By Robert Fiedler The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector In advance of the turmoil, asset markets were buoyant and funding was readily available at low cost The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time Financial regulators across the globe are urging institutions to address this dimension of financial risk more comprehensively ‘Robert Fiedler is one of a handful of thought leaders in the field of liquidity risk management at financial institutions He is also one of the most experienced observers and contributors No one is better qualified than Robert to address the topics in this book.’ Leonard Matz, Liquidity Risk Advisers Liquidity Modelling Liquidity risk is hard to understand It needs to be broken down into its components and drivers in order to manage and model it successfully Liquidity Modelling by Robert Fiedler In this comprehensive guide to modelling liquidity risk, Robert Fiedler’s practical approach equips the reader with the tools to understand the components of illiquidity risk, how they interact and, as a result, to build a quantitative model to display, measure and limit risk Liquidity Modelling is required reading for financial market practitioners who are dealing with liquidity risk and who want to understand it PEFC Certified This book has been produced entirely from sustainable papers that are accredited as PEFC compliant www.pefc.org liquidity modellingCS4.indd 15/11/2011 10:39 ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page i — #1 ✐ ✐ Liquidity Modelling ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page ii — #2 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page iii — #3 ✐ ✐ Liquidity Modelling by Robert Fiedler ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page iv — #4 ✐ ✐ Published by Risk Books, a Division of Incisive Media Investments Ltd Incisive Media 32–34 Broadwick Street London W1A 2HG Tel: +44(0) 20 7316 9000 E-mail: books@incisivemedia.com Sites: www.riskbooks.com www.incisivemedia.com © 2011 Incisive Media ISBN 978-1-906348-46-5 Reprinted with corrections 2012 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Publisher: Nick Carver Commissioning Editor: Sarah Hastings Managing Editor: Lewis O’Sullivan Designer: Lisa Ling Copy-edited and typeset by T&T Productions Ltd, London Printed and bound in the UK by Berforts Group Conditions of sale All rights reserved No part of this publication may be reproduced in any material form whether by photocopying or storing in any medium by electronic means whether or not transiently or incidentally to some other use for this publication without the prior written consent of the copyright owner except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Limited of Saffron House, 6–10 Kirby Street, London EC1N 8TS, UK Warning: the doing of any unauthorised act in relation to this work may result in both civil and criminal liability Every effort has been made to ensure the accuracy of the text at the time of publication, this includes efforts to contact each author to ensure the accuracy of their details at publication is correct However, no responsibility for loss occasioned to any person acting or refraining from acting as a result of the material contained in this publication will be accepted by the copyright owner, the editor, the authors or Incisive Media Many of the product names contained in this publication are registered trade marks, and Risk Books has made every effort to print them with the capitalisation and punctuation used by the trademark owner For reasons of textual clarity, it is not our house style to use symbols such as TM, ®, etc However, the absence of such symbols should not be taken to indicate absence of trademark protection; anyone wishing to use product names in the public domain should first clear such use with the product owner While best efforts have been intended for the preparation of this book, neither the publisher, the editor nor any of the potentially implicitly affiliated organisations accept responsibility for any errors, mistakes and or omissions it may provide or for any losses howsoever arising from or in reliance upon its information, meanings and interpretations by any parties ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page v — #5 ✐ ✐ I dedicate this book to my father, Edvard Fiedler 1924–2005 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page vi — #6 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page vii — #7 ✐ ✐ Contents About the Author ix Preface xi Introduction Setting the Scene: Why Liquidity Is Important in a Bank 11 What Is Liquidity Risk? 19 Illiquidity Risk: The Foundations of Modelling 35 Capturing Uncertainties 53 A Template for an Illiquidity Risk Solution 79 The Counterbalancing Capacity 117 Intra-Day Liquidity Risk 167 Liquidity Transfer Pricing and Limits 219 10 The Basel III Banking Regulation Index 249 281 vii ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page viii — #8 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page ix — #9 ✐ ✐ About the Author Robert Fiedler owns and runs Liquidity Risk Corp, which