the schedule of public expenditures, municipalities tend to run cash surpluses from tax receipts so as to have money on hand to meet expenditures. These tax revenues cannot be invested in risky securities, but neither should the cash collected lie idle. Short-term loans backed by collateral, like repos, again satisfy both revenue and safety considerations. Other institutions with similar cash management issues that choose to invest in repo are mutual funds, insurance companies, pension funds, and even some nonfinancial corporations. It is worth noting, however, that many lenders in the repo market during the recent financial crisis realized that they were not well positioned, either in exper­ tise or operational ability, to take possession of and liquidate repo collateral. Since repo investors place a premium on liquidity, they tend to lend overnight, rather than for term, which refers to any matu­ rity longer than one day. Many investors planning to lend cash through the repo market for an extended period of time will, rather than lend for term, engage in an open repo, i.e., a oneday repo that renews itself day-to-day until cancelled by either party. Nevertheless, investors willing to take on some additional liquidity and counterparty risk, in addition to interest rate risk, do lend through term repos. These are available at various maturities, out to several months, although demand declines rapidly with term. Since safety is the other key consideration of investors in repo, only securities of the highest credit quality are typically accepted as collateral. The most common choices are govern­ ment securities, debt issues of government-sponsored enter­ prises (GSEs), and mortgage-backed securities guaranteed by the government or the GSEs. (See the Overview for institu­ tional descriptions.) Even taking high-quality securities as col­ lateral, however, a lender of cash faces the risk that a borrower defaults at the same time those securities decline in value.1 In that eventuality, selling the collateral might not fully cover the loss of the loan amount. Therefore, repo agreements often provide haircuts through which investors require borrowers to deliver securities worth more than the amount of the loan. In the example of this section, counterparty B might lend only €106 million against the €111.772 million of securities and, of

In risk management parlance, however, this is called a right-way risk. If a repo borrower, typically a well-established financial institution, were to default, the market response would probably be a "flight-toquality trade" in which securities of the most creditworthy governments increase in value. A

course, collect only €106 million plus interest at maturity. In addition, repo agreements are normally subject to margin calls, through which the borrower of cash supplies extra collateral in declining markets but may withdraw collateral in advancing markets. Again using the example of this section, should the value of the bund collateral decline from its initial value of €111.772 million to €110 million, the borrower would have to put up the €1.772 million difference in additional collateral to protect the investor's loan. Combining the haircut and repric­ ing features, after the drop in bund value the investor would still have €111.772 million of collateral against the outstanding loan of €106 million. While repo investors care about the quality of the collateral they accept, they do not usually care about which particular bond they accept. Hence, while repo investors can be very particular about which classes of securities they will take as collateral, e.g., Euro-area government bonds with less than five years to matu­ rity, they will not insist on receiving any particular security within that delineated class. For this reason these investors are said to accept general collateral, which trades at general collateral repo rates. The types and determination of repo rates are discussed later in this chapter.

Repos and Long Financing Financial institutions are the typical borrowers of cash in repo markets. Say that a client wants to sell €100 million face amount of the DBR 4s of January 4, 2037, to the trading desk of a financial institution. The desk will buy the bonds and even­ tually sell them to another client. Until that buyer is found, however, the trading desk needs to raise money to pay the cli­ ent. Put another way, it needs to finance the purchase of the bunds. Rather than draw on the scarce capital of the financial institution for this purpose, the trading desk will repo or repo out the securities, or sell the repo. This means that it will bor­ row the purchase amount from someone, like a money market fund, and use the DBR 4s, which it just bought, as collateral. Thus, the trading desk acts as counterparty A in Figure 14.1. Of course, any haircuts applied will require the trading desk to use some of its capital to make up the difference between the purchase price of the securities and the amount borrowed from the repo counterparty. When the bunds are ultimately sold to some buyer, the desk will, still as counterparty A but now in Figure 14.2, unwind the repo, using the proceeds from the sale of the bunds to repay the repo loan and using the returned collateral to make delivery of those bunds to that buyer. If no buyer is found before the expiration of the repo, the trading desk will have to roll or renew the repo for another period with the same

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The issues surrounding financial institutions' use of repo to finance their businesses are discussed later in this chapter.

Reverse Repos and Short Positions

counterparty or unwind that repo and find a different coun­ terparty to finance the bond. This latter option is illustrated in Figure 14.3. The trading desk, still as counterparty A, will repay counterparty B the approximately €111.838 million due and take back the bunds; then borrow funds from counter­ party C and deliver the bunds as collateral. Note that since the cash obtainable from counterparty C depends on the price of the bond at the time of the roll, while the cash due to coun­ terparty B depends on the amount owed from the previously agreed-upon transaction, this renewal of the repo may leave counterparty A, the trading desk, with a cash surplus or deficit. Of course, had the trading desk hedged the price risk of its inventory, the profit and loss from the hedge would offset this cash surplus or deficit. In the example of this subsection, the financial institution used the repo market to finance its inventory for the purpose of mak­ ing markets. Other uses include financing its proprietary posi­ tions2 and positions for customers. Repo for proprietary positions can be described by Figures 14.1 and 14.2, with the relevant trading desk again as counterparty A, but with internal rather than customer motivations for purchasing and then selling the bunds. Repo for financing customer positions, at initiation, can be described in terms of Figure 14.3. This time a customer, e.g., a hedge fund, is counterparty B, who wants to finance the purchase of the DBR 4s. The trading desk of the financial institu­ tion, counterparty A, does a repo with the customer, lending cash and taking the DBR 4s as collateral. The trading desk then does a back-to-back repo with counterparty C, who provides the cash and takes the collateral originally supplied by the hedge fund. Without haircuts the cash amounts shown would be the same, but, in practice, the haircuts charged on each leg of the trade depend on the creditworthiness and negotiating power of the relevant counterparties.

2 Currently, the "Volcker rule" is envisioned as limiting the magnitude of proprietary positions held by financial institutions.

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Professional investors often want to short a bond, either as an outright bet that interest rates will rise or as part of a relative value bet that the price of another security will rise rela­ tive to the price of the security being sold short. Say that a hedge fund wants to short the DBR 4s of January 4, 2037. It sells the bund, but then needs to borrow it from somewhere in order to make delivery. In terms of Figure 14.1, the hedge fund is counterparty B, initi­ ating the transaction not because it wants to lend cash but because it wants to borrow the bund. From the point of view of the hedge fund, it will do a reverse repurchase agree­ ment,3 will reverse or reverse in the securities, or will buy the repo. After initiating the reverse, the hedge fund will, at some point in time, be ready to cover its short, i.e., to neutralize its eco­ nomic exposure to the bund by buying that bund back. At that time the hedge fund will buy the bund and then unwind its reverse as in Figure 14.2. Specifically, the hedge fund, as counterparty B, will buy the bund at market and then deliver it to counterparty A, who, in exchange, will return the hedge fund's cash with interest. If the return on the bund has been less than the repo rate of interest, the hedge fund will have made money on an outright short position, while if the return on the bund has been greater than the repo rate of interest, the hedge fund will have lost money on an outright short. Of course, the short might very well have been part of a larger trade in which case the P&L has more components. While Figures 14.1 and 14.2 were used to explain both repo investment and reverse repos, it is important to keep in mind that the former are initiated in order to invest cash while the latter are initiated to borrow a bond. So while repo investors are willing to accept general collateral, reverses require the delivery of a particular bond. Repo transactions that require the delivery of a particular bond are called special trades and they take place at special collateral rates. The specials market is dis­ cussed further later in this chapter.

3 The practice of calling the trade a reverse repo is particularly confus­ ing because the same trade that is a reverse repo for the borrower of a security is a repo for the lender of that security.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

14.2 REPO, LIQUIDITY M ANAGEM ENT, AND THE FIN AN CIAL CRISIS O F 2007-2009 Broker-dealers rely less on repo financing currently than they did before the 2007-2009 crisis. A financial institution can borrow funds in many ways, some of which are more stable than others, i.e., some of which can be easily maintained under conditions of financial stress and some of which cannot be so easily maintained. The most stable source of funds is equity capital because equity holders do not have to be paid according to any particular sched­ ule and because they cannot compel a redemption of their shares. Slightly less stable is long-term debt because bondholders have to be paid interest and principal as set out in bond indentures. At the other extreme of funding stability is short-term unsecured funding, like commercial paper: these borrowings have to be repaid in a matter of weeks or months, as they mature, when the institution, under adverse conditions, might not be able to borrow money elsewhere. Not surprisingly, the more stable sources of funds are usually more expensive in terms of the expected return required by the providers of funds. Through liquidity manage­ ment, firms balance the costs of funding against the risks of being caught without the financing necessary to survive. In the spectrum of financing choices, repo markets are relatively liquid and repo borrowing rates relatively low. On the other hand, by nature of its short maturities repo is on the less stable side of the funding spectrum, although more stable than short-term, unsecured borrowing. After all, repo collateral should prevent repo lenders from bolting too quickly in response to unfavorable rumors or news. Nevertheless, if repo investors do lose confi­ dence in a financial institution, that institution's repo financing can disappear as fast as the repos mature, which is mostly overnight. The beleaguered institution would no longer be able to facili­ tate customer trades by holding inventory, would not be able to facilitate customer financing, and might not remain an acceptable counterparty for derivative and even spot security transactions. Furthermore, the institution would have to sell inventory and pro­ prietary positions to repay repo lenders, which sales, given their size and public nature, would likely turn into fire sales and result in significant losses. Essentially then, while significant business losses rather than financing are the usual cause of a financial insti­ tution's difficulties, the loss of financing is often the killing blow. The same argument, of course, applies to all leveraged investors, like part of the hedge fund world. To the extent that a firm bor­ rows money to finance positions, losing the confidence of repo and other secured financing counterparties can result in fire sales, substantial losses, and possible bankruptcy. The risks of repo funding juxtaposed with those of repo investing create tensions between borrowers and lenders of cash as well as

difficulties for regulators. Borrowers want to extend the term of their repo borrowings,4 sometimes at the encouragement of their regulators, so as to have more time, should conditions for refi­ nancing deteriorate, to arrange alternate financing, to raise capi­ tal, or even to sell corporate entities. Lenders, on the other hand, want to shorten the term of their repo lendings, sometimes at the encouragement of their regulators, so as to minimize exposure to borrower defaults. Prices, in this case repo rates, allocate repos of various terms across borrowers and lenders, but the financial system as a whole cannot both extend the maturities of secured financing and contract the maturities of secured lending. In the run-up to the financial crisis of 2007-2009, borrowers financed lower-quality collateral, like lower-quality corporate bonds and lower-quality mortgage-backed securities, at the rela­ tively low rates and haircuts available in the repo market. Lenders, for their part, accepted this collateral in exchange for rates some­ what higher than those available when lending on higher-quality collateral. The resulting expansion of collateral accepted for repo did not work out well during the crisis, particularly for borrowers who were unable to meet margin calls caused by declining security values, who were unable to post sufficient collateral in response to lenders' raising haircuts, or who were unable to replace lost financ­ ing arrangements when lower-quality collateral found fewer and fewer takers. The worst-hit borrowers suffered collateral liquida­ tions, losses, capital depletion, and business failure.

Case Study: Repo Financing and the Collapse of Bear Stearns This is an excerpt from the testimony of Paul Friedman before the Financial Crisis Inquiry Commission on May 5, 2010.5 Mr. Friedman, a Senior Managing Director at Bear Stearns, was responsible for its fixed income repo desk at the time of the firm's demise in March 2008. Bear Stearns generally financed its business by borrow­ ing funds on a secured and unsecured basis and through the use of equity capital. During 2006, Bear Stearns decided to reduce the amount of short-term unsecured funding, primarily commercial paper, that it borrowed. The firm made this decision primarily based on its belief, which I shared, that commercial paper tended to be confidence-sensitive, and could become unavailable at a time of market stress, while secured borrowing based

4 As an operational aside, term repo financing usually includes rights of substitution that enable the borrower of cash who needs to sell a par­ ticular bond being financed to replace that bond as collateral with other bonds of comparable value and quality. 5 Source: http://fcic.gov/hearings/pdfs/2010-0505-Friedman.pdf

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on high-quality collateral is generally less credit sensitive and therefore more stable. Bear Stearns implemented this strategy in late 2006 and 2007, and succeeded in reducing its short-term unse­ cured financing from $25.8 billion at the end of fiscal 2006 to $11.6 billion at the end of fiscal 2007, and spe­ cifically reduced its commercial paper borrowing from $20.7 billion to $3.9 billion. That funding was replaced by secured funding, principally repo borrowing . . . As part of the firm's transition away from unsecured bor­ rowing, Bear Stearns also substantially increased the average term of its secured funding during the first half of 2007. Bear Stearns was able to obtain longer term repo facilities of six months or more to finance assets such as whole loans and non-agency mortgage backed securities, and generally limit its use of short-term secured funding to finance Treasury or agency securities. By increasing the amount of its long-term secured fund­ ing, the firm believed that it could better withstand a liquidity event. From approximately August 2007 to the beginning of 2008, however, the fixed income repo markets started experiencing instability, in which fixed income repo lend­ ers began shortening the duration of their loans and asking all borrowers to post higher quality collateral to support those loans. Although the firm was successful in obtaining some long-term fixed income repo facilities, by late 2007 many lenders, both traditional and nontraditional, were showing a diminished willingness to enter into such facilities. During the week of March 10, 2008, Bear Stearns suf­ fered from a run on the bank that resulted, in my view, from an unwarranted loss of confidence in the firm by certain of its customers, lenders, and counterparties. In part, this loss of confidence was prompted by market rumors, which I believe were unsubstantiated and untrue, about Bear Stearns' liquidity position. Neverthe­ less, the loss of confidence had three related conse­ quences: prime brokerage clients withdrew their cash and unencumbered securities at a rapid and increasing rate;6 repo market lenders declined to roll over or renew

6 Unencumbered securities are securities that have not been posted as collateral or otherwise committed. This part of the testimony seems to imply that Bear Stearns relied on customer cash and customer securities (the latter could be posted as collateral to raise funds) to finance other businesses of the firm. In the spectrum of financing stability, customer cash and unencumbered securities are extremely unstable sources of funding as they can be withdrawn without notice at any time.

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repo loans, even when the loans were supported by high-quality collateral such as agency securities; and counterparties to non-simultaneous settlements of foreign exchange trades refused to pay until Bear Stearns paid firs t. . . [T]his loss of confidence in Bear Stearns . . . resulted in a rapid flight of capital from the firm that could not be survived.

Case Study: JPMorgan Chase's Repo Exposure to Lehman Brothers The counterparty risk of lending money through a repo is that the borrower defaults and the value of the collateral turns out to be insufficient to cover the loan amount. Any sterile discus­ sion of the topic cannot do justice to the bare-knuckle fighting over collateral that takes place when a counterparty is at risk of default. A striking and well-publicized example of this through 2008 was the repo exposure of JPMorgan Chase (JPM) to Lehman Brothers. JPM was Lehman's tri-party repo clearing agent. When repo investors lend money to a financial institution through the tri­ party repo system,7 taking collateral as security, their loans are, literally, overnight.8 During the day, however, the tri-party repo agent is lending this money to the financial institution on a secured basis.9 Furthermore, given the operational structure of the industry, a broker-dealer could not stay in business without its tri-party agent performing this function. Returning to JPM and Lehman, before Lehman's final week, JPM's tri-party lending to Lehman typically exceeded $100 billion.10 Furthermore, JPM had historically not taken any haircuts on its tri-party, intraday advances, but began to do so in early 2008. In Lehman's case, JPM phased in haircuts so as to match, by mid-August 2008, the haircuts posted to overnight repo investors. Against this background, the following two excerpts describe differing viewpoints of the events of September 2008, the first from a lawsuit filed by the estate of Lehman Brothers Holdings

7 For a more complete description, see "Systemic Risk and the Tri-Party Repo Clearing Banks," by Bruce Tuckman, Center for Financial Stabil­ ity Policy Paper, February 2010. www.centerforfinancialstability.org/ research-Tri-Party-Repo20100203.pdf 8 This is the reason that overnight repo trades are called that and not one-day trades. 9 As of the time of this writing, an industry task force is working to elimi­ nate this transfer of intraday risk from repo lenders to the tri-party repo agents. 10 See "Written Statement of Barry Zubrow Before the Financial Crisis Inquiry Commission," September 1, 2010, p. 2. fcic-static.law.stanford. edu/cdn_media/fcic-testimony/2010-0901 -Zubrow.pdf

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Inc. (LBHI) against JPM 11 and the second from the testimony of Barry Zubrow, Chief Risk Officer of JPM, before the Financial Crisis Inquiry Commission. First, from Lehman's estate: On the brink of LBHI's bankruptcy, JPMorgan leveraged its life and death power as the brokerage firm's primary clearing bank to force LBHI into a series of one-sided agreements and to siphon billions of dollars in criticallyneeded assets. The purpose of these last-minute maneu­ vers was to leapfrog JPMorgan over other creditors by putting itself in the position of an overcollateralized creditor, not just for clearing obligations, but for any and all possible obligations of LBHI or any of its subsidiaries that JPMorgan believed could result from an LBHI bank­ ruptcy. The effect of JPMorgan's actions—taken with the benefit of unparalleled inside knowledge—was devas­ tating. JPMorgan not only took billions of dollars more than it needed from LBHI, but it also accelerated LBHI's freefall into bankruptcy by denying it an opportunity for a more orderly wind-down, costing the LBHI estate tens of billions of dollars in lost value . . .

business days before LBHI's Chapter 11 filing, JPMorgan seized $8.6 billion of cash collateral, including over $5 billion in cash on the final business day. All the while that JPMorgan was aggressively leveraging its position to grab increasingly more collateral, JPMorgan knew that it was already overcollateralized by billions of dollars. JPMorgan's . . . unjustified demands for billions in addi­ tional collateral, and its refusal to return that collateral in the critical days before LBHI's bankruptcy filing, severely constrained LBHI's liquidity and impeded its ability to pursue and implement alternatives and initia­ tives that would have resulted in the preservation of bil­ lions in value. . . . Next, from Barry Zubrow of JPM: Increasing margin requirements [during the course of 2008]. . . did not protect JPMorgan fully from the risks it faced in extending tens of billions of dollars of credit to broker-dealers each morning . . . JPMorgan, unlike any single triparty investor, took on a broker-dealer's entire triparty repo book each day. This meant it would face far greater risks in a liquidation scenario. Furthermore, JPM ­ organ had no assurance that investors would return to fund the broker-dealer in the evening . . . with the cash necessary to repay JPMorgan's intraday advances. More­ over, the haircuts negotiated between investors and the broker-dealers did not, in many cases, fully reflect the liquidation risk for the increasingly large amount of structured, difficult-to-value securities that were being financed through the triparty repo program . . . .

In the weeks preceding LBHI's bankruptcy filing, JPM ­ organ's top management were the ultimate insiders to the evolving crisis, enjoying real-time access to the key decision-makers at the United States Treasury and the Federal Reserve Bank of New York. JPMorgan's invest­ ment bankers were also attempting to assist Lehman's primary potential bidder, the Korea Development Bank, and consequently had first-hand knowledge of its inten­ tions regarding a potential acquisition. JPMorgan also had direct access to internal financial information about Lehman, including an opportunity to review and com­

By late August and early September 2008, Lehman's deteriorating financing condition was becoming increas­ ingly apparent. . . . In addition, it came to light that many of the securities Lehman had pledged to JPMor­ gan in June were illiquid, structured debt instruments that appeared to have been assigned overstated values. Nevertheless, JPMorgan . . . continued to . . . act on a business-as-usual basis.

ment on Lehman's presentation to the rating agencies. At one crucial point, JPMorgan was invited to a meeting with Lehman to consider rescue financing proposals, but instead used it as an opportunity to probe Lehman's financial condition and business plans from a risk man­ agement perspective. With all of the bank's tentacles encircling the financial crisis at Lehman, JPMorgan was uniquely positioned to capitalize on the opportunities that crisis presented. . . . JPMorgan . . . drained LBHI of desperately needed cash by making repeated demands that LBHI increase the amount of collateral payments it posted. In the last four

11 Lehman Brothers Holdings Inc., and Official Committee of Unsecured Creditors of Lehman Brothers Holdings Inc., against JPMorgan Chase Bank, N.A.

But JPMorgan's exposure to Lehman was growing. This included exposure in areas unrelated to triparty repo clearing. . . . JPMorgan searched for a way to protect itself without triggering a run on Lehman. . . . JPMor­ gan determined that it could continue to face Lehman in the market if it had $5 billion in additional collat­ eral . . . [This] was far from sufficient to cover all of JPMorgan's potential exposures to Lehman . . . but JPMorgan believed that it was an amount that Lehman could reasonably provide . . . . Lehman executives agreed to pledge additional collateral, and . . . did not

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indicate that JPMorgan's request was putting undue pressure on Lehman. . . . During the second week of September 2008 . . . a broad review of Lehman's collateral securities . . . indicated that some of the largest pieces of collateral pledged to JPMorgan were illiquid, could not reasonably be valued and were supported largely by Lehman's own credit. . . . When the true nature of Lehman's collat­ eral came to light on September 11, 2008, it became apparent that JPMorgan . . . would need additional collateral if it were to continue supporting Lehman. JPMorgan decided that $5 billion in cash was . . . appro­ priate . . . even though its potential collateral shortfall was greater, as it was a number that JPMorgan believed Lehman could handle. . . . Later that night, JPMorgan sent Lehman a letter stating that, if Lehman did not post the collateral by the open of business the next day, JPM ­ organ would exercise its right to decline to extend credit to Lehman. . . . Lehman delivered $5 billion of cash col­ lateral during the morning and early afternoon [of Sep­ tember 12]. . . . Throughout all of this . . . JPMorgan continued to make enormous—discretionary—extensions of credit to the ailing bank, and it continued to trade with Lehman. . . .

14.3 G EN ER A L AND SPECIA L REPO RATES As mentioned earlier in this chapter, repo trades can be divided into those using general collateral (GC) and those using special collateral or specials. In the former, the lender of cash is willing to take any particular security, although the broad categories of acceptable securities might be specified with some precision. In specials trading, the lender of cash initiates the repo in order to take possession of a particular security. For these trades, there­ fore, it makes more sense to say that "counterparty A is lend­ ing a security to counterparty B and taking cash as collateral" as opposed to saying that "counterparty B is lending cash and taking a security as collateral," although the two statements are economically equivalent. For this reason, by the way, when using the words "borrow" or "lend" in the repo context, it is best to specify whether cash or securities are being borrowed or lent. Also, as another note on market terminology, bonds most in demand to be borrowed are said to be trading special, although any request for specific collateral is a specials trade. Each day there is a GC rate for each bucket of collateral and each repo term. The most commonly cited GC rates are for

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repos where any U.S. Treasury collateral is acceptable, and "the" GC rate refers to the overnight rate for U.S. Treasury collateral. With respect to special rates, there can be one for each security for each term, e.g., the 35/ss of August 15, 2019, to September 30, 2010. But every special rate is typically less than the GC rate: being able to borrow cash at a relatively low rate induces holders of securities that are in great demand to lend those securities, while being forced to lend cash at a relatively low rate allocates securities that are in great demand to potential bor­ rowers of that security. Differences between the GC rate and the specials rates for particular securities and terms are called special spreads. Relating GC and specials trades to the market participants discussed earlier in this chapter, GC trades suit repo investors: they obtain the highest rate for the collateral they are willing to accept. Traders intending to short particular securities have to do specials trades and must decide whether they are willing to lend money at rates below GC rates in order to borrow those securities. Funding trades are predominantly GC. Should an institution find itself wanting to borrow money against a security that is trading special, however, it will lend that security in the specials market and borrow cash at a rate below GC, rather than financing that security as part of a GC trade. In the United States the GC rate is typically close to, but below, the federal funds rate. The latter is the unsecured rate for over­ night loans between banks in the Federal Reserve system. By contrast, repo loans secured by U.S. Treasury collateral are safer and should trade at a lower rate of interest. From October 23 through July 1, 2010, for example, the GC rate was, on average, about 16 basis points below the fed funds rate. This fed fundsGC spread can vary, however, with the demand for Treasury collateral. When the U.S. government was running surpluses and paying down debt in the late 1990s and early 2000s, so that U.S. Treasuries were becoming scarcer and expected to become scarcer still, the fed funds-GC spread widened to reflect the decreasing supply of Treasury collateral. The fed funds-GC spread also widens during times of financial stress. At such times the demand to hold Treasury bonds and to lend cash on Treasury collateral increases as part of flight-toquality trades. In addition, willingness to lend Treasury bonds in repo declines as market participants fear that collateral may not be returned, either because a counterparty will fail to return collateral or because a counterparty's counterparty will fail to do so. Shortly after the collapse of Bear Stearns, for example, after the Fed had hurriedly lowered its target for the fed funds rate to 2.25%, GC traded at below .50%. Similarly, extremely wide spreads prevailed in the months after the failure of Lehman Brothers.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 14.1

Special Repo Spreads for Selected, Recently Issued U.S. Treasury Bonds as of May 28, 2010

General Collateral Rate .23% Coupon

Maturity

Issue Date

Designation

Repo Rate

Spread

5/15/20

5/17/10

OTR 10yr

.09%

. 14%

3|%

2/15/20

2/16/10

Old 10yr

.21%

.02%

\0 \0 orloo ooloo 00

11/15/19

11/16/09

Dbl-Old 10yr

.21%

.02%

5/15/40

5/17/10

OTR 30yr

.18%

.05%

4|%

2/15/40

2/16/10

Old 30yr

.20%

.03%

11/15/39

11/16/09

Dbl-Old 30yr

.21%

.02%

sO CO100

3\%

Special rates for a particular issue to a particular date are deter­ mined by the demand of borrowing that issue to that date rela­ tive to the supply available. This statement is obvious in some ways, but the important point is that the demand and supply to borrow and lend issues is not the same as the demand and supply to buy and sell issues. In fact, because some owners of U.S. Treasuries, for institutional reasons, do not lend bonds in repo markets, the amount of a particular issue available for bor­ row might be somewhat less or very much less than the amount outstanding, depending on the distribution of ownership of that issue across various types of institutions. Put another way, a bond that trades rich relative to neighboring bonds, implies a high demand to own that bond relative to the outstanding supply. But the bond may or may not trade very special in repo depending on the extent traders want to short it relative to the supply available for borrow. Given this reasoning, predicting the special spreads of individual bonds is quite difficult. Having said that, there is one predominant explanatory factor for spe­ cial spreads in the United States, namely, the auction cycle: the most recently issued bonds of each maturity trade special. This is the topic of the next subsection.

Special Spreads in the United States and the Auction Cycle As mentioned, the U.S. government sells bonds of different maturities according to a fixed schedule. As of this writing, for example, a new 10-year issue is sold every three months. The most recently issued bond of a given maturity is called the onthe-run (OTR) or current issue while all other issues are called off-the-run (OFR). However, the second most recently issued bond of a given maturity does have its own designation as the old issue; the third most recent as the double-old issue; etc. As a general rule, at each maturity, the OTR trades the most special,

followed by the old, followed by the double-old, etc. Table 14.1 lists the more recent 10- and 30-year U.S. Treasury bonds along with representative overnight repo rates and spreads as of May 28, 2010. The special spreads equal the GC rate minus the respective bond repo rates. Table 14.1 illustrates how the more recently issued bonds at each maturity trade more special. The table also shows that the OTR 10-year trades more special than the OTR 30-year, a regu­ larity that has been true for some time. The discussion now turns to why special rates are related to the auction cycle. Current issues tend to be the most liquid.12 This means that their bid-ask spreads are particularly low and that trades of large size can be conducted relatively quickly. This phenomenon is partly self-fulfilling. Since everyone expects a recent issue to be liquid, investors and traders who require liquidity flock to that issue and thus endow it with the anticipated liquidity. Also, the dealer community, which trades as part of its business, tends to own a lot of a new issue until it seasons and is distributed to buy-and-hold investors. As a matter of historical interest, the OTR 30-year bond had been such a dominant issue in terms of liquidity that traders called it "the bond." This nickname persists to this day despite the decline of the bond's importance relative to that of shorter maturities, in particular of the 10-year. The extra liquidity of newly issued Treasuries makes them ideal candidates not only for long positions but for shorts as well. Most shorts in Treasuries are for relatively brief holding periods:

12 This effect is particularly pronounced in the United States. In Ger­ many, the deliverability of a bond into highly liquid futures contracts is the best determinant of liquidity. See "Liquidity Premia in German Government Bonds," by Jacob W. Ejsing and Jukka Sihvonen, European Central Bank Working Paper Series, no. 1081, August 2009. In Japan, liquidity characteristics develop from a mix of the auction cycle and futures contract deliverability.

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a trading desk hedging the interest rate risk of its cur­ rent position; a corporation or its underwriter hedging an upcoming sale of its own bonds; or an investor betting that interest rates will rise. All else being equal, holders of these relatively brief short positions prefer to sell par­ ticularly liquid Treasuries so that, when necessary, they can cover their short positions quickly and at relatively low transaction costs. Investors and traders who are long an OTR bond for liquidity reasons require compensation if they are to sac­ rifice that liquidity by lending that bond in the repo mar­ ket. At the same time, investors and traders wanting to short the OTR securities are willing to pay for the liquid­ ity of shorting these particular bonds when borrowing them in the repo market. As a result, OTR securities tend to trade special.

Jul-97

Jul-98

Jul-99

Jul-00

Jul-01

Fiaure 14.4 On-the-run 10-year special spread, July 1997 to July 2010, Part I.

The auction cycle is an important determinant not only of which bonds trade special, but also of how special individ­ ual bonds trade over the course of the auction cycle. This will be illustrated first by examining the history of special spreads for the OTR 10-year Treasury and then by exam­ ining the term structure of special spreads for the OTR 10-year Treasury as of May 28, 2010. Figures 14.4 through 14.6 show the history of the OTR 10-year Treasury special spread from July 1997 to July 2010: the 13-year history is broken up into three graphs for better readability.13 The vertical lines indicate 10-year Treasury auctions. These are either auctions of new OTR securities, in which case the OTR security changes over the vertical line, or re-openings of existing OTR securities (i.e., auctions that increase the size of an already existing issue), in which case the same security is featured on both sides of the vertical line.

Nov-01

Nov-02

Nov-03

Oct-04

Nov-05

Fiaure 14.5

On-the-run 10-year special spread, July 1997 to July 2010, Part II.

Several lessons may be drawn from these graphs. First, special spreads are quite volatile on a daily basis, reflecting supply and demand for special collateral each day. Second, special spreads can be quite large: spreads of hundreds of basis points are quite common. Third, special spreads do attain higher levels over some periods rather than oth­ ers, a feature that will be discussed in the next subsection. Fourth, and the main theme of this subsection, while the cycle of OTR special spreads is far from regular, these

13 Note that data from the aftermath of the Lehman bankruptcy, from November 2008 to February 2009, is missing from Figure 14.5. Events at that time will be discussed in the next subsection.

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Mar-06

Mar-07

Mar-08

Mar-09

Fiqure 14.6

Mar-10

On-the-run 10-year special spread, July 1997 to July 2010, Part

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

spreads tend to be small immediately after auctions and to peak before auctions. It takes some time for a short base to develop. Immediately after an auction of a new OTR security, shorts can stay in the previous OTR secu­ rity or shift to the new OTR. This substitutability tends to depress special spreads. Also, the extra supply of the OTR security immediately following a re-opening auction tends to depress special spreads. In fact, a more detailed examination of special spreads indicates that re-opened issues do not get as special as do new issues. In any case, as time passes after an auction, shorts tend to migrate toward the OTR security, and its special spread tends to rise. Furthermore, as many market participants short the OTR to hedge purchases of the to-be-issued next OTR, the demand to short the OTR and, therefore, its special spread, can increase dramatically o=r spike going into the subsequent auction.

D ays S in ce Issu e / D ays B e tw e e n P re v io u s and N e xt Issu e s

Fiaure 14.7 Average OTR 10-year special spread as a function of the auction cycle, July 1997 to July 2010.

While not shown in these figures, the special spread of the 5-year OTR behaves quite similarly to the 10-year. The pat­ tern of spreads of shorter-maturity OTRs is similar although these spreads tend not to be nearly so wide. This difference is primarily due to the more frequent issuance of shortermaturity Treasuries that prevents a particular issue from becoming far and away the most liquid bond or most-favored short. Finally, the 30-year had historically been as liquid and its special spreads as large and volatile as that of the 10-year, but this has not been the case since the years leading up to a discontinuation of 30-year bond issuance in 2001. Subse­ quently, apart from some very active specials trading sur­ rounding the announcement of the re-introduction of "the bond" in 2005 and its sale in 2006, the specials spread of the OTR 30-year has been quite muted relative to those of shorter maturities.

Because special spreads in Figures 14.4 through 14.6 are so vol­ atile, Figure 14.7 reports the average special spread as a func­ tion of the auction cycle. The horizontal axis represents time into an auction cycle, measured as the days since the issue of the 10-year OTR divided by the total number of days between issue dates. The curve gives the average of the special spread across cycles of the 13-year history depicted in Figures 14.4 through 14.6. As expected, the average special spread increases over the cycle, spiking as the subsequent auction approaches. The auction-driven pattern of special spreads can be seen not only from historical data but also from the term structure of spe­ cial spreads of an individual issue. Table 14.2 gives the spot and forward term structure of special spreads for the OTR 10-year Treasury as of May 28, 2010. The terms listed are representa­ tive of commonly-traded terms for OTR issues. These typically include fixed terms from the pricing date (e.g., one month) and expiration dates of the relevant futures contracts. The latter trade because many market participants are interested in OTR

Table 14.2

Term Structure of Special Rates and Spreads for the 10-Year, On-the-Run U.S. Treasury as of May 28, 2010. TYM0, TYU0, and TYZ0 Are the Tickers of the Relevant 10-Year Futures Contracts Term

Term Date

Term Days

Term Rate

Term GC

Term Spread

Forward Spread

Overnight

6/1/10

4

.09%

.23%

.14%

. 14%

1 Week

6/4/10

7

.00%

.23%

.23%

.35%

TYM0

6/30/10

33

-.10%

.22%

.32%

.34%

2 Months

7/28/10

61

-.05%

.23%

.28%

.23%

3 Months

8/30/10

94

.00%

.25%

.25%

.20%

TYU0

9/30/10

125

.04%

.26%

.22%

.13%

TYZ0

12/31/10

217

.17%

.30%

.13%

.01%

Chapter 14 Repurchase Agreements and Financing

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basis trades, that is, trading the OTR against the futures contract into which it is deliverable. Note that the over­ night rate is the business day following the pricing date. The term spreads in Table 14.2 are simply the differences between the term GC rates and the respective term special rates. For this table the forward spreads are com­ puted from the term spreads, but forward repo trades do exist. In any case, to illustrate the calculation, the forward special spread from June 30, 2010, to July 28, 2010, is such that investing at the spread to June 30 and then at forward spread from June 30 to July 28 is equivalent to investing to July 28. Let sfwd be this forward spread. Then, using the numbers supplied in the table, sfwd is approxi­ mated by

Jul-97

Jul-99

Jul-01

Jul-03

10-Year Special Spread

Jul-05

Jul-07

Jul-09

Fed Fund s Target

Fiaure 14.8

OTR 10-year special spread and the Fed funds target rate, July 1997 to July 2010.

33 x .32% + (61 - 33) x s ™ - 61 x .28% s /Wd« .2 3 %

(14.2)

The projected (and realized) 10-year auction schedule as of May 28, 2010, was a re-opening of the current 3 1/2S of May 15, 2020, both in the middle of June and July, to be followed by the issue of a new OTR in the middle of August 2010. In light of the discussion in this subsection and the historical evidence, the special spread would be expected to increase into these auctions. According to the implied forward spreads, the spread is projected to increase into the June re-opening. The 3 1/2S are projected to stay special into and somewhat past the July and August auctions as well, but, for the period September 30 to December 31, the forward special spread is only one basis point. In other words, by the time the then-current 10-year has been around for a month, the specialness of the 31/2S is projected to have dissipated.

Special Spreads in the United States and the Level of Rates By graphing special spreads rather than special rates, Fig­ ures 14.4 through 14.6 hide a factor that has historically limited special spreads. Until very recently, there was no explicit pen­ alty for a fail, i.e., for failing to deliver a bond that had been sold. This has implied that the special rate could not fall below 0%. Reason as follows. If a trader had shorted the OTR 10-year and failed to deliver upon settlement, the trader would not receive the cash from the sale and, consequently, would lose one day of interest on that cash. But what if the trader could borrow the bond overnight in the repo market at 0%, i.e., lend money at 0%, so as to be able to make delivery? The econom­ ics of that borrow to the trader is the same as failing: in both cases no interest is earned on the proceeds from selling the bond. Therefore, because no trader would borrow the bond if

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the special rate were 0% or less, the special rate should never be less than 0%. Equivalently, the special spread should not exceed the GC rate.14 Figure 14.8 superimposes the Fed's target rate for fed funds on the overnight, 10-year special spread. Clearly, over all but the most recent period, the special spread has been limited by the level of rates. The level of rates, therefore, is part of the expla­ nation for the periods of relatively high and relatively low special spreads observed in this figure and in Figures 14.4 through 14.6. In 2009, however, the treatment of fails changed. In October and November 2008, as part of the reaction to the Lehman bankruptcy that September, fails to deliver the 10-year OTR climbed to record levels, $5.311 trillion in the week ending October 22, relative to a pre-crisis average of $165 billion.15 Regulators were extremely unhappy with the situation as it was viewed as a threat to the liquidity and efficiency of the U.S. Trea­ sury market. With their prodding, an industry group called the Treasury Market Practices Group adopted a penalty rate for fails, which took effect on May 1, 2009, equal to the greater of 3% minus the fed funds target rate or zero. Essentially, when the fed funds rate is near zero, the penalty is near 3%, i.e., failing to deliver $100 million of a bond costs $100mm X 3%/360 or $8,333 per day. As the fed funds rate increases, the penalty falls. The logic there is that since higher interest rates are typically 14 This is not strictly true because there are such non-monetary costs of fails as regulatory capital requirements. For a case study on negative OTR 10-year special rates in the second half of 2003, see "Repurchase Agreements with Negative Interest Rates," by Michael Fleming and Kenneth Garbade, Current Issues in Economics and Finance, Volume 10, Number 5, April 2004. www.newyorkfed.orglresearch/currentjssues/ ci10-5/ci 10-5.html 15 Liz Capo McCormick, "Treasury Traders Paid to Borrow as Fed Exam­ ines Repos," Bloomberg, November 24, 2008.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

associated with higher opportunity costs of failing, high penal­ ties are not necessary in high-rate environments to prevent epi­ sodes of system-wide fails. In light of the imposition of a penalty for failing to deliver, the new upper limit for the special spread is the penalty rate rather than the GC rate. In fact, soon after the imposition of the pen­ alty, demand to short the OTR Treasury in June 2009 drove the special spread up to this limit. This episode can be seen to the far right of Figure 14.8.

Valuing the Financing Advantage of a Bond Trading Special in Repo The OTR 10-year, the 3 1/2S of May 15, 2020, was trading extremely rich on May 28, 2010, slightly more than 2 per 100 face value, relative to the C-STRIPS curve. OTR bonds often trade at a premium that is in part due to their liquidity advan­ tages, i.e., the ability to turn positions in these bonds back into cash with minimum effort, even in a crisis, and in part due to their financing advantages, i.e., the ability to lend these bonds and borrow cash at a relatively low rate. It is obvious from Table 14.2 that, in the case of the 3 1/2S, almost all of the premium is due to liquidity. Nevertheless, it is useful here and even more so in other situations to translate special spreads into price or yield premiums. The financing value of a bond is the value, over the entire life of the bond, of lending it in repo, borrowing cash at its special

rate, and investing that cash at the higher GC rate. The key assumption then, is how special the bond will trade and for how long. Professional repo traders have an opinion about how the special spreads of particular issues will evolve over time that can be used in this analysis. Another approach is to accept the mar­ ket's view as expressed in the term structure of special spreads. According to Table 14.2, it is reasonable to assume that the 31/2s will trade as GC past September 30, 2010: the forward special rate from then to December 31 is only one basis point. Also, there is no reason to expect that the issue will ever in its life trade special again. Hence, the financing value of the bond is its financing value over the 125 days from the pricing date, May 28, 2010, to September 30, 2010. But, as will now be shown, this financing value can be easily calculated from the term special spread of .22 % to September 30, 2010. The value of lending 100 of cash at a spread of .22% for 125 days is simply 10Q x 125X 2 2% = .076 360

(14.3)

or 7.6 cents per 100 market value of the bond. At a price of 101.90, therefore, assuming no haircuts, the financing advan­ tage of the 31 2s is worth only about 7.7 cents per 100 face amount, a very small part of its total premium of over 2 dollars. Finally, to translate the dollar value of specialness into a yield value, simply divide by the DV01. In this case, with the DV01 of the 31/2s approximately equal to .085, the value of the special spread is ^ or only about .9 basis points.

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Learning Objectives After completing this reading you should be able to: Discuss the process of liquidity transfer pricing (LTP) and identify best practices for the governance and implemen­ tation of an LTP process.

Compare the various approaches to liquidity transfer pricing (zero cost, average cost, and matched maturity marginal cost).

Discuss challenges that may arise for banks during the implementation of LTP.

Describe the contingent liquidity risk pricing process and calculate the cost of contingent liquidity risk.

Excerpt is Financial Stability Institute Occasional Paper No. 70, by Joel Grant.

287

15.1 INTRODUCTION Internal transfer pricing is an extremely important manage­ ment tool for banks. This paper observes that until the global financial crisis (GFC), many banks treated liquidity as a free good for transfer pricing purposes, and this was one cause for the very poor liquidity outcomes experienced during the GFC. Furthermore, although liquidity transfer pricing (LTP) practices are improving, there is little guidance publicly available to banks, regulators, and other stakeholders on what constitutes good practice. This paper makes a start on filling that gap. LTP is a process that attributes the costs, benefits and risks of liquidity to respective business units within a bank.1 LTP has gained considerable attention since the onset of the GFC with some reports linking poor LTP practices to the funding and liquidity issues witnessed at several banks (Senior Supervisors Group (SSG), 2008; 2009). The purpose of LTP is to transfer liquidity costs and benefits from business units to a centrally managed pool. To achieve this, LTP charges users of funds (assets/loans) for the cost of liquidity, and credits providers of funds (liabilities/deposits) for the benefit of liquidity. LTP also recoups the cost of carrying a liquidity cushion by charging contingent commitments, such as lines of credit, based on their predicted (expected) use of liquidity. This is depicted in Figure 15.1 below. Banks with poor LTP practices typically under­ price or (even worse) fail to price liquidity. Such banks are more likely to accrue illiquid assets and contingent exposures, and under-value stable sources of funding. This outcome applied to many banks and other financial institutions prior to the GFC. In the years preceding the GFC, liquidity was plentiful and cheap, and as we now know, unsustainably plentiful and cheap. Some of the larger and more creditworthy banks could obtain long-term funding at only the slightest margins above swap rates. Such ideal funding conditions proved fruitful for banks, widely encouraging leverage and maturity transformation, which underpinned their record profits. At the same time these conditions led many to believe that funding would always be available, and at permanently cheap rates. One consequence of this belief was that it provided little incentive for banks to devote attention to liquidity risk management. As a result, many banks failed to recognise the true nature of the liquidity risk embedded in their business activities.1 2 1 In this regard, LTP forms part of the funds transfer pricing (FTP) process. 2 This claim is supported by the Basel Committee on Banking Supervi­ sion (BCBS), which reported that many of the basic yet fundamental principles of liquidity risk management were neglected by banks. For more information, see Liquidity Risk: Management and Supervisory Challenges, BCBS, (February 2008).

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One principle of liquidity risk management that lacked attention was LTP. In 2009, a group of prudential regulators conducted an international survey to assess the progress banks are making to enhance LTP. The survey covered 38 banks from nine coun­ tries. Total assets of the banks surveyed ranged from less than US$250 billion to greater than US$1 trillion. The survey responses revealed that many of the LTP practices employed by banks were short of good practice. This paper extracts the lessons learned from the survey, and makes a first attempt at establishing better LTP practice. For confidential­ ity reasons, however, it is not possible to quote or reference directly from any of the survey responses.

15.1.1 A Summary of the Major Lessons Learned

15.1.1.1 Governance of the LTP process Most banks included in the survey lacked an LTP policy. As such, LTP was not defined nor were there any rules or principles in regard to how LTP should operate. Typically, this outcome meant that liquidity generators (such as retail branches raising deposits) were underpaid for their liquidity creation, and liquid­ ity users (such as lending, investment, and trading portfolios) received free or unduly cheap liquidity. Where banks in the survey were operating with decentralised funding centres, most had inconsistent LTP regimes. In addition, these banks relied on manual off-line processes to intervene and to update relevant funding costs, and were more prone to arbi­ trage between business units and internal treasuries. For many of the banks in the survey with large trading businesses, internal treasuries often lacked visibility over individual business balance sheets, limiting their understanding of individual fund­ ing requirements and contingent liquidity exposures. Most of the time this resulted in treasuries charging all trading businesses based on their net funding requirement, with no add-ons for the implicit risk of a blow-out in liquidity needs. Oversight of the LTP process at nearly all banks that partici­ pated in the survey was poor to nonexistent, especially by risk and financial control functions. This was one of the factors that resulted in the accumulation of highly illiquid (and often corre­ lated) assets and the excessive reliance upon short-term (often overnight) funding. Liquidity Management Information Systems (LMIS) employed by most of the banks surveyed were simplistic and inflexible. Many of the systems were unable to attribute the costs, bene­ fits, and risks of liquidity appropriately to respective businesses, and at a sufficiently granular level. This resulted in product mis­ pricing, which distorted profit and performance assessments.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

For a large proportion of banks included in the survey, their LTP process failed to account for the costs, benefits and risks of liquidity in the pricing and performance assessment of various products and business units. As a result, profit measures used as a basis for determining business unit performance and executive remuneration were distorted. Profit pools, for example, which are generally used to determine short-term incentives (bonuses) for employees, were derived from a simple percentage of accrued revenues without any regard for the liquidity risk taken to generate such profits.3*This encouraged revenue and risk maximisation rather than risk-adjusted earnings.

15.1.1.2 The Application of LTP Probably the most striking example of poor LTP practice was how some of the banks that were surveyed treated liquidity as a "free" good, completely ignoring the costs, benefits and risks of liquidity. These banks neglected to charge or credit respective businesses, products and/or transactions accordingly. This was particularly the case for much of the contingent or unfunded business that was written. Examples included trading and invest­ ment banking activities, lines of credit, the need to prepare for collateral calls, and variable-rate (adjustable-rate) products including home mortgages. Most of the banks surveyed recognised the need to attribute the costs, benefits and risks of liquidity to respective businesses. However, a large majority of these banks employed a pooled average cost of funds approach to derive the costs and benefits of liquidity. This resulted in short- and long-term assets receiving

3 Bonus pools often neglected other risks, not just liquidity, and the cost of capital employed to generate such profits. This is the subject of another paper.

the same charge for the cost of liquidity and, conversely, shortand long-term liabilities receiving the same credit for the benefit of liquidity.

15.1.1.3 Sizing and Attributing the Costs of Liquidity Cushions For a large majority of the banks surveyed, liquidity cushions were derived from stress assumptions stemming mainly from idiosyncratic funding scenarios, revolving around a single bank's sudden inability to raise funds. Having little or no regard to sys­ temic funding scenarios, most cushions were too small to with­ stand prolonged or deep market disruptions. In addition, cushions comprised liquid assets that were them­ selves funded short-term. This meant that the cost of carrying the liquidity cushion was quite small, but the real value of the cushion in addressing sudden (contingent) liquidity risks was also minimal. This costing and funding arrangement provided insufficient incentive for banks to attribute true costs back to business units on an expected or predicted usage basis but, rather, to opt for the simpler but incorrect method of averaging the cost across all assets.

15.1.2 Regulatory Developments The Basel Committee on Banking Supervision (BCBS) has been central to regulatory developments in liquidity, first publishing Sound Practices for Managing Liquidity in Banking Organisa­ tions in February 2000. Following this, in 2006, the BCBS established the Working Group on Liquidity (WGL) to "serve as a forum for information exchange on national approaches to liquidity supervision and regulation". The group's initial mandate was to review and evaluate liquidity supervision

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practices, and banks' approaches to liquidity risk manage­ ment, with respect to the sound practices already established. This work was the first to highlight the basic yet fundamental elements that were missing from bank liquidity management. These findings formed the basis of the report Liquidity Risk: Management and Supervisory Challenges (February 2008) and sparked a review of the February 2000 sound practices. An updated version of these practices, articulating 17 principles, was released as Principles on Sound Liquidity Risk Manage­ ment and Supervision (September 2008). Since 2008 the BCBS has released Principles for Sound Stress Testing Practices and Supervision (May 2009) and more recently, Basel III: Interna­ tional Framework for Liquidity Risk Measurement, Standards and Monitoring, aimed at improving the resilience of the financial system (December 2010).4 As part of this, two global standards for liquidity risk were developed. First, a Liquidity Coverage Ratio (LCR) to ensure banks have sufficient high quality liquid assets to survive an idiosyncratic shock and, second, a Net Stable Funding Ratio (NSFR) to encourage banks to fund their business activities using more stable sources of funding.

15.1.3 The Need for More Guidance on LTP The scale and extent of liquidity reform is large. But, given the weaknesses in bank liquidity risk management approaches unveiled by the recent crisis, it is not surprising that certain principles require further guidance. This is particularly the case for LTP. Extant guidance is broad but merely encourages banks to include liquidity risk in their internal pricing mechanisms, with­ out providing specific help.5 For example, Principle 4 of the BCBS Principles on Sound Liquidity Risk Management and Supervision states that: "a bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all signifi­ cant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual busi­ ness units with the liquidity risk exposures their activities create for the bank as a whole" (p 3).

for liquidity costs, benefits and risks". Recommendations pro­ vided in the Second Part o f CEBS's Technical Advice to the European Commission (EC) on Liquidity Risk Management 6, and Point 14 in Annex V of the amendments to the Capital Requirements Directive (Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009)7, led to the development of CEBS's, Guidelines on Liquidity Cost Benefit Allocation (October 2010).8 Efforts by the BCBS and others to improve LTP are acknowl­ edged, but a lack of detailed supporting guidance has left some supervisors and banks asking: "what exactly constitutes better practice?" This paper seeks to assist with this question. It focuses on some of the more widespread poor LTP practices that were identified via the international survey with the aim of drawing out better practices. This more detailed guidance is intended to support and supplement the principles already pro­ mulgated, and assist supervisors and banks in achieving better LTP practices.

15.2 G O VERN IN G LTP Broadly speaking, all policies, processes and practices require governing. This is normally achieved through a combination of external control factors, such as regulation and competition, and internal control factors, such as board oversight and risk man­ agement.9 Because external control factors affect institutions in much the same way, governance is differentiated largely by the internal control factors that are employed. How well an institution is governed can bear heavily on whether group-wide objectives are met. While institutions with strong internal controls are more likely to achieve their goals, institu­ tions with weak internal controls are more prone to the 6 See Recommendation 2 in Second Part o f CEBS's Technical Advice to the European Commission on Liquidity Risk Management, September 2008, which is available at http://www.eba.europa.eu/getdoc/bcadd66 4-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Adviceon-liquidity_2nd-par.aspx. 7 Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ: L:2009:302:0097:0119:EN:PDF.

The Committee of European Banking Supervisors (CEBS) (now the European Banking Authority) has also highlighted the importance of banks having "an effective allocation mechanism

8 Guidelines on Liquidity Cost Benefit Allocation, CEBS, October 2010, can be accessed via http://www.eba.europa.eu/cebs/media/ Publications/Standards%20and%20Guidelines/2010/Liquidity%20 cost%20benefit%20allocation/Guidelines.pdf.

4 These papers can be accessed via http://www.bis.org/list/bcbs/sac_1/ index.htm.

9 The Committee of Sponsoring Organisations of the Treadway Com­ mission (COSO) defines internal control as "a process, effected by an entity's board of directors, management and other personnel, designed to provide "reasonable assurance" regarding the achievement of objectives in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regula­ tions" (http://www.coso.org/resources.htm).

5 A complete list of principles and/or recommendations provided by various regulatory and non-regulatory bodies is included in Appendix 1.

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problems of moral hazard and adverse selection.10 This is likely to weigh on performance. Many of the poor LTP practices that were identified across banks that participated in the survey were the direct result of weak internal controls. Some of these are discussed in more detail below.

15.2.1 Management of the LTP Process Broadly speaking, there were severe deficiencies in how the LTP process was managed.

15.2.1.1 LTP Policies Few banks in the survey had an effective LTP policy. As a result, LTP was not defined, nor were there any principles and/or rules in place to assist businesses understand how LTP should oper­ ate. Having no LTP policy is clearly poor practice, given what we now know about liquidity risk. Banks have traditionally relied on internal transfer pricing to manage interest rate risk in the bank­ ing book, and to assess and monitor the performance of products and business units, but with no or only minimal adjustments for liquidity costs, benefits and risks. For most banks in the survey, the internal pricing of liquidity risk is a relatively new concept, brought to light by the recent breakdown in wholesale funding markets, and the consequent increase in funding costs. It will take time for banks to establish adequate LTP policies and procedures, but this is a necessary first step towards better LTP practice.

15.2.1.2 Internal Funding Structure - Centralised vs Decentralised There is substantial debate surrounding the optimal internal structure of banks - is it better to have a centralised funding centre, whereby wholesale funding is restricted to a group or subsidiary treasury or, alternatively, decentralised funding cen­ tres, whereby certain business units are able to raise funding themselves from their own sources to cover their own liquidity needs? There are reasonable academic and economic argu­ ments that provide support for both approaches. However, the survey identified that banks with decentralised funding centres, particularly those with large prime brokerage business activities, were more susceptible to poor LTP practices. For 10 Moral hazard occurs when a party, insulated from risk, behaves differently than they would if they were fully exposed to the risk (www .wikipedia.com). For example, a bank might be more inclined to engage in risky behaviour, knowing that it will be bailed out if the risks turn bad. Adverse selection, on the other hand, is a process whereby bad results occur because of information asymmetries between buyers and sellers. For example, a used car salesman might sell a car, which he knows has mechanical problems, to a buyer that is less informed.

example, some business units that were able to raise wholesale funds from external sources then sold the funds to treasury and in some cases to other business units, at a higher rate. This resulted in a "risk-free" profit to the business unit at the cost of more and possibly badly managed risk for the bank as a whole. It is clear, however, that decentralised funding structures were not the sole cause of internal arbitrage. Poor oversight and inad­ equate risk controls also played a role. Jointly, these factors lim­ ited the ability of treasury and business units to know what price other business units had paid for funds from external sources and thus provided a basis for arbitrage. In addition to this, most of the banks with decentralised funding structures employed inconsistent LTP regimes and relied on manual off-line processes to update funding costs.

15.2.1.3 Trading Book Funding Policies and Identifying Funding Requirements Probably the worst LTP practices identified in the survey were in relation to trading and investment banking activities. A combi­ nation of poorly designed trading book policies, inadequate risk controls and limits, as well as a lack of oversight were to blame. For example, some banks that took part in the survey lacked trading book funding policies and procedures, which allowed for over-aggressive trading behaviour and the accumulation of illiq­ uid assets in search of revenues, not risk-adjusted profit. Most of the banks included in the survey did have trading book funding policies, but nearly all of these policies assumed that assets were only held short-term (ie for 180 days or less). One problem with this approach is that, irrespective of whether assets are likely to be held for more than the 180-day threshold, long-term fund­ ing charges only apply when assets roll from the trading book to the banking book. This provided little incentive for banks to develop risk controls and limits to adequately measure, monitor and assess the liquidity risk in traded assets, and was evident through the build-up of positions that were highly illiquid. Many of the larger banks included in the survey, particularly those with substantial trading businesses, lacked a line of sight to individual business balance sheets, and thus could not iden­ tify the funding requirements of individual trading desks. As a result, trading and investment banking activities were funded based on the total net funding requirement across all related business units. This method essentially provides a line of credit to the trading book, and gives no regard to the liquidity risk embedded in business activities. This approach is therefore considered to be poor practice. On a separate but related issue, banks with large trading businesses that participated in the survey also applied insufficient haircuts to many of the traded assets they held. These banks clearly underestimated the likeli­ hood of a market disruption, and the extent to which market

Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice

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liquidity could evaporate. The severe drop in market prices led to calls on margin positions and placed severe pressure on banks' abilities to meet funding requirements. Part of the reason this occurred was because no one had previously thought of the need to price the liquidity costs of potential margin calls.

15.2.1.4 Oversight Ineffective oversight of the LTP process contributed to many of the problems that were identified at banks that took part in the survey. For example, the accrual of long-term illiquid assets and short-term volatile liabilities created a large and poorly under­ stood mismatch between the maturities of assets and liabilities, and therefore exposed banks to greater structural liquidity risk. Probably the most striking example highlighting the implications of poor oversight was how some of the banks' LTP processes enabled them to accumulate significant amounts of highly rated, yet highly illiquid, tranches of collateralised debt obligations (CDOs) in their respective trading accounts. These portfolios were assumed to be safely funded with much shorter-term liabil­ ities, typically in the order of overnight to 90-day funds.

15.2.1.5 Towards Better LTP Practice In one form or another, all of the banks included in the survey are enhancing the way LTP is managed. A large portion of the banks surveyed, for example, are creating LTP policies for the first time to outline the purpose of LTP and, to provide some principles and/or rules to ensure business units understand the reasoning behind charges relating to the use of liquidity. For the small proportion of banks in the survey that were oper­ ating with decentralised funding centres, they are all moving towards having wholesale funding managed centrally by a trea­ sury function. In part, this is to restrict arbitrage between busi­ ness units and treasury, and between business units themselves. The survey also identified a small number of banks that are developing trading book policies and procedures for the first time. To complement this change, these banks are also develop­ ing risk controls and limits for trading activities to properly mea­ sure, monitor and assess the liquidity risk embedded in products and business units. Most of the banks included in the survey, however, were found to be updating existing policies. The most notable enhancement includes the application of higher funding charges to trading positions that are more likely to become "stale" (ie positions that have a higher probability of rolling from the trading book to the banking book). Banks in this category are also enhancing existing risk controls and limits to better manage liquidity risk exposures. The follow-on effects from these enhancements are improving risk-adjusted profit measures, and this is prompting business

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units to consider the cost of liquidity as part of their decision to book certain assets. Haircuts on traded assets are also being widened to account for more severe and prolonged market disruptions, and to ensure that assumptions surrounding the amount of liquidity that can be generated during a crisis are appropriately conservative. Banks that were included in the survey whose trading book exposures are small relative to their main business activities, are attempting to curb over-trading behaviour by imposing higher funding charges on net funding requirements when certain funding limits are breached. Other banks in the survey, whose trading book exposures are large relative to their main business activities, are devoting more attention to understanding the funding requirements of individual trading desks, and are look­ ing to apply charges on a more granular basis. Across all banks in the survey, there is an emphasis on improving oversight. Management at all levels, treasury functions, as well as independent risk and financial control personnel are becom­ ing more engaged in the LTP process. In addition, meetings to discuss changes in funding costs are being held more regularly, for example, monthly instead of quarterly or semi-annually, as they were prior to the financial crisis. In one form or another, all of the banks included in the survey are enhancing the way their LTP process is managed. One posi­ tive stemming from these enhancements is that related parties involved in the management of LTP are being forced to better understand the LTP process. Broadly, banks are encouraged to continue with similar changes.

15.2.2 Liquidity Management Information Systems (LMIS) LMIS are widely used by management as a primary source of measuring and monitoring the performance of businesses. LMIS provide information that assists management in liquidity strategic decision-making. In this regard, LMIS play a pivotal role in helping management achieve group-wide goals. Weak LMIS could easily distort the information for decision-making and prevent the bank from achieving its objectives. One application of LMIS is to support internal pricing mecha­ nisms. In relation to LTP, LMIS enable the costs, benefits and risks of liquidity to be attributed to appropriate business activities. Many of the pre-2009 LMIS employed by banks that were included in the survey were too basic, and this limited the effectiveness and efficiency of the LTP process. In some cases, for example, the basic and rigid nature of LMIS meant that certain business activities failed to receive a charge for the cost of liquidity or, conversely, a credit for the benefit of liquidity.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Another weakness in many of the LMIS that were employed by banks in the survey was that they prevented the costs, ben­ efits and risks of liquidity from being attributed at a sufficiently granular level. The SSG (2009) also report similar findings. "Many firms acknowledged shortcomings in their LMIS infrastructure and in their ability to produce useful reports during the crisis, recog­ nizing that better-quality and more timely liquidity reporting was essential to effective management of liquidity and funding issues during a crisis" (p 15). In light of these shortcomings, the SSG recommended that banks improve their LMIS. One implication of the weakness in LMIS and the poor LTP prac­ tices that resulted is that businesses reported performance (and employees claimed bonuses) on a basis that might not have reflected their actual performance. Essentially, this would limit management's ability to monitor performance, accurately dis­ tinguish good performing businesses from those that were not performing so well, and make reliable decisions pertaining to their objectives. A large proportion of the banks included in the survey are in the process of upgrading LMIS after their short-comings were unmasked by the GFC. From a supervisory perspective, it is essen­ tial that this upgrading continues. As outlined above, LMIS are an essential part of the decision-making process so it is vital that the information they provide is accurate and reliable. Upgrading LMIS in a large bank is a costly and long-term process. But the benefits of appropriately charging business activities for the cost, benefits and risk of liquidity, and at a sufficiently granular level, will far outweigh the costs and limitations of the basic LMIS that were previously employed. LMIS that are sufficiently advanced to achieve these outcomes will promote better LTP practice.

15.2.3 Remuneration Practices If designed well, incentive pay can have enormous benefits. It encourages behaviour that is consistent with the culture of an institution, and assists management in achieving group-wide objectives. On the other hand, poorly designed remunera­ tion can promote perverse behaviours such as excessive risk­ taking, which could severely impact the performance of an institution. In 2009, the Financial Stability Board (FSB) reported that poor remuneration practices were one of the factors that contributed to the GFC. "High short-term profits led to generous bonus payments to employees without adequate regard to the longerterm risks they imposed on their firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system and left

firms with fewer resources to absorb losses as risks materi­ alised" (p 1).11 The SSG also identified poor remuneration practices as one of the factors that contributed to the funding and liquidity prob­ lems witnessed at some banks during the recent crisis. Following their survey of firms, the SSG reported that remuneration was largely insensitive to the risks taken to generate income, and to costs associated with long-term funding commitments that were required to hold illiquid assets (p 24). Similarly, many of the banks that participated in the survey on LTP failed to adequately account for the costs, benefits and risks of liquidity in the pricing and performance assessment of various products and business units. As a result, profit mea­ sures used as a basis for determining remuneration were often distorted. Profit pools, for example, which are generally used to determine short-term incentives, or bonuses for employees, were derived from a simple percentage of accrued revenues, without any regard to the cost of liquidity (or capital). This placed more emphasis on maximising revenues rather than risk-adjusted earnings. Another reason the costs, benefits and risk of liquidity were poorly allocated through the LTP process for most of the banks in the survey, was because of the way remuneration was structured, particularly for those employees responsible for oversight. For many staff in these areas, remuneration was designed such that it largely depended on the performance of front-line businesses they were responsible for oversee­ ing. Thus, including the actual costs for liquidity would have impacted negatively upon business unit performance, which inevitably would have reduced personal remuneration and ben­ efits for employees. Clearly, this would have also impacted the independence of their role. Recognising these weaknesses, many of the banks that took part in the survey are developing their respective LTP processes to ensure that profit and performance measures include the relevant costs for liquidity (and capital, although this is a separate issue). Under the new regime, assets will receive a charge for the cost of liquidity consistent with the positions that are funded. In addition to this, many of the larger banks in the survey are moving towards re-designing remuneration for persons in risk control positions consistent with Principle 3 of the FSB's Principles for Sound Compensa­ tion Practices. Principle 3 states that, "staff engaged in finan­ cial and risk control should be compensated in a manner that

11 Principles for Sound Compensation Practices, FSB, (April 2009) is available at http://www.financialstabilityboard.org/list/fsb_publications/ tid_123/index.htm.

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is independent of the business areas they oversee and com­ mensurate with their key role in the firm" (p 2). It is envisaged that this will also promote a more appropriate attribution of liquidity costs to business activities and restore independence in these vital roles.

15.3 LTP IN PRACTICE: M ANAGING ON -BALAN CE SH EET FUNDING LIQUIDITY RISK 15.3.1 Why Banks Need LTP In their daily operations, banks make money by funding long­ term loans (assets) with short-term deposits (liabilities), a pro­ cess that is commonly referred to as maturity transformation. As pointed out by the BCBS (September 2008), this "makes banks inherently vulnerable to liquidity risk, both of an institutionspecific nature and that which affects markets as a whole" (p 3). But provided banks use LTP to account for the costs, benefits and risks of liquidity in product pricing, new product approval processes and profit and performance assessments, they should not be discouraged from engaging in maturity transformation. Banks with poor LTP practices are more likely to accrue larger amounts of long-term illiquid assets, contingent commitments and shorter-dated volatile liabilities, substantially increasing their vulnerability to funding shortfalls.

15.3.2 An Example of What Can Go Wrong with Poor LTP In October 2009, the SSG revealed that firms that encoun­ tered the most severe funding and liquidity problems through the financial crisis were those that relied excessively on short-term financing of longer-term illiquid assets. That is, those that engaged most in maturity transformation. The SSG highlighted that one of the drivers behind the devel­ opment of these business models was poor LTP practices, which failed to penalise businesses for the liquidity risk embedded in the assets that were booked, and which also allowed banks to build up significant amounts of contingent liquidity risk in off-balance sheet exposures. These banks made large apparent profits before the GFC, but failed to recognise that these profits were based upon what proved to be extraordinarily fragile liquidity arrangements.

15.3.3 "Zero" Cost of Funds Approach Liquidity as a "Free" Good Probably the most striking example of poor practice identified in the survey was that some banks failed to account for the costs, benefits and risks of liquidity in all or some aspects of their busi­ ness activities. These banks came to view funding liquidity as essentially free, and funding liquidity risk as essentially zero. As a result, there was simply no charge attributed to some assets for the cost of using funding liquidity, and conversely no credit attributed to some liabilities for the benefit of providing funding liquidity. This was undoubtedly the worst practice identified in the survey. Figure 15.2 below provides a graphical representa­ tion of what this would look like in practice. Note that the rate charged to users of funds in this instance would have been derived from the swap curve only. If we assume that interest rate risk is properly accounted for using the swap curve, then a zero spread above the swap curve implies a zero charge for the cost of funding liquidity. A zero charge for the cost of liquidity and, conversely, a zero credit for the benefit of liquidity exacerbated maturity transformation to the largest degree possible. This approach resulted in the hoarding of long-term highly illiquid assets, and very few long-term stable liabilities to meet funding demands as they became due.

15.3.3.1 Why Did Some Banks Choose This Approach? Ideal funding conditions in the years preceding the crisis could provide one explanation of why some banks viewed liquidity as a free good, and funding liquidity risk as essentially zero. Figure 15.3 below shows how the spread between one-year LIBOR and the one-year swap rate changed during the period June 2005 to October 2010.

The international survey identified many poor LTP practices, which reflected weaknesses in the LTP methods/approaches that were used to manage funding liquidity risk. These are discussed in more detail below.

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rate calculated, all assets irrespective of their maturity are charged the same rate for their use of funds (cost of liquidity), as depicted in Figure 15.4 below.

140

1.06.2005

1.06.2006

1.06.2007

1.06.2008

1.06.2009

To illustrate how charges and credits for the use and benefit of funds would be allocated under an average cost of funds approach, consider the following example. If the average rate across all funding sources was 10 bps, all loans would receive a charge of $1,000 on a principal amount of $1 million, irre­ spective of their maturity. Assuming this rate was also used to reward fund providers, then all deposits would receive a credit of $1,000 on a principal amount of $1 million, irrespective of their maturity. This can be seen in Table 15.1.

1.06.2010

Date

Figure 15.3

1-year LIBOR/Swap spread (Currency = USD).

15.3.4.1 Problems with the Pooled "Average" Cost of Funds Approach

Source: Bloomberg.

Despite its simplicity there are two major weaknesses with this approach. First, it ignores the heightened liquidity risk embedded in longer-term assets. Charging one "aver­ age" rate for the use of funds inherently assumes that all assets, irrespective of their maturity, pose the same liquidity risk. Moreover, if this "average" rate is also used to credit fund providers, then an incentive to write loans will be met with a direct disincentive to gather deposits. For example,

In June 2005, at the peak of robust share market growth, the spread was only 0.5 basis points (bps). With funding conditions so easy, it is likely that banks viewed spreads as pure credit risk adjustments and neglected (ignored) funding liquidity risk alto­ gether. If banks believed funding would always be available and at permanently cheap rates, this simply could have masked the need to charge assets for the cost of liquidity, and conversely, credit liabilities for the benefit of liquidity.

15.3.4 Pooled "Average" Cost of Funds Approach to LTP

Spread= average cost/ benefit of funds

Some banks recognised the need to charge users and credit providers of funding liquidity and employed a pooled approach to LTP, where an average rate was calculated based on the interest expense (cost of funds) across all existing funding sources. For exam­ ple, if deposits were a bank's only source of funding the average rate would be based on the total inter­ est expense for all deposits divided by average total deposits, adjusted for floats and reserve requirements. This approach is much better than the zero cost of funds approach, but because there is only one "average"

Table 15.1

Figure 15.4

Single average for the cost and benefit of funds.

Costs and Benefits of Funds Under an Average Cost Approach

Term in years

2

1

4

3

5

$1 million

$1 million

$1 million

$1 million

$1 million

10

10

10

10

10

Charge for use of funds

$1,000

$1,000

$1,000

$1,000

$1,000

Credit for benefit of funds

$1,000

$1,000

$1,000

$1,000

$1,000

Loan/deposit principal Average cost of funds (bps)

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all deposits irrespective of their maturity receive the same credit for the benefit of funds, as can be seen in Table 15.2.

Average cost of funds Average benefit of funds

Figure 15.5

of funds.

Separate averages for the cost and benefit

decreasing the rate charged to fund users from 10 bps to five bps will encourage loan generation, but at the same time, this will provide less incentive for business units to raise deposits.

Second, using an average cost of funds reflects his­ torical rates and prices, but does not appropriately reflect the actual market cost of funds. If five-year funding was to increase by 20 bps, for example, the respective change in the average (cost of funds) rate would be much less. Changes in the actual market cost of funds would need to be sustained for a period of time for the effect to be fully integrated into the average cost of funds. Because the average cost of funds lags changes in the actual market cost of funds, it does not appropriately reflect market perceptions of risk for new business entering a bank's books.

15.3.4.2 Implications of Pooled "Average" Cost of Funds Approach

To illustrate the effect of having separate average rates for the cost and benefit of funds, consider the following example. If the average cost of funds is 10 bps, as in the example presented above, all loans would be charged $1,000 on a principal of $1 million, irrespective of their maturity. Further, if the average benefit of funds is four bps, all deposits would be credited $400 on a principal of $1 million, irrespective of their maturity. Under this approach, lowering the average cost of funds from 10 bps to five bps will encourage loan generation. However, because of the separate rate for the average benefit of funds, this change will not directly discourage business units from raising deposits. This information is presented in Table 15.2.

Prom otes M aturity Transformation One implication of employing a pooled "average" cost of funds approach to LTP is that it promotes unhealthy as well as healthy maturity transfor­ mation. Business units will be unduly encouraged to write long­ term assets because they do not receive higher charges for their use of funds over a longer period. Conversely, business units will be discouraged from raising long-term liabilities because there is no premium credited to liabilities that provide funding for lon­ ger periods of time. The net effect of this is a larger mismatch between the maturities of assets and liabilities on banks' bal­ ance sheets, which inherently exposes them to greater structural liquidity risk. This point is supported by the SSG (2009), which claims that "borrowers had taken advantage of the opportu­ nity the market afforded to obtain short-term (often overnight) financing for assets that should more appropriately have been funded with long-term, stable funding" (p 2).

However, in much the same way as one "average" rate for fund users ignores the heightened liquidity risk in longer-term assets, having one "average" rate for fund providers ignores the increased benefits of liquidity in longer-term liabilities. That is,

Moreover, some institutions ignored maturity mismatch liquidity risk by not appropriately match-funding originated transactions in their funds transfer pricing (FTP) systems on a cash-flow basis. When combined with average costs of

Having separate "average" rates for the costs and benefits of funds is a better approach. This is depicted in Figure 15.5 below.

Table 15.2

Costs and Benefits of Funds Under a Separate Average Cost Approach

Term in years Loan/deposit principal Average cost of funds (bps) Average benefit of funds Charge for use of funds Credit for benefit of funds

296

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2

1

4

3

5

$1 million

$1 million

$1 million

$1 million

$1 million

10

10

10

10

10

4

4

4

4

4

$1,000

$1,000

$1,000

$1,000

$1,000

$400

$400

$400

$400

$400

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

existing funds across all funding sources to banks' balance sheets, the lack of reference to term cash-flow matched funding entailed the cross-subsidisation of longer-dated liquidity risk at the expense of shorter-dated risk. Such subsidisation skewed business incentives and behaviours to the detriment of bank soundness.

Marginal cost of funds curve Yield Term liquidity premium

Other factors, such as remuneration and information asym­ metries, naturally encourage long-term asset generation, but under an average cost of funds approach the incentive Charges (credits) to short-term assets (liabilities) higher under "p o o led " average cost-of-funds approach is exacerbated. For example, if remuneration is based on Charges (credits) to long-term assets (liabilities) higher performance, which is measured via net interest income, under m atched-m aturity m arginal cost-of-funds approach businesses will ordinarily be encouraged to write long-term loans because they generate more interest income, with less Maturity effort, over several years. Where an average cost of funds Fiqure 15.6 Matched-maturity marginal cost of funds approach is employed, this incentive becomes even more approach to LTP. attractive for business units because assets that require fund­ ing for longer periods of time are not charged more for the of business unit managers and provides central management cost of liquidity. In regard to information asymmetries, business with more control over group-wide objectives. unit managers are likely to know more about their businesses' activities than treasury. Hence, if business unit managers believe treasury is under-charging for the use of long-term funds, it will 15.3.5 Matched-Maturity Marginal Cost naturally encourage them to write long-term assets. But since all of Funds Approach to LTP funds are charged the same rate for the use of funds under an A matched-maturity marginal cost of funds approach to LTP is average cost of funds approach, where information symmetries current best practice for assets and liabilities on the balance exist, this incentive will be magnified. A similar but opposite sheet. From banks' actual market cost of funding, this approach effect will exist for liabilities. calculates the portion of the cost that is attributable to liquidity. D istorts Profit Assessm ent Another implication of the pooled It seeks to achieve this by converting fixed-rate borrowing costs average cost of funds approach to LTP is that it distorts profit to floating-rate borrowing costs through an internal swap trans­ assessment. As outlined above, the average cost of funds lags action and observing the spread over the reference rate, which changes in banks' actual market cost of funds, especially in vola­ is depicted from the swap curve. This spread is usually referred tile markets. Banks employing this approach found that their to as a term liquidity premium and is the rate that charges pricing methodologies resulted in the mispricing of and accu­ assets for the use of funds, and credits liabilities for the benefit mulation of assets on significantly distorted risk-adjusted terms. of funds. This is presented graphically in Figure 15.6. This made it difficult to identify poor performing products and To explain this process more fully, banks incur fixed-rate costs business units on a risk-adjusted basis. when issuing unsecured wholesale term debt. Using these costs There are several reasons why some of the banks included in alone it is difficult to strip out the portion that is attributable to the survey might have chosen to adapt a pooled average cost liquidity. But swapping fixed rate costs to floating rates provides approach to LTP. First, averaging funding costs across all assets a solution. The process generally involves stripping structured is much simpler than having to charge individual assets, prod­ debt issuances into embedded derivatives and floating rate cash ucts or transactions based on their contractual or behavioural instruments, which are pegged to a reference rate.12 The spread (expected) maturities. Second, the simplicity of the average above the reference rate is the rate that values the internal swap cost of funds approach makes it easier for business units to transaction at par. This is the term liquidity premium. It reflects understand the LTP process and therefore provides more incen­ both idiosyncratic credit risks and market access premiums and tive for them to comply. Third, under this approach, the LTP is considered to be a much better measure of the cost of liquid­ process could be managed efficiently using basic LMIS. Fourth, ity than an average cost of funds. the average cost of funds is less susceptible to intermedi­ ate changes in banks' actual market cost of funding, thereby reducing net interest income volatility across businesses. This is advantageous because it limits the subjective decision-making 12 This process is described in detail in Matz and Neu (2007).

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Reference rates are generally depicted from a swap curve, which is constructed from a combination of LIBOR or Euribor rates for funding up to one year, and interest rate swaps for funding above one year. This curve reflects a term structure of interbank lending rates. Although credit risk is somewhat mitigated by the fact that principal amounts are not exchanged between respective parties in a swap agreement, swap curves are still considered to provide better estimates of "base" reference rates for the purpose of teasing out liquid­ ity than, say, government curves. This is because swap curves more closely reflect the risks to which banks are exposed when borrowing and lending money in the interbank market. Swap curves also capture changes in general market conditions.

15.3,5,1 How are Rates for Users and Providers of Funds Determined? Under the matched-maturity marginal cost of funds approach, rates charged for the use of funds and, conversely, rates cred­ ited for the benefit of funds are based on the term liquidity premiums corresponding to the maturity of the transaction, or in the case of amortising or indeterminate-maturity products, blended term liquidity premiums consistent with their known or estimated cash-flow profiles. Even though the matched-maturity marginal cost of funds approach to LTP is considered to be better practice, some of the more advanced banks surveyed that had employed this method failed to actively update term liquidity premiums. As a result, assets were mis­ priced and risk-adjusted profit assessments were distorted, especially as market volatility increased in the early stages of the GFC.

15.3.6 Examples of Pricing Funding Liquidity Risk To illustrate how the matched-maturity marginal cost of funds approach should be applied in practice, and to compare it to the average cost of funds approach, assume the following term liquidity premiums and average cost of funds were recorded by a bank at a point in time prior to the crisis (pre-GFC), and more recently (current). Some examples of how LTP should apply to various transactions are presented below.

15.3.6.1 Non-Amortising Bullet Loans As the name implies, non-amortising bullet loans provide no repayments (cash flows) throughout the life of the loan. Since all principal and interest is repaid at maturity, a funding com­ mitment is required for the entire life (term) of the loan. Hence, using a matched-maturity marginal cost of funds approach,

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Table 15.3 Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds In basis points

Term in years

2

1

4

3

5

Panel A: pre-GFC Term liquidity premium

1

2

3

6

10

Average cost of funds

2

2

2

2

2

Term liquidity premium

5

10

18

28

40

Average cost of funds

8

8

8

8

8

Panel B: current

a one-year non-amortising bullet loan should have received a charge of one bp (Panel A), if originated pre-crisis, and five bps (Panel B) if originated more recently. For simplicity, if the principal of the loan was $1 million, this should have translated to charges of $100 and $500, respectively to the business unit(s) writing the loans. In much the same way, a five-year non-amortising bullet loan should have received a charge of 10 bps (Panel A) if originated pre-crisis, and 40 bps (Panel B) if originated more recently. Assuming the same loan principal of $1 million, this should have translated to charges of $1,000 and $4,000, respectively, to the business unit(s) writing the loans. In contrast, had an average cost of funds approach been applied, both the one- and five-year non-amortising loans would have been charged two bps (Panel A) if originated pre-crisis, and eight bps (Panel B) if originated more recently. Table 15.4 below pres­ ents the differences in the charges for the uses of funding for each of the non-amortising bullet loans in this example. Table 15.4 shows that non-amortising bullet loans with a term of one-year would have received a higher charge for the use of funding if banks applied an average cost of funds approach rather than a matched-maturity marginal cost of funds. However, for all other maturities, the opposite is true. Using an average cost of funds approach in the pre-crisis period, a five-year loan would have been undercharged eight bps ($800 on a loan of $1 million). If the same loan was originated more recently it would have been undercharged 32 bps ($3,200 per $1 million). This example high­ lights one of the major weaknesses of the average cost of funds method, viz., its inability to immediately reflect changes in the actual market cost of funds. For banks in the survey employing this approach, it would have encouraged business units to write long-term loans at the expense of short-term deposits.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 15.4

Differences in Funding Charges

In both cases, the charge for the use of funds indicates that a funding commitment is required for somewhere between three and four years and not the entire term of the loan, which was five years.

Basis points

Term in years

2

1

4

3

5

Panel A: pre-GFC Term liquidity premium

1

2

3

6

10

Average cost of funds

2

2

2

2

2

-1

0

1

4

8

Term liquidity premium

5

10

18

28

40

Average cost of funds

8

8

8

8

8

-3

2

10

20

32

Difference

Panel B: current

Difference

15.3.6.2 Amortising Loans Unlike non-amortising bullet loans, amortising loans do provide repayments (cash flows) throughout the life of the loan. Since a portion of principal (and interest) is repaid prior to maturity, a funding commitment is not normally required for the entire life (term) of the loan. This is because, at some point between origi­ nation and maturity, the loan becomes self-funding. Consider the simplest loan type in this category, a five-year linearly amortising bullet loan with a principal amount of $1 million. If you think of this as five separate annual loans, each of $200,000, using a matched-maturity marginal cost of funds approach, this loan (assuming it was originated pre-crisis) should have received a charge of:

1(1) + 2(2) + 3(3) + 4(6) + 5(10) 1+2+3+4+5

= 5.9bps.

This is a tenor-weighted (blended) term liquidity premium, derived from what is commonly referred to as the tranchinq approach.13 Following this same approach, if the loan was origi­ nated recently it should have received a charge of:

1(5) + 2(10) + 3(18) + 4(28) + 5(40) 1+2+3+4+5

2g '

P

13 Another method used by banks to calculate the charge for the use of funds is the internal rate of return (IRR) approach. This involves calculating an IRR using the rates depicted from the swap curve, and an IRR using the rates depicted from the marginal cost of funds curve. The difference between the resulting rates is the rate used to charge busi­ ness units for the use of funds. For more detail, and an example of this approach, see Matz and Neu (2007).

If an average cost of funds approach had been employed, the loan originated pre-crisis would have received a charge of two bps (Panel A). This would have resulted in an undercharge of 3.9 bps (5.9 — 2). If the loan had been originated more recently, it would have received a charge of eight bps, which would have resulted in an undercharge of 18.1 bps (26.1 — 8). Although the differences in the funding charges are not as severe as in the non-amortising bullet loan example above, it still highlights the weakness of the average cost of funds approach in reflecting changes in the actual market cost of funding. Once again, this would have encouraged long-term loan (asset) generation. Not all amortising loans provide known cash flows for the entire life of the loan. Take standard variable- (adjustable-) rate mort­ gages, for example. Often their contractual maturity will be 25 or 30 years at origination, but their actual maturity will vary depending on factors such as repayment frequency and repay­ ment amount. The uncertainty surrounding future cash flows makes it more difficult to calculate an appropriate charge for the commit­ ment of funds required to service these types of loans. For example, a simple tenor-weighted (blended) term liquidity premium cannot be derived because of the unknown timing of future cash flows. Consider a standard $500,000 variable rate mortgage, with a contractual term of 25 years. Attributing a 25-year term liquidity premium essentially overcharges the loan for the cost of funding liquidity and could discourage asset growth. A better approach is to bundle mortgages into monthly vintages, based on their origination date, and model the repayment history (decay) over time as depicted in Figure 15.7 below. If mortgages tend to behave similarly, as highlighted in the figure above, irrespective of the vintage to which they belong, then a single charge for funding liquidity can be attributed to the entire portfolio, instead of to each individual transaction. This charge is based on the behavioural maturity of the port­ folio, which is often calculated by banks using the weightedaverage life (WAL) method.

WAL = X ^ t i m

P

(15.1)

where P; = principal amount in distribution /, P = amount of loan, and t, = time (in years) of payment /.

Chapter 15 Liquidity Transfer Pricing: A Guide to Better Practice

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299

wholesale, deposits should be credited for the benefit of iquidity they provide. Deposits should be categorised as "sticky" or "hot/volatile" and credited based on their likelihood of withdrawal. As a general rule, sticky money, such as term deposits, are less likely to be withdrawn and should therefore receive larger credits than hot/volatile money, such as demand deposits, savings and transaction accounts, which are more likely to be withdrawn at any time.

WAL can be interpreted as the weighted-average time it takes to recoup $1 of principal (ie the time it takes for the loan to start paying for itself).14 As an example, suppose a large bank writes around $2 billion of mortgage loans on average, per month, and upon examining the decay of its loans finds the behavioural maturity (WAL) of the mortgage portfolio to be approximately four years. If a matchedmaturity marginal cost of funds approach is employed, then all mortgage loans should receive a charge, at point of origination, based on the four-year term liquidity premium. Using the figures from Table 15.3, this would be six bps (Panel A) or 28 bps (Panel B) depending on when the loan was originated. Across the entire portfolio, this would translate into dollar charges of $1.2 million or $5.6 million, respectively. In contrast, if an average cost of funds approach is employed, mortgage loans should receive a charge of two bps (Panel A) if originated pre-crisis, and eight bps (Panel B) if originated more recently. Collectively, for all mortgage loans, this would translate into dollar charges of $400,000 or $1.6 million, respectively. This example further demonstrates how the average cost of funds lags changes in banks actual market cost of funds and, at the same time, highlights how costly this could be, especially when products are priced at the portfolio level and comprise a large portion of bank assets.

15.3.6.3 Deposits Because deposits are a source of funding for banks, busi­ ness units responsible for raising retail, and in some cases

14 The WAL is not the time it takes to repay 50 per cent of the loan. That would be a median calculation. The WAL is an average. Only in the special case of when the interest rate on the loan is zero, will 50 per cent be repaid at the WAL. As the interest rate increases from zero, less than 50 per cent of the loan will be paid at the WAL. This is because most of the initial repayments comprise interest and not principal.

300

■

Using a matched-maturity marginal cost of funds approach, term deposits should receive a credit based on their matu­ rity. For example, using the same figures as presented in Table 15.3, a one-year term deposit should have been credited one bp if originated pre-crisis and five bps if origi­ nated more recently. Similarly, a five-year term deposit should have received a credit of 10 bps if originated pre-crisis and 40 bps if originated more recently. Had an average cost of funds approach been employed, all term deposits would have received a credit of two bps if origi­ nated pre-crisis and eight bps if originated more recently, irre­ spective of their maturities. In the pre-crisis period, this would have resulted in over compensating the one-year term deposit by one bp (2 — 1), and by three bps (8 — 5) if originated more recently. The five-year term deposit on the other hand would have been under compensated by eight bps (2 — 10) if originated pre-crisis and a staggering 32 bps (8 — 40) if origi­ nated more recently. As above, this example highlights the limitations of the average cost of funds approach. For banks employing this approach, it would have encouraged business units to raise short-term deposits rather than long-term, more stable sources of funding. Collectively, with the finding from above, this would have led to more structural liquidity risk on the balance sheet. Hot/volatile sources of deposits are often referred to as inde­ terminate maturity products, given the uncertainty surround­ ing their cash flows. However, despite being categorised as hot or volatile, these types of deposits sometimes provide stable sources of funding. Demand deposits, for example, can be withdrawn at any time without notice. But, if all similar accounts were to be pooled and the behaviour of the cash flows modelled over time, there would be a proportion that is rarely withdrawn (stable or core part) and a proportion that is more often withdrawn (hot or volatile part). Making this dis­ tinction is important, because if a bank were to simply apply a matched-maturity marginal cost of funding approach, all demand deposits would only receive a credit based on the overnight term liquidity premium. Given this is likely to be very close to zero, which translates to a cheap funding source for

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

banks, business units would be discouraged from raising demand deposits. A better approach would be to assign larger credits to core parts of funding, based on the mod­ elled behavioural maturity, and smaller credits to hot/volatile parts of funding. Banks employing an average cost of funds approach would have no incentive to make the distinction between core and volatile parts of funding since, under this approach, the same credit for the benefit of funding is applied to all deposits, irrespective of their maturity.

for a liquidity cushion.

15.3.7 Summary Failing to price liquidity is unacceptably poor LTP practice for a bank, and supervisors should not tolerate this failing. The average cost approach to LTP is simple, but has two major defects. First, it neglects the varying maturity of assets and liabilities by applying a single charge for the use and benefit of funds and, second, it lags changes in banks' actual market cost of funding. These defects essentially promote maturity trans­ formation, which inherently exposes banks to more structural (mismatch/funding) liquidity risk. Overall, a matched-maturity marginal cost of funds approach promotes better LTP practice. It is more complex than the pooled average cost of funds approach, but it has some sig­ nificant advantages. First, it recognises that the costs and benefits of liquidity are related to the maturities of assets and liabilities, and therefore allows higher rates to be assigned to products that use or provide liquidity for longer periods of time. Second, it recognises the importance of having changes in market conditions incorporated quickly and efficiently into the rate used to charge and credit users and providers of funds, and therefore relies on the actual market cost of funds. Banks should be encouraged to move towards this approach, if they are not already doing so.

15.4 LTP IN PRACTICE: M ANAGING CO N TIN G EN T LIQUIDITY RISK For many on-balance sheet items, calculating the charge for using, or the credit for providing, funding liquidity is quite straightforward. However, the same cannot be said about contingent commitments such as lines of credit, collateral postings for derivatives and other financial contracts, and liquid­ ity facilities to name a few. In these cases, the best approach is to impose a scenario model, determine a reasonable low prob­ ability worst-case outcome and charge at the most granular

level the transaction, product, or business unit for the costs of covering this outcome. Banks carry a liquidity cushion, a "buffer" of highly liquid assets or, alternatively, stand-by liquidity to help them survive periods of unexpected funding outflows. A graphical illustration of this is depicted in Figure 15.8. In December 2010, the BCBS published two global standards for liquidity risk. First, a Liquidity Coverage Ratio (LCR) to ensure banks have sufficient high quality liquid assets to meet their daily net cumulative cash outflows during an idiosyncratic shock, for a period of one calendar month. Second, a net stable funding ratio (NSFR) aimed at reducing banks structural liquidity risk by encouraging the use of longer-term funding of assets and other business activities.15 The move to make banks more self-suffi­ cient and stable over a longer period is in part to reduce the burden of central banks having to act as the lender-of-last-resort, and the potential implications of moral hazard as a result of these actions.

15.4.1 Liquidity Cushions: A Principle of Liquidity Risk Management Liquidity cushions are considered a fundamental principle for the management of liquidity risk. This is clearly outlined in Principle 1 of the BCBS Principles for Sound Liquidity Risk Management and Supervision (September 2008), and also reinforced by Principle 12, which states that "a bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impedi­ ment to using these assets to obtain funding" (p 4).

15 For more details, see Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, BCBS, (December 2010).

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15.4.2 Extant Guidance Focuses on Size, Composition and Marketability Extant guidance provided in association with liquidity cushions focuses mainly on size, composition and marketability of the assets contained within the cushion. To ensure banks' liquid­ ity cushions are adequately sized, the BCBS recommends they be aligned with stress-testing outcomes that consider both idiosyncratic and systemic scenarios, plus a combination of the two. The level of stress assumed in the tests should reflect a bank's overall risk tolerance. To assess their risk tolerance, banks should consider factors such as structural liquidity risk (ie the liquidity gap between the weighted average maturities of assets and liabilities) and the complexities of both on- and off-balance sheet business activities, which affect the frequency and irregularities of cash flows. According to the BCBS, liquidity cushions should comprise "a core of the most reliably liquid assets, such as cash and high quality government bonds or similar instruments, to guard against the most severe stress scenarios" (p 30). Banks should also consider the marketability of these assets. Although this is likely to vary in relation to the stress scenario and survival period (ie assets will generally remain more marketable throughout less severe market disruptions), there are some generic characteris­ tics that tend to improve asset liquidity. For example, assets that are more transparent are generally also easier to value, and the certainty surrounding this will inherently improve marketability. In addition, assets that are central bank-eligible and/or have good market depth will generally be more marketable. A bank's reputation, credit rating and active participation in certain mar­ kets will also impact asset marketability (p 30).