consults on methodology and processes and also builds prototypes and IT solutions for liquidity risk In the first half of his career, Robert spent over a decade in the treasury/dealing rooms of numerous international major banks as a money market liquidity manager, trading interest rate products and derivatives Later he switched to risk management and developed Deutsche Bank Group’s liquidity risk methodology, on which he successfully built a global system (LiMA) which measures and limits the bank’s funding liquidity Moving into software development, Robert became country coordinator for Germany and executive director of Asset Liability Management (ALM) and Liquidity Risk Solutions at Algorithmics Inc, Toronto Subsequently, he joined the board of Fernbach Software, Luxembourg, where he oversaw the development of ALM, performance measurement, IFRS and liquidity risk software During this time he constantly developed liquidity methodologies and taught his research results Jointly with the University of St Gallen, Switzerland, he developed a stochastic model that optimises the risk and return of investing non-maturing assets and liabilities ix ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 276 — #290 ✐ ✐ LIQUIDITY MODELLING the possibility to gradually adjust its balance sheet within a year to suit the NSFR The simplest but possibly most expensive measure would be to match-fund every asset until the end of its tenor The NSFR can be fixed for now with a funding that is “just” longer than one year but its positive effect will diminish when its maturity drops below one year and will preserve this negative effect until it matures.21 If the bank increases its balance sheet and purchases an asset with a low RSF factor to improve the NSFR, the positive effect will only fully function if the ASF factor of the corresponding funding is high enough If the bank buys short-term corporate bills (an RSF factor of 0) and simultaneously acquire less stable demand deposits, the effect will be +80%; whereas, in the case of unsecured wholesale funding, the advantage drops to 50% The specific impact depends of course on every bank’s individual balance sheet In general, it can be said that the NSFR is enhanced if less stable funding is substituted by more stable funding and assets that require more stable funding are replaced with assets that require less stable funding CONCLUSIONS Basel III sets out the regulatory minimum requirements for the measurement and management of liquidity risk It is a big step forward for the inclusion of liquidity risk in the overall risk management process Basel III allows and entails from each bank the implementation of individual liquidity methods that are adapted to the concrete situation and business model of the bank but correspondingly defines the framework and parameters to be applied The measures of Basel III relate primarily to illiquidity risk and not to liquidityinduced value risks The term structure is very raw: the LCR relates to the period of one month, while the NSFR covers a period of one year; however, the main parts of the illiquidity risk methods, FLE and CBC, are integrated into the concept The regulatory constraints come as traditional ratios, which makes the conceptions a little technically cumbersome: cash outflows are positive and, instead of the worst liquidity situation within the 30 days of the LCR, the end of the time interval is regarded In particular, the LCR comes in the form HLA / TNCO > 100%, which can be expressed as HLA > TNCO or, in our notation CBC > FLE 276 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 277 — #291 ✐ ✐ THE BASEL III BANKING REGULATION The HLA is a simplified version of the CBC: the liquifiability classes are rigidly restricted to HLA1 , HLA2 and “not eligible” The liquification process is likewise extremely simplified: the value of an asset in the HLA is multiplied by a haircut and thus represents a hypothetical cash inflow with indefinite time of occurrence On the one hand, the banks will improve the liquifiability of their asset holdings, which is strongly correlated to the quality of these assets; on the other hand, the HLAs will generate additional costs for the banks, which have entered into the funding incongruities in order to generate additional income and thus improve their poor profitability As an overall economic effect, it is likely that in a future crisis the markets will regard all assets that are not HLA-eligible as illiquid In the TNCO, cash outflows and inflows are opposed, although cashflows in the sense of the LCR are not cashflows in the understanding of this book but are rather adjusted outstandings of assets or liabilities with plus and minus signs The regulation uses a scenario which is implicitly given by its parameters; there are, however, no other scenarios The uncertainties of the future liquidity situation are aggregated into a single condition that caps the offsetting inflows at 75% of the outflows, thus reflecting generically that inflows are not under the control of the bank and are therefore less certain than outflows The