15.4.3 Problems with Banks Liquidity Cushions Unveiled by the GFC The recent crisis exposed some fundamental problems with banks' liquidity cushions. First, for the banks that participated in the survey, very few used the results of stress-testing to deter­ mine the size of their liquidity cushion. For the few banks that did consider the results of stress-tests, the size of their liquidity cushion was based on outcomes stemming from idiosyncratic funding scenarios only. Having little or no regard for prolonged market-wide disruptions meant that cushions were inadequately sized to protect the banks from larger-scale unexpected (contin­ gent) outflows. On a separate but related issue, one of the flaws with many of the banks' stress-testing processes was that the parameters used were too narrow, and were based purely on historical data. This meant that events that had not previously occurred were neglected.

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Second, most of the banks that were surveyed had liquidity cushions comprised of assets that were thought to be highly liquid, but were found to be highly illiquid and highly corre­ lated. There were instances where some assets held as stand­ by liquidity were not unencumbered, meaning that the bank did not have legal claim over the asset or that the asset was not entirely free from debt. Third, nearly all of the banks included in the survey funded their liquidity cushions short-term (e.g. overnight), consistent with the perception that funding could be easily accessed and any mar­ ket disruption would only be short-lived. While this minimised negative carry costs, it also provided banks little incentive to attribute the relevant costs back to the businesses that created the need to carry additional liquidity. When assets in the cushion could not be sold to generate funding, it became apparent that the real cost of carrying stand-by liquidity was much greater than what the banks had assumed.

15.4.4 LTP and Liquidity Cushions - Both Principles, Both Treated Separately To date, there has been limited guidance about how to attribute the cost of carrying liquidity cushions, but this paper offers some ideas. Even though it is common practice for banks to attribute this cost via LTP, no link between LTP and liquidity cushions is established in extant material. In fact, LTP and liquidity cushions are very much treated as mutually exclusive principles for sound liquidity risk management.

15.4.5 Poor Attribution of Cost of Carrying a Liquidity Cushion Carrying a "buffer" of highly liquid assets is costly for banks because the cost of funding assets comprising the cushion generally outweighs the return they generate.16 As such, banks often seek to minimise the size of their liquidity cushion so that the negative carry does not drag on profits. Most of the banks included in the survey consider the cost of carrying additional liquidity a cost of doing business, rather than an opportunity cost. In this regard, the cost of carry should not be borne by central management (ie treasury). It should instead be attributed back to businesses via the LTP process. While this appears common practice amongst banks participating in the survey, generally through incorporating a liquidity premium in the LTP process, most simply averaged the cost across all assets

16 The survey identified that this is the typical method banks use to cal­ culate the cost of carry.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

without giving specific attention to those businesses and prod­ ucts that generate the need to carry additional liquidity. As a simple example, if it costs a bank $30 million to carry a buffer of liquid assets and total assets of the bank equate to $300 billion, then under the approach described above, all assets would receive a charge of one bp through the LTP process. This is depicted in Figure 15.9. Note that the one bp charge is in addition to the term liquidity premium, which is charged to assets based on their commitment of funds. This is highlighted in equation 2. One explanation of why this approach might have been adopted by most of the banks surveyed is because they underestimated the "actual" cost of carrying additional liquidity. As mentioned above, assets in the cushion most often incurred short-term (overnight) funding charges on the premise that funding could be easily accessed and that any market disruption would be short-lived. This minimised the negative cost of carry, making it easy for banks to recoup the cost by simply adding a small spread (liquidity premium) to the funding cost that was charged to assets, as depicted in Equation 2. FTP=base rate + term liquidity premium + liquidity premium (15.2) where FTP = funds transfer price, base rate = rate depicted from the swap curve corresponding to the asset's contractual/ behavioural maturity or repricing term, whichever is less, term liquidity premium = spread between the swap curve and the bank's marginal cost of funds curve based on the contractual/ behavioural maturity of the asset, and liquidity premium = cost of carrying liquidity cushion averaged over total assets of the bank. Generally speaking, banks would not have believed this would create problems despite the fact that only assets were being charged because the spread charged to recoup the cost of carrying the liquidity cushion was so small. But there are some

recoup the cost of carry

charge via LTP for the cost of carry

Fiaure 15.9 Recouping the cost of carrying a liquidity cushion via LTP.

serious implications associated with this poor practice. First, it inherently assumes that all assets expose the bank to the same unexpected (contingent) liquidity risk. Second, it completely neglects the contingent liquidity risk embedded in liabilities, for example, deposit run-off during stress environments, and offbalance sheet activities such as drawdowns on lines of credit. Third, it makes no attempt to charge businesses based on their predicted liquidity usage during stress environments. Fourth, the attribution of charges is not granular enough to discour­ age businesses from writing or buying products that pose more contingent liquidity risk than others. Although some banks that were surveyed did attempt to charge the negative cost of carry back to businesses on a predicted usage basis, the attribution was generally at a very high level. One problem with not having a granular charge is that it encour­ ages businesses to deal in products that are not being charged for the contingent liquidity risk they actually present. The impli­ cation of distorting behaviour by not charging products for the risks they present was discussed in Section 2.

15.4.6 Towards Better Management of Contingent Liquidity Risk In one form or another, all banks that participated in the survey are enhancing the way they manage contingent liquidity risk. Many are incorporating a wider variety of scenarios as part of their stress-testing processes to account for different types of market disruptions that might occur. These are largely in con­ junction with BCBS recommendations and include idiosyncratic and systemic funding shocks and a combination of the two. In another step forward, senior management are becoming more engaged with stress-testing results and using them as a basis for deriving the size of the liquidity cushion. The composition of assets in liquidity cushions is broadly improving, once again in line with BCBS recommendations. For example, many of the larger banks are now holding a larger proportion of cash and government securities than previously. This is most likely due to the development of the LCR. Probably the most substantial enhancement that is occurring is the application of higher funding costs to liquid assets. Before the GFC, banks believed funding could be accessed almost immediately and always. But the recent market tur­ moil has demonstrated that funding markets can remain disrupted for a significant period of time. As such, banks are applying higher funding charges to assets held as part of the liquidity cushion on the premise that it could take lon­ ger than expected to generate liquidity when needed. The charges applied depend on banks' assumptions surrounding the length and severity of potential market disruptions. If,

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for example, a bank assumes funding markets for a particular asset could remain stressed for two years, then the cost of hold­ ing that asset as additional liquidity should be based on the two-year term liquidity premium. The move to apply higher funding costs to liquid assets is con­ sidered significant for banks because carrying a more costly liquidity cushion creates more profit drag. As described above, banks previously recouped this cost by charging all assets equally, a small liquidity premium via LTP. Following the same approach now, however, is likely to cause conjecture amongst business units and distort business unit behaviour given the larger costs. As such, this method is no longer feasible for banks. A better approach is to examine the contingent liquidity risk embedded in various business activities and to attribute charges based on their predicted, or expected, use of funding liquidity. Higher contingent liquidity charges should be applied to business activities that pose more threat to large and unexpected funding outflows. This process is depicted in Figure 15.10. Some examples of pricing contingent liquidity risk are presented in the following section.

15.4.7 Example of Pricing Contingent Liquidity Risk The uncertainty surrounding future cash-flow demands stem­ ming from contingent commitments makes it particularly difficult for banks to assess and price contingent liquidity risk. This is one of the reasons why it was neglected prior to the GFC. Some of the products that received little attention but then warranted significant funding included: credit card loans and investments, trading positions and derivatives, revolving lines of credit, and liquidity lines. The first step towards better management of contingent liquidity risk is not to address the question of how much should be charged but, rather, for banks to understand that all contingent commit­ ments need to be charged. Once this is clear, then methods for pricing contingent liquidity risk can be refined and improved. At the most basic level of what is considered to be better prac­ tice, all banks should be charging contingent commitments based on their likelihood of drawdown. For example, suppose a line of credit with a limit of $10 million has $4 million already drawn. The rate charged for contingent liquidity risk should be derived as: limit - drawn amount limit

x likelihood of drawdown

x cost of funding liquidity cushion

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1.

Id e n tify c o n tin g e n t co m m itm e n ts th a t are likely to c re a te u n e x p e c te d

2.

P e rfo rm stre ss te s ts u n d e r va rio u s sc e n a rio s to a p p ro x im a te th e fu n d in g th a t m ig h t be re q u ire d .

3.

N e t a p p ro x im a tio n s fro m a b o v e a g a in st inflo w s g e n e ra te d , fo r e x a m p le , th ro u g h th e sa le o f m a rk e ta b le se c u ritie s to d e riv e th e size o f th e liq u id ity cu sh io n .

/---------------------------- \ L iq u id ity cu sh io n v________________________ /

4.

C a lc u la te th e c o st of c a rry as th e c o st o f fu n d in g liquid a sse ts m inus th e retu rn th e y g e n e ra te . E n su re th a t a p p ro p ria te h a ircu ts and u n se cu re d te rm fu n d in g c h a rg e s h ave b e en a p p lie d to a sse ts.

5.

R e co u p c o st o f c a rry by ch a rg in g a liq u id ity p re m iu m , a t th e m o st g ra n u la r le v e l, to th e b u sin e ss unit, p ro d u c t or tra n sa c tio n th a t c re a te s th e n ee d fo r th e b an k to c a rry su ch liq uid a sse ts.

Retail deposit run-off

Wholesale funding run-off

Taw downs onlines of credit

Collateral calls on derivatives

Secured funding run-off

FSI Occasional Paper No 10

Fiqure 15.10 Toward better management contingent liquidity risk. The likelihood of drawdown (sometimes referred to as a draw­ down factor) should be assessed using behavioural modelling and should depend on factors such as customer drawdown his­ tory, credit rating of the customer, and other factors the bank deems important in making this prediction. In the example above, assume there is a 60 per cent chance the customer will draw on the remaining credit and that the cost of term fund­ ing assets in the liquidity cushion is 18 bps (depicted from the three-year term liquidity premium in Table 15.3). The rate charged for the cost of contingent liquidity risk should be equal to: ($10m -$4m ) x o 6 x 0.0018 = 0.000648% or 6.4 8 bps $10m

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Multiplying this by the limit of $10 million on the line of credit yields a dollar charge of $6,480. As explained earlier, prior to the crisis, banks applied short-term and often overnight funding charges to assets comprising their liquidity cushions on the belief that funding was abundant and permanently cheap. If the overnight funding rate was 0.5 bp and banks had applied the same approach as in this example, the dollar charge for the contingent liquidity risk would have been $1,800. However, banks did not follow this approach. Instead they averaged the cost of funding their liquidity cushions across all of their assets. By doing this it is likely that the lines of credit such as the one in this example did not even receive a charge for the cost of contingent liquidity risk. This would have encour­ aged business units to grant lines of credit and other contingent commitments. A similar approach to that in the example above can be applied to other types of contingent commitments. For exam­ ple, credit card accounts will generally have a proportion of the limit that is undrawn. With some behavioural analysis the likeli­ hood of drawdown can be estimated and contingent funding liquidity costs can be attributed accordingly. More advanced banks might assess the behaviour of individual customers and assign a weighted probability of drawdown. All banks, how­ ever, are encouraged to at least examine and attribute charges based on the behaviour of a portfolio of like- contingent commitments.

15.5 CO N CLUSIO N The international survey identified some badly deficient LTP practices. The worst practices are summarised below. • Management of the LTP process was poor. There were a lack of LTP policies, decentralised funding structures accompa­ nied by weak internal risk controls and limits, inconsistent LTP regimes, off-line and manually adjusted LTP processes, a lack of trading book funding policies, as well as poor independent oversight by risk and financial control personnel. • LMIS were often not advanced enough to incorporate the costs, benefits and risks of liquidity at a sufficiently granular level. • Profit pools, which were used to determine bonuses to employees, were derived from unadjusted revenues, without any regard to the risks (liquidity and capital) taken to gener­ ate such profits. • Probably the most striking example of poor practice was that some banks applied a zero charge for the cost of funding liquidity based on the premise that liquidity was a free good.

• Other banks applied a single pooled approach to LTP, whereby one average rate was used to charge users of funds and to credit providers of funds. • Liquidity cushions were not linked to stress-testing outcomes, and scenario analyses were not severe enough to account for prolonged market-wide disruptions. • Charges applied to fund liquid assets were often based on short-term rates, reflecting the belief that funding was abun­ dant and would remain permanently cheap. • To recoup the cost of carrying a liquidity cushion, most banks simply charged all assets an equal and small liquidity premium, which failed to account for the varying amounts of contingent liquidity risk embedded in different business activities. Collectively, these poor LTP practices encouraged long-term illiquid asset creation and discouraged long-term stable liability creation, with obvious consequences. By and large, banks have realised that many of their LTP prac­ tices were insufficient. As a result, banks are now working towards enhancing their LTP processes to ensure their business activities adequately account for the costs, benefits and risks of liquidity. To assist banks and supervisors throughout this pro­ cess, below is a compilation of what is considered to be better LTP practices. Governing LTP • Banks should have an LTP policy that defines LTP, states the purpose of LTP and provides some principles and/or rules to ensure LTP achieves its intended purpose. The LTP policy should apply to all business units that are material users or providers of funding liquidity. • LTP should be managed centrally, within group treasury or a subsidiary treasury, and applied consistently across the group. Wholesale funding should be confined to this function. • Trading book funding policies should exist and, where appro­ priate, funding should be provided at the most granular level e.g., at the trading desk level as opposed to the trading book level. This requires treasury to have a full line of sight to individual business balance sheets. Banks are also encour­ aged to examine individual positions and apply higher fund­ ing charges to those that are more likely to become stale, or that present significantly greater amounts of funding liquidity risk. Finally, banks should have in place limits and adequate controls to curb over-trading behaviour. • Oversight of the LTP process should be provided by indepen­ dent risk and financial control personnel. Senior management should also be involved in the LTP process. Meetings should be held regularly, and include various stakeholders such as

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ALCO, senior management and treasury functions to discuss changes in funding costs. • To assist with performance assessments and decision-making, LMIS should be advanced enough to attribute, at a suffi­ ciently granular level, all of the relevant costs, benefits and risks of liquidity to the appropriate business activities. • Remuneration practices should be more sensitive to the risks taken to generate profits. For example, profit pools, which are used to derive short-term incentives such as bonuses, should be adjusted for the cost of liquidity through the LTP process.

Using LTP to manage on-balance sheet funding liquidity risk • When applying LTP in practice, banks should by now have come to the realisation that liquidity is not a free good. Hence, employing a zero cost of funds approach to LTP is extremely poor practice and should not be tolerated by supervisors. • Banks should instead be moving towards incorporating a matched-maturity marginal cost of funding approach to LTP. This approach is superior to any other established. First, it recognises the need to charge more for the cost of liquidity for assets that require funding for longer periods of time. Conversely, it recognises the need to credit more for the benefit of liquidity for liabilities that provide funding for lon­ ger periods of time. Second, the rate charged for the use and for the benefit of funds is based on banks' actual market costs of funds. This rate incorporates both idiosyncratic credit risk adjustments and market access premiums.

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• Charges for the use of liquidity and credits for the benefit of liquidity should not be borne by central management (ie trea­ sury), but should instead be attributed, at a sufficiently granu­ lar level, to the business activities using or providing liquidity. Managing contingent liquidity risk • The size of liquidity cushions should be derived from stress­ testing outcomes and scenario analyses that at a minimum account for idiosyncratic and systemic scenarios, including prolonged market disruptions, and a combination of the two. • Assets held as part of the liquidity cushion should be of the highest form of liquidity. • Funding charges applied to assets in the liquidity cush­ ion should not be based on short-term overnight rates but should instead be derived from longer-term rates to account for the possibility of longer than expected market disruptions. • The cost of carrying a liquidity cushion is a cost of doing business and should thus be recouped from the business activities that require the bank to carry such liquid assets. The charge attributed to business activities should not be equal and based on the assumption that the contingent liquid­ ity risk is the same for all types of business. Instead, indi­ vidual business activities should be charged based on their expected, or predicted, use of contingent liquidity. To conclude, one size does not fit all. Banks vary in size and complexity, and the LTP process employed should reflect these factors. While banks should, at least, consider all better practices promoted through this paper, only those that are appropriate and will most likely improve their own LTP process should be adopted.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

APPENDIX LTP Principles and Recommendations Working Group

Principles/Recommendations

B asel C o m m itte e on Banking S u p erv isio n (B C B S)

"A bank should incorporate liquidity costs, benefits and risks in the internal pric­ ing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole" (p 3).

Principle 4 of "Principles fo r S o u n d Liq u id ­ ity Risk M anagem en t and S u p ervisio n "

(September, 2008).1

"Robust strategies, policies, processes and systems shall exist for the identification, measurement, management and monitoring of liquidity risk over an appropriate set of time horizons, including intra-day, so as to ensure that credit institutions main­ tain adequate levels of liquidity cushions. Those strategies, policies, processes and systems shall be tailored to business lines, currencies and entities and shall include adequate allocation mechanisms of liquidity costs, benefits and risks" (L302/116).

E u ro p e a n C o m m issio n (EC)

Point 14 in Annex V of "D irective 2 0 0 9 /1 1 1/EC o f the European Parliam ent and o f the Council o f 16 S e p te m b e r".2

"Institutions should have in place an adequate internal mechanism - supported where appropriate by a transfer pricing mechanism - which provides appropriate incentives regarding the contribution to liquidity risk of the different business activi­ ties. This mechanism should incorporate all costs of liquidity (from short to long­ term, including contingent risk)" (p 8).

C o m m itte e fo r E u ro p e a n Banking S u p e rv iso rs (C E B S )

Recommendation 2 in "S e c o n d Part o f C E B S ' Technical A d v ic e to the European Com m ission on Liquidity Risk M a n a g em en t" (September, 2008).3

"Firms should ensure that they have in place effective internal transfer pricing poli­ cies to reflect implied or incurred actual or potential costs related to reasonably anticipated liquidity demands from both on- and off-balance sheet business. Transfer pricing should take closely into account the liquidity of relevant underlying assets; the structure of underlying liabilities, and any legal or reasonably anticipated repu­ tational contingent liquidity risk exposures. Transfer pricing should be designed to ensure that lines of business within the firm that create liquidity exposures are pro­ portionately charged for the cost to the firm of maintaining corresponding prudent liquidity positions" (p 56).

T h e In stitu te fo r In ternatio nal Fin a n ce (IIF)

Recommendation III.4 of "Final R e p o rt o f the IIF C om m ittee on M arket B e st P ractices: Principles o f C o n d u ct and B e st Practice R eco m m en d a tio n s" (July, 2008).4

"The Policy Group recommends that all large integrated financial intermediaries incorporate appropriate pricing-based incentives for the full spectrum of their fund­ ing activities. This includes a funds transfer pricing policy that assigns the cost of funding to businesses that use funding and credits the benefits of funding to busi­ nesses that provide it. This must encompass both on- and off-balance sheet activi­ ties (for example, contingent funding), as well as potential funding needs related to actions that might be taken to preserve the institution's reputation. The funds trans­ fer pricing process should be informed by stress testing efforts that identify potential vulnerabilities and assign the related costs to the businesses that create them. The methodology should provide direct economic incentives factoring in the related liquidity value of assets and behavioral patterns of liabilities. The costs and benefits identified should be assigned to specific businesses and, under all circumstances, used in evaluating the businesses' performance" (p 30).

C o u n te rp a rty Risk M a n a g e m e n t Policy G ro u p III (CR M PG III)

Recommendation IV-17 o f "C ontain­ ing System ic Risk: The R oad to R efo rm "

(August, 2008).5

1 Available at http://www.bis.org/publ/bcbs144.pdf. 2 Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0097:0119:EN:PDF. 3 Available at http://www.eba.europa.eu/getdoc/bcadd664-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Advice-on-liquidity_2nd-par.aspx. 4 Available at http://www.iif.com/press/press+releases+2008/press+75.php. 5 Available at http://www.crmpolicygroup.org/.

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Learning Objectives After completing this reading you should be able to: Identify the causes of the US dollar shortage during the Great Financial Crisis. Evaluate the importance of assessing maturity/currency mismatch across the balance sheets of consolidated entities.

Discuss how central bank swap agreements overcame challenges commonly associated with international lenders of last resort.

E x c e rp t is BIS W orking Paper No. 291, by Patrick M cG uire and G o tz von Peter.

16.1 INTRODUCTION The global financial crisis has shown just how unstable banks' sources of funding can become. Throughout the crisis, but particularly following the collapse of Lehman Brothers in September 2008, many banks faced severe difficulties securing short-term US dollar funding. In response, central banks around the world adopted extraordinary policy measures, including international swap arrangements with the US Federal Reserve, to enable them to provide US dollars to commercial banks in their respective jurisdictions. What caused this global shortage of US dollars? Which banking systems have been most affected? How could a shortage develop so quickly after dollar liquidity had been viewed as plentiful? This paper provides a systematic analysis of the build-up of stresses on banks' international balance sheets which set the stage for the shortage of US dollars.1 It relies on the BIS interna­ tional bankinq statistics to reconstruct the qlobal balance sheet positions for each of the major national banking s y s te m s 21 These data provide information on both the currency and the counter­ party of banks' foreign assets and liabilities, facilitating an analy­ sis of how banks fu n d e d their foreign currency investments. With this dataset, the dynamics of the crisis can be analysed along the contours of banks' co n so lid a ted global balance sheets, argu­ ably the most appropriate framework for assessing funding pres­ sures, rather than along geographical (ie residency-based) lines. Understanding the global US dollar shortage requires a depar­ ture from the familiar domestic bank run story. In the open economy version of the traditional bank run model, depositors run the bank and convert their domestic deposits to foreign cur­ rency (Chang and Velasco (2000, 2001)) or, in the case of liability dollarization, directly withdraw dollars (Rajan and Tokatlidis (2005)). The resulting demand for foreign currency, being pro­ portional to domestic bank liabilities, can easily exhaust the country's FX reserves (Obstfeld et al (2009)). While the domestic run story remains relevant in the emerging market context, this paper traces the origins of the US dollar shortage to the inter­ national opera tion s of the major banking systems and to the global funding and swap markets on which they rely. Previous

1 The historical usage of the term "dollar shortage" (notably by Kindleberger (1950), and Triffin (1957)) refers to the main structural monetary problem of the postwar period, namely the global scarcity of gold and dollar assets which resulted from chronic US current account surpluses. The use of the term here refers to the difficulty banks face in securing short-term US dollar funding. 2 "National banking system", the primary unit of analysis in this paper, refers to the set of large internationally active banks headquartered in a particular country (eg US banks, German banks, Swiss banks), as opposed to banks located in a particular country.

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episodes with similar international dimensions include the lengthening of the maturity of Latin American dollar debt in the early 1980s, which raised concerns about a maturity mismatch on European banks' balance sheets (McCauley (1984)). Another case is the "Japan Premium" faced in the 1990's by Japanese banks, which had financed their global expansion in the eurodol­ lar and euroyen markets (Peek and Rosengren (2001)). The funding difficulties which arose during the crisis are directly linked to the remarkable expansion in banks' global balance sheets over the past decade. Reflecting in part the rapid pace of financial innovation, banks' (particularly European banks') foreign positions have surged since 2000, even when scaled by measures of underlying economic activity. As banks' balance sheets grew, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities. These assets include retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on US mortgages and other underlying assets. During the build-up, the low perceived risk (high ratings) of these instruments appeared to offer attractive return opportuni­ ties; during the crisis they became the main source of mark to market losses. The accumulation of US dollar assets saddled banks with sig­ nificant funding requirements, which they scrambled to meet during the crisis, particularly in the weeks following the Lehman bankruptcy. To better understand these financing needs, we break down banks' assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another. We find that, since 2000, the Japanese and the major European banking systems took on increasingly large n et (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over. The magnitude of this risk is gauged in a second step, where we attempt to quantify banks' total short-term US dollar financ­ ing needs at the onset of the crisis. This requires breaking down banks' US dollar-denominated assets and liabilities further, by residual maturity, to quantify the degree of maturity transfor­ mation embedded in banks' balance sheets. Although data limitations make direct measurement of the maturity of banks' positions impossible, we argue that information on counterparty type (bank, non-bank or central bank) can serve as a proxy since the average maturity of positions is likely to vary systematically with the sector of the counterparty, with interbank positions having a shorter maturity than positions vis-a-vis non-bank enti­ ties. This yields a lower-bound estimate of banks' US dollar

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

funding gap—the amount of short-term US dollar funding banks require— measured here as the net amount of US dollars chan­ nelled to non-banks. By this estimate, European banks' need for short-term US dollar funding was substantial at the onset of the crisis, at least $1.0-1.2 trillion by mid-2007. Events during the crisis led to severe disruptions in banks' sources of short-term funding. Interbank markets seized up, and dislocations in FX swap markets made it even more expensive to obtain US dollars via swaps. Banks' funding pressures were compounded by instability in non-bank sources of funds as well, notably dollar money market funds and dollar-holding central banks. The market stress meant that the effective maturity of banks' US dollar funding shortened just as that of their US dol­ lar assets lengthened, since many assets became difficult to sell in illiquid markets. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the global US dollar short­ age. Our estimate of the size of banks' US dollar funding gaps at the onset of the crisis shed light on why the international pol­ icy response was necessary, and why it took the form of a global network of central bank swap lines. One point highlighted throughout this analysis is the importance of taking banks' worldwide consolidated positions as the unit of analysis. Banks have become so globalised, with offices in many countries around the world, that it is impossible to iden­ tify vulnerabilities in their balance sheets using residency-based statistics alone (eg, domestic credit data, balance of payments data, the BIS locational banking statistics by residency). Stresses build up across the global balance sheet, as mismatches in the currency or maturity of assets and liabilities, and thus can be understood only by looking at banks' worldwide positions con­ solidated across all office locations. In some cases, banks' crossborder assets booked by offices in a particular host country can account for the bulk of that country's external asset position, and yet still represent a relatively small part of the consoli­ dated banking systems' worldwide assets. This fact clouds the interpretation of the "national balance sheet" for many host countries, since banks' long or short currency positions booked in one office location and offset in another may signal a "mis­ match" in the host country's net external position when none may, in fact, exist. The remainder of the paper is organised as follows. The next section introduces concepts related to banks' international investment and funding choices, from which we derive the data requirements. Section 3 examines banks' investment and fund­ ing patterns since 2000 which set the stage for the US dollar shortage and policy responses examined in Sections 4 and 5. The final section concludes, and the data appendix provides detail on the BIS international banking statistics and the con­ struction of the dataset.

16.2 BANKS' INTERNATIONAL POSITIONS: CONCEPTS AND DATA We first introduce concepts related to an internationally active bank's investment and funding choices. Consider a bank that seeks to diversify internationally, or expand its presence in a specific market abroad. This bank will have to finance a particu­ lar portfolio of loans and securities, some of which are denomi­ nated in foreign currencies (eg a German bank's investment in US dollar-denominated structured finance products). The bank can finance these foreign currency positions in several ways: 1. The bank can borrow domestic currency, and convert it in a straight FX spot transaction to purchase the foreign asset in that currency. 2. It can also use FX swaps to convert its domestic currency liabilities into foreign currency and purchase the foreign assets.3 3. Alternatively, the bank can borrow foreign currency, either from the interbank market, from non-bank market partici­ pants or from central banks. The first option produces no subsequent foreign currency needs, but exposes the bank to currency risk, as the on-balance sheet mismatch between foreign currency assets and domestic currency liabilities remains unhedged. Our working assumption is that banks employ FX swaps and forwards to hedge any onbalance sheet currency mismatch.4 That is, a bank funding in domestic currency (option 1 or 2) is likely to do so as described in option 2. Importantly, the second leg of the swap in option 2 is not that different from funding a position through foreign cur­ rency borrowing in the first place (option 3): in both cases, the bank needs to "deliver" foreign currency when the contractual liability comes due. For concreteness, let A, denote the bank's claims (assets) denominated in currency /, with /=0 representing the domes­ tic currency. The assets are financed by liabilities L,- (where L0 includes equity). The net position in currency / equals (A,—L(), where the term "long" ("short") is used to denote a positive (negative) net on-balance sheet position. Funding option 1 above produces a long foreign currency position of A/>0

3 An FX swap is an exchange of two currencies at the current spot exchange rate today, coupled with the promise to exchange back at a future date at a fixed exchange rate. 4 Stigum and Crescenzi (2007) describe in detail how banks use deriva­ tives to hedge their international operations. In some circumstances, banks may find it advantageous to maintain open foreign currency posi­ tions (eg to insulate capital/asset ratios against a depreciation of the domestic currency (Fukao (1991)).

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financed by Lq —A,. Option 2 couples the same on-balance sheet positions with a(n off-balance sheet) promise to repay A, when the swap comes due, to be met by the proceeds from, or sale of, Aj. Option 3 matches foreign currency funding to foreign assets, leaving a zero net position (A,—L,=0). The balance sheet identity implies that net foreign currency positions (if positive) are mirrored in net borrowing in domestic currency. That is,

X U Ai ~ Li ) = L o - A 0.

(16.1)

The various funding options expose the bank to funding risk, or the risk that funding liabilities cannot be rolled over. The magni­ tude of this risk depends on the degree of maturity transforma­ tion embedded in the bank's balance sheet. The bank is said to face a foreign currency funding gap if the investment horizon of its foreign currency assets A, exceeds the maturity of its foreign currency funding or FX swaps. The portfolio's investment hori­ zon depends on the desired holding period, on the maturity of the underlying assets and on market liquidity. If the contractual liabilities (L,-, or swaps) cannot be rolled over for some reason, then foreign currency assets that were intended to be held have to be sold instead, possibly in distressed market conditions. Suppose the bank finances its foreign currency assets A, by fully hedging currency risk, ie by a combination of foreign currency borrowing L(-and FX swaps S, such that A; = L(- + S,-. Denote by A [ t (if-7) the foreign currency assets (liabilities) with a long investment horizon or long effective maturity. Ideally, one would measure short-term funding liabilities (including FX swaps) in currency i directly, as (L, — Lj-T) + S h However, since FX swaps are typically (unobserved) off-balance sheet transac­ tions, we use the hedging equality to replace S, and express short-term funding liabilities as (A,- — L[t). These short-term for­ eign currency liabilities can be met with banks' liquid or matur­ ing assets, worth (A,- — Af7). The difference yields the foreign currency funding gap:5

( A - 4 T) - ( A - A tT) = AtT- 4 T-

(16.2)

Why is funding risk in foreign currencies of special interest? Banks also face the risks inherent in transforming maturities in their domestic currency market, of course. Indeed, maturity transformation is an essential function of banking, and banks

5 If a bank borrows more than it invests in currency /', it can swap the proceeds into domestic currency to increase A0. The resulting swap position, S-, — A, — L,• < 0, represents a short-term claim on currency /, but to realise this claim the bank must come up with as much domestic currency at short notice. If the proceeds were channelled into long-term domestic assets, then the foreign currency funding gap is measured as (A/-7 — L/-7) + (I,- —A,) = (L,- —L}t) —(A,- - Af7). In the extreme case where A-. — 0, the qap simply equals foreiqn currency short-term liabilities, (L,- - Lf7).

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would find it unprofitable to eliminate maturity mismatch alto­ gether (Morgan and Smith (1987), Goodhart (1995), Diamond and Rajan (2001), Stigum and Crescenzi (2007)). However, in a purely domestic banking context, the central bank can act as lender of last resort and provide sufficient liquidity to eliminate a domestic funding shortage; doing so is both time-honoured practice (Bagehot (1873), Goodhart (1995)) as well as optimal policy (Allen and Gale (1998), Diamond and Rajan (2006)). By contrast, central banks cannot create foreign currencies; their ability to meet banks' demand for foreign currencies is con­ strained by the exchange rate regime or limited to available FX reserves (Chang and Velasco (2000, 2001), Obstfeld et al (2009)). Banks' foreign currency requirements may therefore have to be met from international sources (Fischer (1999), Mishkin (1999)). Funding risk is inherently tied to stresses across the global balance sheet: mismatches between the maturity, currency and counterparty of assets and liabilities. Quantifying this risk requires measurement of banking activity on a co n so lid a ted basis, preferably at the level of the decision-making economic unit (ie individual banks). Data designed to identify vulnerabili­ ties in banks' funding patterns would ideally include, for both assets and liabilities, a complete breakdown of positions by cur­ rency, maturity and counterparty type, along with the relevant risk characteristics and off-balance sheet positions. The publicly available information on banks' international positions typically falls far short of this ideal. Published accounts (collected in BankScope and Bloomberg) are available at the level of individ­ ual (consolidated) banks, but lack the essential breakdowns (coun­ terparty, maturity and currency) needed here. Such information may be collected by bank examiners in the course of their supervi­ sory activity, but is not included in publicly available data sources.66 Statistics compiled at the national level (from national authorities, the IMF and the OECD) generally do not provide a complete picture either. As shown in Section 16.3.1, banks have become so globalised that residency-based data are insufficient for identifying vulnerabilities in any particular national banking system. The analysis in this paper relies on the BIS international bank­ ing statistics, the most comprehensive source of information on banks' international balance sheet positions.7 With these

6 Also, their focus on individual banks may mean that macroprudential issues, such as the extent to which different banks rely on the same fund­ ing patterns or trade and invest in the same direction, can be overlooked. 7 The Bank for International Settlements disseminates four sets of inter­ national banking statistics compiled from underlying data reported by monetary authorities in over 40 countries, including the major offshore centres. As described in the appendix, the analysis in this paper relies (primarily) on two of these: the BIS consolidated banking statistics on an immediate borrower basis (CBS) and the BIS locational banking statistics by residency (LBSN).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

data, it is possible to reconstruct the consolidated global balance sheets for the major national banking systems. This effectively involves adding up the cross-border and local (ie vis-a-vis residents of the host country) balance sheet posi­ tions reported by banks' home offices and their offices in host countries around the world into a consolidated whole for each banking system. The end result is a dataset with the consoli­ dated balance sheet positions for 19 banking systems for the Q2 1999-Q1 2009 period at a quarterly frequency. It is impor­ tant to note that the constructed positions are estimates based on imperfect underlying data, and in places require assumptions to address known data limitations. More informa­ tion on these assumptions and the construction of the dataset is provided in the appendix. We use this dataset to investigate how banks fund their foreign currency investments, and to derive their funding requirements across currencies and counterparties. While not at the individual bank level, the advantages of these data are that they provide (i) the consolidated foreign assets and liabil­ ities for each banking system, (ii) estimates of the gross and net positions b y cu rren cy, and (iii) information on the sources of financing (ie interbank market, central banks and non-bank counterparties). Table 16.1 presents summary statistics on the 11 banking sys­ tems analysed in later sections. Row 1 lists the number of inter­ nationally active banks which are h ea d q u a rtered in the country listed in the column heading, and whose foreign claims (row 4) are thus included in the BIS consolidated banking statistics.8 Row 2 provides the total assets for this select group of banks in each banking system. For some banking systems (eg Germany, France and Italy), the number of individual reporting institutions is large since it includes many banks that hold small foreign exposures. However, international banking is highly concen­ trated. Estimated concentration ratios (row 3) for each banking system, calculated using bank-level information on total assets from BankScope, indicate that the five largest institutions account for more than 90% of Belgian, Swiss, French and Dutch

8 A banking system's foreign positions (assets or liabilities) are com­ posed of four components: (i) cross-border positions booked by all offices worldwide and in all currencies; (ii) "local positions", or claims booked by banks' foreign offices vis-a-vis residents of the host country (in either the local currency or a foreign currency); (iii) positions booked by the home office vis-a-vis residents of the home country in foreign currencies; and (iv) cross-border positions booked by banks' foreign offices vis-a-vis residents of the home country. Only by splicing the CBS and the LBSN can these four components be assembled into a consoli­ dated whole for each banking system (see Table A in the appendix). The remaining component, banks' "strictly domestic" activity, or posi­ tions booked by home offices vis-a-vis residents of the home country in the domestic currency, is not included in the BIS banking statistics.

banks' total assets (row 2) and more than 70% of Canadian, Italian and UK banks' assets. Across all banks in BankScope, the top 50 institutions account for some 80% of total bank assets in the database. Banks' foreign positions (row 4) is even more concentrated in the familiar names.

16.3 THE LONG AND SHORT OF BANKS' GLOBAL BALANCE SHEETS 16.3.1 The Structure of Banks' Operations Internationally active banks have offices in many countries around the world. Their currency and maturity positions are managed across the consolidated global entity rather than office by office. Thus, large measured "mismatches" on the balance sheet of an office in one location may be hedged offbalance sheet or offset by on-balance sheet positions booked by offices elsewhere, leaving a matched book for the bank as a whole. This section provides some simple measures of how banks' offices are organised across countries, and highlights the importance of measuring stresses across the balance sheets of co n so lid a ted entities. Overall, foreign offices account for a significant share of banks' worldwide consolidated balance sheets. The bottom five rows of Table 16.1 show the share of banks' total foreign claims (assets) which are booked by their offices in various countries/regions.9 In most cases, /ess than half o f banks' foreign claims are booked by their home offices, with French and Japanese banks being exceptions. At the extreme are Swiss banks, with more than $3 trillion in foreign claims, accounting for over 80% of their total balance sheet assets. Only 18% of their foreign claims are booked by offices in Switzerland. Banks' offices in the United Kingdom tend to be the largest outside the home country, fol­ lowed by offices in the United States; combined, US and UK offices account for roughly one third of German, Spanish and Dutch banks' foreign claims. Looking at these data from the perspective of h o st countries shows just how large banks' international operations really are. Table 16.2, where the column headings now indicate host countries, shows the gross and net international asset position of each country, and compares these to banks' cro ss-b o rd er claims (here, including banks' cross-border inter-office positions as well). The table distinguishes between positions booked by 9 For banks' home offices, the figures in Table 16.1 include cross-border lending in all currencies and lending to residents of the home country in foreign currencies. For banks' foreign offices, the figures include crossborder and local claims in all currencies, ie the complete balance sheet of the foreign office. See footnote 8.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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313

Table 16.1

Size and Structure of Banks' Foreign Operations

Positions at end-2007

Banking system

BE

CA

CH

DE

ES

FR

IT

NL

JP

UK

US

Number of banks1

18

17

23

1,801

96

135

724

106

49

17

33

Total assets ($bn)2

2,218

2,437

3,810

10,585

4,541

8,359

4,180

9,845

4,649

10,008

9,904

Asset concentration3

94.9

72.4

89.3

53.5

62.9

96.1

70.6

62.3

93.6

75.3

50.5

Foreign claims($bn)45

1,608

912

3,390

5,177

1,416

4,456

1,543

2,571

2,962

4,378

2,285

over total assets (%)

72

37

89

49

31

53

37

26

64

44

23

over annual GDP (%)

348

63

776

155

98

171

18

58

378

157

16

23

70

60

33

36

31

10

48

31

42

52

42

23

18

44

27

51

39

75

27

44

22

6

18

30

22

28

6

5

6

20

6

41

23

6

9

12

3

9

12

16

37

2

4

16

10

15

35

2

23

11

7

3

9

21

7

2

6

2

6

6

14

24

6

7

4

4

24

10

17

3

13

15

22

42

26

80

27

22

27

19

7

47

29

21

US dollar share (%) Home entry6 UK 1 c •.2 CD M US u u c o Euro Area U) — ’m ® 0) u O 3= OFC7 LL O Other Assets booked by foreign offices (%)8

25

1 Number of banking groups (headquartered in the country shown in the columns) that report in the BIS consolidated banking statistics. 2 Total assets (including "strictly domestic assets") aggregated across BIS reporting banks. For reporting jurisdictions which do not provide this aggre­ gate (DE, ES, FR, IT, JP), total assets are estimated by aggregating the worldwide consolidated balance sheets (from BankScope) for a similar set of large banks headquartered in the country. 3 Share of total assets accounted for by the five largest reporting institutions. 4 Foreign claims as reported in the BIS consolidated banking statistics (immediate borrower basis) plus foreign currency claims vis-a-vis residents of the home country booked by home offices (taken from the BIS locational banking statistics by nationality). See footnote 8 in the main text. Excludes inter-office claims. 5 Total claims (cross-border claims plus claims on residents of the host country) booked by offices in each location over total worldwide consolidated foreign claims. 6 Excludes banks' "strictly domestic" claims, or their claims on residents of the home country in the domestic currency. 7 Offshore financial centres: here Bahamas, Bahrain, Bermuda, the Cayman Islands, Guernsey, Hong Kong SAR, the Isle of Man, Jersey, Macao SAR, Panama and Singapore. 8 Share of total assets (row 2) booked by offices outside the home country. Sources: IMF IFS; BankScope; BIS consolidated statistics (immediate borrower basis); BIS locational banking statistics by nationality.

offices of "domestic" and "foreign" banks in each host country. In five countries (BE, CH, DE, JP and UK), banks' cross-border positions accounted for almost half of that country's external assets at end-2007, and as much as a quarter in five other countries (CA, ES, FR, IT and NL). The offices of foreign banks alone accounted for nearly 40% of the United Kingdom's exter­ nal assets. In contrast, positions booked by the home offices of domestic banks were much larger in the case of Belgium, Germany, Japan and Switzerland.

314

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What Tables 16.1 and 16.2 make clear is that "bank nationality" and "bank residency" are fundamentally different concepts. Positions booked by offices in any one country are generally a small part of that banking system's global consolidated balance sheet (Table 16.1), yet cross-border positions booked by banks' offices in any one country can be large relative to that host country's external asset position (Table 16.2). This has implica­ tions for how one should interpret a "national balance sheet", the unit of analysis used in a growing literature on international

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table 16.2

Bank Assets in Total External Assets3 4

Positions at end-2007

Country

BE

Gross external assets ($bn)1 Net external assets ($bn)

CA

CH

DE

FR

ES

IT

NL

JP

UK2

US

2,407

1,199

3,231

7,367

2,091

7,758

2,827

5,355

3,795

12,777

17,640

141

-127

635

949

-1,081

375

-119

2,195

14

-586

-2,442

Cross-border bank claims ($bn)3 1,162

303

1,539

3,561

613

2,821

648

2,402

1,342

6,844

2,961

Domestic banks

881

282

1,235

2,953

471

2,497

478

2,169

1,133

1,966

1,113

Foreign banks

280

21

304

608

141

324

169

233

209

4,878

1,848

All banks

Cross-border bank claims / external assets (%)4 All banks

48

25

48

48

29

36

23

45

25

54

17

Domestic banks

37

24

38

40

23

32

17

41

30

15

6

Foreign banks

12

2

9

8

7

4

6

4

5

38

10

Net cross-border bank claims ($bn) All banks

191

40

146

1,568

-8 9

11

-294

1,690

149

-1,274

-754

Domestic banks

160

64

117

1,339

68

123

-130

1,623

207

-400

-814

32

-2 4

30

229

-157

-111

-165

67

-5 9

-874

60

Foreign banks

Pre-crisis: change in net positions Q4 2000-Q2 2007 ($bn) 3

36

221

882

-729

145

-143

844

21

-488

-1,003

126

24

50

1,276

18

89

-176

771

109

-680

-573

Domestic banks

97

32

48

986

124

172

-6 3

631

161

-190

-420

Foreign banks

30

-8

2

290

-106

-8 4

-113

140

-51

-490

-152

External assets All banks

During crisis: change in net positions Q2 2007-Q4 2007 ($bn) External assets

-5

-2 3

128

5

-202

111

-1 6

193

53

46

-108

All banks

51

17

25

277

-1 8

-3 2

-41

284

49

-269

7

Domestic banks

47

24

14

327

10

-4 6

-1 8

301

39

-107

-194

3

-6

10

-5 0

-2 9

14

-2 3

-1 6

10

-162

200

Foreign banks

1 Stock of international assets held by residents (banks and non-banks) of the country listed in the column heading. 2 The calculations in the bottom half of the table on banks' net cross-border positions should be interpreted with caution. Banks located in the United Kingdom reported roughly $800 billion in liabilities for which the residency of the counterparty is unknown (see data appendix). The calculation in the table assumes that these "unallocated" liabilities are held by non-residents. Were we to assume that they were held by residents, then the net crossborder claims of domestic (foreign) banks would change from —$400 billion (-$874 billion) to —$48 billion (-$412 billion). 3 Cross-border claims (including inter-office claims) booked by banks' offices located in the country in the column heading. 4 Ratio of cross-border bank claims to gross external assets (row 1). Sources: IMF IFS; BIS locational statistics by nationality.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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315

investment and capital mobility.10 For at least two reasons, the national balance sheet may be a poor indicator of vulnerabilities (eg currency or maturity mismatches) faced by residents of a particular country. First, changes in a country's external position can be driven to a large extent by the activity of foreign banks' offices, and thus be only loosely related to vulnerabilities in residents' portfo­ lios. For instance, suppose banks headquartered in country A double their balance sheet size through greater cross-border lending and/or acquisition of foreign banks. If the balance sheet adjustment occurs in these banks' foreign offices, it can gener­ ate large swings in other countries' external positions without necessarily affecting country A's external position. For instance, the expansion in the global balance sheets of Swiss, German and Dutch banks since 2000 was driven to a large extent by greater cross-border positions booked by their offices in the United Kingdom (see next section). Indeed, as shown in the bottom rows of Table 16.2, the offices of foreign banks located there saw larger changes in their net cross-border balance sheet positions in the pre-crisis period than did UK headquartered banks (—$490 billion compared to —$190 billion). Over this same period, foreign banks' offices contributed significantly to the change in the net external position in Italy and Spain as well. In any particular host country, a long or short net cross-border positions in a particular currency booked by the offices of for­ eign banks there may be offset or hedged elsewhere on those banks' global balance sheet. How, then, should we interpret the associated "mismatches" on the national balance sheet of the host country? And to what extent do they reflect vulnerabilities faced by the host country residents? The converse of this point is that it is generally difficult to identify a particular banking system's vulnerabilities by looking at the home country's domestic and external positions data. For example, in at least six countries (BE, CH, DE, FR, JP and NL), domestic banks' cross-border positions account for a third or more of the home country's external position (Table 16.2). Yet, Table 16.1 (bottom row) indicates that assets booked by offices outside the home country account for a significant share (a quarter or more) of each of these countries' national banking systems' total worldwide assets (with the exception of Japanese

10 Lane and Shambaugh (2009a) construct estimates of the currency composition of the external asset and liability positions for a large sam­ ple of countries, and show that the effect of exchange rate movements is sizeable. Lane and Shambaugh (2009b) and Faria and Mauro (2009) build on this by investigating the determinants of countries' long and short currency positions. See Lane and Milesi-Ferretti (2001) for back­ ground, Forbes (2008) for an analysis of capital flows into the United States, and Tille and van Wincoop (2007) and Devereux and Sutherland (2009) for recent models of international portfolio choice.

316

■

banks, at 6%). Therefore, vulnerabilities in these banks' balance sheets may not be visible in the home country's external posi­ tion, even when combined with data on these banks' domestic positions (eg domestic credit and other such aggregates). Vulnerabilities can only be measured by taking into account the entire balance sheet of the consolidated global entity. More­ over, these vulnerabilities relate to domestic residents only to the extent that the residents hold exposures in the national banking system.

16.3.2 Balance Sheet Expansion since 2000 The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks' international bal­ ance sheets. The outstanding stock of banks' foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity (Figure 16.1, left panel). The year-onyear growth in foreign claims approached 30% by mid-2007, up from around 10% in 2001. This acceleration took place during a period of financial innovation, which included the emergence of structured finance, the spread of "universal banking", which combines commercial and investment bank­ ing and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services. At the level of individual banking systems, the growth in European banks' global positions is most noteworthy (Figure 16.1, centre panel). For example, Swiss banks' foreign claims jumped from roughly five times Swiss nominal GDP in 2000 to more than seven times in mid-2007 (Table 16.1). Dutch, French, German and UK banks' foreign claims expanded considerably as well. In contrast, Canadian, Japanese and US banks' foreign claims grew in absolute terms over the same period, but did not significantly outpace the growth in domestic or world GDP (Figure 16.1, right panel). While much of the increase for some European banking systems reflected their greater intra-euro area lending following the introduction of the single currency in 1999, their estimated US dollar- (and other non-euro-) denominated positions accounted for more than half of the overall increase in their foreign assets between end-2000 and mid-2007.

16.3.3 Cross-Currency Funding Positions How did banks finance this expansion, especially their foreign currency asset positions? This section examines cross-currency funding, or the extent to which banks invest in one currency and fund in another. This requires a breakdown by currency of banks' gross foreign positions, as shown in Figure 16.2, where positive (negative) positions represent foreign claims (liabilities).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Foreign claims scaled by world GDP In per cent

All banks, by currency

a

00 01 02 03 04 05 06 07 08

__

European banks (all currencies)

00 01 02 03 04 05 06 07 08

1

Estimated totals for 19 banking systems (see data appendix). booked by banks' foreign offices.

O

r\

Other banks (all currencies)

00 01 02 03 04 05 06 07 08

Foreign claims excluding claims on residents of the home country

Sources: IMF; BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality.

For some European banking systems, foreign claims are primar­ ily denominated in the home country (or "domestic") currency, typically representing intra-euro area crossborder positions (eg Belgian, Dutch, French and German banks). For others (eg Japanese, Swiss and UK banks), foreign claims are predomi­ nantly in foreign currencies, mainly US dollars. Foreign currency assets often exceed the extent of funding in the same currency. This is shown in Figure 16.3, where, in each panel, the lines indicate the overall net position (foreign assets minus liabilities) in each of the major currencies.11 If we assume that banks' on-balance sheet open currency positions are small, these cross-currency net positions are a measure of banks' reli­ ance on FX swaps. Many banking systems maintain long posi­ tions in foreign currencies, where "long" ("short") denotes a positive (negative) net position. These long foreign currency positions are mirrored in net borrowing in domestic currency from home country residents (recall equation (16.1)).*12

Figure 16.1

UK banks, for example, borrowed (net) in sterling (some $550 billion in mid-2007, both cross-border and from UK resi­ dents) in order to finance their corresponding long positions in US dollars, euros and other foreign currencies. By mid-2007, their long US dollar positions stood at $200 billion, on an esti­ mated $2 trillion in gross US dollar claims. Similarly, German and Swiss banks' net US dollar books approached $300 billion by mid-2007, while that of Dutch banks surpassed $150 billion. In comparison, Belgian and French banks maintained a relatively neutral overall US dollar position prior to the crisis, while Spanish banks had borrowed US dollars to finance euro lending at home, at least until mid-2006.13

The "unknown" liabilities in Figure 16.2 have been allocated (by currency) in Figures 16.3-16.5 using information on the currency split from the BIS International Debt Securities database (see the appendix for explanation).

Taken together, Figures 16.2 and 16.3 thus show that several European banking systems expanded their long US dollar posi­ tions significantly since 2000, and funded them primarily by bor­ rowing in their domestic currency from home country residents. This is consistent with European universal banks using their retail banking arms to fund the expansion of investment banking activities, which have a large dollar component and are concen­ trated in major financial centres. In aggregate, European banks' combined long US dollar positions grew to roughly $700 billion by mid-2007 (Figure 16.5, top left panel), funded by short

12 As mentioned in footnote 8, banks' "strictly domestic" positions are not reported in the BIS banking statistics. Their gross positions in their domestic currency booked by their home offices vis-a-vis home country residents are therefore unknown, but their net position (shown as the shaded area in Figure 16.3) can be inferred as a residual from the bal­ ance sheet identity (see equation (16.1) and data appendix). German banks' foreign claims in Figure 16.2, for example, comprise all of their foreign currency positions, but their euro positions only vis-a-vis counter­ parties outside Germany.

13 The long net foreign claims of Japanese banks and the short net foreign claims of US banks mirror the (cumulative) current account posi­ tions of their respective home countries, reflecting the degree to which domestic banks' home offices accommodate international capital trans­ fers. However, for the reasons elaborated in Section 16.3.1, the relation­ ship between a country's external position and the foreign assets of the banks headquartered there is tenuous.

11

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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317

Gross foreign assets and Iiabilities, by currency1 In trillions of US dollars UK banks

Swiss banks

German banks

USD EUR JPY 2 Domestic Other Unknown

0

Spanish banks

0

-2

-2

-4

-4

Belgian banks

French banks 1.0

0.5

0.7

0.0

0.0

- -0.5

-0.7

1.0

-1.4

-

-1.5

Japanese banks

Dutch banks'

US banks

3.0

1.5

1.5

1

o.o

0

0.0 -1.5

. -1.5

-1

-3.0

-3.0 00 01 02 03 04 05 06 07 08 09

-2

00 01 02 03 04 05 06 07 08 09

-4.5 00 01 02 03 04 05 06 07 08 09

q:

1

o

Positive (negative) values are assets (liabilities). For UK banks, gross positions in domestic currency booked by these banks' 3 home offices. Prior to Q4 2005, local liabilities in local currency (LLLC) vis-a-vis some large European countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units of Fortis. 4 Local positions (LCLC and LLLC) visa-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 2008 in part reflects the sale of some business units of ABN AMRO. x

Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality.

318

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Figure 16.2

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Net foreign positions, by currency

A

In billions of US dollars UK banks

German banks

Swiss banks 500

1,200

250

600

0

0

-2 5 0

-6 0 0

-5 0 0

D o m (re sid e n ts) D o m (c ro ssb o rd e r)

-7 5 0

Spanish banks

French banks

-

J___I___L

1,200

- 1 ,8 0 0

Belgian banks 600 300

0 -3 0 0

-9 0 0

Dutch banks

US banks

Japanese banks *

5

1 ,2 0 0

800

600

400

0

0 -6 0 0

-4 0 0

- 1 ,2 0 0

-8 0 0

- 1 ,8 0 0 00

01

02

03

04

05 0 6

07

08

09

0 0 01 0 2 03 0 4 05 06 07 08 09

1 N e t fo re ig n p o sitio n s a re a sse ts m inus lia b ilitie s.

1,200

2 Im p lie d n e t p o sitio n s in d o m e stic c u rre n c y vis-a-vis re sid e n ts o f th e h o m e

co u n try , in fe rre d fro m th e b a la n c e s h e e t id e n tity (se e d a ta a p p e n d ix ). c u rre n c y b o o k e d by th e s e b a n k s' h o m e o ffic e s .

-

0 0 01 0 2 03 0 4 05 0 6 07 08 09

F o r U K b a n k s, n e t c ro ss -b o rd e r p o sitio n s in d o m e stic

4 P rio r to Q 4 2 0 0 5 , local lia b ilitie s in local c u rre n c y (L L L C ) vis-a-vis so m e larg e

E u ro p e a n c o u n trie s a re e s tim a te d . T h e c o n tra c tio n in p o sitio n s in Q 4 2 0 0 8 in p a rt re fle c ts th e sa le o f so m e b u sin e ss units o f F o rtis.

5 Lo cal p o sitio n s (L C L C and L L L C ) vis-a-vis a d v a n c e d e c o n o m ie s a re a v a ila b le fro m Q 4 2 0 0 2 . T h e c o n tra c tio n in p o sitio n s

in Q 3 2 0 0 8 in p a rt re fle c ts th e sa le o f so m e b u sin e ss units o f A B N A M R O . S o u rc e s: B IS c o n so lid a te d sta tistic s (im m e d ia te b o rro w e r b a sis); BIS lo ca tio n al sta tistic s by n a tio n a lity.

F ig u re 16.3

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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319

positions in sterling, euros and Swiss francs.14 As banks' cross­ currency funding grew, so did their hedging requirements and FX swap transactions, which are subject to funding risk when these contracts have to be rolled over.

16.3.4 Maturity Transformation across Banks' Balance Sheets As discussed in Section 2, funding risk hinges on the degree of maturity transformation embedded in banks' balance sheets. Unfortunately, data limitations make it difficult to obtain an aggregate maturity profile of banks' foreign assets and liabili­ ties. In this section, we argue that the counterparty sector break­ down available in the BIS banking statistics can serve as a proxy for maturity transformation, and hence funding risk, since the maturity of positions is likely to vary systematically with the type of counterparty.15 We use this counterparty information to con­ struct a measure of banks' US dollar funding gap, the amount of US dollars invested in longer-term assets which is not supported by longer-term US dollar liabilities, this gap being the amount that banks must roll over before their investments mature (equa­ tion (16.2)). We build up this argument in several steps. The counterparty sector breakdown for European banks' gross US dollar assets and liabilities is shown in Figure 16.5 (top right panel). Interbank claims, which include interbank loans and debt securities claims, tend to be shorter-term or can be realised at shorter notice than claims on non-banks. We think of US dollar claims on non-banks as banks' desired US dollar investment portfolio. This portfolio of non-bank assets includes banks' retail and corporate lending, lending to hedge funds, and holdings of securities ranging from US Treasury and agency securities to structured finance products.16 Whether these non-bank assets 14 Adding in Japanese banks' $600 billion long US dollar position (Figure 16.3) brings the estimated total to $1.3 trillion. 15 Using the counterparty sector also addresses the common problem that the effective maturity may differ from the maturity stated on bank balance sheets (Flannery and James (1984)). Demand deposits held by households, for instance, are a stable source of funding with a long effective maturity. 16 No counterparty sector breakdown is available for banks' US dollar claims on US residents booked by their offices in the United States ("Local US positions" in Figure 16.5, top right panel), since these positions are taken from the CBS (see Table A in appendix). Overlaying our data set with the BIS consolidated banking statistics (ultimate risk basis) suggests that over 70% of these positions are vis-a-vis non-bank private entities. Alterna­ tive sources of data also indicate that the bulk of these positions is likely to be transactions with nonbank counterparties. For instance, BankScope data suggest that European bank subsidiaries in the United States book a small share (below 5%) of their total assets as interbank assets. Data on foreign banks' offices in the United States from the Federal Reserve H.8 release point in the same direction. Thus, our estimate of US dollar posi­ tions vis-a-vis non-banks (in Figures 16.4 and 16.5) is the sum of banks' international US dollar positions in non-banks and their local US positions.

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can be readily converted to cash depends upon the maturity of the underlying positions as well as on their market liquidity. These US dollar investments are funded by liabilities to various counterparties. Banks can borrow US dollars directly from the interbank market, typically short-term. They can also raise US dollars via FX swaps (with bank or non-bank counterparties), which are even shorter-term on average.17 In contrast, US dollar funding provided directly by non-banks includes corporate and retail deposits, deposits from central banks, and financing from money market funds, and is thus of varying maturities.18 As described in Baba et al (2009), money market funds had become an important source of short-term US dollar financing, providing an estimated $1 trillion to European banks in 2007. If the effective maturity of liabilities to non-banks matches that of their investments in non­ banks (ie is "longer-term"), then a lower-bound estimate of their US dollar funding gap is the net US dollar position vis-a-vis non­ banks. If, on the other hand, banks' liabilities to non-banks were all short-term, then an upper-bound estimate of their funding gap is their gross US dollar position in non-banks. Figure 16.4, which focuses on the lower-bound measure, shows the considerable het­ erogeneity in the way European banks met their US dollar funding requirements. For example, Dutch, German, Swiss and UK banks had the largest funding gaps (green lines) by mid-2007. However, their reliance on the interbank market (blue line), cen­ tral bank deposits (red line) and FX swaps (shaded area) differed markedly.19 UK banks maintained largely balanced net interbank US dollar positions, thus implying cross-currency funding, while German banks relied relatively more on interbank funding. Taken together, these estimates suggest that European banks' US dollar investments in non-banks were subject to considerable funding risk at the onset of the crisis. The net US dollar book, aggregated across the major European banking systems, is por­ trayed in Figure 16.5 (bottom left panel), with the non-bank com­ ponent tracked by the green line. By this measure, the major European banks' US dollar funding gap had reached $1.0-1.2 trillion by mid-2007. Until the onset of the crisis, European banks 17 Evidence from the BIS Triennial Central Bank Survey (of 2007) indi­ cates that 78% of FX swap turnover is accounted for by contracts with a maturity of less than seven days. 18 In the BIS banking statistics, reporting banks' liabilities to official monetary authorities mostly reflect international deposits of foreign exchange reserves. 19 The figures on net interbank lending to other (unaffiliated) banks should be interpreted with caution. Incomplete reporting of inter-office positions makes it impossible to precisely pin down banks' net position visa-vis other banks, and hence their net FX swap position, which is backed out as a residual. In Figures 16.4 and 16.5, the solid blue lines and the corre­ sponding shaded areas are the primary set of estimates; the dashed blue lines and corresponding dashed black lines are alternative estimates (see data appendix). This problem is particularly severe for Swiss banks.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Net US dollar-denominated foreign positions, by counterparty sector In b illio n s o f US d o llars

Swiss banks

German banks

Spanish banks

French banks

Belgian banks

Dutch banks'

Japanese banks

US banks

UK banks -j

Monetary authorities Other banks Non-banks Cross currency

300

-300

00 01 02 03 04 05 06 07 08 09

00 01 02 03 04 05 06 07 08 09

00 01 02 03 04 05 06 07 08 09

1 Cross-border positions in all currencies and local positions in foreign currencies vis-a-vis official monetary authorities. Excluding liabilities to Japanese monetary authorities placed in banks located in Japan. The solid blue line tracks net interbank lending to other (unaffiliated) banks. The dashed blue line is an alternative measure of interbank positions which makes use of the available information on inter-office positions (see data appendix). The estimated net position vis-a-vis non-banks is the sum of net international claims on non-banks and net local claims on US residents (vis-a-vis all sectors) booked by the US offices of the reporting bank. See footnote 16 in the main text. 4 Implied cross-currency funding (ie FX swaps) which equates gross US dollar assets and liabilities. The dashed black line is an alternative measure of cross-currency funding which makes use of the available information on inter-office positions (see data appendix). 5 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-a-vis some large European countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units of Fortis. 6 Local positions (LCLC and LLLC) vis-a-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 2008 in part reflects the sale of some business units of ABN AMRO. Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality.

Figure 16.4

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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321

European banks' balance sheet positions

A

In trillio n s o f US d o lla rs

Net positions, by currency

Gross US dollar positions, by counterparty sector Local US positions'3 Interbank Non-banks (international) Monetary authorities Unknown r

8

0 -4 -8

-12 Net USD positions vis-a-vis non-banks

Net USD positions, by counterparty sector Monetary authorities Other banks5 Non-banks6 Cross currency7

00

01

02

03

Lower bound6 Lower bound (incl MMF) 8 Upper bound9 Vis-a-vis public sector u

04

05

06

07

08

09

00

01

02

03

04

05

06

07

08

1 Estimates are constructed by aggregating the on-balance sheet cross-border and local positions reported by Belgian, Dutch, French, German, Italian, Spanish, Swiss and UK banks' offices. Positions booked by offices located in Switzerland (for CHF) and in the United Kingdom (for GBP). CHF and GBP positions reported by offices located elsewhere are included in "Other".3 US dollar positions vis-a-vis US residents booked by banks' offices in the United States (LCLC and LLLC). No sectoral breakdown is available for these positions. See footnote 16 in the main text. 4 Cross-border positions in all currencies and local positions in foreign currencies vis-a-vis official monetary authorities. Excluding liabilities to Japanese monetary authorities placed in banks located in Japan. 5 The solid blue line tracks net interbank lending to other (unaffiliated) banks. The dashed blue line is an alternative measure of interbank positions which makes use of the available information on inter-office positions (see data appendix). 6 The net position vis-a-vis non-banks is estimated as the sum of net international positions vis-a-vis non-banks and net local US positions (vis-a-vis all sectors). The dashed green line is the estimate of the US dollar funding gap when (cumulative) writedowns are incorporated (see text). 7 Implied cross-currency funding (ie FX swaps) which equates gross US dollar assets and liabilities. The dashed black line is an alternative measure of cross-currency funding which makes use of the available information on inter-office positions (see data appendix). Lower bound estimate plus estimated US dollar liabilities to money market funds. Consolidated gross claims on non-banks. 10 Consolidated gross claims (ultimate risk basis) on the US public sector. Sources: BIS consolidated statistics (immediate borrower and ultimate risk basis); BIS locational statistics by nationality.

had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion),20 and used FX swaps ($315 billion) to convert (primarily) domestic currency 20 In the BIS locational banking statistics, several countries (eg Germany, Japan and the United States) do not report liabilities (in for­ eign currency) vis-a-vis domestic official monetary authorities, which

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Figure 16.5

makes it difficult to identify precisely total liabilities to these coun­ terparties. For example, data on foreign exchange reserve holdings reported to the IMF indicate that Japanese monetary authorities held roughly $118 billion in banks located in Japan in mid-2007 ($26 billion in Japanese banks and $92 billion in foreign banks in Japan). To the extent that these reserves are US dollar-denominated, the red lines in Figure 16.4 understate liabilities to official monetary authorities for all those banking systems which have offices in Japan, and which receive deposits from Japanese monetary authorities.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

funding into dollars.21 If we assume that these banks' liabilities to money market funds (roughly $1 trillion, Baba et al (2009)) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0-2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion (Figure 16.5, bottom right panel). The funding patterns for Japanese and US banks in Figure 16.4 deserve comment as well. Japanese banks' estimated net US dollar claims on non-banks had risen beyond $600 billion by end-2007 and, compared with other banking systems, were skewed towards holdings of US government securities.22 They financed these holdings primarily by borrowing in yen from Japanese residents. In contrast to Japanese banks, the data show that US banks borrowed roughly $750 billion internation­ ally by end-2007, and channelled these funds to US residents (as implied by the shaded area in Figure 16.3). A closer look at the underlying data suggests that a large portion of their inter­ national liabilities to non-banks were booked by their offices in Caribbean offshore centres as liabilities to non-bank counterpar­ ties located in the United States (eg firms or money market mutual funds). This could be regarded as an extension of US banks' domestic activity since it does not reflect (direct) funding from non-banks outside the United States. Netting these posi­ tions would imply that their US dollar net borrowing from non­ banks in the rest of the world is smaller than the green line in Figure 16.4 suggests (some $500 billion at end-2007).

16.4 THE US DOLLAR SHORTAGE The implied maturity transformation in Figure 16.5 became unsus­ tainable as banks' major sources of short-term funding turned out to be less stable than expected. Beginning in August 2007, heightened counterparty risk and liquidity concerns compromised short-term interbank funding (Taylor and Williams (2009)), vis­ ible in the rise of the blue line in the lower left panel. The related dislocations in FX swap markets made it even more expensive to obtain US dollars via currency swaps (Baba and Packer (2009a)), as European banks' US dollar funding requirements exceeded other entities' funding needs in other currencies.

21 The alternative estimates in Figure 16.5 (bottom left panel) for net interbank borrowing (dashed blue line) and cross-currency financing (dashed black line) were $127 billion and $620 billion, respectively, in mid-2007. 22 Japanese banks' foreign claims on the public sector stood at $627 billion at end-2007, or 29% of their foreign claims. These public sector shares are higher than for any other banking system.

European banks' funding difficulties were compounded by insta­ bility in the non-bank sources of funds as well. Money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (Baba et al (2009)). Less abruptly, a por­ tion of the US dollar foreign exchange reserves that central banks had placed with commercial banks was withdrawn durinq the course of the crisis.23 In particular, some monetary authori­ ties in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars. Market conditions during the crisis have made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securi­ ties (Figure 16.5, bottom right panel), other claims on non-bank entities—such as structured finance products—have been harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: banks brought off-balance sheet vehicles back onto their balance sheets and prearranged credit commitments were drawn.24 Indeed, as shown in Figure 16.5 (top right panel), the estimated outstanding stock of European banks' US dollar claims actually rose slightly (by $248 billion or 3%) between Q2 2007 and Q3 2008.25 It was not until the fourth quarter of 2008 that signs of deleveraging emerged.26 The frequency of rollovers required to support European banks' US dollar investments in non-banks became difficult to maintain as suppliers of funds withdrew from the market. Banks were thus forced to come up with US dollars, given their reliance on wholesale funding and short-term FX swaps. Essen­ tially, the effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in

23 Data complied from the 63 monetary authorities which report details on their foreign exchange holdings to the IMF indicate that central bank deposits with commercial banks dropped by $257 billion between mid-2007 and end-2008. See BIS (2009a) for discussion. 24 Consistent with lines being drawn (or discontinued), unused credit commitments reported by European banks declined by $657 billion (18%) between mid-2007 and Q1 2009, primarily vis-a-vis US entities (down 29%). 25 This is despite substantial asset writedowns of $280 billion by end-Q3 2008; by Q1 2009, the writedowns of European banks and brokers had reached $441 billion (Bloomberg). 26 Between end-Q3 2007 and end-Q1 2009, the outstanding stock of European banks' US dollar claims fell by $1.5 trillion (17%). It is difficult to distinguish reductions in lending and asset disposal from writedowns of assets still on bank balance sheets (see BIS (2009a) for discussion). In addition, part of the overall reduction reflects the restructuring of several major European banks.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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323

US dollar positions of European banks' US offices In billions Vis-a-vis non-US residents, by counterparty sector

Vis-a-vis residents of the United States1

00 A

01

02

03

04

05

Vis-a-vis counterparties in all sectors.

06

07

08

09

00

01

02

03

04

05

06

07

Sources: BIS consolidated banking statistics (immediate borrower basis); BIS locational banking statistics by nationality.

maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage. Banks reacted to the dollar shortage in various ways, supported by actions taken by central banks to alleviate the funding pres­ sures.27 Prior to the collapse of Lehman Brothers (up to end-Q2 2008), European banks tapped funds in the United States; their local US dollar liabilities booked by their US offices, which included their borrowing from Federal Reserve facilities,28 grew by $329 billion (13%) between Q2 2007 and Q3 2008, while their local assets remained largely unchanged (Figure 16.6, left panel). This allowed European banks to channel funds out of the United States via inter-office transfers (right panel), presumably to help their head offices replace US dollar funding previously obtained from the market.29 From the onset of the crisis to end-Q1 2009, the lower bound estimate of European banks' US dollar funding gap declined by

27 The range of rescue programmes and their effects are reviewed in BIS (2009b) and ECB (2009). 28 European banks with an established presence in the United States can borrow against collateral from the facilities the Federal Reserve makes available to depository institutions. A number of European banks have access to additional facilities in their capacity as primary dealers. The borrowing of US dollars by European banks' US offices from the Federal Reserve is captured in banks' local liabilities in local currency vis-a-vis the United States. This is not captured in their international liabilities to official monetary authorities (as in Figures 16.4 and 16.5), as it is neither in foreign currency nor cross-border. on

Similarly, Cetorelli and Goldberg (2008) present evidence that inter­ nationally active US banks often rely on internal markets, ie borrow from foreign affiliates to smooth liquidity shortages.

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08

09

Net positions. Figure 16.6

nearly 50% (Figure 16.5, bottom panels). However, writedowns of securities and other mark-to-market losses during the crisis make this observed decline difficult to interpret. Specifically, writedowns of assets lead to decreases in the reported stock of US dollar claims, and thus a decline in net claims on non-banks. Ideally, we would measure the US dollar funding gap directly, as the sum of net interbank funding, net FX swap transactions and (possibly) net liabilities to official monetary authorities, in order to pick up the changes in actual net short-term funding liabilities (see equation (16.2)). However, in this analysis, the net FX swap positions are backed out as a residual. Thus, any writedown on the asset side is automatically reflected in a reduction in the esti­ mated net FX swap positions.30 When asset writedowns are positive, the accuracy of the esti­ mated US dollar funding gap thus depends on the extent to which banks actually unwound the funding positions supporting these written-down assets. If banks closed out all these funding positions by, for example, buying US dollars in the spot market, then the original estimate of the US dollar funding gap (solid green line in Figure 16.5, lower left panel) is correct through end-Q1 2009. If, on the other hand, banks have not closed out their funding positions, but rather rolled them over, then the observed measure will underestimate the true funding gap by the amount of the writedowns. In this case, if we assume that the bulk of European banks' writedowns (estimated by

30 Only in the period prior to the crisis, when asset writedowns were zero, will the sum of the three components of net short-term liabilities be identically equal to the (negative of) the US dollar funding gap (net claims on non-banks).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Bloomberg at $423 billion between Q2 2007 and Q1 2009) were related to their US dollar-denominated non-bank assets, then their US dollar funding gap at end-Q1 2009 would be in the neighbourhood of $880 billion (dashed green line)—still down from the pre-crisis peak, but considerably higher than the esti­ mated $583 billion gap which results when the funding positions are assumed to have been closed.

16.5 THE INTERNATIONAL POLICY RESPONSE The severity of the US dollar shortage among banks outside the United States called for an international policy response. While European central banks adopted measures to alleviate banks'

funding pressures in their domestic currencies, they could not provide sufficient US dollar liquidity. Thus they entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (Figure 16.7). Swap lines with the ECB and the Swiss National Bank were announced as early as December 2007. Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion. As the funding disruptions spread to banks around the world, swap arrangements were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network (Figure 16.7). Various central banks

Central bank network of swap lines

Bank of Canada

Reserve Bank of Australia

Bank of Mexico

Reserve Bank of New Zealand

Central Bank of Brazil

Monetary Authority of Singapore US Federal Reserve

Bank of England

Bank of Japan

Sveriges Riksbank

People's Bank of China

Bank of Korea Eurosystem

National Bank of Denmark

Central Bank of Iceland

National Bank of Poland

Magyar Nemzeti Bank

The arrows indicate the direction of flows (where known); light shaded arrows represent US dollars provided to other central banks, dark arrows represent other currencies (evaluated at the average exchange rate during Q4 2008). The thickness of the arrows is proportional to the size of central bank swap lines, as announced; where swap lines are unlimited, the figure shows maximum usage instead, derived from auction allotments (Figure 16.8). The ASEAN swap network is not shown. Source: Central banks.

Figure 16.7

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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325

Central banks' US dollar swap lines

A

In b illio ns

Eurosystem

Q1 08

Q3 08

Bank of England

Q1 09

Q3 09

Q4 08

Q1 09

Swiss National Bank

Q2 09

Q3 09

Q1 08

Q3 08

Q1 09

Q3 09

1 Amounts outstanding are constructed by cumulating US dollar auction allotments, taking into account the term to maturity. The shaded area indicates the period of unlimited swap lines (as of 13 October 2008). Source: Central banks.

also entered regional swap arrangements to distribute their respective currencies across borders. On 13 October 2008, the swap lines between the Federal Reserve and the Bank of England, the ECB and the Swiss National Bank became unlimited to accommodate any quantity of US dollar funding demanded. The swap lines provided these central banks with ammunition beyond their existing foreign exchange reserves (Obstfeld et al (2009)), which in mid-2007 amounted to $294 billion for the euro area, Switzerland and the United Kingdom combined, an order of magnitude smaller than our lower-bound estimate of the US dollar funding gap.31 In providing US dollars on a global scale, the Federal Reserve effectively engaged in international lending of last resort. The swap network can be understood as a mechanism by which the Federal Reserve extends loans, collateralised by foreign currencies, to other central banks, which in turn make these funds available through US dollar auctions in their respective jurisdictions.32 This made US dollar liquidity accessible to com­ 31 Line "Foreign currency reserves (in convertible foreign currencies)" from the IMF Template on International Reserves and Foreign Currency Liquid­ ity, which includes reserves disclosed by central government and mon­ etary authorities (Eurosystem, Swiss National Bank and Bank of England). 32 The Federal Reserve press release of 13 October 2008 explicitly stated that the swap lines are to provide US dollar funding via the central banks to financial institutions abroad. The foreign currencies pledged to the Federal Reserve in exchange are best regarded as collat­ eral. A new set of swap arrangements (announced on 6 April 2009) was necessary to authorise the Federal Reserve, should the need arise, to obtain and disburse the foreign currencies to US banks.

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Figure 16.8

mercial banks around the world, including those that have no US subsidiaries or insufficient eligible collateral to borrow directly from the Federal Reserve System. The quantities of US dollars actually allotted through US dollar auctions in Europe provide an indication of European banks' US dollar funding shortfall at any point in time (Figure 16.8). Most of the Federal Reserve's international provision of US dollars was indeed channelled through central banks in Europe, consistent with the finding that the funding pressures were particularly acute among European banks. Once the swap lines became unlimited, the share provided through the Eurosystem, the Bank of England and the Swiss National Bank combined was 81% (15 October 2008), and it has remained in the range of 50-60% since December 2008. How successful has the international policy response been? While it is too soon for conclusive answers, the immediate effects have been largely positive. Reflecting considerable demand in the aftermath of the Lehman bankruptcy, the amount of US dollars provided globally through international dollar swap lines surged in October 2008, and peaked at $583 billion in December 2008 (Federal Reserve Statistical Release H.4.1). Since then, the use of swap lines has gradually subsided, to $50 billion by early October 2009. In tandem, the level and spreads of US dollar interest rates, notably Libor, have receded from their historical peak in autumn 2008. Baba and Packer (2009b) find evidence that the US dollar auctions reduced the level and volatility of swap spreads. The policy also helped avert more extensive distress-selling of dollar-denominated assets, and

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

possibly mitigated interbank rate volatility and upward pressure on the US dollar.33 Beyond addressing the immediate exigencies, however, the international swap arrangements are of broader interest from an institutional perspective.34 The structure of the arrange­ ments appears to overcome two challenges commonly associ­ ated with international lending of last resort. First, the Federal Reserve and its foreign counterparts have the power, in princi­ ple, to create any amount of money, in contrast with interna­ tional financial institutions administering limited resources.35 Demands in other currencies can similarly be met by including the respective currency-issuing central banks in the network of swap lines. Second, the swap network does not compound the informational problems that can give rise to moral hazard. By lending against collateral to foreign central banks that interme­ diate those funds to banks in their jurisdictions, the Federal Reserve assumes no credit risk vis-a-vis the ultimate borrowers, and delegates the task of monitoring the banks (or collateralis­ ing the loans) to the national authorities closer to the bank supervision process.36

16.6 CONCLUDING REMARKS The recent financial crisis has highlighted just how little is known about the structure of banks' international balance sheets and their interconnectedness. The globalisation of banking over the past decade and the increasing complex­ ity of banks' international positions have made it harder to construct measures of funding vulnerabilities that take into

33 At the same time, banks' increased reliance on the public availability of US dollar funding may have delayed the necessary restructuring of their balance sheets. 34 The international swap arrangements are not unprecedented. A net­ work of swap lines, also centred on the Federal Reserve Bank of New York, was set up in 1962 to support dollar parities in the Bretton Woods system of fixed exchange rates (Kindleberger (1996)). 35 Effective lending of last resort requires sufficient resources to reassure markets that the means of payment will remain available in all circum­ stances (Bagehot (1873)). As the ultimate issuers of currencies, central banks are the natural lenders of last resort, which some take to imply that an international financial institution cannot play an analogous role interna­ tionally (Capie (1998), Schwartz (1999)). The recent literature on the design of the IMF or its lending policies takes into account its limited resources and focuses on moral hazard issues (Fischer (1999), Lerrick and Meltzer (2003)). 36 The regulation and supervision of banks remains decentralised, and vested with domestic authorities at the national level. An international institution may find it difficult to contain moral hazard when lending to banks outside its regulatory and supervisory reach (Jeanne and Wyplosz (2003)).

account currency and maturity mismatches. This paper par­ tially fills this void, investigating how banks funded their inter­ national positions across currencies and counterparties. The analysis shows that between 2000 and mid-2007, the major European banking systems built up long US dollar positions vis-a-vis non-banks and funded them by interbank borrow­ ing, borrowing from central banks and FX swaps. We argue that this greater transformation across counterparties in fact reflected greater maturity transformation across these banks' balance sheets, exposing them to considerable funding risk. When heightened credit risk compromised sources of short­ term funding during the crisis, the chronic US dollar funding needs became acute, particularly in the wake of the Lehman Brothers bankruptcy. In contrast to many previous international financial crises, it was banks' international exposures to other industrialised countries that deteriorated, and the global interbank and FX swap funding structure which seized up. The build-up of such stresses at the global level can only be identified by track­ ing the extent of cross-currency funding, and by implication, banks' reliance on short-term interbank and FX swap positions. What pushed the system to the brink was not cross-currency funding per se, but rather too many large banks employing funding strategies in the same direction, the funding equiva­ lent of a "crowded trade". Only when examined at the aggre­ gate level can such vulnerabilities be identified. By quantifying the US dollar overhang on non-US banks' global balance sheets, this paper contributes to a better understanding of why the extraordinary international policy response was neces­ sary, and why it took the form of a global network of central bank swap lines. A broader message of this paper is that vulnerabilities in the international financial system are best measured along the con­ tours of banks' consolidated balance sheets, rather than along national borders. This is because (i) stresses build up across the balance sheet—as mismatches between the maturity, currency and counterparty of assets and liabilities—and (ii) the consoli­ dated balance sheets of the relevant decision-making units (ie banks) transcend national borders. The dataset constructed for this paper provides a fairly comprehensive picture of banks' funding patterns at the level of national banking systems. The macroprudential perspective afforded by these data shows that (i) stresses can build up in a national banking system that cannot be identified with the home country's residency-based statistics alone, and (ii) banks' cross-border positions are large relative to countries' external positions, clouding the interpre­ tation of what the "national balance sheet" implies for domes­ tic residents.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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DATA APPENDIX Reconstructing Banks' Global Balance Sheets The analysis in this paper requires estimates of banks' consoli­ dated asset and liability positions broken down by currency and counterparty sector. This data appendix describes how we con­ struct these estimates, and highlights known data limitations.

The BIS International Banking Statistics Table A shows the relevant balance sheet components (first col­ umn) and how the required breakdowns are captured in the BIS international banking statistics. The underlying data are taken from the BIS consolidated banking statistics on an immediate borrower basis (CBS) and the BIS locational banking statistics by nationality (LBSN). The CBS are organised on the principle of bank nationality. They provide reporting banks' worldwide consolidated foreign claims (FC), which comprise cross-border claims (XBC) booked by all offices worldwide, and local claims (LC), or positions booked by banks' foreign offices vis-a-vis residents of the host country. Local claims are denominated in either "local curren­ cies" (LCLC), ie the domestic currency of the host country, or in foreign currencies (LCFC). The statistics record cross-border claims and local claims in foreign currencies as a joint item called international claims (INTC = XBC + LCFC). These claims can be broken down by the country of residence of the counterparty. Therefore, banking system b's foreign claims on borrowers in country c are

residents of that country (LCFC and LCFL, if a foreign office; DCFC and DLFC if the home office). Importantly, these positions are broken down by bank nationality (ie the parent country of the booking office) as well as by currency and counterparty sec­ tor.37 For instance, XBC^ represents US dollar cross-border claims booked in reporting country r by banks headquartered in parent country b. The LBSN do not include information on the location (country) of the counterparty, nor do they include local claims and liabilities (ie vis-a-vis residents) in the domestic cur­ rency of the reporting country (LCLC and LLLC).

Construction of the Dataset The two sets of statistics contain complementary information on banks' global balance sheets. We merge these statistics to construct the required balance sheet components as shown in Table A. The key step is to aggregate the LBSN data across the 40 reporting countries to obtain total international claims and international liabilities for each bank nationality (ie bank­ ing system), along with the currency and counterparty sector breakdowns that are unavailable in the CBS. As shown in the last column of Table A, combining these pieces from the LBSN with those from the CBS splice yields a complete breakdown by cur­ rency of all foreign positions. The only remaining missing pieces of the balance sheet are banks' "strictly domestic" positions, or their domestic currency assets and liabilities booked by home offices vis-a-vis residents of the home country (DCLC and DLLC). While their gross "strictly domestic" positions are unknown, their net position can be inferred as a residual from the balance sheet identity, as illustrated in equation (16.1) in the main text.

Consider, for example, UK-headquartered banks. Summing across all reporting countries (indexed by r) in the LBSN where rC bc = LCLCbb+ INTCbc=> FCb = Z cFCbc UK banks have offices gives UK banks' international claims and liabilities on a global consolidated basis, or While the counterparty sector (bank, non-bank private sec­ INTCb = Y r(XBCrb + L C F C j. tor and public sector) is known for international claims, there is no currency breakdown for these positions nor information This aggregate compares to INTC in the CBS, but now comes about the location of the booking office. Moreover, the CBS with detailed breakdowns by currency and counterparty sector. data contain no information on international liabilities (INTL). In To match worldwide consolidated foreign claims (FC from the contrast to international positions, both the currency and the CBS), the only missing balance sheet components are UK banks' location of the booking office are known for LCLC by definition. local claims and liabilities in the domestic currencies of various In addition, banks report their locally booked liabilities in local host countries (LCLC and LLLC). This information is available in currencies (LLLC). the CBS reported by the United Kingdom. In contrast to the CBS, the LBSN are collected on the principle of bank residence. The "reporting unit" in the LBSN is any bank office (head office, branch or subsidiary) in a particular country 37 The sectoral breakdown distinguishes positions vis-a-vis non-banks, or jurisdiction—including major offshore financial centres. Each vis-a-vis official monetary authorities and vis-a-vis banks. The interbank bank office reports its cross-border claims and liabilities (XBC positions are further divided into inter-office positions (within the same and XBL) as well as foreign currency claims and liabilities vis-a-vis bank group) and positions vis-a-vis other (unaffiliated) banks.

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Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Table A

A Breakdown of Banks' Consolidated Worldwide Positions Breakdowns by Totals

Booking office location

Residence of counterparty

Sector of counterparty

Currency of positions

Domestic claims (DC)1 LBSN

in foreign currency (DCFC)

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

ASSETS

in local currency (DCLC) Foreign claims (FC)

CBS

Cross-border claims (XBC) International claims (INTC)2

CBS

CBS LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

CBS

CBS

Local claims (LC)3 in foreign currency (LCFC) in local currency (LCLC)

CBS

CBS

LBSN CBS

CBS

Domestic liabilities (DL)1 LBSN

LBSN

Cross-border liabilities (XBL)

LBSN

International liabilities (INTL)2

in foreign currency (DLFC)

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LBSN

LIABILITIES

in local currency (DLLC) Foreign liabilities (FL)

Local liabilities (LL)3 in foreign currency (LLFC) in local currency (LLLC)

CBS

CBS

LBSN CBS

CBS

CBS = consolidated banking statistics on an immediate borrower basis; LBSN = locational banking statistics by nationality. 1 Domestic claims (liabilities including equity) in the home country. 2 International claims INTC = XBC + LCFC, and international liabilities INTL = XBL + LLFC. 3 Local positions booked by banks' foreign offices outside the home country.

The combined dataset thus yields, for 19 banking systems, foreign claims and liabilities on a worldwide consolidated basis both broken down by (i) the currency of the position, (ii) the location of the booking office and (iii) the counterparty type (bank, non-bank, central bank), and with partial information on the residency (country) of the counterparty (ie for local positions, the residency of the counterparty is known by con­ struction; for cross-border positions, the residency of the coun­ terparty is unknown).

Consistency Check and Data Limitations In principle, for each banking system, total INTCb (summed across reporting countries in the LBSN) plus LCLC (summed

across borrowing countries in the CBS) should correspond to total foreign claims reported in the CBS. That is,

T ,iX B Crt, + LCFCrb)+Y,LCLCbc = FCb. This serves as a consistency check across the two datasets for the asset side of the balance sheet. There is no correspond­ ing check on the liability side since banks do not report foreign liabilities (FL) in the CBS. In practice, some statistical discrepancies arise because the two sets of statistics are collected in fundamentally different ways. For many banking systems (Belgian, Canadian, Dutch, French, German, Italian, Spanish and UK banks) the match is fairly close. The match is not as satisfactory for Swiss and US banks. Discrep­ ancies arise for three main reasons. First, the set of reporting

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response

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329

banks in the CBS differs from that reporting LBSN in various reporting countries.38 Second, some banking systems have offices in countries that do not report in the LBSN, yet those offices are included in the worldwide consolidated positions reported in the CBS. In addition, some countries report incom­ plete positions in the LBSN; the United States, for example, does not report foreign currency positions vis-a-vis US residents. A third problem that affects the calculations is that the resi­ dency, counterparty sector and currency of a portion of banks' liabilities are unknown. These "unknown" liabilities are typi­ cally debt securities issued by banks. Once these securities are traded on secondary markets, reporting banks no longer know the residency or the counterparty sector of the entity that holds these securities. Unfortunately, when the data are reported to the BIS, the currency of these "unallocated" posi­ tions is not reported, even though, in principle, this is known by the reporting banks. While these positions are small on a gross basis (Figure 16.2), they are large on a net basis (Figures 16.3 and 16.4), and thus should not be excluded from the analysis.

with a corresponding equation for interbank liabilities. The inter-office asset and liability positions must be stripped out of total foreign claims in order to make the LBSN and CBS data comparable on a gross basis, as in Figures 16.2 and 16.5. Some LBSN-reporting countries/regions, however, do not provide a complete currency breakdown (eg Singapore, Hong Kong SAR and the Channel Islands), while others provide only limited currency information for inter-office positions (eg France, Germany, Italy and Japan split inter-office activity into domestic and foreign currencies). To the extent possible, we estimate the missing inter-office components, although some uncertainty still remains in the overall interbank positions for some banking systems. This makes it difficult to pin down the extent of reliance on interbank financing, as shown by the two alternative estimates presented in Figures 16.4 and 16.5. On a net basis (claims minus liabilities), inter-office positions should, in principle, sum to zero across all reporting office locations. This implies that net "interbank" claims (IBC — IBL) should equal net claims on "other banks", both of which are observ­ able in the data:

Across all reporting countries, the United Kingdom reports by far T ^O C rb - IOLrb) = 0 => the largest "unallocated" liability positions (roughly $800 billion in mid-2007 for the major European banks' offices located there). I , (lBCrb IBL rb ) = X , (0 THBCrb - OTHBLrb). The currency denomination of these liabilities can be estimated by using the BIS international debt securities database, which The solid blue lines in Figures 16.4 and 16.5 track provides information on issuance of debt securities by banks ^ r(/BCrb — IBL^), or net interbank positions calculated without located in various countries around the world. In Figure 16.2, stripping out inter-office positions, while the dashed blue line the unknown positions are plotted in their raw form, whereas in tracks ^ r(OTHBCrb — OTHBLrb), or the reported positions visFigures 16.3, 16.4 and 16.5 the positions are allocated by currency a-vis unaffiliated banks only. The dashed black lines in Figures by applying the currency split from the debt securities database. 16.4 and 16.5 track the implied reliance on FX swaps which Because the counterparty sector of these positions, needed for corresponds to this alternative estimate of interbank positions. Figures 16.4 and 16.5, remains unknown, we make the conserva­ Which set of estimates is more accurate depends on the rela­ tive assumption that all unallocated US dollar liabilities are held by tive sizes of observed versus missing inter-office positions, and non-banks. This assumption biases downwards the net positions whether banks have offices with (unobserved) offsetting posi­ vis-a-vis non-banks (our lower-bound estimate of the US dollar tions in non-reporting countries. funding gap) in Figure 16.4 and Figure 16.5 (bottom panels). Finally, the breakdowns by sector and currency in the LBSN are in some cases incomplete. For each banking system b, total interbank claims (IBC) in a particular currency are the sum of claims on other (unaffiliated) banks (OTHBC) and inter-office claims (IOC). That is, = Y .r IBCrb = Y .r(OTHBCrD+IOCrD),

38 This is problematic in the case of US banks, since the major US invest­ ment banks are generally included in the LBSN (reported by all coun­ tries), but were not included in the CBS reported by the United States until Q1 2009, the last quarter of our sample.

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References Allen, F and D Gale (1998): "Optimal financial crises", Journal of Finance, 53(4), pp 1245-84. Baba, N and F Packer (2009a): "Interpreting deviations from covered interest parity during the financial market turmoil of 2007-08", Journal of Banking and Finance, forthcoming. — (2009a): "From turmoil to crisis: dislocation in the FX swap market before and after the failure of Lehman Brothers", Journal of International Money and Finance, forthcoming.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Baba, N, R McCauley and S Ramaswamy (2009): "Dollar money market funds and non-US banks", BIS Quarterly Review, March. Bagehot, W (1873): Lombard Street: a description of the money market, New York: Scribner, Armstrong & Co. Bank for International Settlements (2009a): "Highlights of inter­ national banking and financial market activity", BIS Quarterly Review, June. — (2009b): "An assessment of financial sector rescue pro­ grammes", BIS Papers, no 48, July. Bernanke, B (2008): "Policy coordination among central banks", speech at the Fifth European Central Bank central banking con­ ference, Frankfurt, 14 November. Capie, F (1998): "Can there be an international lender of last resort?", International Finance, 1(2), pp 311-25. Cetorelli, N and L Goldberg (2008): "Banking globalization, monetary transmission, and the bank lending channel", NBER Working Papers, no 14101. Chang R and A Velasco (2000): "Financial fragility and the exchange rate regime", Journal of Economic Theory, 92, pp 1-34. — (2001): "A model of financial crises in emerging markets", Quarterly Journal of Economics, 116, pp 489-517. Devereux, M and A Sutherland (2009): "Valuation effects and the dynamics of net external assets", Journal of International Economics, forthcoming. Diamond, D and R Rajan (2001): "Liquidity risk, liquidity cre­ ation, and financial fragility: a theory of banking", Journal of Political Economy, 109(2), pp 287-327. — (2006): "Money in a theory of banking", American Economic Review, 96(1), pp 30-53.

Forbes, K (2008): "Why do foreigners invest in the United States?", NBER Working Papers, no 13908. Fukao, M (1991): "Exchange rate movements and capital-asset ratio of banks: on the concept of structural positions", BO J Monetary and Economic Studies, 9(2), September. Goodhart, C (1995): The central bank and the financial system, MIT Press. Jeanne, O and C Wyplosz (2003): "The international lender of last resort: how large is large enough?", in M Dooley and J Frankel (eds), Managing currency crises in emerging markets, University of Chicago Press, pp 89-118. Kindleberger, C (1950): The dollar shortage, MIT Press and John Wiley & Sons, Inc. — (1996): Manias, panics, and crashes—a history o f financial crises, John Wiley & Sons, Inc. Lane, P and G M Milesi-Ferretti (2001): "The external wealth of nations: measures of foreign assets and liabilities for industrial and developing countries", Journal o f International Economics, 55(2), pp 263-294. Lane, P and J Shambaugh (2009a): "Financial exchange rates and international currency exposures", American Economic Review, forthcoming. — (2009b): "The long of short of it: determinants of foreign currency exposure in external balance sheets", NBER Working Papers, no 14909. Lerrick, A and A Meltzer (2003): "Blueprint for an international lender of last resort", Journal o f Monetary Economics, 50, pp 289-303. McCauley, R (1984): "Maturity matching in the euromarkets", New York Federal Reserve Quarterly Review, 9(1), pp 33-5.

European Central Bank (2009): EU banks' funding structures and policies, May.

Mishkin, F (1999): "Global financial instability: framework, events, issues", Journal of Economic Perspectives, 13(4), pp 3-20.

Faria, A and P Mauro (2009): "Institutions and the external capi­ tal structure of countries", Journal of International Money and Finance, 28, pp 367-91.

Morgan, G and S Smith (1987): "Maturity intermediation and intertemporal lending policies of financial intermediaries", Journal of Finance, 42(4), pp 1023-34.

Fischer, S (1999): "On the need for an international lender of last resort", Journal o f Economic Perspectives, 13(4), pp 85-104.

Obstfeld, M, J Shambaugh, and A Taylor (2009): "Financial instability, reserves, and central bank swap lines in the panic of 2008", American Economic Review, 99(2), pp 480-86.

Flannery, M and C. James (1984): "Market evidence on the effective maturity of bank assets and liabilities", Journal of Money, Credit and Banking, 16(4,1), pp 435-45.

Peek, J and E Rosengren (2001): "Determinants of the Japan premium: actions speak louder than words", Journal of Interna­ tional Economics, 53, pp 283-305.

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Rajan, R and I Tokatlidis (2005): "Dollar shortages and crises", International Journal of Central Banking, 1(2), pp 177-220.

Taylor, J and J Williams (2009): "A black swan in the money market", American Economic Journal: Macroeconomics, 1(1), pp 58-83.

Schwartz, A (1999): "Is there a need for an international lender of last resort?", Cato Journal, 19(1), pp 1-6.

Tille, C and E van Wincoop (2007): "International capital flows",

Stigum, M and A Crescenzi (2007): Stigum's Money Market, fourth edition, McGraw Hill.

Triffin, R (1957): Europe and the money muddle—from bilater­ alism to near-convertibility 1947-1956, Yale University Press.

NBER Working Papers, no 12856.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Covered Interest Parity Lost: Understanding the Cross-Currency Learning Objectives After completing this reading you should be able to: Differentiate between the mechanics of foreign exchange (FX) swaps and cross-currency swaps.

Assess the causes of covered interest rate parity violations after the financial crisis of 2008.

Identify key factors that affect the cross-currency swap basis.

Excerpt is by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko, from BIS Quarterly Review.

Covered interest parity verges on a physical law in inter­ national finance. And yet it has been systematically vio­ lated since the Great Financial Crisis. Especially puzzling have been the violations since 2014, even once banks had strengthened their balance sheets and regained easy access to funding. We offer a framework to think about these violations, stressing the combination of hedging demand and tighter limits to arbitrage, which in turn reflect a tighter management of risks and bank balance sheet constraints. We find empirical support for this frame­ work both across currencies and over time. JE L classification: F31, G15, G2.

Covered interest parity (CIP) is the closest thing to a physical law in international finance. It holds that the interest rate dif­ ferential between two currencies in the cash money markets should equal the differential between the forward and spot exchange rates. Otherwise, arbitrageurs could make a seem­ ingly riskless profit. For example, if the dollar is cheaper in terms of yen in the forward market than stipulated by CIP, then anyone able to borrow dollars at prevailing cash market rates could profit by entering an FX swap—selling dollars for yen at the spot rate today and repurchasing them cheaply at the for­ ward rate at a future date. Yet since the onset of the Global Financial Crisis (GFC), CIP has failed to hold. This is visible in the persistence of a cross­ currency basis since 2007. The cross-currency basis indicates the amount by which the interest paid to borrow one currency by swapping it against another differs from the cost of directly borrowing this currency in the cash market. Thus, a non-zero cross-currency basis indicates a violation of CIP. Since 2007, the basis for lending US dollars against most currencies, nota­ bly the euro and yen, has been negative: borrowing dollars through the FX swap market became more expensive than direct funding in the dollar cash market. For some currencies, such as the Australian dollar, it has been positive (Graph 1, lefthand and centre panels). Initially, the violations of CIP were seen as a reflection of strains in global interbank markets. Specifically, heightened concerns about counterparty risk and constrained bank access to wholesale dollar funding inhibited arbitrage during the GFC, and again during the subsequent euro area sovereign debt crisis. But, puzzlingly, the violations have persisted even after these strains dissipated. The basis has widened since 2014, for both short- and long-term borrowing, despite fading concerns about bank credit quality and recovery in wholesale

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dollar funding markets.1 Why has arbitrage not reduced the basis to zero? In this special feature, we argue that the answer to this puzzle lies in the combination of the evolving demand for FX hedges and new constraints on arbitrage activity. The former explains why the basis opens up, and the latter why it does not close. A growing demand for dollar hedges on the part of banks, institu­ tional investors and issuers of non-US dollar bonds has put pres­ sure on the basis. At the same time, limits to arbitrage (in the sense discussed by Shleifer and Vishny (1997), among others) have become more binding. These reflect lower balance sheet capacity because of tighter management of the risks involved and the associated balance sheet constraints. Empirically, we find that proxies for the volume of hedging demand, together with proxies for balance sheet costs, help explain CIP violations, both across currencies and over time. If the factors we identify are the right ones, CIP deviations look to be here to stay even in non-crisis times, as long as the demand for currency hedges is sufficiently high and imbalanced across currencies.1 2 The rest of this feature is organised as follows. The first section lays out the framework for our analysis. The second and third sections examine, respectively, the variation of the basis across currencies and over time in the yen/dollar basis. The conclusion highlights some implications and outstanding questions.

17.1 A FRAMEWORK The basic mechanics behind CIP are fairly simple. Interest rates in the cash market and the spot exchange rate can be taken as given—these markets are much larger than those for FX deriva­ tives. Hence, it is primarily shifts in the demand for FX swaps or currency swaps that drive forward exchange rates away from CIP and result in a non-zero basis (Box 17.1). Any such deviations should, in principle, immediately trigger arbitrage transactions, bringing the basis back to zero. The reason is that, in an ideal world, CIP arbitrage is treated as riskless. By construction, FX swaps do not entail an open currency position. In addition, it is assumed that the credit, counterparty, market and liquidity risks involved are negligible. Unimpaired access to cash and deriva­ tives markets then allows arbitrageurs to close the basis.

1 Also, unlike in earlier US dollar funding stress episodes (Cetorelli and Goldberg (2011, 2012)), banks have drawn very little on central bank swap lines: https://apps.newyorkfed.org/markets/autorates/ fxswaps-search-result-page. 2 Sushko et al (2016) treat these issues from a more technical perspec­ tive and provide broader econometric results.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Cross-currency basis against the US dollar, interbank credit risk and market risk1 fhree-month basis

Three-year basis

Libor-OIS spreads and the VIX

Basis points

Basis points

70

40 IfJ jA J A M U

Percentage points

Percentage points

0

_____

I A.

Graph 1

A

A

-40 I

H

f

i

06

08

10 12 USD/AUD

14 16 ---- USD/EUR

I I 06

I I I I 08 10 USD/JPY

>

r

x

W ’ if*

-80

................................. ..... 12 14 16 Libor-OIS spread (Ihs): ---- US ----EA

Rhs: • - - VIX2

1 The vertical lines indicate 15 September 2008 (Lehman Brothers file for Chapter 11 bankruptcy protection) and 26 October 2011 (euro area authorities agree on debt relief for Greece, leveraging of the European Financial Stability Facility and the recapitalisation of banks). 2 Chicago Board Options Exchange S&P 500 implied volatility index; standard deviation, in percentage points per annum. Sources: Bloomberg; authors' calculations.

BOX 17.1 CIP, FX SWAPS, CROSS-CURRENCY SWAPS AND THE FACTORS THAT MOVE THE BASIS CIP is a textbook no-arbitrage condition according to which interest rates on two otherwise identical assets in two differ­ ent currencies should be equal once the foreign currency risk is hedged:

F S

1+ r 1 + r*

a premium in FX swaps. In this case, rearranging the CIP equation yields the following relationship between (F — S), rand r*:

1+ r l + r*

where S is the spot exchange rate in units of US dollar per foreign currency, F is the corresponding forward exchange rate, r is the US dollar interest rate, and r* is the foreign cur­ rency interest rate. In practice, the relationship between F and S is read off market transactions in FX instruments, nota­ bly FX swaps and cross-currency swaps.

A positive ("wide") value of (F — S), above, indicates that a party lending US dollars sells the foreign currency forward at a higher dollar price than warranted by the interest dif­ ferential. Equivalently, a party borrowing US dollars via an FX swap—say, to hedge its US dollar asset—is effectively paying a higher interest rate on the swapped dollars than is paid in the cash market.

In an FX swap, one party borrows one currency from, and simultaneously lends another currency to, a second party (see also Baba et al (2008)). The borrowed amounts are exchanged at the spot rate, S, and then repaid at the pre-agreed forward rate, F, at maturity. The implicit rate of return in an FX swap is determined by the difference between Fand S, and the contract is typically quoted in forward points (F — S). If the party lending a currency via FX swaps makes a higher or lower return than implied by the interest rate differential in the two currencies, then CIP fails to hold. Typically, the US dollar has tended to command

A cross-currency swap is a longer-term instrument, typically above one year, in which the two parties also simultaneously borrow and lend an equivalent amount of funds in two dif­ ferent currencies. At maturity, the borrowed amounts are exchanged back at the initial spot rate, S, but during the life of the swap the counterparties also periodically exchange interest payments. In a cross-currency basis swap, the refer­ ence rates are the respective Libor rates plus the basis, b. Again, if the forward points (F — S) are greater than war­ ranted by CIP, then, assuming a oneperiod maturity, the basis, b, will effectively be the amount by which the interest

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis

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335

(Continued) rate on one of the legs has to be adjusted so that the parity with the pricing of FX swaps holds:

(1 + r + b\ F - S = S[ ---------- 1 - 5 V 1 + r* /

In the above example, the FX swap implied US dollar rate, 7s (1 + r*), exceeds actual US dollar Libor, 1 + r, if the party borrowing US dollars in a cross-currency swap pays the basis, b, on top of US dollar Libor. Thus, failure of CIP has implica­ tions for the relative cost of funding in the cash and swap markets. Whenever CIP fails, one party ends up paying the currency basis on top of the cash market rates to borrow the corresponding currency, while the other counterparty in effect receives an equivalent discount when borrowing the other currency. A number of factors can cause CIP to fail. For example, market liquidity in the underlying instruments may evapo­ rate, so that the difference between bid and ask prices for forward and spot transactions is non-trivial. For simplicity, let us assume that r* is sufficiently small, so that 1 + r* ~ 1. Denoting by Sa the spot ask rate and by Fb the forward bid rate, CIP deviations due to a drop in market liquidity will be given by:

CIP can also fail because of credit risks in the underlying investments. If CIP arbitrage is conducted by global banks borrowing and lending in the respective Libor markets, then a rise in counterparty credit risks in the interbank markets, typically captured using Libor-OIS spreads, could result in CIP deviations. Similarly, if banks or asset managers engage in CIP arbitrage using government bonds in the two cur­ rencies, then deviations might result from differences in sovereign credit risks, typically measured using sovereign CDS spreads. More generally, suppose rand r* are the respective risk-free rates and rp is the risk premium for the underlying investment over the duration of the swap. Then CIP deviations measured using risk-free rates will be given by: F -S S

—(r —r ' )

=

rp

In recent years, the textbook CIP arbitrage framework has been challenged in two ways. Initially, the focus was on the con­ straints on arbitrage arising from the banks' counterparty credit risk concerns and the wholesale US dollar funding strains that surfaced during crisis episodes. These episodes included the Japanese banking crisis (the "Japan premium", Hanajiri (1999)); the onset of the GFC in 2007-08 (eg Baba et al (2008), Baba and

336

Even if risk premia in the underlying transaction are low, CIP deviations can arise if the demand to hedge one of the cur­ rencies is large. Then, even small risk premia can have big effects when scaled by the large size of the balance sheet exposures needed to meet the hedgers' demand. For exam­ ple, Sushko et al (2016) show that CIP deviation can be pro­ portional to the hedging demand multiplied by the per-dollar balance sheet costs of FX derivatives exposures:

F-S b = —----- ( r iJ

- r* ) oc rp

x FX Fledging Demand

In each of the above examples, the price that is actually set in FX derivatives is that of the forward leg of the swap, F. As shown, CIP arbitrageurs will pass on their balance sheet costs of taking the other side of FX hedging demand via FX swaps as wider forward points, (F — S), than warranted by CIP. The per-dollar balance sheet costs themselves are repre­ sented by rp in this example. Since markets have to clear, the aggregate position of CIP arbitrageurs when the US dollar is at a premium in FX swaps will be equal to the aggregate net position of currency hedgers. The latter will be paying the forward points, (F — S), to hedge their US dollar assets. What are some of the real-world counterparts to rp in non­ crisis times? In aggregate, rp will reflect any costs that banks or other participants assign to deploying their balance sheet in CIP arbitrage, which in turn will reflect their risk manage­ ment practices. For individual players, these practices may even include absolute credit limits that would set a maximum for the underlying exposures to the underlying instruments and counterparties. Even without strict limits, the funding cost of the capital allocated to the arbitrage activity, notably to the (current and potential future) derivatives exposures involved, will prevent the basis from closing when it opens up owing to changes in hedging demand. The specific constraints, and hence the instruments involved, will also depend on the players acting as arbitrageurs. For instance, for highly rated supranational and quasi-govern­ ment agencies, which can arbitrage the long-term basis thanks to their top credit rating by issuing bonds in US dol­ lars at attractive rates and then swapping them out, rp is more closely related to the costs of placing bonds in different currencies. For hedge funds, which rely on collateralised mar­ kets to fund CIP arbitrage, the price and availability of repo market funding will play a significant role.

Packer (2009), Coffey et al (2009), Mancini-Griffoli and Ranaldo (2012), Levich (2012)); and the euro area sovereign debt crisis in 2011-12 (McCauley and McGuire (2014), Ivashina et al (2015)). Since 2014, attention has shifted to other factors and con­ straints. Most studies have invoked some notion of capital constraints of CIP arbitrageurs in the face of FX swap funding

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

demand from banks (lida et al (2016)), from foreign currency bond issuers (Liao (2016)) or from broader saving and invest­ ment imbalances (Du et al (2016)).3 Similarly, Shin (2016) attributes the persistent deviations from the CIP to a sys­ temic risk factor linked to the US dollar's role as the global funding currency.4 Drawing on our more technical work (Sushko et al (2016)), the framework we propose in this study has two features. First, it focuses on one key source of pressure on the basis, namely net foreign currency hedging demand that is largely insensi­ tive to the size of the basis. Second, similarly to other studies, it also assumes the presence of limits to arbitrage linked to the costs involved in deploying balance sheets, in turn reflect­ ing tighter management of capital and funding risks. This can create a balance sheet constraint on CIP arbitrage that becomes more binding as the size of the aggregate FX hedg­ ing positions grows.

markets. The remaining gaps between banks' assets and liabili­ ties in a given currency would be closed using currency deriva­ tives such as FX swaps.5 The second source of demand arises from the strategic hedging decisions of institutional investors, such as insurance companies and pension funds. Institutional investors use swaps to strategi­ cally hedge foreign currency investments. In recent years, the term and credit spread compression on the back of unconven­ tional monetary policies in major jurisdictions has boosted these cross-currency investment and funding flows.6 These investors' hedge ratios tend to be quite insensitive to hedging costs and to move slowly over time.7 Thus, anything that induces these investors to increase or reduce their foreign currency invest­ ments tends to put pressure on the basis.

Demand for Currency Hedges: Why the Basis Opens Up

The third source of demand arises from non-financial firms' debt issuance across currencies as they seek to borrow oppor­ tunistically in markets where credit spreads are narrower. Under normal market conditions and for most currencies, this may not be an important factor. But it can become quite relevant when credit spreads differ systematically, for example when they are compressed by central bank large-scale asset pur­ chases. Recently, for instance, many US firms needing dollars have been issuing in euros to take advantage of very attractive spreads in that currency and have then swapped the proceeds into dollars (Box 17.2). This allows them to use the dollars for their business purposes while avoiding a currency mismatch in euros. Essentially, through the swap market, they borrow dol­ lars and lend euros.

Hedging of open FX positions is the main proximate driver of the demand for FX swaps. We focus on three sources of hedg­ ing demand that are rather insensitive to the size of the basis, and, hence, exert sustained pressure on it even when it is non-zero: demand from banks, institutional investors and non-financial firms.

Other factors could also put pressure on the basis, but we exclude them from our analysis because of data limitations. Firms' hedging of trade receivables or subsidiary cash flows are one case in point. Another could be speculative FX positions, which can rely on forwards and swaps (eg yen carry trades). We posit, therefore, that the sources of pressure we identify are

Our framework gives rise to two hypotheses. First, in the cross section, the size and sign of the basis across currencies should be related to the net hedging position vis-a-vis the US dollar. Second, over time, the evolution of the basis should depend on that of net dollar hedging needs. Let us first consider each of the two components of the framework— FX hedging demand and constraints on arbitrage—in more detail.

A first, structural source of demand for foreign currency hedges arises from banks' business models. For a long time, banks have been the main players running currency mismatches on their bal­ ance sheets (managed mainly via swaps). Banking systems may be structurally short or long in specific currencies, given their core deposit base. A shortfall in foreign currency funding can then be managed by cash borrowing in money and bond

3 He et al (2015) take the currency basis as given, to study the effects of FX swap market dislocations on the ability of non-US banks to supply US dollar loans when US monetary conditions tighten. 4 Transaction costs also appeared to play a temporary role for some cur­ rencies in the aftermath of the Swiss National Bank's abandonment of the currency peg (Pinnington and Shamloo (2016)).

5 For example, in the second half of 2015, temporary pressure on nonUS banks' dollar funding emerged as US money market funds (MMFs) divested from their unsecured obligations. This reflected adjustment to US MMF regulatory reform set to take effect in October 2016. Still, at least in aggregate, non-US banks retained $5.5 trillion in deposits off­ shore and at their US branches in the last three quarters of 2015, which rose to $5.7 trillion in Q1 2016, according to BIS and Federal Reserve flow of funds data. 6 Domanski et al (2015) document increasing investment in long-term foreign currency bonds by the German insurance sector seeking to extend asset duration so as to match the rising duration of its liabilities as yields in the euro area fell to very low levels. 7 The FX-hedged investment has a payoff that resembles the return of leveraged investors in the target bond market: in the case of bonds, this is equal to the excess of the bond yield over the short-term financing cost ("the carry"), plus or minus a price gain or loss on the bond.

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BOX 17.2 REVERSE YANKEE ISSUANCE IN THE EURO AND THE EUR/USD BASIS Corporate credit spreads in the euro bond market have fallen relative to those in the US dollar bond market, largely driven by ECB bond purchase programmes (Graph B, lefthand and centre panels). In response, US firms have found it more cost-effective to issue in euros, through so-called reverse yankee bonds, and then swap the proceeds into US dollars (right-hand panel). The hedging of currency risk by US firms issuing in the euro increases demand for cross-currency swaps. Hence, the widening of corporate asset swap spread differentials and the surge in euro issuance since 2014 have coincided with a marked widening of the currency basis (cen­ tre panel). For example, consider a BBB-rated US telecoms firm whose bonds yield 100 basis points over the interest rate swap rate in dollars, but only 50 basis points in euros. If CIP held, the

firm would save 50 basis points by issuing in euros and swap­ ping back to dollars. In fact, the firm would have an incentive to do that for all its new debt. One can then see the widen­ ing of the basis as tending to reconcile the different spreads in the two markets. According to data from Thompson Reuters, the majority of reverse yankee issuance has been long-term, with an aver­ age maturity of about 10 years and with 15- and 20-year tenors also commonplace. Issuance at shorter maturities is rare, because, from the perspective of the US non-financial issuer, the all-in issuance costs (ie taking the currency swap into account) of short-term euro-denominated debt are still greater than issuing short-term US dollar debt, owing to the wider currency basis relative to the corporate asset swap spread differential at the short end.

Corporate credit spreads, reverse yankee issuance and the EUR/USD basis Corporate asset swap spread

Spread differential and the basis

Basis points

Graph B

US non-financial firms' EUR debt issuance

Basis points

375

06 08 10 12 14 16 United States (US) ---- Euro area (EA)

06 08 10 12 14 16 Corp spread gap: 5-year currency basis: ■- - US minus EA ---- EUR/USD

Sources: Bank of America Merrill Lynch; Bloomberg; BIS debt securities statistics; authors' calculations.

sufficient to capture the key relationships.8 At the more funda­ mental level, monetary (Box 17.3) and financial conditions, as well as institutional differences across the respective jurisdic­ tions, largely determine the extent of foreign currency funding and investment flows in the first place. 8 This would be so if the other sources of FX hedging demand co-move positively with those we identify. The exclusion of speculative demand may actually make it harder for us to find a relationship with hedging demand, as speculation may lead to offsetting pressure on the basis. For instance, easy monetary policy could boost FX-hedged investments in search of higher returns, but it could also encourage carry trades. Those carry trades could push down the forward rate even as hedging demand pushed it up.

338

Limits to Arbitrage: Why the Basis Does Not Close Structural changes in how market participants have been pricing market, credit, counterparty and liquidity risks post-crisis have tightened limits to arbitrage. Balance sheet space is rented, not free.9 Specifically, as a result of tighter management of risks and related balance sheet constraints, arbitrage now incurs a cost per unit of balance sheet. This cost is passed on to the

9 For a conceptual discussion, see Duffie (2016).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

pricing of FX swaps, introducing a premium (or discount, depending on the currency) in response to imbalances in the swap market. One result is that the currency spot-forward rela­ tionship goes out of line with CIP (Box 17.1).

mind that the sample is necessarily limited, as we have to restrict it to freely tradable currencies in jurisdictions with no capital controls, with a highly rated sovereign and for which data are available.

Arbitrage can be both costly and risky. Typically, it requires the arbitrageur to enlarge its balance sheet, incur credit risk in both borrowing and investing, and possibly face mark-to-market and liquidity risk (given the need to transfer collateral or take paper gains or losses) in the valuation of the positions.

Quantitative Indicators of Hedging Demand

While these risks and costs exist all the time, participants have been managing them more actively post-crisis. Before the GFC, these risks were not fully priced in the relevant markets and, partly as a result, dealer banks had raised their leverage to dangerous levels (Shin (2010)). The crisis brought them to light. Since then, pressure from shareholders, creditors and prudential authorities has reinforced and hard-wired participants' aware­ ness. As a result, leverage has declined and there has been less willingness to deploy the balance sheet for activities that make heavy demands on it, such as arbitraging the basis. Changes in regulation have reinforced market pressures for a tighter management of balance sheet risks. For example, changes related to credit value adjustments have sought to incentivise dealers to price the counterparty risk in their deriva­ tives portfolios more accurately. Similarly, potential future expo­ sure adjustment charges in both Basel III and US leverage ratios require market participants to hold capital in proportion to their derivatives and other exposures. 10

Assembling estimates of hedging demand runs into two types of limitation. The first is conceptual. Some financial institutions play the dual role of putting pressure on the basis and arbitraging it. For instance, banks' business models may lead them to fund them­ selves through swaps in order to hedge their balance sheet mismatches, even as they act as arbitrageurs. This means that proxies for their swap positions conflate their two roles. How­ ever, and despite such ambiguity, our results suggest that the balance sheet hedging motive dominates. The second relates to data availability. No statistics fully cover the hedging demand for a given currency; tough choices and approx­ imations are needed. Hence, we focus on the three main sets of players—banks, institutional investors and nonfinancial firms—and even there we have to make a number of assumptions.

The bottom line is clear. These tighter limits on arbitrage make it harder to narrow the basis whenever it opens up as a result of pressures that reflect underlying order imbalances. In particular, even in the absence of bank funding strains like those seen dur­ ing the GFC, a sufficiently high net demand for currency hedges could result in persistent deviations from CIP.

For banks, our benchmark measure is their "funding gap" in the US dollar. 1 2 The funding gap, derived from the BIS international banking statistics, is an estimate of banks' demand for hedging through the FX swap market (McGuire and von Peter (2009, 2012), Fender and McGuire (2010)). Specifically, for banks head­ quartered in a particular country (eg Japan or Australia), we mea­ sure the difference between their consolidated global on-balance sheet assets and liabilities in a particular foreign currency. Assum­ ing that banks hedge their currency risk, the resulting gap indi­ cates the size of their off-balance sheet position in a given currency, which will largely be managed by FX swaps. 1 3

17.2 THE CURRENCY BASIS IN THE CROSS SECTION

For institutional investors, we rely on central banks for esti­ mates of Australian, euro area and Swedish institutions' hedged foreign assets; and on industry sources for Japanese life insur­ ers' holdings and hedge ratios. 1 4 We neglect US investors'

Can our framework help explain how the sign and, possibly, the size of the basis vary across currencies? We test this by juxtaposing quantitative indicators for the various players' hedging demands and the basis. 11 In evaluating the results, it should be borne in

10 This need not result from individual pricing decisions. For instance, internal credit limits may constrain individual balance sheets and, in aggregate, be reflected in a larger basis. 11 Our findings also hold if price indicators are used; see Sushko et al ( 2016 ).

12 Except in the case of Sweden, where we also look at the euro (see below). 1Q Partly owing to data limitations, we do not include US banks' cor­ responding positions. US-headquartered banks' estimated net long positons in the key currencies we are considering are relatively small compared with non-US banks' net long dollar positions. As a result, the bulk of our analysis can safely focus on the latter. 14 This means that, except for the euro area, we cannot single out US dollar holdings, so that our estimate is an upper bound for the institu­ tions covered.

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BOX 17.3 CIP DEVIATIONS AND MONETARY POLICY ANNOUNCEMENTS Monetary policy can boost hedging demand through both price and quantity effects. By lowering the yield curve and, in particular, by compressing the term premium and credit spreads, easing encourages investors to seek return and duration in foreign currency bonds and foreign issuers to sell bonds in the corresponding currency to obtain cheaper funding. Large-scale asset purchases strengthen these effects by withdrawing securities from the market. And so does the adoption of negative interest rates, which can result in nega­ tive yields stretching out to long maturities.© Much of the widening of the USD basis since 2014 has coincided with monetary policy easing announcements by the Bank of Japan (BoJ) and the ECB. Indeed, the widen­ ing began in earnest with the ECB's ramping-up of easing measures, including the 5 June 2014 announcement of nega­ tive rates (Graph C, left-hand panel). The announcement of ECB government bond buying (quantitative easing, QE) on 22 January 2015 also had a significant impact on the USD/ JPY basis, owing perhaps to expected policy contagion or more technical factors (eg French banks' role as JPY/USD arbitrageurs). Similarly, the BoJ's Quantitative and Qualitative Monetary Easing (QQE) announcements as well as its move to negative policy rates saw the USD/JPY basis widen. In fact,

the short-term announcement effects were even starker for the BoJ (Graph C, right-hand panel). One possible explanation for the responsiveness of the basis to monetary policy announcements is that the swap dealers that provide currency hedges expect the outflows from the euro or the yen to increase when the ECB or the BoJ eases policy. This includes the flows hedged for cur­ rency risk, which push up the demand for FX swaps or cross-currency swaps. Hence, the swap dealers set higher prices for currency hedges, which results in wider CIP devia­ tions. Conversely, when the ECB or the BoJ surprises with less easing than anticipated, dealers revise downwards the expected hedging demand coming their way, lower their prices and, hence, help narrow the basis. This happened on 3 December 2015 (green vertical line, left-hand panel): the announced ECB stimulus was lower than what market participants had expected in the run-up to the Federal Reserve's first rate hike. Such expectations had been firm­ ing during the previous month following the upbeat US jobs data release in November (orange vertical line). After the ECB announcement, market participants revised down their expected volumes of cross-currency flows out of the euro area.

M onetary policy announcem ents and one-year currency basis In basis points

Graph C

One-year currency basis

USD/EUR basis

---- USD/JPY basis

One-year basis around selected announcements

days ---- Average USD/EUR basis (Ihs) ---- Average USD/JPY basis (rhs)

The solid vertical lines in the left-hand panel correspond to the following ECB monetary policy announcements: 8 May 2014, 5 June 2014, 22 August 2014 (Jackson Hole), 22 January 2015 and 21 January 2016. The green vertical line corresponds to the ("disappointing") 3 December 2015 ECB announcement. The orange vertical line indicates the 6 November 2015 US job report. The dashed vertical lines in the left-hand panel correspond to the following Bank of Japan monetary policy announcements: 4 April 2013, 31 October 2014, 29 January 2016 plus the 16 September 2015 (S&P) Japan downgrade. The same dates are used to calculate the basis reaction around the announcement dates. Sources: Bloomberg; BIS calculations. ©See Borio and Zabai (2016) for a survey of unconventional monetary policy measures that documents and discusses these effects. On the relationship of central bank deposit rate changes and the currency basis, see Brauning and Ivashina (2016, Table IX).

340

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Currency hedging by banks, institutional investors and non-financial corporates As a percentage of 2015 GDP Australia

Graph 2 Sweden

Japan

Euro aresf

20

5.0

10

2.5

0

O0

-10

-2.5

-20

-5.0 Non-financial corporates5

Banks, in US dollars2

1 Foreign currency securities holdings of institutional investors (eg pension funds and insurance companies) multiplied by the respective currency hedge ratios; for the euro area, US dollar debt securities holding only, assuming 100% currency hedge ratios. 2 Each jurisdiction's BIS reporting banks' consolidated net US dollar assets. 3 Each jurisdiction's BIS reporting banks' consolidated net euro assets. 4 2015 quarterly average. 5 Local currency debt outstanding issued by US non-financial corporations. Sources: Hilander (2014); Rush et al (2013); ECB; Eurosystem Working Group on Securities Statistics; The Life Insurance Association of Japan; Barclays; BIS international banking statistics and debt securities statistics; authors' calculations.

positions. This is not likely to be a problem, however, since US investors have more opportunity to diversify without buying foreign currency assets, given the size of the global dollar financial markets. 1 5 For non-financial firms, we consider bonds outstanding issued by corporations headquartered outside the country, drawing on BIS international debt securities statistics. For instance, we take euro issues by US firms to fund their dollar operations, and exclude issues by banks to avoid double-counting . 1 6 We do not include dollar issuance by non-US firms because, given the predominance of the US dollar as an invoicing

15 Three quarters of US investors' holdings of foreign bonds were dollardenominated at the end of 2014 (US Treasury et al (2016)). In general, hedge ratios for foreign equity holdings are low and well below those for bonds, so that they are less of an issue (although those of Japanese shares are often hedged). Hilander (2014, p 13) reports a 20% hedge ratio on foreign shares in Sweden. 16 We could also include domestic currency issuance by foreign firms from outside the United States, which may hedge into the US dollar (given its extensive international use), or hedge back into eg the Australian dollar or Canadian dollar through the US dollar. So, our figure should best be regarded as a lower bound. At the same time, not all issuance need be hedged: some firms may prefer to incur currency risk in an attempt to lower their funding costs further.

currency, many such firms do not hedge dollar debt (eg Borio (2016)).1 17 6 1 5 Graph 2 shows indicators of hedging demand from the various sectors for four jurisdictions for which we were able to obtain better data: Australia, the euro area, Japan and Sweden. A posi­ tive value for a bar indicates net borrowing of US dollars against local currency via swaps (positive net FX hedging demand vis-avis the US dollar) for the corresponding sector, while a negative value shows net dollar lending. The figures are scaled by GDP. The graph reveals clear differences across countries and sectors. Especially noteworthy is the position of the banking sector rela­ tive to that of institutional investors. Where banks have a surplus of domestic currency deposits relative to domestic currency loans, they use the FX swap market to borrow dollars to hedge their dol­ lar lending. In doing so, they compete with domestic institutional investors that use swaps to hedge their dollar investments. As a

17 Moreover, given that credit spreads favour one currency over another, incentives to issue and put pressure on the basis are bound to be one­ sided. In the case of the dollar/euro pair, for instance, where spreads have favoured issuance in euros, euro area issuers in dollars have typi­ cally been toprated European supranationals and agencies, which can afford to issue in USD thanks to their topnotch creditworthiness. These institutions in effect operate as arbitrageurs, actively harvesting the basis (see also below). They do the same in the Australian dollar market.

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341

Currency hedging demand and three-year basis

-0.75

-0.50 -0.25 Banks' net USD liabilities (2015 average, USD trn)

0.00

0.25

AU = Australia; CA = Canada; CH = Switzerland; EA = euro area; GB = United Kingdom; JP = Japan; NO = Norway; SE = Sweden. For Sweden, net euro liabilities (horizontal axis) and the SEK/EUR basis (vertical axis). Sources: Bloomberg; BIS international banking statistics and debt securities statistics; authors' calculations.

result, banks add to the aggregate hedging demand and hence to the size of the potential imbalance. This is the case in Japan, where they have used domestic yen deposits to fund their expan­ sion abroad, mainly in dollars, by making heavy use of swaps. By contrast, in Australia and Sweden the banking sector provides a natural counterpart to institutional investors' hedging needs. That is, given the large domestic currency mortgage book relative to the domestic deposit base, banks rely on the FX swap market for funding. This offsets institutional investors' hedging demand. The hedging needs of US corporate bond issuers, which add to those of domestic institutional investors, are in general quite small compared with those of other sectors. The main exception is the recent experience in the euro area, where US nonfinancial firms' issuance in euros has surged since 2014. This reverse yankee issuance reflects the fact that euro-denominated cor­ porate credit spreads have fallen significantly relative to those in dollars, largely because of ECB bond purchase programmes (Boxes 17.2 and 17.3). The sign of the basis aligns quite well with these indicators. Where banks compete with institutional investors to borrow dol­ lars through the swap market, as in Japan, the currency basis is negative, ie dollar borrowing via the FX swap market is in higher demand and hence more costly than in the cash market. The same is true in the euro area, where non-financial firms' demand for dollar borrowing via FX swaps looms large. By contrast, in Australia, where banks offset institutional demand for hedges by lending dollars in the swap market, the currency basis is positive.

342

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In the case of Sweden, the dollar basis is negative, even though banks are in the same position as those in Australia in that cur­ rency. However, the euro/krona basis is positive. This reflects the fact that the FX swap euro market, rather than the dollar market, is the marginal funding source for excess krona lending (darker colour bars), since swapping out of euros is more expensive than out of dollars. Accordingly, the picture in Sweden resembles that in Australia once the right currency pair is chosen. 18 Focusing exclusively on the position of the banking sector in US dollars (or euros for Sweden) confirms the previous finding. In a sample of eight economies (now including also Canada, Nor­ way, Switzerland and the United Kingdom), the banks' position is consistent with the sign of the basis (Graph 3). This also sug­ gests that, in our sample, when banks are in the opposite posi­ tion to institutional investors, their hedging needs are typically larger, so that they end up being the swing factor. Note also that Australian and Swedish banks' position is indeed exceptional: banks typically add to resident institutional investors' hedging needs, rather than offsetting them. In the case of the euro area, the fit improves significantly when we add eurodenominated bonds issued by US non-financial firms (reverse yankees). This addition raises our measure of currency hedging demand in the EUR/USD pair from less than $28 billion to as much as $250 bil­ lion (the EA dot moves to the left in Graph 3). 18 Hilander (2014, Table 5) shows that, in addition to Swedish banks, foreign banks too provide currency hedges to Swedish investors, balancing them against the hedges provided to non-Swedish holders of Swedish bonds.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Sources of currency hedging demand and the JP Y /U SD basis FX hedging demand by sector USD trn

05 07 09 11 13 15 USD cross-currency funding: 4 JP banks' net USD claims JP life ins cos' FX hedged bonds2 US corporates' JPY bonds ---- Total net USD positioning

Graph 4 FX hedging demand and the basis (Jan 2008-Dec 2015)

FX hedging demand and the basis USD trn

Basis points

1.20

0

1.05

-25

0.90

-50

0.75

-75

0.60 | | | | | | | | | | | | | -100 06 08 10 12 14 16 Total net USD positioning (Ihs) Three-year basis (rhs)

I

I

I

I

- io o

1.0 1.1 1.2 1.3 Total net USD positioning, USD trn

1 Difference between gross US dollar assets and liabilities of Japanese banks; quarterly data linear-interpolated to monthly frequency. 2 Japan life insurance companies' currency-hedged US dollar bond holdings estimated by multiplying the stock of the insurance companies' FX bond holdings by their time-varying currency hedge ratios; monthly frequency. Sources: Bank of Japan; Japanese Ministry of Finance; The Life Insurance Association of Japan; Barclays FICC Research; Bloomberg; BIS international banking statistics and debt securities statistics; authors' calculations.

17.3 THE CURRENCY BASIS IN THE TIME SERIES: THE YEN/DOLLAR CASE We next test our hypothesis by examining the time series of the yen/dollar basis. This has been the most extreme and persistent non-zero basis among the major currencies, with banks and insti­ tutional investors both bidding for hedges. Moreover, it is the currency pair for which better data on the evolution of institu­ tional investors' hedging needs are available. Before turning to the evidence, a few facts can help set the context.

$0.9 trillion. During this period, banks needed dollars to finance their overseas loan expansion and to hedge their own foreign bond holdings. 1 9 Since 2015, Japanese banks have also relied more on FX swaps for USD funding due to the lower availability of wholesale USD funding, because of US MMFs' disinvestment from foreign banks' certificates of deposit and time deposits in anticipation of upcoming US MMF reform. Japanese banks have been especially affected, as they have been the largest foreign bank issuers of unse­ cured paper in US money markets; approximately two thirds of

Demand for Currency Hedges and the Basis Our measure of the aggregate US dollar hedging needs of Japanese banks, institutional investors and US non-financial firms (samurai bond issuers) has increased considerably since the crisis: from $0.9 trillion in 2009 to over $1.2 trillion in 2015 (Graph 4, left-hand panel). The banking sector has been the main driver, with its esti­ mated dollar funding gap growing from around $0 . 6 trillion to

19 The figures for Japanese banks' net US dollar positions, which are derived from the BIS international banking statistics, include both these banks' own dollar positions and those managed on behalf of their cli­ ents (in trust accounts). As a result, the figures overstate the former. It is not known how much of trust account positions is hedged. However, for the analysis that follows, it is the dynamics of the series rather than the absolute amount that is important. As long as the share of the dol­ lars held on behalf of clients in the total net dollar position of Japanese banks and their hedge ratios are relatively stable, then the inclusion of these positions should not bias our results.

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343

JP Y /U SD basis and U S-Japan repo spreads

Graph 5

The basis and the US-JP repo spread differential

The basis and quarter-end jumps in the repo spreads3

Basis points

Basis points

09 10 11 12 13 14 15 16 Lhs: Rhs: ---- 1-month basis ---- 1-month repo spread differential, US minus JP (basis points)1 2 ---- VIX (percentage points)

Basis points

2014 2015 2016 1-week repo spread differential, US minus JP (lhs) 1-week basis (rhs)

1 For the United States, repo rate minus federal funds rate; for Japan, repo rate minus call rate. 2 Chicago Board Options Exchange S&P 50( implied volatility index; standard deviation, in percentage points per annum. 3 Repo spreads and currency basis calculated using the respective OIS rates. Sources: Bloomberg; authors' calculations.

their $600 billion of liabilities in New York is unsecured funding (Pozsar and Smith (2016)).20 Thus, Japanese banks' reliance on swaps to fund their foreign assets has reduced their capacity to serve as counterparties to non-bank hedgers in cross-currency markets and to arbitrage the basis. In particular, Japanese life insurers' search for yield overseas has led them to increase FX-hedged investments in US dollar-denominated bonds (with average hedge ratios of 60-70%).21 Issuance of samurai bonds has not played a signifi­ cant role, owing to the thin corporate bond market in Japan. Confirming our hypothesis, after a clear break during the GFC, a remarkably close relationship emerged between variations in our measure of hedging demand and the basis (Graph 4, centre and right-hand panels). This is shown using the three-year basis, but

20 Assets under management have been migrating from prime US insti­ tutional MMFs to government MMFs due to the reform to be phased in in October 2016. By August 2016, prime MMFs had lost more than $360 billion in assets, according to Fitch. Non-US banks, in particular, had lost substantial amounts of MMF funding, inducing them to seek other sources of US dollars, including through FX swaps. 21 We obtained the time-varying hedge ratios of Japan's life insurance companies by courtesy of Barclays FICC Research team; see Barclays (2015). In contrast to those of life insurance companies, the hedge ratios for Japan's pension funds (dominated by the unhedged Government Pen­ sion Investment Fund) are low, and therefore ought not to affect the basis.

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the picture would be similar for other maturities. Pre-crisis, the basis was very small and stable, regardless of hedging volumes; post-crisis, it has tracked them remarkably closely. In particular, an increase in hedging demand has coincided with a widening of the basis further into negative territory.

Tighter Limits to Arbitrage and the Basis The sudden break in the basis during the GFC points to the emergence of the limits to arbitrage discussed above. But is it possible to find more direct evidence of these new balance sheet constraints? Some developments are consistent with them. First, as the GFC raised awareness of counterparty risk, many market participants switched from unsecured to secured fund­ ing sources, notably repo markets. Reliance on the repo market constrains the arbitrageurs' flexibility, since the borrower cannot obtain funds without having the underlying security to pledge as collateral. Since mid-2014, the Bank of Japan's move to increase government bond purchases (making them more scarce as col­ lateral), even as the Federal Reserve stopped its net purchases, has made dollar repo funding more expensive relative to yen repo funding. As a result, arbitraging the yen/dollar basis has become more expensive, and the basis has widened even when financial market volatility (the VIX) has remained within normal ranges (Graph 5, left-hand panel).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

CIP arbitrage by banks in U SD /JPY and by supranational bond issuers in USD/EUR

Graph

Foreign bank claims on theJapanese official sector1 and JPY/USD basis

European supranationals' 2 cumulative issuance in euros and US dollars and EUR/USD basis

Basis points

Basis points

USD bn

05 106 107 108 109 1 10 1 11 1 12 1 13 1 14 1 15 1 16 1 —

3-month USD/JPY basis (Ihs) Foreign bank claims on Japanese official sector (rhs)

6

USD bn

2014

1

Lhs: — 3-year USD/EUR basis

2015

1

2016

Bond issuance denominated in (rhs): Euros US dollars

1 Non-Japanese banks' consolidated claims on an ultimate risk basis, including yen claims booked in Japan, on the official sector, which includes the Ministry of Finance and the Bank of Japan. There was a series break in Q1 2009, when two US securities firms started to report as bank holding companies. 2 European supranational and agency issuers include CADES, the EIB, Eurofima, the KfW and OKB. Sources: Bloomberg; European Investment Bank (EIB); BIS international banking statistics and debt securities statistics; BIS calculations.

Second, since 2014 the basis has started to exhibit quarterend spikes, along with repo rates, indicating that arbitrage has become harder (Graph 5, right-hand panel). This has coincided with the greater importance attached to quarter-end reporting and regulatory ratios following regulatory reforms. Third, the riskiness of claims on the Japanese official sector may also have played a significant role. Banks' exposures to the Japanese official sector are already sizeable relative to their equity. As the basis widened, BIS reporting banks, especially big US, French and UK banks, increased their claims on the Japanese official sector from about $200 billion in Q4 2014 to $323 billion at the end of 2015, no doubt in part reflecting their arbitrage activities (Graph 6 , left-hand panel). At the end of the period, their exposure to the Japanese official sector, including both the central bank and the government, represented 10-19% of their equity. The widening of the yen/dollar basis following Standard & Poor's downgrade of Japan in 2015 highlights the role of internal limits on these exposures as a factor constraining arbitrage (see also Box 17.3). Finally, in less direct ways, developments in related markets can impede arbitrage activities. Markets for interest rate swaps are one such example. Top-rated European supranationals and agencies have relied on their funding cost advantage to arbi­ trage the basis by issuing bonds in US dollars and swapping the proceeds back into euros, thus collecting the currency basis

(Box 17.1 and Du et al (2016)). This activity is reflected in the ris­ ing share of US dollar bond liabilities of major euro area supra­ national agencies compared with their home currency (ie euro) bond liabilities (Graph 6 , righthand panel). However, such "issu­ ance arbitrage" slowed when the interest rate swap rate fell below the US Treasury yield in Q3 2015. Since such supranation­ als have to issue at rates above US Treasury yields, this inversion of US dollar interest rate swap spreads sharply increased their costs of placing a 7- to 10-year bond in US dollars and swapping it into euros. 22

Regression Results We next test for the presence of a link between hedging demand and the basis as well as the role of arbitrage constraints econometrically. Specifically, we add our quantitative indicator of aggregate hedging demand to standard specifications of the basis. 2 3 Our results provide evidence for such a link.

22 At the end of 2013, major euro area supranationals had $660 billion equivalent in euro bonds outstanding, but only $355 billion in dollar bonds. In the following six quarters, they issued $192 billion in dollar bonds and only $178 billion in euro bonds, pointing to a shift of over $10 billion per quarter from euro to dollar. 23 For a much more extensive analysis, see Sushko et al (2016).

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis

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345

Table 17.1

Regression Analysis of the JPY/USD Basis, Decem ber 2007-D ecem ber 2015

Dependent Variable

Libor-OIS (a)

Three-

-113.62***

-29.30*

month

(27.00)

(17.10)

Three-

0.06

month

(33.90)

(1.16)

-16.23***

-0.91**

-26.11***

(4.30)

(0.39)

(6 .0 0 )

Two-year Two-year

-

Demand (b)

-1.53

10 .0 2

-0.88**

(13.10)

(0.38)

Interaction Repo Spread (c) = (a) x (b) Difference (d)

-44.48*** (13.3)

-2.42 (4.80)

-44.70*** (13.60)

-26.67*** (5.98)

FX bid-ask (e) 2.16*** (0.74) 2.07*** (0.52) -0.17 (0.23) -0 .1 4 (0.23)

Constant _ 19

42

***

Observations

R2

72

0.679

67

0.794

67

0.506

67

0.509

(2.54) -15.49*** (2.3) -0.25 (0.76) -0 .1 4 (0.81)

Robust standard errors in parentheses; ***/**/* denotes significance at the 1/5/10% level. Unit root test (ADF) rejects the null in levels for three-month, which is regressed in levels; unit root test fails to reject null in levels for two-year, which is regressed in first differences. AR(1) not significant. Source: Sushko et al (2016).

The standard specification for the three-month basis—the tenor on which most of the empirical work has focused—is shown in the first row of Table 17.1. The size of the basis is considered to be a function of counterparty risk (Libor-OIS spread), funding liquidity (repo spreads) and market liquidity (currency market bid-ask spreads). This is in the spirit of, for instance, ManciniGriffoli and Ranaldo (2012) and Pinnington and Shamloo (2016). The specification performs reasonably well: the coef­ ficients of the explanatory variables are all economically and statistically significant. Once we add the quantitative indicator of hedging demand, the performance clearly improves (Table 17.1, second row). The indicator is added on its own and interacted with the Libor-OIS spread, as derived formally in Sushko et al (2016). In particular, the interaction of money market strains and hedging demand pressures (column (c), in bold) matters and money market strains alone (column (a)) now no longer exert a significant impact. The coefficient on the interaction term suggests that a 1 % rise in the Libor-OIS spread combined with 1% higher demand for forward hedges is associated with a 45 basis point wider basis. This result indicates that higher demand for hedges works together with the market dislocations identified in previous research to drive the basis. Furthermore, for the two-year basis swap, the pressure of hedg­ ing demand has a direct (linear) effect on the basis (Table 17.1, third row, in bold), while the interaction term is no longer sig­ nificant (fourth row). In particular, the estimated coefficient of —0.913 indicates that 1% higher demand for currency hedges translates into roughly a 1 basis point wider basis. This points to the cost of long-term cross-currency swaps being a more direct

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barometer of the imbalances in cross-currency flows hedged for currency risk, whereas the cost of short-term FX swaps is much more sensitive to risk premia and bank funding strains, particu­ larly during crisis episodes (Graph 1). Overall, the econometric evidence indicates that, while gener­ ally ignored, hedging demand played a role even before the widening of the basis from 2014, when market tensions were subdued. No doubt, heightened counterparty risks did influence the basis in 2008-09 and again in 2011-12. But the demand for dollar hedging has been at work throughout. 2 4 And it has con­ tinued to play a significant role since.

CONCLUSIONS We have argued that the puzzling systematic and persistent violation of CIP since the GFC reflects the combination of FX hedging demand and limits to arbitrage arising from lower balance sheet capacity, in turn due to tighter management of risks and associated balance sheet constraints. This explanation suggests that, even at the height of market tensions, hedging demand played an important, but underappreciated, role. We use BIS banking and debt securities statistics in combination with national data to construct estimates of currency hedging demand for select major currencies against the US dollar. We find that quantity-based indicators of hedging demand track the

24 See Sushko et al (2016) for broader results, including panel evidence that extends the key results beyond the yen/dollar basis using exclu­ sively the banks' position, for which consistent data are available.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

variation in the basis both across currencies at a given point in time and, in the case of the dollar/yen basis, over time. Importantly, our analysis has been largely confined to the proxi­ mate determinants of the basis, as we have not looked much into the factors driving currency hedging demand in the first place. We have mainly limited ourselves to documenting the possible importance of extraordinary monetary accommodation by the Bank of Japan and the ECB in widening the basis around policy announcements.

References Baba, N and F Packer (2009): "From turmoil to crisis: disloca­ tions in the FX swap market before and after the failure of Lehman Brothers", Journal of International Money and Finance, vol 28, no 8 , pp 1350-74. Baba, N, F Packer and T Nagano (2008): "The spillover of money market turbulence to FX swap and cross-currency swap mar­ kets", BIS Quarterly Review, March, pp 73-86.

Fender, I and P McGuire (2010): "Bank structure, funding risk and the transmission of shocks across countries: concepts and measurement", BIS Quarterly Review, September, pp 63-79. Hanajiri, T (1999): "Three Japan premiums in autumn 1997 and autumn 1998—why did premiums differ between markets?", Bank of Japan Financial Markets Department Working Paper Series, no 99-E-1. He, D, E Wong, A Tsang and K Ho (2015): "Asynchronous monetary policies and international dollar credit", Hong Kong Institute for Monetary Research, Working Papers, no 19-2015, September. Hilander, E (2014): "Short-term funding in foreign currency by major Swedish banks and their use of the short-term currency swap market", Sveriges Riksbank Economic Review, no 1, pp 1-23. lida, T, T Kimura and N Sudo (2016): "An upsurge in a CIP devia­ tion during the noncrisis period and the role of divergence in monetary policy", Bank of Japan Working Paper Series, no 16-E-14, August.

Barclays (2015): "Asia-Pacific cross-currency basis: widening pressure, from Japan to Asia", 1 December.

Ivashina, V, D Scharfstein and J Stein (2015): "Dollar funding and the lending behavior of global banks", Quarterly Journal of Eco­ nomics, vol 130, no 3, pp 1241-81.

Borio, C (2016): "More pluralism, more stability?", speech at the Seventh High-level SNB-IMF Conference on the International Monetary System, Zurich, 10 May.

Levich, R (2012): "FX counterparty risk and trading activity in currency forward and future markets", Review of Financial Eco­ nomics, 2 1 , pp 1 0 2 - 1 0 .

Borio, C and A Zabai (2016): "Unconventional monetary policies: a re-appraisal", BIS Working Papers, no 570, July.

Liao, G (2016): "Credit migration and covered interest parity", Harvard University, mimeo.

Brauning, F and V Ivashina (2016): "Monetary policy and global banking", June, mimeo.

Mancini Griffoli, T and A Ranaldo (2012): "Limits to arbitrage during the crisis: finding liquidity constraints and covered inter­ est parity", Working Papers on Finance, no 1212, University of St Gallen School of Finance.

Cetorelli, N and L Goldberg (2011): "Global banks and interna­ tional shock transmission: evidence from the crisis", IMF Eco­ nomic Review, vol 59, no 1, pp 41-76. ____(2012): "Follow the money: quantifying domestic effects of foreign bank shocks in the Great Recession", American Eco­ nomic Review, vol 102, no 3, pp 213-18. Coffey, N, W Hrung and A Sarkar (2009): "Capital constraints, counterparty risk, and deviations from covered interest parity", Federal Reserve Bank of New York, Staff Reports, no 393. Domanski, D, H S Shin and V Sushko (2015): "The hunt for dura­ tion: not waving but drowning?", BIS Working Papers, no 519, October. Du, W, A Tepper and A Verdelhan (2016): "Covered interest rate parity deviations in the post-crisis world", May, available at SSRN 2768207 2768207, SSRN. Duffie, D (2016): "Why are big banks offering less liquidity to bond markets?", Forbes, 11 March.

McCauley, R and P McGuire (2014): "Non-US banks' claims on the Federal Reserve", BIS Quarterly Review, March, pp 89-97. McGuire, P and G von Peter (2009): "The US dollar shortage in global banking", BIS Quarterly Review, March, pp 47-63. ____(2012): "The US dollar shortage in global banking and the international policy response", International Finance, June. Pinnington, J and M Shamloo (2016): "Limits to arbitrage and deviations from covered interest rate parity", Bank of Canada, Staff Discussion Papers, 16-4. Pozsar, Z and S Smith (2016): "Japanese banks, LIBOR and the FX swap lines", Credit Suisse Fixed Income Research, Global Money Notes #7, August. Rush, A, D Sadeghian and M Wright (2013): "Foreign currency exposure and hedging in Australia", Reserve Bank of Australia, Bulletin, December, pp 49-57.

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis

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347

Shin, H S (2010): Risk and liquidity, Oxford University Press. ____(2016): "Global liquidity and procyclicality", speech at the World Bank conference on The state of economics, the state of the world, Washington DC, 8 June. Shleifer, A and R Vishny (1997): "The limits of arbitrage", Journal of Finance, vol 52, no 1, pp 35-55.

348

Sushko, V, C Borio, R McCauley and P McGuire (2016): "Failure of covered interest parity: FX hedging demand and costly bal­ ance sheets", BIS Working Papers, forthcoming. US Treasury, Federal Reserve Bank of New York and Board of Governors of the Federal Reserve System (2016): US portfolio holdings o f foreign securities as of December 31, 2014, January.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques Learning Objectives After completing this reading you should be able to: Discuss how asset-liability management strategies can help a bank hedge against interest rate risk.

Describe duration gap management and apply this strategy to protect a bank's net worth.

Describe interest-sensitive gap management and apply this strategy to maximize a bank's net interest margin.

Discuss the limitations of interest-sensitive gap management and duration gap management.

Excerpt is Chapter 7 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

349

K EY TOPICS IN THIS CHAPTER • Asset, Liability, and Funds Management • Market Rates and Interest Rate Risk • The Goals of Interest Rate Hedging • Interest-Sensitive Gap Management • Duration Gap Management • Limitations of Interest Rate Risk Management Techniques

18.1 INTRODUCTION Financial institutions today are often highly complex organiza­ tions, offering multiple financial services through multiple departments, each staffed by specialists in making different kinds of decisions. 1 Thus, different groups of individuals inside each modern financial firm usually make the decisions about which customers are to receive credit, which securities should be added to or subtracted from the institution's portfolio, which terms should be offered to the public for loans, investment advice, and other services, and which sources of funding the institution should draw upon. Yet, all of the foregoing management decisions are intimately linked to each other. For example, decisions on which customer credit requests should be fulfilled are closely related to the ability of the financial firm to raise funds in order to support the requested new loans. Similarly, the amount of risk that a financial firm accepts in its portfolio is closely related to the ade­ quacy and composition of its capital (net worth), which protects its stockholders and creditors against loss. Even as a financial institution takes on more risk it must protect the value of its net worth from erosion, which could result in ultimate failure. In a well-managed financial institution all of these diverse management decisions must be coordinated across the whole institution in order to ensure they do not clash with each other, leading to inconsistent actions that damage earnings and net worth. Today financial-service managers have learned to look at their asset and liability portfolios as an integrated whole, con­ sidering how their institution's whole portfolio contributes to the firm's broad goals of adequate profitability and acceptable risk. This type of coordinated and integrated decision making is known as asset-liability management (ALM). The collection of managerial techniques known as asset-liability manage­ ment provides financial institutions with defensive weapons to handle such challenging events as business cycles and seasonal 1 Portions of this chapter are based upon Peter S. Rose's article in The Canadian Banker [6] and are used with the permission of the publisher.

350

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pressures and with offensive weapons to shape portfolios of assets and liabilities in ways that promote each institution's goals. The key purpose of this chapter is to give the reader a picture of how this integrated approach to managing assets, liabilities, and equity really works.

18.2 ASSET-LIABILITY M AN AGEM EN T STRATEGIES Asset Management Strategy Financial institutions have not always possessed a completely integrated view of their assets and liabilities. For example, through most of the history of banking, bankers tended to take their sources of funds— liabilities and equity— largely for granted. This asset management view held that the amount and kinds of deposits a depository institution held and the vol­ ume of other borrowed funds it was able to attract were largely determined by its customers. Under this view, the public deter­ mined the relative amounts of deposits and other sources of funds available to depository institutions. The key decision area for management was not deposits and other borrowings but assets. The financial manager could exercise control only over the allocation of incoming funds by deciding who was to receive the scarce quantity of loans available and what the terms on those loans would be. Indeed, there was some logic behind this asset management approach because, prior to recent deregula­ tion of the industry, the types of deposits, the rates offered, and the nondeposit sources of funds depository institutions could draw upon were closely regulated. Managers had only limited discretion in shaping their sources of funds.

Liability Management Strategy Recent decades have ushered in dramatic changes in assetliability management strategies. Confronted with fluctuating interest rates and intense competition for funds, financial firms began to devote greater attention to opening up new sources of funding and monitoring the mix and cost of their deposit and nondeposit liabilities. The new strategy was called liability management. Its goal was simply to gain control over funds sources comparable to the control financial managers had long exercised over their assets. The key control lever was price—the interest rate and other terms offered on deposits and other borrowings to achieve the volume, mix, and cost desired. For example, a lender faced with heavy loan demand that exceeded its available funds could simply raise the offer rate on its borrow­ ings relative to its competitors, and funds would flow in. On the other hand, a financial institution flush with funds but with few

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

profitable outlets for those funds could leave its offer rate unchanged or even lower that price, letting competitors out­ bid it for whatever funds were available in the marketplace. Exhibit 18.1 charts the goals of asset-liability management.

Funds Management Strategy

Managing a financial institution’s response to changing market interest rates

The maturing of liability management Exhibit 18.1 Asset-liability management in banking and financial services. techniques, coupled with more volatile interest rates and greater risk, eventu­ ally gave birth to the funds management approach, which 18.3 INTEREST RATE RISK: O N E dominates today. This view is a more balanced approach to asset-liability management that stresses several key objectives: O F THE GREATEST M AN AGEM EN T 1. Management should exercise as much control as possible over the volume, mix, and return or cost of both assets and liabilities in order to achieve the financial institution's goals. 2. Management's control over assets must be coordinated with its control over liabilities so that asset management and liability management are internally consistent and do not pull against each other, Effective coordination in man­ aging assets and liabilities will help to maximize the spread between revenues and costs and control risk exposure. 3. Revenues and costs arise from both sides of the balance sheet (i.e., from both asset and liability accounts). Manage­ ment policies need to be developed that maximize returns and effectively control costs from supplying services. The traditional view that all income received by financial firms must come from loans and investments has given way to the notion that financial institutions today sell a bundle of financial services—credit, payments, savings, financial advice, and the like—that should each be priced to cover their cost of produc­ tion. Income from managing the liability side of the balance sheet can help achieve profitability goals as much as revenues generated from managing loans and other assets. Many financial firms carry out daily asset-liability management (ALM) activities through asset-liability committees (ALCO), usually composed of key officers representing different departments of the firm.

CONCEPT CHECK 18.1. What do the following terms mean: asset manage­ ment? liability management? funds management? 18.2. What factors have motivated financial institutions to develop funds management techniques in recent years?

CH A LLEN G ES

No financial manager can completely avoid one of the toughest and potentially most damaging forms of risk that all financial institutions must face— interest rate risk. When interest rates change in the financial marketplace, the sources of revenue that financial institutions receive—especially interest income on loans and investment securities—and their most important source of expenses—interest cost on borrowings—must also change. Moreover, changing interest rates also change the market value of assets and liabilities, thereby changing each financial institution's net worth—the value of the owner's invest­ ment in the firm. Thus, changing interest rates impact both the balance sheet and the statement of income and expenses of financial firms.

Forces Determining Interest Rates The problem with interest rates is that although they are criti­ cal to most financial institutions, the managers of these firms simply cannot control either the level of or the trend in market rates of interest. The rate of interest on any particular loan or security is ultimately determined by the financial market­ place where suppliers of loanable funds (credit) interact with demanders of loanable funds (credit) and the interest rate (price of credit) tends to settle at the point where the quantities of loanable funds demanded and supplied are equal, as shown in Exhibit 18.2. In granting loans, financial institutions are on the supply side of the loanable funds (credit) market, but each lending institu­ tion is only one supplier of credit in an international market for loanable funds that includes many thousands of lenders. Similarly, financial institutions also come into the financial

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 351

Quantity of loanable funds

Exhibit 18.2 Determination of the rate of interest in the financial marketplace where the demand and supply of loanable funds (credit) interact to set the price of credit.

marketplace as demanders of loanable funds (credit) when they offer deposit services to the public or issue nondeposit lOUs to raise funds for lending and investing. But, again, each financial institution, no matter how large it is, is only one demander of loanable funds in a market containing many thou­ sands of borrowers. Thus, whether financial firms are on the supply side or the demand side of the loanable funds (credit) market at any given moment (and financial intermediaries are usually on both sides of the credit market simultaneously), they cannot determine the level, or be sure about the trend, of market interest rates. Rather, the individual institution can only react to the level of and trend in interest rates in a way that best allows it to achieve its goals. In other words, most financial managers must be price takers, not price makers, and must accept interest rate levels as a given and plan accordingly. As market interest rates move, financial firms typically face at least two major kinds of interest rate risk— price risk and reinvestment risk. Price risk arises when market interest rates rise, causing the market values of most bonds and fixed-rate loans to fall. If a financial institution wishes to sell these finan­ cial instruments in a rising rate period, it must be prepared to accept capital losses. Reinvestment risk rears its head when market interest rates fall, forcing a financial firm to invest incoming funds in lower-yielding earning assets, lowering its expected future income. A big part of managing assets and liabilities consists of finding ways to deal effectively with these two forms of risk.

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The Measurement of Interest Rates When we use the term interest rates exactly what do we mean? How are interest rates measured? Most of us understand what interest rates are because we have borrowed money at one time or another and know that interest rates are the price of credit, demanded by lenders as compensa­ tion for the use of borrowed funds. In simplest terms the interest rate is a ratio of the fees we must pay to obtain credit divided by the amount of credit obtained (expressed in percentage points and basis points [i.e., 1/100 of a percentage point]). However, over the years a bewildering array of interest rate measures have been developed. For example, one of the most popular rate measures is the yield to maturity (YTM)—the discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan or security will generate. In terms of a formula, the yield to maturity may be found from Expected cash flow Expected cash flow Current market price _ in Period 1 ^ in Period 2 ( 1 + YTM ) 1 (1 + YTM )2 of a loan or security Expected cash flow in Period n (1 + YTM)n

Sale or redemption price of security or loan in Period n (1 + YTM)n

V

where n is the number of years that payments occur. For exam­ ple, a bond purchased today at a price of $950 and promising

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

v '

an interest payment of $ 1 0 0 each year over the next three years, when it will be redeemed by the bond's issuer for $ 1 , 0 0 0 , will have a promised interest rate, measured by the yield to matu­ rity, determined by: $950 =

$100 (1 + YTM ) 1

+

$100 (1 + YTM ) 2

+

$100 (1 + YTM )3

+

$1000 (1 + YTM)

This bond's YTM is determined to be 12.10 percent. 2 Another popular interest rate measure is the bank discount rate, which is often quoted on short-term loans and money market securities (such as Treasury bills). The formula for calculating the discount rate (DR) is as follows: 100 — Purchase price on loan or security

(100 - 96) 360 DR = ----- —---- X — — = 0.16, or 16 percent 100 90 M We note that this interest rate measure ignores the effect of compounding of interest and is based on a 360-day year, unlike the yield to maturity measure, which assumes a 365-day year and assumes that interest income is compounded at the calcu­ lated YTM. In addition, the DR uses the face value of a financial instrument to calculate its yield or rate of return, a simple approach that 2 Financial calculators and spreadsheets such as Excel will give this yield to maturity figure directly after entering the bond's purchase price, promised interest payments, sales or redemption price, and number of time periods covered. (Note: the YTM for bonds is parallel to the APR for loans.) We should also note that in the real world many bonds (including those issued by the U.S. Treasury) pay interest twice a year. This feature changes the timing of various cash flows off each bond and affects the YTM, The YTM formula becomes

Price

Expected cash flow in Period 2

(1 + YTM/k)1

(1 + YTM/k)2

YTM (100 — Purchase price) equivalent = Purchase price yield

365 Days to maturity

(18.3)

For the money market security discussed previously, its equivalent yield to maturity would be

or 16 percent + 90 basis points

(18.2)

For example, suppose a money market security can be pur­ chased for a price of $96 and has a face value of $100 to be paid at maturity. If the security matures in 90 days, its interest rate measured by the DR must be

Expected cash flow in Period 1

To convert a DR to the equivalent yield to maturity we can use the formula

, (100 - 96) 365 - = 0.1690, or 16.90 percent YTM equivalent = ---- — ------ X

100 360 Number of days to maturity

makes calculations easier but is theoretically incorrect. The pur­ chase price of a financial instrument, rather than its face amount, is a much better base to use in calculating the instrument's true rate of return.

Expected cash flow and sale or redemption price in Period n X k

+ * • • H---------------------------------;----------------(1 + YTM/k)nXk

where k is the number of times interest is paid each year. Thus, the total number of payment periods is n X k.

While the two interest rate measures listed above are popular, we should keep in mind that there are literally dozens of other measures of "the interest rate," many of which we will encoun­ ter in later chapters of this book.

The Components of Interest Rates Over the years many financial managers have tried to forecast future movements in market interest rates as an aid to combat­ ing interest rate risk. However, the fact that interest rates are determined by the interactions of thousands of credit suppliers and demanders makes consistently accurate rate forecasting vir­ tually impossible. Adding to the forecasting problem is the fact that any particular interest rate attached to a loan or security is composed of multiple elements or building blocks, including

Nominal (published) market interest rate on a risky loan or security

Risk-free real Risk premiums to interest rate compensate lenders (such as the who accept risky lOUs inflationto cover their default MQ + (To.4; adjusted (credit) risk, inflation return on risk, term or maturity government risk, liquidity risk, call bonds) risk, and so on

Film toid What 2001 Australian drama finds the head of Centabank enthralled with a computer program that forecasts interest rate movements in the world's money markets?

Answer: The Bank.

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 353

Not only does the risk-free real interest rate change over time with shifts in the demand and supply for loanable funds, but the perceptions of lenders and borrowers in the financial market­ place concerning each of the risk premiums that make up any particular market interest rate on a risky loan or security also change over time, causing market interest rates to move up or down, often erratically.

Factoid True or false—interest rates cannot be negative? Answer: Contrary to popular belief they can go negative. Some of the most famous examples include (1) during the Great Depression of the 1930s when government securities sometimes sold above par as frightened depositors fled from banks; (2) briefly in the fall of 2003 in the market for repur­ chase agreements; and (3) briefly in the Treasury bill market in 2008. (See www.newyorkfed.org/research.)

Risk Premiums To cite some examples, when the economy goes into a reces­ sion with declining business sales and rising unemployment, many lenders will conclude that some businesses will fail and some individuals will lose their jobs, increasing the risk of bor­ rower default. The default-risk premium component of the interest rate charged a risky borrower will increase, raising the borrower's loan rate (all other factors held constant). Similarly, an announcement of rising prices on goods and services may trigger lenders to expect a trend toward higher inflation, reduc­ ing the purchasing power of their loan income unless they demand from borrowers a higher inflation-risk premium to com­ pensate for their projected loss in purchasing power. According to the so-called Fisher effect nominal (published) interest rates are equal to the sum of the real interest rate (or purchasing power return) on a loan plus the expected rate of inflation over the life of a loan. Many loan and security interest rates also contain a premium for liquidity risk, because some financial instruments are more difficult to sell quickly at a favor­ able price to another lender. Another rate-determining factor is call risk, which arises when a borrower has the right to pay off a loan early, possibly reducing the lender's expected rate of return if market interest rates have fallen. Finan­ cial instruments with a greater call risk tend to carry higher interest rates, other factors held equal.

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Yield Curves Another key component of each interest rate is the maturity, or term, premium. Longer-term loans and securities often carry higher market interest rates than shorter-term loans and securi­ ties due to maturity risk because of greater opportunities for loss over the life of a longer-term loan. The graphic picture of how interest rates vary with different maturities of loans viewed at a single point in time (and assuming that all other factors, such as credit risk, are held constant) is called a yield curve. Exhibit 18.3 charts different U.S. Treasury yield curves plotted in October 2009 and October 2010. The maturities of Treasury securities (in months and years) are plotted along the horizon­ tal axis of the chart and their yields to maturity (YTMs) appear along the vertical axis. Yield curves constantly change their shape because the yields of the financial instruments included in each curve change all the time. For example, we notice in Exhibit 18.3 that the relatively steep yield curve prevailing in October 2009 had become a somewhat flatter, more shallow yield curve about one year later. Moreover, different yields tend to change at different speeds with short-term interest rates tending to rise or fall faster than long-term interest rates. As illustrated in Exhibit 18.3 long-term interest rates (principally distributed along the right-hand por­ tion of the yield curve) had moved slightly downward during the October 2009 to October 2010 period, while short-term interest rates (predominantly arrayed along the left-hand portion of the yield curve) had moved over a somewhat wider range during the same time period. Thus, relative changes in short-term interest rates versus long-term interest rates clearly vary over time. This rate variation or changing yield "spread" based on maturity is very evident in the picture presented to us in Exhibit 18.4. In this exhibit, which plots the 3-month U.S. Treasury bill rate com­ pared to 10-year Treasury bond rates, we detect a significant sensitivity of short-versus long-term yield spreads to changes in

Treasury Yield Curve Percent 4.0 - ...........................

Source: Federal Reserve Bank of St. Louis, Monetary Trends, October 19, 2010.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

security holdings on the asset side of their balance sheet tend to have longer maturities than their sources of funds (liabilities).

Interest Rates Percent 18

i

-

....................................................................................................

■ • • • 9 9 mm • • » • • •

9 * 0 9 0 m•

b

» » • '• • • • * * ' * • »»

• • • »»»••»■ **•«*

••* •* » •» * * •••« * * •» •-* * •

♦• * « •

Thus, most lending institutions experience a positive maturity gap between the average maturity of their assets and the average maturity of their liabilities. If the yield curve is upward sloping, then reve­ nues from longer-term assets will outstrip expenses from shorter-term liabilities. Exhibit 18.4 The spread between short-term and long-term interest rates The result will normally be a positive net on treasury securities (October 2010). interest margin (interest revenues greater than interest expenses), which tends to Source: Federal Reserve Bank of St. Louis, Monetary Trends, November 2010. generate higher earnings. In contrast, a the economy. For example, in periods of recession (such as hap­ relatively flat (horizontal) or negatively sloped yield curve often pened in 1991, 2001, and 2007-2009 with the economy facing generates a small or even negative net interest margin, putting substantial decline), short-term interest rates tended to fall rela­ downward pressure on the earnings of financial firms that bor­ tive to long-term interest rates and the yield "spread" or "gap" row short and lend long. between short and long maturities often tended to widen. In contrast, a period of economic prosperity usually begins with a Responses to Interest Rate Risk fairly wide gap between long- and short-term interest rates, but that interest-rate gap tends to narrow and sometimes becomes As noted at the outset, changes in market interest rates can negative. damage a financial firm's profitability by increasing its cost In summary, yield curves will display an upward slope (i.e., a rising yield curve) when long-term interest rates exceed short­ term interest rates. This often happens when all interest rates are rising but short-term rates have started from a lower level than long-term rates. Modern financial theory tends to associate upward-sloping yield curves with rising interest rates and with expansion in the economy. Yield curves can also slope downward (i.e., a falling yield curve) with short-term interest rates higher than long-term rates. Such a negatively sloped yield curve suggests that interest rates will begin falling and the economy may soon head into a recession. Finally, horizontal yield curves prevail when long-term interest rates and short-term rates are approximately at the same level so that investors receive the same yield to maturity no matter what maturity of investment security they purchase. A horizontal yield curve suggests that interest rates may be stable for a time with little change occurring in the slope of the curve.

The Maturity Gap and the Yield Curve Typically managers of financial institutions that focus on lending fare somewhat better with an upward-sloping yield curve than they do under a horizontal or downward-sloping yield curve. The upward-sloping yield curve is usually more favorable for the profitability of lending institutions because their loans and

of funds, by lowering its returns from earning assets, and by reducing the value of the owners' investment (net worth or equity capital). Moreover, recent decades have ushered in a period of volatile interest rates, confronting financial managers with a more unpredictable environment to work in. A dramatic example of the huge losses associated with interest-rate risk exposure occurred some years ago in Minnesota when First Bank System, Inc., of Minneapolis bought unusually large quanti­ ties of government bonds. First Bank's management had fore­ cast a decline in interest rates. Unfortunately, bond prices fell as interest rates rose, and First Bank reported a loss of about $500 million, resulting in the sale of its headquarters building (see Bailey [2]).

Factoid As the 21st century opened and market interest rates fell to record lows, interest rate risk threatened to severely impact the net asset values of what major competitor of banks? Answer: Money market funds, which were often forced to lower their fees in order to avoid reducing the net value of their assets below the accepted market standard of $ 1 . 0 0 per share; a few money market funds were forced to actually "break the buck" during the 2007-2009 credit crisis.

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

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Asset-Liability Committee (ALCO) In recent decades managers of financial institutions have aggres­ sively sought ways to insulate their asset and liability portfolios and their profits from the ravages of changing interest rates. For example, many banks now conduct their asset-liability manage­ ment strategies under the guidance of an asset-liability commit­ tee, or ALCO. A well-run ALCO meets regularly (quarterly, monthly, or even more frequently) to manage the financial firm's interest rate risk (IRR) and other risk exposures as well. The committee is expected to have a firm grasp of the organization's principal goals, usually centered on the maximization of shareholder wealth, maintain­ ing adequate profitability, and achieving sufficient capitalization. These are often stated as specific numerical targets (e.g., an ROA of 1.5 percent and an equity-to-assets ratio of at least 10 percent). The AOL regularly conveys to the board of directors the firm's financial condition plus suggestions for correcting identi­ fied weaknesses. The committee lays out a plan for how the firm should be funded, the quality of loans that it should take on, and the proper limits to its off-balance-sheet risk exposure. The ALCO estimates the firm's risk exposure to its net interest margin and net worth ratios, develops strategies to keep that risk exposure within well-defined limits, and may employ simulation analysis to test alternative management strategies.

18.4 O N E O F THE G O ALS O F INTEREST RATE HEDGING: PROTECT THE NET INTEREST MARGIN In dealing with interest rate risk, one important goal is to insulate profits—net income—from the damaging effects of fluctuating interest rates. No matter which way interest rates go, managers of financial institutions want stable profits that achieve the level of profitability desired. To accomplish this goal, management must concentrate on those elements of the institution's portfolio of assets and liabili­ ties that are most sensitive to interest rate movements. Normally this includes loans and investments on the asset side of the balance sheet—earning assets—and borrowings on the liability side. In order to protect profits against adverse interest rate changes, then, management seeks to hold fixed the financial firm's net interest margin (NIM), expressed as follows: income ( Interest from loans

N IM

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Interest expense on\ — deposits and other

and investments borrowed funds Total earning assets Net interest income ------:-------- — = Total earning assets

/

= ------------------ -------:--------:--------------------------------

(18.5)

For example, suppose a large international bank records $4 billion in interest revenues from its loans and security invest­ ments and $2 . 6 billion in interest expenses paid out to attract borrowed funds. If this bank holds $40 billion in earning assets, its net interest margin is NIM

($4 billion — $2.6 billion) X 100 — 3.50 percent $40 billion

Note how narrow this net interest margin (which is fairly close to the average for the banking industry) is at just 3.5 percent, which is not this bank's profit from borrowing and lending funds because we have not considered noninterest expenses (such as employee salaries, taxes, and overhead expenses). Once these expenses are also deducted, the manager of this bank gener­ ally has very little margin for error against interest rate risk. If management does find a 3.5 percent net interest margin accept­ able, it will probably use a variety of interest-rate risk hedging methods to protect this NIM value, thereby helping to stabilize net earnings. If the interest cost of borrowed funds rises faster than income from loans and securities, a financial firm's NIM will be squeezed, with likely adverse effects on profits. 3 If interest rates fall and cause income from loans and securities to decline faster than interest costs on borrowings, the NIM will again be squeezed. In other words, yield curves do not usually move in parallel fashion over time, so that the spread between borrow­ ing costs and interest revenues is never constant. Management must struggle continuously to find ways to ensure that borrow­ ing costs do not rise significantly relative to interest income and threaten the margin of a financial firm.

Interest-Sensitive Gap Management as a Risk-Management Tool Among the most popular interest rate hedging strategies in use today is interest-sensitive gap management. Gap manage­ ment techniques require management to perform an analysis of the maturities and repricing opportunities associated with interest-bearing assets and with interest-bearing liabilities. If management feels its institution is excessively exposed to interest rate risk, it will try to match as closely as possible the

3 In recent years, as noted by Alden Toevs [7], the net interest income of U.S. banks has accounted for about 60 to 80 percent of their net earn­ ings. Toevs also found evidence of a substantial increase in the volatility of net interest income over time, encouraging managers of financial institutions to find better methods for managing interest-rate risk. One interesting management strategy that became prominent near the close of the 20th century and into the new century has been to deemphasize interest rate-related sources of revenue and to emphasize noninterest rate-related revenue sources (e.g., fee income).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

CONCEPT CHECK 18.3. What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates changes?

18.4. What makes it so difficult to correctly forecast inter­ est rate changes?

18.5. What is the yield curve, and why is it important to know about its shape or slope?

18.6. What is it that a lending institution wishes to protect from adverse movements in interest rates?

18.7. What is the goal of hedging? 18.8. First National Bank Bannerville has posted interest revenues of $63 million and interest coasts from all of its borrowings of $42 million. If this bank pos­ sesses $700 million in total earning assets, what is First National's net interest margin? Suppose the bank's interest revenues and interest costs double, while its earning assets increase by 50 percent. What will happen to its net interest margin?

volume of assets that can be repriced as interest rates change with the volume of liabilities whose rates can also be adjusted with market conditions during the same time period. For example, a financial firm can hedge itself against interest rate changes—no matter which way rates move—by making sure for each time period that the Dollar amount of repriceable (interest-sensitive) assets

Dollar amount of repriceable (interest-sensitive) liabilities (18.6)

In this case, the revenue from earning assets will change in the same direction and by approximately the same proportion as the interest cost of liabilities. What is a repriceable asset? A repriceable liability? The most familiar examples of repriceable assets include loans that are about to mature or will soon to come up for renewal or repric­ ing, such as variable-rate business and household loans (includ­ ing credit card accounts and adjustable-rate home mortgages (ARMs)). If interest rates have risen since these loans were first made, the lender is likely to renew them only if it can get a rate of return that approximates the higher yields currently expected on other financial instruments of comparable quality. Similarly, loans that are maturing will provide the lender with newly released funds available to reinvest in new loans at today's inter­ est rates. In contrast, repriceable liabilities include a depository institu­ tion's certificates of deposit (CDs) about to mature or eligible to be renewed, where the financial firm and its customer must negotiate new deposit interest rates that capture current market conditions. Other examples include floating-rate deposits whose yields move up or down automatically with market interest rates; savings accounts that may be likely to be withdrawn at any time to seek out more favorable returns; interest-bearing checkable deposits (such as NOW accounts); and nondeposit money mar­ ket borrowings whose interest rates are often adjusted several times daily to reflect the latest market developments. What happens when the amount of repriceable assets does not equal the amount of repriceable liabilities? Clearly, a gap then exists between these interest-sensitive assets and interestsensitive liabilities. The gap is the portion of the balance sheet affected by interest rate risk: Interest-sensitive qap = Interest-sensitive assets 1 — Interest-sensitive liabilities

/I O

7\

Examples of Repriceable (Interest-Sensitive) Assets and (Interest-Sensitive) Liabilities and Nonrepriceable Assets and Liabilities Repriceable (Interest-Sensitive) Assets

Repriceable (Interest-Sensitive) Liabilities

Nonrepriceable Assets

Nonrepriceable Liabilities

Short-term securities issued by governments and private borrowers (about to mature)

Borrowings from the money market (such as federal funds or RP borrowings)

Cash in the vault and deposits at the Central Bank (legal reserves)

Demand deposits (which pay no interest rate or a fixed interest rate)

Short-term loans made to borrowing customers (about to mature)

Short-term savings accounts

Long-term loans made at a fixed interest rate

Long-term savings and retirement accounts

Variable-rate loans and securities

Money-market deposits (whose interest rates are adjustable frequently

Long-term securities carry­ ing fixed rates Buildings and equipment

Equity capital provided by the financial institution's owners

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If interest-sensitive assets in each planning period (day, week, month, etc.) exceed the volume of interest-sensitive liabilities subject to repricing, the financial firm is said to have a positive gap and to be asset sensitive. Thus: Asset-sensitive (positive) gap

Interest-sensitive assets (18.8) — Interest-sensitive liabilities > 0

For example, a bank with interest-sensitive assets of $500 million and interest-sensitive liabilities of $400 million is asset sensi­ tive with a positive gap of $100 million. If interest rates rise, this bank's net interest margin will increase because the interest revenue generated by assets will increase more than the cost of borrowed funds. Other things being equal, this financial firm will experience an increase in its net interest income. On the other hand, if interest rates fall when the bank is asset sensitive, this bank's NIM will decline as interest revenues from assets drop by more than interest expenses associated with liabilities. The financial firm with a positive gap will lose net interest income if interest rates fall. In the opposite situation, suppose an interest-sensitive bank's liabilities are larger than its interest-sensitive assets. This bank then has a negative gap and is said to be liability sensitive. Thus: Liability-sensitive (negative) gap

_____ 4 Interest-sensitive assets (18.9) —Interest-sensitive liabilities < 0

A financial institution holding interest-sensitive assets of $150 million and interest-sensitive liabilities of $ 2 0 0 million is liability sensitive, with a negative gap of $50 million. Rising interest rates will lower this institution's net interest margin, because the ris­ ing cost associated with interest-sensitive liabilities will exceed increases in interest revenue from interest-sensitive assets. Falling interest rates will generate a higher interest margin and probably greater earnings as well, because borrowing costs will decline by more than interest revenues. Actually, there are several ways to measure the interestsensitive gap (IS GAP). One method is called simply the Dol­ lar IS GAP. For example, as we saw above, if interest-sensitive assets (ISA) are $150 million and interest-sensitive liabilities (ISL) are $200 million, then the Dollar IS GAP = ISA — ISL = $150 million — $200 million = —$50 million. Clearly, an insti­ tution whose Dollar IS GAP is positive is asset sensitive, while a negative Dollar IS GAP describes a liability-sensitive condition.

An Asset-Sensitive Financial Firm Has:

A Liability-Sensitive Financial Firm Has:

Positive Dollar IS GAP

Negative Dollar IS GAP

Positive Relative IS GAP

Negative Relative IS GAP

Interest Sensitivity Ratio greater than one

Interest Sensitivity Ratio less than one

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We can also form the Relative IS GAP ratio: Relative _ IS GAP IS GAP Size of financial institution (measured, for example, by total assets)

—$50million $150million

-0.33

(18.10) A Relative IS GAP greater than zero means the institution is asset sensitive, while a negative Relative IS GAP describes a liability-sensitive financial firm. Finally, we can simply com­ pare the ratio of ISA to ISL, sometimes called the Interest Sensitivity Ratio (ISR). Based on the figures in our previous example, , ^ .. . _ . ISA $150 million Interest Sensitivity Ratio (ISR) = —— = — — — —— = 0.75 ISL $200 million (18.11) In this instance an ISR of less than 1 tells us we are looking at a liability-sensitive institution, while an ISR greater than unity points to an asset-sensitive institution. Only if interest-sensitive assets and liabilities are equal is a financial institution relatively insulated from interest rate risk. In this case, interest revenues from assets and funding costs will change at the same rate. The interest-sensitive gap is zero, and the net interest margin is protected regardless of which way interest rates go. As a practical matter, however, a zero gap does not eliminate all interest rate risk because the interest rates attached to assets and liabilities are not perfectly correlated in the real world. Loan interest rates, for example, tend to lag behind interest rates on many money market borrowings. So interest revenues often tend to grow more slowly than interest expenses during economic expansions, while interest expenses tend to fall more rapidly than interest revenues during economic downturns. Gapping methods used today vary greatly in complexity and form. All methods, however, require financial managers to make some important decisions:

1. Management must choose the time period during which the net interest margin (NIM) is to be managed (e.g., six months or one year) to achieve some desired value and the length of subperiods ("maturity buckets") into which the planning period is to be divided.

2. Management must choose a target level for the net inter­ est margin—that is, whether to freeze the margin roughly where it is or perhaps increase the NIM.

3. If management wishes to increase the NIM, it must either develop a correct interest rate forecast or find ways to real­ locate earning assets and liabilities to increase the spread between interest revenues and interest expenses.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

4. Management must determine the volume of interestsensitive assets and interest-sensitive liabilities it wants the financial firm to hold.

Computer-Based Techniques Many institutions use computer-based techniques in which their assets and liabilities are classified as due or repriceable today, during the coming week, in the next 30 days, and so on. Man­ agement tries to match interest-sensitive assets with interestsensitive liabilities in each of these maturity buckets in order to improve the chances of achieving the financial firm's earnings goals. For example, a financial firm's latest computer run might reveal the following:

(dollars in millions) Maturity Buckets 1 day (next 24 hours)

Day 2-day 7

Interest- InterestSensitive Sensitive Assets

Size of Gap

Cumulative Gap

$40

$30

+1 0

+1 0

120

160

-4 0

-3 0

+ 20

- 1 0

Day 8 -day 30

85

65

Day 31-day 90

280

250

+30

+ 20

Day 91-day 120

455

395

+60

+80

•

•

•

•

•

•

•

•

•

•

•

•

•

•

•

It is obvious from the table above that the time period over which the gap is measured is crucial to understanding this finan­ cial institution's true interest-sensitive position. For example, within the next 24 hours, the institution in this example has a positive gap; its earnings will benefit if interest rates rise between today and tomorrow. However, a forecast of rising money market interest rates over the next week would be bad news because the cumulative gap for the next seven days is negative, which will result in interest expenses rising by more than interest revenues. If the interest rate increase is expected to be substantial, management should consider taking coun­ termeasures to protect earnings. These might include selling longer-term CDs right away or using futures contracts to earn a profit that will help offset the margin losses that rising inter­ est rates will almost surely bring in the coming week. Looking over the remainder of the table, it is clear the institution will fare much better over the next several months if market interest rates rise, because its cumulative gap eventually turns positive again.

The foregoing example reminds us that the net interest margin of a financial-service provider is influenced by multiple factors: 1. Changes in the level of interest rates, up or down. 2. Changes in the spread between asset yields and liability costs (often reflected in the changing shape of the yield, curve between long-term rates and short-term rates). 3. Changes in the volume of interest-bearing (earning) assets a financial institution holds as it expands or shrinks the overall scale of its activities. 4. Changes in the volume of interest-bearing liabilities that are used to fund earning assets as a financial institution grows or shrinks in size. 5. Changes in the mix of assets and liabilities that manage­ ment draws upon as it shifts between floating and fixed-rate assets and liabilities, between shorter and longer maturity assets and liabilities, and between assets bearing higher versus lower expected yields (e.g., a shift from less cash to more loans or from higher-yielding consumer and real estate loans to lower-yielding commercial loans). Table 18.1 provides a more detailed example of interest-sensitive gap management techniques as they are applied to asset and liability data for an individual bank. In it, management has arrayed (with the help of a computer) the amount of all the bank's assets and liabilities, grouped by the future time period when those assets and liabilities will reach maturity or their interest rates will be subject to repricing. Note that this bank is liability sensitive during the coming week and over the next 90 days and then becomes asset sensitive in later periods. Consciously or uncon­ sciously, management has positioned this institution for falling interest rates over the next three months and for rising interest rates over the longer horizon. At the bottom of Table 18.1, we calculate this financial firm's net interest income to see how it will change if interest rates rise. Net interest income can be derived from the following formula: Net interest income = Total interest income - Total interest cost = [Average interest yield on rate-sensitive assets X Volume of rate-sensitive assets + Average interest yield on fixed (non-rate-sensitive) assets X Volume of fixed assets] - [Average interest (18.12) cost on rate-sensitive liabilities X Volume of interestsensitive liabilities + Average interest cost on fixed (non-rate-sensitive) liabilities X Volume of fixed (non-rate-sensitive) liabilities] For example, suppose the yields on rate-sensitive and fixed assets average 1 0 percent and 1 1 percent, respectively, while rate-sensitive and non-rate-sensitive liabilities cost an average of

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

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Table 18.1

Sample Interest-Sensitivity Analysis (GAP Management) for a Bank

Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Asset and Liability Items

One Week

Next 8-30 Days

Next 31-90 Days

Next 91-360 Days

More than One Year

Total for All Assets, ■+I+I+I+ Liabilities, and1 Net Worth on the Bank's Balance Sheet

Assets $100

—

Marketable securities

200

$50

$80

Business loans

750

150

220

Real estate loans

500

80

80

70

170

900

Consumer loans

100

20

20

70

90

300

40

200

Cash and deposits owned

— $ 110

170

—

$100

$460 210

900 1,500

50 —

—

40 —

60 —

$1,700

$310

$440

$480

$1,170

$4,100

—

—

—

$900

Farm loans Buildings and equipment Total repriceable (interest sensitive) assets

—

10

200

200

Liabilities end Net Worth Checkable deposits

$800

$100

50

50

—

—

—

100

Money market deposits

550

150

—

—

—

700

Long-term time deposits

100

200

450 —

150 —

300 —

—

—

Savings accounts

Short-term borrowings

300 —

Other liabilities

100

—

Interest-sensitive gap (repriceable assets repriceable liabilities) Cumulative gap Ratio of interest-sensitive assets to interest-sensitive liabilities

$1,800 -$ 1 0 0

-$ 1 0 0

94.4%

$600 -$290

$450 - $ 1 0

400

100

100

700

700

$150

$1,100

$4,100

+$330

+$70

Net worth Total repriceable (interest-sensitive) liabilities and net worth

1,20 0

-$390

-$400

—$70

51.7%

97.8%

320%

- 0

106.4%

This bank is

Liability sensitive

Liability sensitive

Liability sensitive

Asset sensitive

Asset sensitive

The bank's net interest margin will likely be squeezed if

Interest rates rise

Interest rates rise

Interest rates rise

Interest rates fall

Interest rates fall

Suppose that interest yields on interest-sensitive assets currently average 10%, while interest-sensitive liabilities have an average cost of 8 %, In contrast, fixed assets yield 11% and fixed liabilities cost 9%. If interest rates stay at these levels, the bank's net interest income and net interest margin measured on an annualized basis will be as follows:

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Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Next 91-360 Days

More than One Year

Total for All Assets, Liabilities, and Net Worth on the Bank's Balance Sheet

Next 8-30 Days

Next 31-90 Days

Next 91-360 Days

More than One Year

0.10 x $1,700

0.10 x $310

0.10 X $440

0.10 X $480

0.10 x $1,170

+0.11 X

+0 . 1 1 x

+0.11 X

+0.11 X

+0.11 X

[4,100 - 1,700]

[4,100 - 310]

4,100 - 440]

[4,100 - 480]

[4,100 - 1,170]

-0 .0 8 x $1,800

-0.08 X

-0.08 X

-0 ,0 8 X

-0 .0 8 X

-0 .0 9 x

$600 - 0.09 X

$450 - 0.09 X

$150 - 0,09 X

$1,100 - 0.09 X

[4,100 - 1,800]

[4,100 - 600]

[4,100 - 45]

[4,100 - 150]

[4,100 - 1,100]

Annualized net interest income

=$83

=$84.9

=$82.10

= $80.20

=$81.30

Annualized net interest margin

$83 -5- 4,100

$84.9

$78.7 -J- 4,100

$81.3 -5- 4,100

= 2 .0 2 %

=2.07%

= 1,92%

= 1.98%

Asset and Liability Items

Total interest income on an annualized basis

Total interest costs on an annualized basis

One Week

Next 8-30 Days

One Week

Next 31-90 Days

4,100

$82.10

-5-

4,100

= 2 .0 0 %

Suppose the interest rates attached to rate-sensitive assets and liabilities rise two full percentage points on an annualized basis to 1 2 % and 1 0 %, respectively. Total interest income on an annualized basis

0.12 X $1,700

0.12 X $310

0.12 X $440

0.12 X $480

0.12 x $1,170

+0.11 X [4,100-

+0,11 X

+0.11 X

+0.11 X

+0.11 X

Total interest cost on an annualized basis

1,700] - 0.10 X

[4,100 - 310]

[4,100 - 440]

+[4,100 - 480] [4,100 - 1,170]

$1,800 - 0.09 X

-0 .1 0 X 600

-0 .1 0 X 450

-0 .1 0 X 150

-

[4,100 - 1,800]

-0 .0 9 X [4,100 - 600]

-0.09 X [4,100 - 450]

-0 .0 9 [4,100 - 150]

x 1,100 - 0.09 [4,100 - 1,100

Annualized net interest income

=$81

=$79.10

=$81.90

=$85.30

=$82.70

Annualized net interest margin

$81 - 4,100

$79.1

$85.3 - 4,100

$82.7

= 1.98%

= 1.93%

=2.08%

= 2 .0 2 %

4,100

$81.9 = 2 .0 0 %

4,100

0 .10

4,100

We note by comparing annualized interest income and margins for each time period (maturity bucket) that this bank's net interest income and margin will tend to fall if it is liability sensitive when interest rates go up. When the bank is asset sensitive and market interest rates rise, the net interest income and margin will tend to increase.

8 percent and 9 percent, respectively. During the coming week the bank holds $1,700 million in rate-sensitive assets (out of an asset total of $4,100 million) and $1,800 million in rate-sensitive liabilities. Suppose, too, that these annualized interest rates remain steady. Then this institution's net interest income on an annualized basis will be

0.10 X $1,700 + 0.11 x [4,100 - 1,700] - 0.08 X $1,800 - 0.09 X [4,100 - 1,800] = $83 million

However, if the market interest rate on rate-sensitive assets rises to 1 2 percent and the interest rate on rate-sensitive liabilities rises to 1 0 percent during the first week, this liability-sensitive institution will have an annualized net interest income of only 0.12 x $1,700 + 0.11 X [4,100 - 1,700] - 0.10 x $1,800 - 0.09 X [4,100 - 1,800] = $81 million Therefore, this bank will lose $2 million in net interest income on an annualized basis if market interest rates rise in the coming

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 361

week. Management must decide whether to accept that risk or to counter it with hedging strategies or tools.

interest rates rise, but lose net interest income if market interest rates decline.

A useful overall measure of interest rate risk exposure is the cumulative gap, which is the total difference in dollars between those assets and liabilities that can be repriced over a desig­ nated period of time. For example, suppose that a bank has $ 1 0 0 million in earning assets and $ 2 0 0 million in liabilities subject to an interest rate change each month over the next six months. Then its cumulative gap must be -$600 million— that is: ($100 million in earning assets per month X 6 ) — ($200 million in liabilities per month X 6 ) = —$600 million.

Some financial firms shade their interest-sensitive gaps toward either asset sensitivity or liability sensitivity, depending on their degree of confidence in their own interest rate forecasts. This is often referred to as aggressive GAP management. For example, if management firmly believes interest rates are going to fall over the current planning horizon, it will probably allow interest-sensitive liabilities to climb above interest-sensitive assets. If interest rates do fall as predicted, liability costs will drop by more than revenues and the institution's NIM will grow. Similarly, a confident forecast of higher interest rates will trig­ ger many financial firms to become asset sensitive, knowing that if rates do rise, interest revenues will rise by more than interest expenses. Of course, such an aggressive strategy cre­ ates greater risk. Consistently correct interest rate forecasting is impossible; most financial managers have learned to rely on hedging against, not forecasting, changes in market interest rates. Interest rates that move in the wrong direction can mag­ nify losses. (See Table 18.2.)

The cumulative gap concept is useful because, given any specific change in market interest rates, we can calculate approximately how net interest income will be affected by an interest rate change. The key relationship is this: Change in net interest income

=

Overall change in interest rate (in percentage points)

X

Size of the cumulative gap (in dollars) (18.13)

For example, suppose market interest rates suddenly rise by 1 full percentage point. Then the bank in the example given above will suffer a net interest income loss of approximately (+0.01) X (—$600 million) =

— $6

million

Aggressive Interest-Sensitive GAP Management Expected Changes in interest Rates (Management's Forecast) Rising market interest rates

Best Interest-Sensitive GAP Position to Be in:

Aggressive Management's Most Likely Action

Positive IS GAP

Increase interestsensitive assets Decrease interestsensitive liabilities

Falling market interest rates

Negative IS GAP

Decrease interestsensitive assets Increase interestsensitive liabilities

If management anticipates an increase in interest rates, it may be able to head off this pending loss of income by shifting some assets and liabilities to reduce the size of the cumulative gap or by using hedging instruments (such as financial futures con­ tracts, to be discussed in Chapter 8 ). In general, financial insti­ tutions with a negative cumulative gap will benefit from falling interest rates but lose net interest income when interest rates rise. Institutions with a positive cumulative gap will benefit if

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Many financial-service managers have chosen to adopt a purely defensive GAP management strategy: Defensive Interest-Sensitive GAP Management Set interest-sensitive GAP as close to zero as possible to reduce the expected volatility of net interest income

Problems with Interest-Sensitive GAP Management While interest-sensitive gap management works beautifully in theory, practical problems in its implementation always leave financial institutions with at least some interest-rate risk expo­ sure. For example, interest rates paid on liabilities (which often are predominantly short term) tend to move faster than interest rates earned on assets (many of which are long term). Then, too, changes in interest rates attached to assets and liabilities do not necessarily move at the same speed as do interest rates in the open market. In the case of a bank, for example, deposit interest rates typically lag behind loan interest rates. Some financial institutions have developed a weighted interestsensitive gap approach that takes into account the tendency of interest rates to vary in speed and magnitude relative to each other and with the up and down cycle of business activity. The interest rates attached to assets of various kinds often change by different amounts and at different speeds than many of the interest rates attached to liabilities—a phenomenon called basis risk.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The Weighted Interest-Sensitive Gap: Dealing with Basis Risk Original Balance Sheet Entries

Interest-Rate Sensitivity Weight

Balance Sheet Refigured to Reflect interest Rata Sensitivities

Asset items sensitive to interest rate movements: Federal funds loans Government securities and other investments Loans and leases Total rate-sensitive assets

$50 25

X

1.0

X

1.3

125

X

1.5

—

$50.00 32.50 187.50 $270.00

$200

Liability items sensitive to interest rate movements: Interest-bearing deposits Other borrowings in the money market

$159 64

Total rate-sensitive liabilities

$223

$195.00

—$23i

+$75

The interest-sensitive GAP

X

0 .8 6

X

0.91

$137,00 58.00

How net interest income would change if the federal funds rate in the money market increases by 2 percentage points: Predicted movement in net interest income

Original Balance Sheet

Refigured Balanced Sheet

-$0.46

+$1.50

(= -$23 X 0.02)

(= +$75 X 0.02)

Eliminating an Interest-Sensitive Gap With Positive Gap

The Risk

Possible Management Responses

Interest-sensitive assets > interestsensitive liabilities (asset sensitive)

Losses if interest rates fall because the net interest margin will be reduced.

1. Do nothing (perhaps interest rates will rise or be stable).

2. Extend asset maturities or shorten liability maturities.

3. Increase interest-sensitive liabilities or reduce interest-sensitive assets.

With Negative Gap

The Risk

Possible Management Responses

Interest-sensitive assets < interestsensitive liabilities (liability sensitive)

Losses if Interest rates rise because the net interest margin will be reduced.

1. Do nothing (perhaps interest rates will fall or be stable).

2. Shorten asset maturities or lengthen liability maturities.

3. Decrease interest-sensitive liabilities or increase interest-sensitive assets.

For example, suppose a bank has the current amount and distribution of interest-sensitive assets and liabilities shown in the table at the bottom of page 234 with rate-sensitive assets totaling $ 2 0 0 million and rate-sensitive liabilities amounting to $223 million, yielding an interest-sensitive GAP of-$23 on its present balance sheet. Its federal funds loans generally carry interest rates set in the open market, so these loans have an

interest rate sensitivity weight of 1 . 0 —that is, we assume the bank's fed funds rate tracks market rates one for one. In this bank's investment security portfolio, however, suppose there are some riskier, somewhat more rate-volatile investments than most of the security interest rates reported daily in the financial press. Therefore, its average security yield moves up and down by somewhat more than the interest rate on

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 363

Factoid Financial institutions that hold large volumes of home mort­ gage loans tend to be especially vulnerable to interest rate risk due, in part, to the long average maturities of these loans. A prominent example is two of the largest homemortgage finance companies in the world, which were created by the U.S. government and then privatized. Who are these two giant mortgage banking firms that have run into serious trouble recently? Answer: The Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac), both of which have recently passed under government control and may eventu­ ally be disposed of.

federal funds loans; here the interest-rate sensitivity weight is estimated to be 1.3. Loans and leases are the most ratevolatile of all with an interest rate sensitivity weight half again as volatile as federal funds rates at an estimated 1.5. On the liability side, deposit interest rates and some money market borrowings (such as borrowing from the central bank) may change more slowly than market interest rates. In this example, we assume deposits have a rate-sensitive weight of 0 . 8 6 and money market borrowings are slightly more volatile at 0.91, close to but still less than the volatility of federal funds interest rates. We can simply multiply each of the rate-sensitive balance-sheet items by its appropriate interest rate sensitivity indicator, which acts as a weight. More rate-volatile assets and liabilities will weigh more heavily in the refigured (weighted) balance sheet we are constructing in the previous table. Notice that after mul­ tiplying by the interest rate weights we have created, the new weighted balance sheet has rate-sensitive assets of $270 and rate-sensitive liabilities of $195. Instead of a negative (liabilitysensitive) interest rate gap of —$23, we now have a positive (asset-sensitive) rate gap of +$75. Thus, this institution's interest-sensitive gap has changed direction and, instead of being hurt by rising market interest rates, for example, this financial firm would actually benefit from higher market interest rates. Suppose the federal funds interest rate rose by 2 percentage points (+0.02). Instead of declining by —$0.46, this bank's net interest income increases by $1.50. Clearly, management would have an entirely differ­ ent reaction to a forecast of rising interest rates with the new weighted balance sheet than it would have with its original,

364

■

CONCEPT CHECK 18.9.

Can you explain the concept of gap management?

18.10. When is a financial firm asset sensitive? Liability sensitive? 18.11. Commerce National Bank reports interest-sensitive assets of $870 million and interest-sensitive liabili­ ties of $625 million during the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the bank's net interest mar­ gin if interest rates rise? If they fall?

18.12. People's Savings Bank has a cumulative gap for the coming year of +$135 million, and interest rates are expected to fall by two and a half per­ centage points. Can you calculate the expected change in net interest income that this thrift insti­ tution might experience? What change will occur in net interest income if interest rates rise by one and a quarter percentage points?

18.13. How do you measure the dollar interest-sensitive gap? The relative interest-sensitive gap? What is the interest sensitivity ratio?

18.14. Suppose Carroll Bank and Trust reports interestsensitive assets of $570 million and interestsensitive liabilities of $685 million. What is the bank's dollar interest-sensitive gap? Its relative interest-sensitive gap and interest-sensitivity ratio?

18.15. Explain the concept of weighted interest-sensitive gap. How can this concept aid management in measuring a financial institution's real interestsensitive gap risk exposure?

conventionally constructed balance sheet. Indeed, when it comes to assessing interest rate risk, things are not always as they appear! Moreover, the point at which certain assets and liabilities can be repriced is not always easy to identify. For example, checkable deposits and savings accounts may have their inter est rates adjusted up or down at any time. And the choice of planning periods over which to balance interest-sensitive assets and liabilities is highly arbitrary. Some items always fall between the cracks in setting planning periods, and they could cause trouble if interest rates move against the

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

financial firm. Wise asset-liability managers use several dif­ ferent lengths of planning periods ("maturity buckets") in measuring their possible exposure to changing market interest rates. Finally, interest-sensitive gap management does not con­ sider the impact of changing interest rates on the owners' (stockholders') position in the financial firm as represented by the institution's net worth. Managers choosing to pursue an aggressive interest rate sensitive gap policy may be able to expand their institution's net interest margin, but at the cost of increasing the volatility of net earnings and reducing the value of the stockholders' investment (net worth). Effective assetliability management demands that financial managers work to achieve desirable levels of both net interest income and net worth.

The standard formula for calculating the duration (D) of an indi­ vidual financial instrument, such as a loan, security, deposit, or nondeposit borrowing, is ^ X Expected CF in Period t X Period t/(1 + YTM )1 : =1_______________________________________________________ Expected CF in Period t

(1 + YTM )1 (18.14) D stands for the instrument's duration in years and fractions of a year; t represents the period of time in which each flow of cash off the instrument, such as interest or dividend income, is to be received; CF indicates the volume of each expected flow of cash in each time period (t); and YTM is the instrument's current yield to maturity. We note that the denominator of the above formula is equivalent to the instrument's current market value (price). So, the duration formula can be abbreviated to this form:

18.5 THE C O N C EP T O F DURATION AS A RISK-M ANAGEM ENT TO O L In the preceding sections of this chapter we examined a key management tool— interest-sensitive gap management—that enables managers of financial institutions to combat the pos­ sibility of losses to their institution's net interest margin or spread due to changes in market interest rates. Unfortunately, changing interest rates can also do serious damage to another aspect of a financial firm's performance—its net worth, the value of the stockholders' investment in the institution. Just because the net interest margin is protected against interest rate risk doesn't mean an institution's net worth is also shel­ tered from loss, and for most companies net worth is more important than their net interest margin. This requires the application of yet another managerial tool— duration gap management. We turn now to look at the concept of duration and its many valuable uses.

What Is Duration? Duration is a value- and time-weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities. It measures the average maturity of a promised stream of future cash payments (such as the payment streams that a financial firm expects to receive from its loans and security investments or the stream of interest payments it must pay out to its depositors). In effect, duration measures the average time needed to recover the funds committed to an investment.

n

^ Expected CF X Period t/(1 + YTM )11 Current Market Value or Price

(18.15)

For example, suppose that a bank grants a loan to one of its customers for a term of five years. The customer promises the bank an annual interest payment of 1 0 percent (that is, $ 1 0 0 per year). The face (par) value of the loan is $1,000, which is also its current market value (price) because the loan's current yield to maturity is 10 percent. What is this loan's duration? The formula with the proper figures entered would be this: 5

i~) L o a n

L o a n

D Loan

2 $ 1 0 0 X t/(1 + .10)* + $1,000 X 5/(1 + .10 )5 _ t =i_________________________________________________ $1,000 _ $4,169.87 _ $ 1,000 — 4.17 years

We can calculate duration of this loan a little more simply by setting up the table below to figure the components of the for­ mula. As before, the duration of the loan is $4,169.87/$1,000.00, or 4.17 years. We recognize from Chapter 5 that the net worth (NW) of any business or household is equal to the value of its assets less the value of its liabilities: NW = A — L

(18.16)

As market interest rates change, the value of both a finan­ cial institution's assets and its liabilities will change, resulting in a change in its net worth (the owner's investment in the institution):

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 365

Period of Expected Cash Flows r Expected Interest Income from loan


oUU

Then Average liability duration (D J = 3324 y6arS Suppose, once again, market interest rates all rise from 8 percent to 10 percent. Then the change in the value of net worth would be as shown below: Change in ( — 0 . 02 ) value of — —3.047 years X —----- — — X $300 million y (1 + 0.08) net worth = —$16.93 million + $16.93 million = 0

( + 0 .02) —3.324 years X —----X $275 million y (1 + 0.08)

As expected, with asset and liability durations perfectly balanced (and adjusted for differences in the amounts of total assets ver­ sus total liabilities), the change in net worth must be zero. Net worth doesn't move despite the rise in market interest rates. It shouldn't surprise us to discover that if market interest rates drop from, say, 8 percent to 6 percent, net worth will also not change if asset and liability durations are perfectly balanced. Thus: Change in ( — 0 . 02 ) value of — —3.047 years X —----- — — X $300 million y (1 + 0.08) net worth = +$16.93 million — $16.93 million = 0

( - 0 . 02) —3.324 years X ------- — X $275 million y 1 + .08

The change in the value of the financial firm's net worth must be zero because assets and liabilities, adjusted for the difference in their dollar amounts, exhibit a similar response to interest rate movements. In summary, the impact of changing market interest rates on net worth is indicated by entries in the following table:

If the Financial Institution's Leverage-Adjusted Duration Gap Is: Positive DA > DL X

Liabilities Assets

And If Interest Rates:

The Financial Institution's Net Worth Will:

Rise

Decrease

Fall

Incrgease Increase

Negative Zero

Decrease — Di X

Liabilities Assets

Rise

No Change

Fall

No Change

In the final case, with a leverage-adjusted duration gap of zero, the financial firm is immunized against changes in the value of its net worth. Changes in the market values of assets and liabilities will simply offset each other and net worth will remain where it is. Of course, more aggressive financial-service managers may not like the seemingly "wimpy" strategy of portfolio immunization

(duration gap = 0). They may be willing to take some chances in an effort to maximize the shareholders' position. For example,

Expected Change in Interest Rates

Management Action

Possible Outcome

Rates will rise

Reduce DA and increase DL (moving closer to a negative duration gap).

Net worth increases (if management's rate forecast is correct).

Rates will fall

Increase DA and reduce DL (moving closer to a positive duration gap).

Net worth Increases (if management's rate forecast is correct).

18.7 THE LIMITATIONS O F DURATION GAP M AN AGEM EN T While duration is simple to interpret, it has limitations. For one thing, finding assets and liabilities of the same duration that fit into a financial-service institution's portfolio is often a frustrating task. It would be much easier if the maturity of a loan or security

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

equaled its duration; however, for financial instruments paying out gradually over time, duration is always less than calendar maturity. Only in the case of instruments like zero-coupon secu­ rities, single-payment loans, and Treasury bills does the duration of a financial instrument equal its calendar maturity. The more frequently a financial instrument pays interest or pays off princi­ pal, the shorter is its duration. One useful fact is that the shorter the maturity of an instrument, the closer the match between its maturity and its duration is likely to be. Some accounts held by depository institutions, such as check­ able deposits and passbook savings accounts, may have a pattern of cash flows that is not well defined, making the cal­ culation of duration difficult. Moreover, customer prepayments distort the expected cash flows from loans and so do customer defaults (credit risk) when expected cash flows do not happen. Moreover, duration gap models assume that a linear relationship

CONCEPT CHECK 18.16. What is duration? 18.17. How is a financial institution's duration gap determined? 18.18. What are the advantages of using duration as an asset-liability management tool as opposed to interest-sensitive gap analysis? 18.19. How can you tell if you are fully hedged using duration gap analysis? 18.20. What are the principal limitations of duration gap analysis? Can you think of some way of reducing the impact of these limitations? 18.21. Suppose that a savings institution has an aver­ age asset duration of 2.5 years and an average liability duration of 3.0 years. If the savings/institutiori holds total assets of $560 million and total liabilities of $467 million, does it have a significant leverage-adjusted duration gap? If interest rates rise, what will happen to the value of its net worth? 18.22. Stilwater Bank and Trust Company has an aver­ age asset duration of 3.25 years and an average liability duration of 1.75 years. Its liabilities amount to $485 million, while its assets total $512 million. Suppose that interest rates were 7 percent and then rise to 8 percent. What will happen to the value of the Stilwater bank's net worth as a result of a decline in interest rates?

exists between the market values (prices) of assets and liabilities and interest rates, which is not strictly true. A related problem with duration analysis revolves around the concept of convexity. Duration gap analysis tends to be reason­ ably effective at handling interest rate risk problems if the yield curve (i.e., the maturity structure of interest rates) changes by relatively small amounts and moves in parallel steps with short­ term and long-term interest rates changing by about the same proportion over time. However, if there are major changes in interest rates and different interest rates move at different speeds, the accuracy and effectiveness of duration gap manage­ ment decreases somewhat. Moreover, yield curves in the real world typically do not change in parallel fashion—short-term interest rates tend to move over a wider range than long-term interest rates, for example—and a big change in market inter­ est rates (say, one or two percentage points) can result in a distorted reading of how much interest rate risk a financial man­ ager is really facing. Duration itself can shift as market interest rates move, and the durations of different financial instruments can change at differing speeds with the passage of time. Fortunately, recent research suggests that duration balancing can still be effective, even with moderate violations of the tech­ nique's underlying assumptions. We need to remember, too, that duration gap analysis helps a financial manager better man­ age the value of a financial firm to its shareholders (i.e., its net worth). In this age of mergers and continuing financial-services industry consolidation, the duration gap concept remains a valu­ able managerial tool despite its limitations.

SUMMARY The managers of financial-service companies focus heavily today on the management of risk—attempting to control their exposure to loss due to changes in market rates of interest, the inability of borrowers to repay their loans, regulatory changes, and other risk-laden factors. Successful risk management requires effec­ tive tools that provide managers with the weapons they need to achieve their institution's goals. In this chapter several of the most important risk-management tools for financial firms were dis­ cussed. The most important points in the chapter include: • Early in the history of banking managers focused principally upon the tool of asset management—emphasizing control and selection of assets to achieve institutional goals because liabilities were assumed to be dominated by customer deci­ sions and government rules. • Later, liability management tools emerged in which managers discovered they could achieve a measure of control over the

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 373

liabilities on their balance sheet by changing interest rates and other terms offered to the public, in order to raise new funds. • More recently, many financial firms have practiced funds management, discovering how to coordinate the manage­ ment of both assets and liabilities in order to achieve institu­ tional goals. • One of the strongest risk factors financial-service managers have to deal with every day is interest rate risk. Managers cannot control market interest rates, but instead they must learn how to react to interest rate changes in order to control their risk exposure. • One of the most popular tools for handling interest rate risk exposure is interest-sensitive gap management, which focuses upon protecting or maximizing each financial firm's net inter­ est margin or spread between interest revenues and interest costs. Managers determine for any given time period whether

their institution is asset sensitive (with an excess of interest rate-sensitive assets) or liability sensitive (with more ratesensitive liabilities than rate-sensitive assets). These interestsensitive gaps are then compared with the financial firm's inter­ est rate forecast, and management takes appropriate action. • Managers soon discovered that interest-sensitive gap man­ agement didn't necessarily protect a financial firm's net worth—value of shareholders' investment in the institu­ tion. This job required the development of duration gap management. • Based on the concept of duration—a value- and timeweighted measure of maturity— the managers of financial institutions learned how to assess their exposure to loss in net worth from relative changes in the value of assets and liabilities when market interest rates change. This technique points to the importance of avoiding large gaps between average asset duration and average liability duration.

K E Y TERMS asset-liability management, 350 asset management, 350 liability management, 350 funds management, 351 interest rate risk, 351

374

yield to maturity (YTM), 352 bank discount rate, 353 maturity gap, 355 net interest margin, 356 interest-sensitive gap management, 356

duration gap management, 365 duration, 365 convexity, 366 duration gap, 367 portfolio immunization, 372

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

ial. They are not actual FRM exam questions.

PROBLEM S AND PROJECTS 1. A government bond is currently selling for $1,195 and pays $75 per year in interest for 14 years when it matures. If the redemption value of this bond is $1,000, what is its yield to maturity if purchased today for $1,195?

2. Suppose the government bond described in Problem 1 above is held for five years and then the savings institu­ tion acquiring the bond decides to sell it at a price of $940. Can you figure out the average annual yield the savings institution will have earned for its five-year invest­ ment in the bond?

3. U.S. Treasury bills are available for purchase this week at the following prices (based upon $100 par value) and with the indicated maturities:

a. $97.25, 182 days b. $95.75, 270 days c. $98.75, 91 days Calculate the bank discount rate (DR) on each bill if it is held to maturity. What is the equivalent yield to maturity (sometimes called the bond-equivalent or coupon-equivalent yield) on each of these Treasury bills?

7. New Comers State Bank has recorded the following financial data for the past three years (dollars in millions):

Current Year

Previous Year

Interest revenues

$82.00

$80.00

$78.00

Interest expenses

64.00

66.00

68.00

Loans (excluding nonperforming)

450.00

425.00

400.00

Investments

200.00

195.00

200.00

Total deposits

450.00

425.00

400.00

Money market borrowings

150.00

125.00

100.00

What has been happening to the bank's net interest margin? What do you think caused the changes you have observed? Do you have any recommendations for New Comers' management team? 8 . The First National Bank of Dogsville finds that its asset

and liability portfolio contains the following distribution of maturities and repricing opportunities:

4. Farmville Financial reports a net interest margin of 2.75 percent in its most recent financial report, with total interest revenue of $95 million and total interest costs of $82 million. What volume of earning assets must the bank hold? Suppose the bank's interest revenues rise by 5 percent and interest costs and earning assets increase 9 percent. What will happen to Farmville's net interest margin?

5. If a credit union's net interest margin, which was 2.50 percent, increases 10 percent and its total assets, which stood originally at $575 million, rise by 20 percent, what change will occur in the bank's net interest income? 6 . The cumulative interest rate gap of Poquoson Sav­

ings Bank increases 60 percent from an initial figure of $25 million. If market interest rates rise by 25 percent from an initial level of 3 percent, what changes will occur in this thrift's net interest income?

Two Years Ago

Coming Week Loans

Next 30 Days

Next 31-90 Days

More Than 90 Days

$200.00

$300.00

$475.00

$525.00

21.00

26.00

40.00

70.00

$320.00

$0.00

$0.00

$0.00

Time accounts

100.00

290.00

196.00

100.00

Money market borrowings

136.00

140.00

100.00

65.00

Securities Interestsensitive assets Transaction deposits

Interestsensitive liabilities

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 375

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

When and by how much is the bank exposed to interest rate risk? For each maturity or repricing interval, what changes in interest rates will be beneficial and which will be damaging, given the current portfolio position? 9. Sunset Savings Bank currently has the following interestsensitive assets and liabilities on its balance sheet with the interest-rate sensitivity weights noted.

Expected Cash Inflows of Principal and Interest Payments

Annual Period in Which Cash Receipts Are Expected

341,555

Three years from today

62,482

Four years from today

9,871

Five years from today

Deposits and money market borrowings are expected to require the following outflows:

$ Amount

Rate Sensitivity Index

$50.00

1.00

Security holdings

50.00

1.20

Loans and leases

350.00

1.45

$ Amount

Rate Sensitivity Index

831,454

Two years from today

$250.00

0.75

123,897

Three years from today

90.00

0.95

1,005

Interest-Sensitive Assets Federal fund loans

Interest-Sensitive Liabilities Interest-bearing deposits Money-market borrowings

What is the bank's cureent interest-sensitive gap? Adjust­ ing for these various interest rate sensitivity weights what is the bank's weighted interest-sensitive gap? Suppose the federal funds interest rate increases or decreases 50 basis points. How will the bank's net interest income be affected (a) given its current balance sheet makeup and (b) reflecting its weighted balance sheet adjusted for the foregoing rate-sensitivity indexes? 10. Sparkle Savings Association has interest-sensitive assets of $400 million, interest-sensitive liabilities of $325 million, and total assets of $500 million. What is the bank's dollar interest-sensitive gap? What is Sparkle's relative interest-sensitive gap? What is the value of its interest sensitivity ratio? Is it asset sensitive or liability sensitive? Under what scenario for market interest rates will Sparkle experience a gain in net interest income? A loss in net interest income? 11. Snowman Bank, N.A., has a portfolio of loans and securi­ ties expected to generate cash inflows for the bank as follows:

Expected Cash Inflows of Principal and Interest Payments $1,275,600 746,872

376

■

Annual Period in Which Cash Receipts Are Expected Current year Two years from today

Expected Cash Outflows of Principal and Interest Payments $1,295,500

—

Annual Period during Which Cash Payments Must Be Made Current year

Four years from today Five years from today

If the discount rate applicable to the previous cash flows is 4.25 percent, what is the duration of Snowman's port­ folio of earning assets and of its deposits and money market borrowings? What will happen to the bank's total returns, assuming all other factors are held constant, if interest rates rise? If interest rates fall? Given the size of the duration gap you have calculated, in what type of hedging should Snowman engage? Please be spe­ cific about the hedging transactions needed and their expected effects. 12. Given the cash inflow and outflow figures in Problem 11 for Snowman Bank, N.A., suppose that interest rates began at a level of 4.25 percent and then suddenly rise to 4.75 percent. If the bank has total assets of $20 billion, and total liabilities of $18 billion, by how much would the value of Snowman's net worth change as a result of this movement in interest rates? Suppose, on the other hand, that interest rates decline from 4.25 percent to 3.5 per­ cent. What happens to the value of Snowman's net worth in this case and by how much in dollars does it change? What is the size of its duration gap? 13. Conway Thrift Association reports an average asset duration of 7 years and an average liability duration of 4 years. In its latest financial report, the association recorded total assets of $1.8 billion and total liabilities of

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

The following questions are intended to help candidates understand the

$1.5 billion. If interest rates began at 5 percent and then suddenly climbed to 6 percent, what change will occur in the value of Conway's net worth? By how much would Conway's net worth change if, instead of rising, interest rates fell from 5 percent to 4.5 percent?

14. A financial firm holds a bond in its investment portfolio whose duration is 15 years. Its current market price is $975. While market interest rates are currently at 6 per­ cent for comparable quality securities, a decrease in inter­ est rates to 5.75 percent is expected in the coming weeks. What change (in percentage terms) will this bond's price experience if market interest rates change as anticipated?

15. A savings bank's weighted average asset duration is 8 years. Its total liabilities amount to $925 million, while its assets total 1.25 billion dollars. What is the dollarweighted duration of the bank's liability portfolio if it has a zero leverage-adjusted duration gap?

16. Bl ue Moon National Bank holds assets and liabilities whose average durations and dollar amounts are as shown in this table:

Asset and Liability Items

Investment-grads bonds

Avg. Duration (years)

Dollar Amount (millions)

15.00

$65.00

Commercial loans

3.00

400.00

Consumer loans

7.00

250.00

Deposits

1.25

600.00

Nondeposit borrowings

0.50

50.00

What is the weighted-average duration of Blue Moon's asset portfolio and liability portfolio? What is its leverage-adjusted duration gap?

17. A government bond currently carries a yield to maturity of 6 percent and a market price of $1,168,49. If the bond promises to pay $100 in interest annually for five years, what is its current duration?

ial. They are not actual FRM exam questions.

18. Carter National Bank holds $15 million in government bonds having a duration of 12 years. If interest rates suddenly rise from 6 percent to 7 percent, what per­ centage change should occur in the bonds' market price?

Internet Exercises 1. At www.almprofessional.com you will find a network devoted to articles and discussions of the asset-liability management field. Visit the site and find an article entitled "Principles for the Management of Interest Rate Risk." What are the major sources of interest rate risk according to this article?

2. If you would like to view the current yield curve go to www.bloomberg.com/markets/rates/index.html. What are the current yields on 3-month Ttreasury bills, 5-year Treasury notes, and 30-year Ttreasury bonds? Describe the shape of the yield curve.

3. If you want to learn more about duration, go to www .bionicturtle.com/how-to/article/modified-vsmacaulay-duration/ and read through this How-To learn­ ing segment. Define modified duration, and describe why it is useful.

4. See if you can find the meaning of modified duration on the Web. Where did you find it, and what did you find? (Hint: Try the website in Internet Exercise 3.)

5. Duration gap management is a powerful analytical tool for protecting net worth of a financial institution from damage due to shifting interest rates. Asset-liability managers have found this tool surprisingly resilient and robust even when its basic assumptions are not fully met. Go to www.ots.treas.gov/docs/4/422196.pdf, and see how bank regulators in the U.S. Treasury understand duration gaps.

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

■ 377

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

CA SE ASSIGN M EN T FOR CH APTER 18 find net interest income (Nil) as a percentage of total assets (TA). This is one calculation of NIM. You may have noticed from a footnote in Chapter 6 that sometimes NIM is calculated using total assets as the denominator, and sometimes total earning assets (TEA) is used as the denominator as illustrated in Equation (18.5). To trans­ form the first measure of NIM(NII/TAA) to the second measure using TEA, we need to collect one more item from the FDIC's website. Using the directions in Chapter 5's assignment, go to the FDIC's Statistics for Depository Institutions, www2.fdic.gov/sdi/, and collect from the Memoranda section of Assets and Liabilities the earning assets as a percentage of total assets for your BHC and its peer group for the two periods. We will add this informa­ tion to this spreadsheet to calculate NIM (NII/TEA) as follows:

ANALYSIS OF INTEREST RATE SENSITIVITY In Chapter 18, the focus is interest rate risk management. Regulatory agencies began to collect relevant information in the 1980s when large numbers of thrift institutions failed due to their interest rate risk exposure at a time when market rates were increasing both in level and volatility. You will find Interest Rate Risk Analysis or Interest Sensitivity Reports included in both the UBPR and the Bank Holding Company Performance Report (BHCPR). Both reports are available at www.ffiec.gov. This is one area where measurement within banks and BHCs is more sophisticated than the measures used by regulatory agencies. For instance, to date none of the regulatory agencies require their financial institutions to submit measures of duration gaps.

Part One: NIM: A Comparison to Peers A. Open your Excel Workbook and access the spreadsheet with Comparisons with Peer Group. On line 36, you 0

C*

Real Numbers for Real Banks Chapter 7 - Microsoft Excel

;

File

Insert

Asset class returns vs illiquidity

there do not seem to be significant illiquidity risk premiums across classes, there are large illiquidity risk premiums within asset classes.

Illiquidity Risk Premiums within Asset Classes Within all the major asset classes, securities that are more illiq­ uid have higher returns, on average, than their more liquid coun­ terparts. These illiquidity premiums can be accessed by dynamic factor strategies which take long positions in illiquid assets and short positions in liquid ones. As illiquid assets become more liquid, or vice versa, the investor rebalances.

U.S. Treasuries A well-known liquidity phenomenon in the U.S. Treasury market is the on-the-run/off-the-run bond spread. Newly auctioned Treasuries (which are "on the run") are more liquid and have higher prices, and hence lower yields, than seasoned Treasuries (which are "off the run").23 The spread between these two types of bonds varies over time reflecting liquidity conditions in Trea­ sury markets.24 There were pronounced illiquidity effects in Treasuries during the 2008 to 2009 financial crisis. Treasury bonds and notes are identical, except that the U.S. Treasury issues bonds with

23 The on-the-run bonds are more expensive because they can be used as collateral for borrowing funds in the repo market. This is called "spe­ cialness." See Duffie (1996). 24 See Goyenko, Subrahmanyam, and Ukhov (2011).

392

■

Most Illiquid

original maturities of twenty to thirty years and notes originally carry maturities of one to ten years. But after ten years, a Trea­ sury bond originally carrying a twenty-year maturity is the same as a Treasury note. If the maturities are the same, whether this particular security is bond or a note should make no difference. During the financial crisis Treasury bond prices with the same maturity as Treasury notes had prices that were more than 5% lower—these are large illiquidity effects in one of the world's most important and liquid markets.25

Corporate Bonds Corporate bonds that trade less frequently or have larger bidask spreads have higher returns. Chen, Lesmond, and Wei (2007) find that illiquidity risk explains 7% of the variation across yields of investment-grade bonds. Illiquidity accounts for 22% of the variation in junk bond yields; for these bonds, a one basis point rise in bid-ask spreads increases yield spreads by more than two basis points.26

Equities A large literature finds that many illiquidity variables predict returns in equity markets, with less liquid stocks having higher returns.27 These variables include bid-ask spreads, volume, vol­ ume signed by whether trades are buyer or seller initiated, turn­ over, the ratio of absolute returns to dollar volume (commonly

25 See Musto, Nini, and Schwarz (2011). 26 See also Chapter 9, Bao, Pan, and Wang (2011), Lin, Wang, and Wu (2011), and Dick-Nielsen, Feldhutter, and Lando (2012). 27 See the summary article by Amihud, Mendelson, and Pedersen (2005).

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

called the "Amihud measure" based on his paper of 2002), the price impact of large trades, informed trading measures (which gauge adverse, informed trading; see below), quote size and depth, the frequency of trades, how often there are "zero" returns (in more liquid markets returns will bounce up and down), and return auto correlations (which are a measure of stale prices).28 These are all illiquidity characteristics, which are properties unique to an individual stock. There are also illiquidity risk betas. These are covariances of stock returns with illiquidity measures, like market illiquidity or signed volume. Estimates of illiquidity risk premiums in the literature range between 1% and 8% depending on which measure of illiquid­ ity is used. However, Ben-Rephael, Kadan, and Wohl (2008) report that these equity illiquidity premiums have diminished considerably—for some illiquidity measures the risk premiums are now zero! In pink sheet stock markets, which are over-thecounter equity markets, Ang, Shtauber, and Tetlock (2013) find an illiquidity risk premium of almost 20% compared to about 1% for comparable listed equities.

Illiquid Assets There are higher returns to hedge funds that are more illiquid, in the sense that they place more restrictions on the withdrawal of capital (called lockups) or for hedge funds whose returns fall when liquidity dries up.29 Franzoni, Nowak, and Phalippou (2012) report that there are significant illiquidity premiums in private equity funds—typically 3%. In real estate, Liu and Qian (2012) construct illiquidity measures of price impact and search costs for U.S. office buildings. They find a 10% increase in these illiquidity measures leads to a 4% increase in expected returns.

and rarely treat them consistently as a whole. This happens on both the sell-side, where fixed income, equity desks, and other divisions rarely talk with each other, and on the buy-side, where each asset class is managed by separate divisions. (Canada Pension Plan's factor investing strategy is a notable exception to this.) The potential mispricing of illiquidity across asset classes could reflect institutional constraints, slow-moving capital, and limits to arbitrage.31 On the other hand, perhaps asset class illiquidity risk premi­ ums might be small because investors overpay for illiquid asset classes; they chase the illusion of higher returns and bid up the prices of these illiquid assets until the illiquidity premiums go away. Lack of integrated asset class markets cause investors to make ill-informed decisions for illiquid asset classes. In con­ trast, within asset classes—especially the more liquid stock and bond markets—illiquidity-shy investors are willing to pay for the privilege to trade as soon as they desire. As investors compete within an asset class, they covet and pay up for liquidity.

Market Making A market maker supplies liquidity by acting as an intermediary between buyers and sellers.32 Liquidity provision is costly. Market makers need capital to withstand a potential onslaught of buy or sell orders, and at any time they can be transacting with investors who have superior information. In compensation for these costs, market makers buy at low prices and sell at prices around "fair value." Investors transacting with the market maker pay the bid-ask spread.

To my knowledge, we have yet to develop formal equilibrium models explaining the large illiquidity risk premiums within asset classes but not across asset classes.

In liquid stock and bond markets, market making is now synony­ mous with high frequency trading by investors who build mas­ sive computer infrastructure to submit buy and sell orders within fractions of a second. More than 70% of dollar trading volume on U.S. equity exchanges is believed due to high frequency traders.33 Many successful hedge funds specialize in high fre­ quency trading.

Perhaps the reason is limited integration across asset classes. There are significant impediments to switching capital and investment strategies seamlessly even across liquid stock and bond markets.30 Investors put asset classes into different silos

Many asset owners cannot collect illiquidity risk premiums by building high-frequency trading systems, nor would they wish to enter this business (directly or indirectly). But there is a way large asset owners can do a low-frequency version of market making.

Why Illiquidity Risk Premiums Manifest within but Not across Asset Classes

OH

Sorting stocks on all these variables results in spreads in average returns. But some of these illiquidity measures produce spreads in expected returns opposite to an illiquidity risk premium. Stocks with higher than average (normalized) volume, for example, tend to have lower future returns as shown by Gervais, Kaniel, and Mingelgrin (2001). 29 See Aragon (2007) and Sadka (2010), respectively. 30 See Kapadia and Pu (2012) for evidence of lack of integration across stock and bond markets.

Dimensional Funds Advisors (DFA) is a funds management com­ pany that started in 1981 by specializing in small-cap equities.

31 See Merton (1987), Duffie (2010), and Shleifer and Vishny (1997), respectively. 32 O'Hara (1995) provides a summary of theoretical models of market making. 33 See Zhang (2010).

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DFA's strategies have deep roots in academic factor models, and its founders, David Booth and Rex Sinquefield, roped in the big guns of the finance literature, Fama, French, and others, in building the company. From the start, DFA positioned itself as a liquidity provider of small stocks, and market making was an integral part of its investment strategy.34 When other investors seek to urgently offload large amounts of small stocks, DFA takes the other side and buys at a discount. Similarly, DFA offers small-cap equities at a premium to investors who demand immediate liquidity. Large asset owners, like sovereign wealth funds and large pen­ sion funds, are in a position to act as liquidity providers, espe­ cially in more illiquid markets. They can accept large blocks of bonds, shares, or even portfolios of property at discount and sell these large blocks at premiums. They can do this by calcu­ lating limits within their (benchmark tracking error) constraints on how much they are willing to transact. That is, they can provide liquidity in different securities up to a certain amount so that they do not stray too far from their benchmarks. Buyers and sellers will come to them as they develop reputations for providing liquidity.

Secondary Markets for Private Equity and Hedge Funds Exchanges for secondary transactions in hedge funds and pri­ vate equity have sprung up, but these markets are still very thin.35 Many transactions do not take place on organized sec­ ondary market platforms. There are two forms of secondary markets in private equity. First, in secondary (and tertiary) market buyout markets, private equity firms trade private companies with each other. These markets have blossomed: in 2005, secondary buyouts repre­ sented around 15% of all private equity buy-out deals.36 From the perspective of asset owners (limited partners [LPs]), this market provides no exit opportunities from the underlying pri­ vate equity funds and is at worst a merry-go-round of private equity firms swapping companies in circular fashion. At best, more transactions at market prices (assuming there is no fina­ gling between the transacting funds) allow asset owners to better value their illiquid investments. The LPs are still stuck in the fund, but they might receive some cash when a company in their fund's portfolio is sold to another private equity firm.

Secondary markets for LPs, which allow them to exit from pri­ vate equity funds, are much smaller and more opaque. Even industry participants acknowledge this market "still remains rela­ tively immature . . . and still represents a very small percentage of the primary market."37 Bid-ask spreads in these transactions are enormous. As Cannon (2007) notes, the secondary market for LPs was dominated in the 1990s by distressed sellers. Specialized firms on the other side of these deals got discounts of 30% to 50%; there was a reason these firms were called "vultures." In the 2000s, discounts fell to below 20% but shot up during the financial crisis. Harvard University found this out when it tried to disinvest in private equity funds during 2008 and faced discounts of 50%. Discounts for hedge funds are much smaller than private equity. This reflects the fact that hedge funds investors can, in most cases, access capital at predetermined dates after lock­ ups have expired and notice requirements have been satisfied (unless the hedge fund imposes gates). Reflecting this greater underlying liquidity, hedge fund discounts in secondary mar­ kets in 2007 and 2008 were around 6% to 8%.38 (A few hedge funds that are closed to new investors actually trade at premiums.) The nascent secondary markets for private equity and hedge funds are tremendous opportunities for large asset owners to supply liquidity. Secondary private equity is like second-hand cars that are still brand new. When you drive a new car off the lot, it immediately depreciates by a quarter, even though it is exactly the same as a car sitting in the dealer's inventory. Secondary private equity is still private equity, and you can get it a lot cheaper than direct from the dealer.

Adverse Selection A market maker faces a risk that a buyer has nonpublic infor­ mation, and the stock is selling at a price that is too high or too low relative to true, fundamental value. A buyer knowing that the stock will increase in value will continue to buy and increase the price. In this case, the market maker has sold too early and too low. This is adverse selection. Glosten and Milgrom (1985) and Kyle (1985)—the papers that started the market-making microstructure literature—developed theo­ ries of how the bid-ask spread should be set to incorporate the effects of adverse selection. DFA provides some exam­ ples of how to counter adverse selection. To avoid being exploited, DFA trades with counterparties that fully disclose

34 See Keim (1999) and the Flarvard Business School case study, Dimensional Fund Advisors, 2002, written by Randolph Cohen. 35 An academic study of this market is Kleymenova, Talmor, and Vasvari (2012).

37 From the introduction to Luytens (2008) written by Andrew Sealey and Campbell Lutyens.

36 Report of the Committee on Capital Markets Regulation, 2006.

38 See Ramadorai (2012).

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Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

their information on stocks. At the same time, DFA itself operates in a trustworthy way by not front running or manipulating prices.39

Rebalancing The last way an asset owner can supply liquidity is through dynamic portfolio strategies. This has a far larger impact on the asset owner's total portfolio than liquidity security selec­ tion or market making because it is a top-down asset allocation decision. Rebalancing is the simplest way to provide liquidity, as well as the foundation of all long-horizon strategies. Rebalancing forces asset owners to buy at low prices when others want to sell. Con­ versely, rebalancing automatically sheds assets at high prices, transferring them to investors who want to buy at elevated levels. Since rebalancing is counter-cyclical, it supplies liquidity. Dynamic portfolio rules, especially those anchored by simple valuation rules, extend this further—as long as they buy when others want to sell and vice versa. It is especially important to rebalance illiquid asset holdings too, when given the chance (see also below). Purists will argue that rebalancing is not strictly liquidity provi­ sion; rebalancing is an asset management strategy. Rebalanc­ ing, in fact, can only occur in the context of liquid markets. But prices exhibit large declines often because of blowouts in asym­ metric information, or because funding costs rapidly increase so that many investors are forced to offload securities—some of the key elements giving rise to illiquidity listed at the start of an earlier section. Brunnermeier (2009) argues that these effects played key roles in the meltdown during the financial crisis. In the opposite case, rebalancing makes available risky assets to new investors, potentially with lower risk aversions than existing clientele or those who chase past high returns, or to investors who load up on risky assets when prices are high because they have abundant access to leverage and they perceive asymmetric information is low. In this general framework, rebalancing pro­ vides liquidity. Large asset owners give up illiquidity premiums by sheepishly tracking standard indexes. When indexes change their constitu­ ents, asset owners demand liquidity as they are forced to follow these changes. Index inclusion and exclusion induce price effects of 3% to 5%, and these effects have become stronger in more recent data.40 Large asset owners should be collecting

39 See MacKenzie (2006). 40 See the literature on index reconstitution effects summarized by Ang, Goetzmann, and Schaeffer (2011).

index reconstitution premiums instead of paying them. They can do this by using their own proprietary benchmarks. Candidate indexes could emphasize illiquidity security characteristics but more generally would be built around harvesting factor risk premiums. Even an index without illiquidity tilts allows asset owners to harvest a liquidity premium collected from all the other investors forced to track standard indexes.

Summary Of all the four ways to collect an illiquidity premium: (i) holding passive allocations to illiquid asset classes, (ii) holding less liquid securities within asset classes, (iii) market making at the indi­ vidual security level, and (iv) dynamic rebalancing at the aggre­ gate level; the last of these is simplest to implement and has the greatest impact on portfolio returns.

19.6 PORTFOLIO CH O ICE WITH ILLIQUID ASSETS In deciding on how much of their portfolios to devote to illiquid assets, investors face many considerations specific to their own circumstances. Investors have different horizons. Illiquid markets don't have tradeable indices, so investors have to find talented active portfolio managers. Then they face agency issues and evaluating and monitoring portfolio managers requires skill. Thus the premium for bearing illiquidity risk might be individualspecific. Computing these illiquidity premiums requires asset allocation models with liquid and illiquid assets. These models also prescribe an optimal amount of illiquid assets to hold. Practitioners generally use one-period investment models— usually the restrictive Markowitz (1952) mean-variance model with ad hoc adjustments (yes, most of the industry is still using models from the 1950s)—which are inappropriate for illiquid asset investing. The fact that you cannot trade an illiquid asset now but will do so in the future makes illiquid asset investing a dynamic, long-horizon problem. There are two important aspects of illiquidity—large transaction costs and long times between trading—that have been captured in portfolio choice models with illiquid assets.41

Asset Allocation with Transactions Costs George Constantinides (1986) was the first to develop an asset allocation model where the investor had to pay transaction costs. Selling $100 of equities, for example, results in a final position of 41 Parts of this are based on Ang (2011) and Ang and Sorensen (2012).

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$90 with 10% transactions costs. Not surprisingly, the investor trades infrequently—to save on transactions costs. Constantinides proved that the optimal strategy is to trade whenever risky asset positions hit upper or lower bounds. Within these bounds is an interval of no trading. The no-trading band straddles the optimal asset allocation from a model that assumes you can continuously trade without frictions (the Merton 1971 model).42 The no-trade interval is a function of the size of the transac­ tions costs and the volatility of the risky asset. Constantinides estimates that for transactions costs of 10%, there are no-trade intervals greater than 25% around an optimal holding of 25% for a risky asset with a 35% volatility. (I bet Harvard wished it could have received just a 10% discount when it tried to sell its private equity investments in 2008.) That is, the asset owner would not trade between (0%, 50%)—indeed, very large fluctuations in the illiquid asset position. Illiquid asset investors should expect to rebalance very infrequently. Constantinides' model can be used to compute an illiquid­ ity risk premium, defined as the expected return of an illiquid asset required to bring the investor to the same level of utility as in a frictionless setting. This is the risk premium the inves­ tor demands to bear the transactions costs and is a certainty equivalent calculation. For transaction costs of 15% or more, the required risk premium exceeds 5%. Compare this value with (the close to) zero additional excess returns, on average, of the illiq­ uid asset classes in data. A major shortcoming of the transaction costs models is that they assume trade is always possible by paying a cost. This is not true for private equity, real estate, timber, or infrastructure. Over a short horizon, there may be no opportunity to find a buyer. Even if a counterparty can be found, you need to wait for due dili­ gence and legal transfer to be completed and then the counter­ party can get cold feet.43 Many liquid assets also experienced liquidity freezes during the financial crisis where no trading—at any price—was possible because no buyers could be found.

Asset Allocation with Infrequent Trading In Ang, Papanikolaou, and Westerfield (2013), I develop an asset allocation model in which the investor can transact illiquid 42 Chapter 4 discusses extensions of Constantinides (1986) to double bands, contingent bands, and rebalancing to the edge or center of the bands. 43 For some illiquid assets, investors may not be even willing to trans­ act immediately for one cent; some investments do not have liability limited at zero. For example, on June 30, 2008, a real estate invest­ ment by CalPERS was valued at negative $300 million! See Corkery, M., C. Karmin, R. L. Rundle, and J. S. Lublin, "Risky, Ill-Timed Land Deals Hit CalPERS," Wall Street Journal, Dec. 17, 2008.

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assets only at randomly occurring liquidity events. This notion of illiquidity is that usually illiquid assets are just that—illiquid and cannot be traded. But when the liquidity event arrives, investors can trade. I model the arrival of liquidity events by a Poisson arrival process with intensity A. The interval between liquidity events is 1/A. For real estate or private equity, intervals between trading would occur every ten years or so, so A = 1/10. As A increases to infinity, the opportunities to rebalance become more and more frequent and in the limit approach the standard Merton (1981) model where trading occurs continuously. Thus A indexes a range of illiquidity outcomes. Poisson arrival events have been used to model search-based frictions since Peter Diamond (1982), who won his Nobel Prize in 2010. The following year, he was nominated to serve on the Federal Reserve Board of Governors, but Republican opposition blocked his confirmation. Illiquidity risk causes the investor to behave in a more risk-averse fashion toward both liquid and illiquid assets. Illiquidity risk induces time-varying, endogenous risk aversion. Harvard discov­ ered in 2008 that although it is wealthy, it cannot "eat" illiquid assets. Illiquid wealth and liquid wealth are not the same; agents can only consume liquid wealth. Thus the solvency ratio of illiq­ uid to liquid wealth affects investors' portfolio decisions and payout rules—it becomes a state variable that drives investors' effective risk aversion. The takeaways from the Ang, Papanikolaou and Westerfield model are:

Illiquidity Markedly Reduces Optimal Holdings Start with the bottom line in Panel A of Table 19.2, which reports a baseline calibration where the investor holds 59% in a risky asset that can always be traded. This weight is close to the standard 60% equity allocation held by many institutions. As we go up the rows, the asset becomes more illiquid. If the risky asset can be traded on average every six months, which is the second to last line, the optimal holding of the illiquid asset contingent on the arrival of the liquidity event is 44%. When the average interval between trades is five years, the optimal alloca­ tion is 11%. For ten years, this reduces to 5%. Illiquidity risk has a huge effect on portfolio choice.

Rebalance Illiquid Assets to Positions below the Long-Run Average Holding In the presence of infrequent trading, illiquid asset wealth can vary substantially and is right-skewed. Suppose the optimal hold­ ing of illiquid assets is 0.2 when the liquidity event arrives. The

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

Investors do not load up on illiquid assets because these assets have illiquidity risk and cannot be continuously traded to con­ struct an "arbitrage."

Table 19.2 Panel A Average Time between Liquidity Events (or Average Turnover)

Optimal Rebalance Value

10 Years

0.05

5 Years

0.11

2 Years

0.24

1 Year

0.37

1/2 Year

0.44

Continuous Trading

0.59

Panel B Average Time between Liquidity Events (or Average Turnover)

Illiquidity Risk Premium

10 Years

6.0%

5 Years

4.3%

2 Years

2.0%

1 Year

0.9%

1/2 Year

0.7%

Continuous Trading

0.0%

investor could easily expect illiquid holdings to vary from 0.1 to 0.35, say, during nonrebalancing periods. Because of the rightskew, the average holding of the illiquid asset is 0.25, say, and is greater than the optimal rebalanced holding. The optimal trading point of illiquid assets is lower than the long-run average holding.

Consume Less with Illiquid Assets Payouts, or consumption rates, are lower in the presence of illiquid assets than when only comparable liquid assets are held by the investor. The investor cannot offset the risk of illiquid assets declining when these assets cannot be traded. This is an unhedgeable source of risk. The investor offsets that risk by eating less.

Investors Must Demand High Illiquidity Hurdle Rates How much does an investor need to be compensated for illi­ quidity? In Panel B of Table 19.2, I compute premiums on an illiquid asset required by an investor to bear illiquidity risk. Let's define the illiquidity premium, or hurdle rate, as a certainty equivalent. Suppose an investor holds two liquid assets and replaces one asset with another that is identical except for being illiquid. The illiquidity premium is the increase in the expected return of the illiquid asset so that the investor has the same util­ ity as the case when all assets are liquid. When liquidity events arrive every six months, on average, an investor should demand an extra 70 basis points. (Some hedge funds have lockups around this horizon.) When the illiquid asset can be traded once a year, on average, the illiquidity premium is approximately 1%. When you need to wait ten years, on aver­ age, to exit an investment, you should demand a 6% illiquidity premium. That is, investors should insist that private equity funds generate returns 6% greater than public markets to com­ pensate for illiquidity. Most illiquid assets are not generating excess returns above these hurdle rates. The Ang, Papanikolaou, and Westerfield (2013) model is highly stylized. Given the other issues the model misses, like agency conflicts of interest, cash flow management issues of capital calls and distributions, and asset-liability mismatches, the true illiquidity hurdle rates are even higher than those reported in Table 19.2.

Summary Portfolio choice models with illiquid assets recommend holding only modest amounts of illiquid assets. Investors should demand high illiquidity risk premiums.

19.7 LIQUIDATING HARVARD REDUX

There Are No Illiquidity "Arbitrages"

The Case for Illiquid Asset Investing

In a mean-variance model, two assets with different Sharpe ratios and perfect correlations produce positions of plus or minus infinity. This is a well-known bane of mean-variance models, and professionals employ lots of ad hoc fixes, and arbitrary constraints, to prevent this from happening. This does not happen when one asset is illiquid—there is no arbitrage.

Large, long-term investors often cite their large amounts of capital and their long horizons as rationales for investing in illiquid assets. Size and patience are necessary but not sufficient conditions for illiquid asset investing; these conditions simply aren't adequate justifications in themselves. Since illiquid asset classes do not offer high risk-adjusted returns, the case for

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passively them is not compelling. Illiquid investing also poses huge agency problems; asset owners, for example, find it tough to monitor external managers. Many institutions face "fiefdom risk" as illiquid assets are run as separate empires within an organization, detrimentally affecting how the aggregate portfolio is allocated. In addition, investors in illiquid markets face high idiosyncratic risk because there is no "market" portfolio. It is exactly this large idiosyncratic risk, however, that is the most compelling reason for investing in illiquid assets. Suppose you are a skilled investor (assume you have true alpha) and have a choice between investing in (i) a market where prices quickly reflect new information, almost everyone sees the same information, and news gets spread around very quickly, or (ii) a market where information is hard to analyze and even harder to procure, only a select few have good information, and news takes a long time to reach everyone. Obviously you pick (ii). This, in a nutshell, is the Swensen (2009) justification for choos­ ing illiquid assets. The argument is not that illiquid asset classes have higher risk-adjusted returns. Empirical evidence suggests they don't. Investing in illiquid assets allows an investor to transfer idiosyn­ cratic risk from liquid equity and bond markets, which are largely efficient, to markets where there are large information asymme­ tries, transactions costs are punishing, and the cross-sections of alpha opportunities are extremely disperse. These are the mar­ kets, in other words, where you can make a killing! The Swensen case crucially relies on one word: "skilled." Whereas skilled investors can find, evaluate, and monitor these illiquid investment opportunities, assuming they have the resources to take advantage of them, unskilled investors get taken to the cleaners. If you are unskilled, you lose. Harvard, Yale, Stanford, MIT, and a few other select endowments have the ability to select superior managers in illiquid markets because of their size, their relationships, and their commitment to support these managers through long investment cycles. What about the others? An endowment specialist says, "It's a horror show. [Performance has] been flat to even negative. The strong get stronger and the weak get stuck with non-top quartile managers and mediocre returns and high fees.44

management theorists. In a 2012 paper, they provocatively argue that the optimal allocation policy for successful universi­ ties is to hold large amounts of fixed income, not risky assets, and by extension not illiquid risky assets. Gilbert and Hrdlicka model universities as creators of "social div­ idends," which are research and teaching. Universities can invest internally, in research and teaching projects, or they can invest externally through the endowment. If the endowment is taking on external risk—via equities, for example—this signals that the university does not have enough good internal risky projects generating social dividends. If the endowment is invested in safe assets, through bonds, the university takes on risk through inter­ nal research and teaching projects. Gilbert and Hrdlicka argue that a university endowment's large investment in risky assets is a sign that it does not have enough fruitful research and teach­ ing assignments! Harvard, with its large endowment heavily invested in risky illiquid assets, would take issue with Gilbert and Hrdlicka. An endowment allows a university to be more independent, rather than depend entirely on grants from government or private foundations. As Dershowitz argues, the endowment could be used as a rainy day account to be tapped precisely during times like 2008. Harvard's endowment has historically yielded a predictable stream of cash for operating budgets, but 2008 blew this predictability away. Harvard claims its endowment allows for future generations to share in its riches, saying, "Although their specific uses vary, endowment funds have a common purpose: to support activities not just for one year, or even one generation, but in perpetuity.45 The price of education, however, has been rising in real terms, and if education is costlier in the future than in the present, being stingy on research and teaching now makes no sense because it substitutes a more expensive good in the future for a cheaper one today.46 Henry Hansmann, a professor at Yale Law School, describes large private universities as "institutions whose business is to run large pools of investment assets. . . . They run educational insti­ tutions on the side, that can expand and contract to act as buf­ fers for investment pools."47*He contends that a large part of why universities like large endowments is prestige, pursued as its own objective. Journalist Kevin Carey puts it another way,

Investment Advice for Endowments Thomas Gilbert and Christopher Hrdlicka at the University of Washington are probably the world's only endowment

45 "About HSPH: Endowment Funds: What Are Endowment Funds?" Harvard School of Public Health, http://www.hsph.harvard.edu/about/ what-are-endowment-funds 46 See Hansmann (1990).

44 Quoted by Stewart, J. B., "A Hard Landing for University Endow­ ments," New York Times, Oct. 12, 2012.

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47 "Q&A. Modest Proposal. An Economist Asks, Does Harvard Really Need $15 Billion?" New York Times, Aug. 2, 1998.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management

echoing the cadences of the Book of Common Prayer when he says that large endowments per se are "aspiration without limit, accumulation without end."48

Liquidate Harvard? Did Harvard generate excess returns, or an illiquidity risk pre­ mium, from its large investments in illiquid, alternative assets? Yes. Harvard could extract value from illiquid asset investing not because illiquid asset classes have a large risk premium but because it is a skillful investor. And it is one of the few investors able to do so. But this didn't help Harvard solve its cash crunch. The worst failing of Harvard was in basic asset-liability management. Even without using the asset allocation models with illiquidity risk or the advice given by Gilbert and Hrdlicka, Harvard should have recognized that its assets did not match its liabilities. In technical terms the duration of its liabilities was shorter than the duration of its assets. Harvard faced five choices: 1. Liquidate a portion of the endowment. But a lot of the endowment is illiquid and cannot be sold.

48 Kevin Carey, "The 'Veritas' About Harvard," Chronicle o f Higher Education, Sept. 28, 2009.

2. Cut expenses. Universities are like government bureaucracies: big, bloated, and inefficient. You can hardly fire anyone. So there is a limit to how much can be cut. 3. Increase donations. It's embarrassing to ask for funds to replace those lost as a result of mismanagement. 4. Increase other revenue. Harvard could rescind its need-blind financial-aid policy. But it turns out this doesn't save much money. 5. Borrow. Harvard did (5). It issued $2.5 billion in bonds and more than doubled its leverage ratio between 2008 and 2009. It did try to cut expenses and deferred its Allston campus expansion. Was the endowment a rainy day fund Joseph could use to save his family and all of Egypt, as suggested by Dershowitz? No. Harvard actually reduced its payout ratio in 2009, preferring to keep as much of the endowment intact as it could.49 Maybe Hansmann is right in suggesting that prestige maximization is the driving motivation in endowment management. After all, everyone likes to be well-endowed.

49 Brown et al. (2013) show that most universities do the same thing: they hoard endowments when bad times come.

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399

A active risk management, 126 adverse price impact, 38, 40-41 amortising loans, 299-300 Ang, A., 397 Ang, Papanikolaou, and Westerfield (2013) model, 396-397 arbitrages, 397 Ashanti Goldfields, 8 asset conversion, 91 asset-liability committee (ALCO), 181 asset-liability management (ALM), 350 convexity and duration, 366-367 definition, 350 duration gap limitations, 372-373 management, 365, 367-372 funding liquidity risk measurement, 38 interest rate risk, 351 components, 353-355 forces determining, 351-352 measurement, 352-353 responses to, 355-356 interest-sensitive gap management, 356 net interest margin (NIM), 356 price sensitivity to changes in interest rates, 366 problems with interest-sensitive GAP management, 362-364 risk-management tool, 365 sample interest-sensitivity analysis (GAP Management), 360-362 strategies asset management strategy, 350 funds management, 351 liability management strategy, 350-351 asset liquidity management strategies, 91-92 asset management, 350

dealer banks, 160 strategy, 350 asset purchases/funding, 122 available assets bond buy/sellback and sell/buyback, 148 lending and borrowing, 148 purchase, 146 repo and reverse repo, 147 selling, 146 buy/sellback transactions, 144 contracts types, 145 repo transactions, 144 reverse repo transactions, 144 security borrowing, 145 security lending, 144 sell/buyback transactions, 144 available funds gap (AFG), 261

B balanced liquidity management strategies, 93 balance sheet risk, see funding liquidity risk bank discount rate, 353 bankers' acceptances, 59-60 Bank for International Settlements (BIS), 121 bank liquidity fragility of commercial banking, 21-22 liquidity transformation by banks, 20-21 banks' global balance sheets, US dollar shortage balance sheet expansion since 2000, 316 cross-currency funding positions, 316-320 maturity transformation across banks' balance sheets, 320-323 structure of banks' operations, 313-316 banks' international positions, 311-313

401

bank size and borrowing, 109-110 bank specific indicators, 52-54 Basel Committee on Banking Supervision (BCBS), 121,289, 307 principles for sound liquidity risk management and supervision, 301-302 baseline scenario, 177 basic (lifeline) banking, 239-240 BCBS recommended early warning indicators, 47

central bank borrowing, 8 central bank reserve requirements, 111 certificate of deposit (CD), 59 clearing balance rules, 106 client intraday credit usage, 128 collateral markets, 131 economic function of markets, 28-29

bid-ask spread, 38

prime brokerage and hedge funds, 29 risks in, 29-31

BIS international banking statistics, 328

securitization process, 26

black holes, liquidity, see also liquidity risk diversity, importance of, 14 irrational exuberance, 13-14 leveraging and deleveraging, 12-13

structure

positive and negative feedback traders, 11-12 regulation, impact of, 14

margin loans, 26-27 repurchase agreements, 27 securities lending, 27 total return swaps, 27

board of directors, 212 bond buy/sellback and sell/buyback, 148

collateral pledging, 122 collateral requirements, 180 commercial paper, 60 commercial paper market, 259-260

lending and borrowing, 148 purchase, 146 repo and reverse repo, 147 selling, 146 borrow, ability to, 7

Committee for European Banking Supervisors (CEBS), 290, 307 Committee on Payment and Settlement Systems (CPSS), 121 Committee on Payments and Market Infrastructures (CPMI), 121 conditional pricing, 233 consistency check and data limitations, 329-330

borrowed liquidity (liability) management strategies, 92-93 borrowing, 92

Constantinides, G., 395 Constantinides' model, 396 contingency funding plan (CFP), 10 actions in liquidity crisis, 210 capabilities and enhancements, 210

Federal reserve banks, 255-256 liquidity, 92 business dial back, 180 business risk, 70-71 buy/sellback transactions, 144

C

design considerations align to business and risk profiles, 210-211 appropriate stakeholder groups, 211 broader risk management frameworks, 211 communication plan, 211

call risk, 71 capital and performance metrics, 181 capital market investment instruments corporate bonds, 61 corporate notes, 61

operational, actionable, but flexible playbook, 211 different types of institutions, 218 framework and building blocks contingent actions, 214-215 data and reporting, 218

municipal bonds, 60-61 municipal notes, 60-61 treasury bonds, 60 treasury notes, 60 capital stress testing, 184 cash and treasury securities, 6 cash balances, 125 cash flow classifications, 134 liquidity risk reporting asset and liability, 194 survival horizon, 197, 198 treatment, 204 at risk, 150-154 taxonomy, 134 cash management, repurchase agreements and, 274-275

402

■

Index

governance and oversight, 212-213 monitoring and escalation, 215-218 scenarios and liquidity gap analysis, 213-214 liquidity and capital, 219 organizational structure of, 218-219 contingent liabilities, 180 contingent liquidity, 131 requirements, measurement, 173 contingent liquidity risk management banks liquidity cushions unveiled by GFC, 302 extant guidance focuses on size, 302 liquidity cushions, 301 poor attribution of cost of carrying, 302-303 pricing contingent liquidity risk, 304-305 towards better management, 303-304 contracts types, 145

convexity, 366

deposits

core deposits, 226 corporate bonds

conditional pricing, 233-237 by depository institutions

capital market investment instruments, 61 illiquidity risk premiums, 392

nontransaction (savings/thrift), 224 retirement savings, 224-225

corporate notes

transaction (payments/demand), 222-224

capital market investment instruments, 61 corporate treasury, 212

insurance coverage by FDIC, 231-232 interest rates composition, 225-226

cost of trade processing, 37 cost-plus pricing, 230 Counterparty Risk Management Policy Group III (CRMPGIII), 307 counterparty stress, 129

cost of different deposit accounts, 228-229 ownership, 226-228 LTP, 299-300

covered interest parity (CIP) factors, 335

marginal cost to set interest rates on, 232-233 outflows, 179-180

hedging demand, quantitative indicators, 339-343 limits to arbitrage, 338-339

ownership of, 226-228 pricing deposit

mechanics, 334

at cost plus profit margin, 230 services, 229

regression results, 345-346 tighter limits to arbitrage and basis, 344-345

total customer relationship vs. depository, pricing, 237-239

violations, 334

wholesale and retail, 7-8

yen/dollar case, 343-344 crash of 1987, 12

depth, characteristics of market liquidity, 38 Dershowitz, A., 383

credit availability risk, 266

Dimensional Funds Advisors (DFA), 393 discount window, 255

credit crisis, 2 credit/default risk, 69-70 cross-currency swaps, 335 currency, 176

distorts profit assessment, 297 duration, 365 duration gap, 367

customer relationship doctrine, 248 customer stress, 129 cyclical component, 95 cyclical element, 95

D daily maximum intraday liquidity usage, 127-128 data aggregation, 126 daylight overdraft (DOD), 42, 120, 131 dealer banks failure mechanisms derivatives counterparties, 164-165 flight of prime brokerage clients, 162-164 flight of short-term creditors, 161-162 loss of cash settlement privileges, 165 internal hedge funds, 157

limitations, 372-373 management, 365, 367-372 duration, maturity management immunization, 77-78 portfolio immunization, 78

E early warning indicators (EWI) bank specific indicators, 52-54 BCBS recommended, 47 beyond, 46 dashboard, 46 dimensions, 49 key supervisory guidelines, 46, 48 market indicators, 51 M.E.R.l.T.

off-balance-sheet financing, 160-161 over-the-counter derivatives, 158-160 policy responses, 165-166

forward looking bias/view, 49-50

prime brokerage and asset management, 160

industry practices, 51

securities dealing, 158 trading, 158

integrated systems, 50 measures, 47, 49 reporting, 50

underwriting, 158 deleveraging, 12-13, 18 deposit behavioral characteristics, 180 depositors, 156 Depository Trust and Clearing Corporation (DTCC), 159

environments, both normal and stressed, 50 escalation, 50

spanning various time horizons, 50 thresholds, 50-51 regulatory emphasis in recent times, 46 risk identification and, 47, 49

Index

■ 403

e-banking, 227 e-commerce, 227 endowments, investment advice, 398-399 equities

transactions measurement adverse price impact, 40-41 transaction cost liquidity risk, 39-40 funding optimization, 183

illiquidity risk premiums, 392-393

funds approach, sources and uses, 94-96

private, 394

funds management, 351 funds transfer pricing, 184

Eurocurrency deposit, 59, 92, 258 market, 258-259 European Commission (EC), 290, 307 expected rate of return, 65

G Geltner, D., 386 Geltner-Ross-Zisler unsmoothing process, 386 Gilbert, T„ 398

F Faust, D., 382

global financial crisis (GFC), 46, 288, 310, 334

federal agency securities, 59 Federal Deposit Insurance Corporation (FDIC), 231-232

Greenspan, A., 14

federal funds borrowings, 92 federal funds market (Fed funds), 109, 250-252 Federal Home Loan Bank (FHLB), 92 advances from, 256 feedback traders, positive and negative, 11-12 financial market utilities (FMUs) risk

Goldman Sachs Global Core Excess, 38

H Hansmann, H., 398 Harvard Management Company (HMC), 382 hedge funds cash, 39

collateral, 131 contingent liquidity, 131

collateral markets, prime brokerage and, 29 dynamic, 11

liquidity savings mechanism, 131

funding liquidity management, 39 funding liquidity risk, 24

management, 129-130 monitoring, 130-131

funding liquidity risk measurement, 39 issues, 8

net debit caps, 130-131 settlement windows, 131

secondary markets for, 394

financial market utility, 131 financial stress, 129 foreign exchange (FX) swaps, 335 Forst, E., 382 fragility, commercial banking, 21-22 funding liquidity bank liquidity fragility of commercial banking, 21-22 liquidity transformation by banks, 20-21 definition, 18 hedge funds, 24 liquidity transformation, 19-20 maturity transformation, 18-19 measurement asset-liability management, 38 Goldman Sachs Global Core Excess, 38 hedge funds, 39

unpledged assets, 39 unused borrowing capacity, 39 holding period yield (HPY), 65 Hrdlicka, C., 398

I illiquid assets consume less with, 397 liquidating HARVARD, 382-383 liquidating HARVARD redux case for investing, 397-398 investment advice, endowments, 398-399 markets characteristics of, 383-385 sources of, 383

structured credit and off-balance-sheet funding, 22-23

portfolio choice with asset allocation infrequent trading, 396-397 transactions costs, 395-396

systematic, 24-25 and system risk

rebalance, long-run average holding, 396-397 returns are not returns

money market mutual funds, 23-24

interconnectedness, 43 and market liquidity, 42 and plumbing, 42

infrequent trading, 386 selection bias, 389-390 survivorship bias, 385-386

solvency, 41

unsmoothing returns, 386-389

404

■

Index

illiquidity

international interest, 121

asymmetric information, 383

measurement, 126

causes of, 38

measures for understanding flows

clientele effects and participation costs, 383 crises, 385

other cash transactions, 127

funding constraints, 383 hurdle rates, 397

time sensitive obligations, 127

optimal holdings reduction, 396

total intraday credit lines to clients and counterparties, 127 total payments, 127

price impact, 383 risk premiums

settlement positions, 127 total bank intraday credit lines available and usage, 127

quantifying measurement and monitoring risk levels

across asset classes, 391-392

client intraday credit usage, 128

within asset classes, 392-393

daily maximum intraday liquidity usage, 127-128 intraday credit relative to tier 1 capital, 128

market making, 393-395 rebalancing, 395 search frictions, 383 sources of, 383 transaction costs, 383 immunization, 77-78 impact factors, 178, 179 inflation risk, 72 infrequent trading, 396-397 illiquid assets returns are not returns, 386 Institute for International Finance (IIF), 307 interconnectedness, 43 interest-bearing transaction deposits, 223 interest rate asset-liability management, 351 components, 353-355 forces determining, 351-352 measurement, 352-353 responses to, 355-356 deposits composition, 225-226 cost of different deposit accounts, 228-229 ownership, 226-228 risk, 69, 262, 266, 351 interest-sensitive gap management, 356 internal audit, 182 internal hedge funds, dealer banks, 157 international Eurocurrency deposits, 59 intraday credit, 125 intraday credit relative to tier 1 capital, 128 intraday liquidity, 132 intraday liquidity risk, 132 intraday liquidity risk management FMU risk collateral, 131 contingent liquidity, 131 liquidity savings mechanism, 131 management, 129-130 monitoring, 130-131 net debit caps, 130-131 settlement windows, 131 governance of, 125-126

payment throughput, 128 stress testing role, 128-129 uses and sources, 121, 123, 124 asset purchases/funding, 122 cash balances, 125 collateral pledging, 122 funding of nostro accounts, 122 intraday credit, 125 liquid assets, 125 other term funding, 125 outgoing wire transfers, 122 overnight borrowings, 125 settlements, at PCS systems, 122 inventory management by dealers, 37 investments, 56 advantages and disadvantages, 58 capital market instruments, 57 corporate bonds, 61 corporate notes, 61 municipal bonds, 60-61 municipal notes, 60-61 treasury bonds, 60 treasury notes, 60 factors affecting business risk, 70-71 call risk, 71 credit/default risk, 69-70 expected rate of return, 65 inflation risk, 72 interest rate risk, 69 liquidity risk, 71 pledging requirements, 72-73 prepayment risk, 71-72 tax exposure, 65-69 maturity management tools duration, 77-78 yield curve, 76-77 maturity strategies back-end load maturity policy, 75 barbell strategy, 75 front-end load maturity policy, 74-75

Index

■ 405

investments (continued) ladder/spaced-maturity policy, 73-74 rate expectations approach, 75-76 money market instruments, 57 bankers' acceptances, 59-60 certificate of deposit (CD), 59 commercial paper, 60

vs. capital, 183 definition, 2, 18 demand for and supply of, 88-90 problems in financial firms, 90 sources of ability to borrow, 7

federal agency securities, 59

cash and treasury securities, 6 central bank borrowing, 8

international Eurocurrency deposits, 59

hedging issues, 8

short-term municipal obligations, 60 treasury bills, 57

securitization, 8 trading book positions, 6-7

treasury bonds, 59

wholesale and retail deposits, 7-8 vs. yield, 182-183

treasury notes, 59 portfolio haircuts, 179

liquidity coverage ratio (LCR), 9

recent development, instruments securitized assets, 61-63

liquidity crisis team, 212 liquidity dashboard, 183

structured notes, 61 securities held by banks, 63-64

liquidity gap, 94

security portfolio, 57

liquidity generation capacity (LGC) AFS bonds, 143

irrational exuberance, 13-14

classification, 142 definition, 141

L

security-linked liquidity, 142 security-unlinked liquidity, 142

lagged reserve accounting (LRA), 103

liquidity indicator approach, 94, 100-101

legal reserves, 103 clearing balance rules, 106

liquidity management, 206-207

required reserves calculation, 104-106 reserve computation, 103-104 reserve maintenance, 104 reserve requirements, 104 leverage asset volatility and, 37 definition, 31 derivatives, 35-36 liquidity black holes, 12-13 margin loans and leverage, 33 measurement, 31 short positions, 34 structured credit, 36-37 liability management, 92, 248, 350 strategy, 350-351 liquid asset, 91, 125 buffer, 174 liquidating HARVARD, 382-383 liquidating HARVARD redux case for investing, 397-398 investment advice, endowments, 398-399 liquidity, 88 black holes (see also liquidity risk) diversity, importance of, 14 irrational exuberance, 13-14 leveraging and deleveraging, 12-13

Liquidity Management Information Systems (LMIS), 288, 292-293 liquidity managers strategies asset liquidity management strategies, 91-92 balanced liquidity management strategies, 93 borrowed liquidity (liability) management strategies, 92-93 guidelines for, 93 liquidity needs estimation funds approach, sources and uses, 94-96 liquidity gap, 94 liquidity indicator approach, 100-101 structure of funds method, 97-100 ultimate standard, 101-103 liquidity options, 135-136 liquidity position metrics, 181 prospective, 181 liquidity risk, 71 adjusted VaR, 5 bid-offer spread, market liquidity., 6 credit crisis, 2 definition, 137, 138 in funding regulation, 9-10 reserve requirements, 9 sources of, 6-9 funding cost risk, 137 market liquidity measurement, 4 quantitative measurement

positive and negative feedback traders, 11-12

causes of, 138

regulation, impact of, 14

sources of, 138

406

■

Index

solvency from, 2 in trading bid-offer, 2 predatory trading, 3 transparency, importance of, 3 unwinding position optimally, 5-6 liquidity risk reporting cash flow asset and liability, 194 survival horizon, 197, 198 treatment, 204 cumulative liquidity report, 195

liquidity vs. capital, 183 liquidity vs. yield, 182-183 organizational scope currency, 176 liquidity transfer restrictions, 175 regulatory jurisdiction, 176 outputs of model, 180 capital and performance metrics, 181 liquidity position metrics, 181 prospective liquidity position metrics, 181 stress testing assumptions, 181 planning horizon, 176

daily liquidity report, 188-192 deposit tracker report, 188

position data collection and aggregation, 183

firm-specific funding yield curve, 201

with related risk models, integration of, 184

frequency of reporting, 202-203 funding concentration report, 192-193, 198 funding maturity gap ("mismatch") report, 192

scenario development historical scenarios, 177

group treasury qualitative reporting, 203 liability profile, 193, 200 liquid securities list, 193 maturity gap report, 196 stress test reports, 203-207 summary and qualitative reports, 201-202 UK liquidity reporting requirements, 203 undrawn commitment report, 193 wholesale pricing and volume, 200-201 liquidity savings mechanism, 131 liquidity stress test analytics, 183 and asset liability management, 184 assumptions development business dial back, 180 collateral requirements, 180 contingent liabilities, 180

regulatory report generation, 183

hypothetical scenarios, 177-178 stressed inflows, 174 stressed liquid asset buffer, 174 stressed outflows, 174 sustainable infrastructure, 183 testing techniques deterministic models, 177 historical statistical techniques, 176 Monte Carlo simulation, 177 liquidity transfer pricing (LTP) application, 289 contingent liquidity risk management banks liquidity cushions unveiled by GFC, 302 extant guidance focuses on size, 302 liquidity cushions, 301 poor attribution of cost of carrying, 302-303 pricing contingent liquidity risk, 304-305

deposit behavioral characteristics, 180 deposit outflows, 179-180

towards better management, 303-304 definition, 288 governance of, 288-289

impact factors, 178, 179

governing, 290-291

investment portfolio haircuts, 179

Liquidity Management Information Systems (LMIS), 292-293

unsecured wholesale funding, 180

management

baseline scenario, 177 and capital stress testing, 184 design components, 176 funding optimization, 183 and funds transfer pricing, 184 governance and controls asset-liability committee (ALCO), 181 internal audit, 182

internal funding structure, centralised vs. decentralised, 291 oversight, 292 policies, 291 trading book funding policies and identifying funding requirements, 291-292 need for more guidance on, 290 on-balance sheet funding liquidity risk management matched-maturity marginal cost of funds, 297-298

model risk management, 182

maturity transformation, 294

risk management, 182 treasury, 182

pooled "average" cost of funds approach, 295 poor LTP practices, 294

liquid asset buffer, 174 liquidity dashboard, 183 liquidity optimization

pricing funding liquidity risk, 298-301 "zero" cost of funds approach, 294 principles and recommendations, 307

Index

■ 407

liquidity transfer pricing (LTP) (Continued) purpose, 288

mobile apps, 223 model risk management, 182

regulatory developments, 289-290

money market deposit accounts, 223

remuneration practices, 293-294 sizing and attributing costs, 289

money market investment instruments

liquidity transfer restrictions, 175 locational banking statistics by nationality (LBSN), 328 long financing, 275-276

bankers' acceptances, 59-60 certificate of deposit (CD), 59 commercial paper, 60 federal agency securities, 59

long-term capital management (LTCM), 12

international Eurocurrency deposits, 59

LTP, see liquidity transfer pricing (LTP)

short-term municipal obligations, 60 treasury bills, 57

M

treasury bonds, 59 treasury notes, 59

management committee, 212 margin, 12 margin loans, 26-27 market indicators, 51 market liquidity, 42 markets structure, collateral markets margin loans, 26-27 repurchase agreements, 27 securities lending, 27 total return swaps, 27 market-wide credit/liquidity stress, 129 Markowitz, H., 382, 395 maturity gap, 355 maturity management tools duration immunization, 77-78 portfolio immunization, 78 yield curve carry trade, 77 forecasting interest rates and economy, 76 riding, 77 risk-return trade-offs, 76-77 maturity strategies, investments back-end load maturity policy, 75 barbell strategy, 75 front-end load maturity policy, 74-75 ladder/spaced-maturity policy, 73-74 rate expectations approach, 75-76 maturity transformation, 18-19 M.E.R.l.T. early warning indicators environments, both normal and stressed, 50 escalation, 50 forward looking bias/view, 49-50 industry practices, 51 integrated systems, 50 measures, 47, 49 reporting, 50 spanning various time horizons, 50 thresholds, 50-51 Metallgesellschafi (MG), 9

408

■

Index

money market mutual funds, 23-24 money position management, 106-110 manager, 103 Monte Carlo simulation, 177 mortgage-backed bond, 61 municipal bonds, 60-61 municipal notes, 60-61 municipal obligations, short-term, 60

N National Council of Real Estate Investment Fiduciaries (NCREIF), 388-389 negotiable CD, 256-258 negotiable order of withdrawal (NOW) accounts, 223 net debit cap, 130-131, 132 net interest margin, 356 net interest margin (NIM), 356 net liquidity position, 89 net stable funding ratio (NSFR), 9 netting/net settlement, 132 non-amortising bullet loans, 298 nondeposit funds demand for, 261 factors to consider, 262-267 sources, 249 long-term, 260 noninterest-bearing transaction (demand) deposits, 223 nontransaction (savings/thrift) deposits, 224 Northern Rock, 7 nostro account, 122, 132 NOW accounts, 223

O off-balance-sheet financing, 160-161 off-balance-sheet funding, 22-23 off-the- run (OFR), 281 on-balance sheet funding liquidity risk management matched-maturity marginal cost of funds, 297-298 maturity transformation, 294

pooled "average" cost of funds approach, 295 poor LTP practices, 294

2007-2009 crisis, 277-280 and long financing, 275-276 rates, 280-281

pricing funding liquidity risk, 298-301 "zero" cost of funds approach, 294 on-the-run (OTR), 281

reverse repos and short positions, 276 in United States

opportunity cost, 91 order-driven system, 38 other term funding, 125 outgoing wire transfers, 122

and auction cycle, 281-284 and level of rates, 284-285 reserves computation, 103-104

overdraft penalties, 110 overnight borrowings, 125

computation period, 103 maintenance, 104

over-the-counter derivatives, 158-160

required calculation, 104-106

P

sources of, 110

requirements, 104

passbook savings deposits, 224 payment finality, 132 payments, clearing, and settlement services (PCSs), 132 settlements, 122 Payment System Risk (PSR) policy, 121 payment throughput, 128 Pioneering Portfolio Management, 382 pledging requirements, 72-73 plumbing, system and funding liquidity risk, 42 policy responses, 165-166 portfolio immunization, 78, 372 portfolio shifting, 68 predatory trading, 12 prepayment risk, 71-72 price sensitivity to changes in interest rates, 366 pricing deposit at cost plus profit margin, 230 services, 229 primary credit, 256 primary obligor, 59 prime brokerage, 160 private equity, secondary markets, 394 problems with interest-sensitive GAP management, 362-364

Q quote-driven system, 38

R real estate market, 3

resiliency, 38 retirement savings deposits, 224-225 reverse repos and short positions, 276 transactions, 144 reverse Yankee issuance, 338 risk assessment, 126 Ross, S., 386

S seasonal component, 95 seasonal credit, 256 secondary credit, 256 securitization process, 8, 26 securitized assets, 61-63 security borrowing, 145 dealing, 158 held by banks, 63-64 lending, 27, 144 linked liquidity, 142 portfolio, 57 unlinked liquidity, 142 selection bias, illiquid assets returns, 389-390 sell/buyback transactions, 144 seller's market, see real estate market settlement windows, 131 solvency, 2 system and funding liquidity risk, 41

rebalance, long-run average holding, 396-397

sources and uses, funds approach, 94-96 stop-loss rules, 11

Recommendations for Securities Settlement Systems (RSSS), 121 regulatory jurisdiction, 176

stress testing assumptions, 181 stripped security, 62

relationship pricing, 237 repo transactions, 144

structured credit and off-balance-sheet funding, 22-23 structured notes, 61 Super NOWs, 223

repurchase agreements (repo), 27, 92, 252-255 back-to-back trades, 276 bond trading special, 285 and cash management, 274-275

survivorship bias, 385-386 sweep accounts, 107 Swensen, D., 382

Index

■ 409

system and funding liquidity risk interconnectedness, 43 and market liquidity, 42 and plumbing, 42 solvency, 41 systematic funding liquidity risk, 24-25 Systemically Important Financial Institutions (SIFIs), 132 systemic risk, 132 definition, 18

transparency, 3 treasury, 182 treasury bills, 57 treasury bonds, 59, 60 treasury notes, 59, 60 trend component, 95 trend trading, 11 Truth in Savings Act, 234

U

T tax exposure, 65-69 tax swap, 67 term structure of expected cash flows (TSECF), 138-141 term structure of expected liquidity (TSLe), 149-150 thrift deposits, 224 time critical payment, 132 time deposits, 224 total return swaps, 27 trading book positions, 6-7 dealer banks, 158

underwriting, dealer banks, 158 unsecured wholesale funding, 180 unsmoothing returns dramatic effect, 389 Geltner-Ross-Zisler unsmoothing process, 386 illiquid assets returns are not returns, 386-389 properties, 388 real estate, 388-389 transfer function, 386 US dollar shortage banks' international positions, 311-313 during crisis, 310 international policy response, 325-327 long and short of banks' global balance sheets balance sheet expansion since 2000, 316

liquidity risk bid-offer, 2 predatory trading, 3 transaction cost liquidity risk, 39-40 costs, portfolio choice with asset allocation, 395-396 (payments/demand) deposits, 222-224 liquidity, definition, 18 measurement adverse price impact, 40-41 transaction cost liquidity risk, 39-40 transactions liquidity risk causes adverse selection, 37 cost of trade processing, 37 differences of opinion, 38 inventory management by dealers, 37 order-driven system, 38 quote-driven system, 38 characteristics of market liquidity adverse price impact, 38 bid-ask spread, 38 depth, 38 resiliency, 38 slippage, 38 tightness, 38 definition, 18

410

■

Index

cross-currency funding positions, 316-320 maturity transformation across banks' balance sheets, 320-323 structure of banks' operations, 313-316 magnitude, risk, 310 market conditions, 323 U.S. Treasury bill, 57 U.S. Treasury market, 392

W wholesale and retail deposits, 7-8

Y yen/dollar case, 343-344 yield curve carry trade, 77 forecasting interest rates and economy, 76 riding, 77 risk-return trade-offs, 76-77 yield to maturity (YTM), 65, 352

Z Zisler, R., 386