potential effect of the LCR and the NSFR on a bank’s balance sheet is immense: banks have in the past tried to generate additional income by skewing longer assets with shorter liabilities Basel III forces them to cover these mismatches with asset holdings that can be easily liquified This process will reduce funding incongruities and thus illiquidity risk; but even if a bank were to decide to matchfund all assets, the 75% rule would require the bank to hold a certain amount of HLAs which will produce costs The NSFR supports resilience over a longer time horizon by forcing banks to use more stable sources of funding on an on-going basis The crux of the matter is the parameterisation: in the ASF, “stable” non-maturing or term deposits are assumed to roll over with 90%; which means that less than 1% are assumed to irrevocably flow out within a month: this seems to be highly optimistic in a crisis scenario Therefore, the costs of these deposits might increase sharply because of the competition among banks, and thus reduce the income from these instruments which has been a pillar of profit for banks with the 277 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 278 — #292 ✐ ✐ LIQUIDITY MODELLING corresponding business model During the 2008 crisis the owners of savings deposits and similar instruments believed the affirmations of the governments that their funds would be secure in the troubled banks In a future liquidity crisis, the ability of the governments to protect depositors might be cast into doubt and thus can lead to bank runs On the RSF side, several asset categories are assumed to be self-financing, which either means that a liquidity crisis will not last for a full year or the NSFR contradicts the assumption in the LCR that only HLAs can be used for liquification purposes Finally, the liabilities in the ASF are assumed to be rolled over at least to a certain degree, but the assets are not expected to be renewed Either the bank is assumed to cease dealing in credits or the roll-over assumption in the NSFR is inconsistent In summary, Basel III is in line with the liquidity measurement methods used by the more sophisticated banks but, due to its restriction in complexity, it is only a basic standard and not a fully fledged liquidity management methodology, which will it make difficult to integrate into more refined approaches The parameterisation is critical: many banks perceive it as too restraining, whereas from an academic point of view it is possibly not preventive enough All HLAs should ideally be central bank eligible, but not every central-bank-eligible asset is automatically an HLA RWA denotes “risk weight asset” under the Basel II standardised approach The HLAs are naturally positive numbers; the cash outflows in this context, however, need to include also a “+” sign, because otherwise the left-hand side of the inequality, which has to be greater than 1, would be negative The eligibility criteria in Basel III are not identical to the ECB eligibility criteria The LCR only regards maturities within the 30-day horizon However, it is not the “real” maturity that counts, but the modelled tenors of assets and liabilities which have no specific maturity date Even match-funded transactions can cause affect the LCR: different roll-off factors for the asset (respectively, the liability) can result in significant “cliff-effects”, when match-funded pairs of cashflows are running down (eg, covered bonds) If the standing of the bank weakens in a potential counterparty’s view, the credit risk of making a deposit with the bank is far higher than entering into an interest rate swap with it Consequently, interest rate hedging will still be possible for the bank (though costly) when the possibility to fund with longer term deposits has already ceased In practice it is not so clear how this can be done, as, for example, the tenor of a loan with an embedded extension option for the loan taker is not unequivocally determined and can thus not be match-funded in a straightforward way Financial bonds and equities in particular not qualify as HLAs 10 For liability-driven banks this might be different 11 For example, contingent liquidity risks such as drawings on credit or liquidity facilities 278 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 279 — #293 ✐ ✐ THE BASEL III BANKING REGULATION 12 The line items on p 32ff in the Basel III Liquidity document 13 The type of customer is another dimension which is very important for the LCR and can be used as a steering instrument, since different roll-over assumptions are applied to different types of counterparts For the current view on tactical improvements we can, however, not assume that changes of customer types can be immediately be realised 14 When the residual maturity of the security is less than 30 days The HLA move from the buffer into the inflows (TNCO) (LCR line item 203) 15 Changes to counterparts with higher roll-over factors would also help, but can only be executed in a longer perspective 16 The treasury has internally match-funded the originated transaction for the originator, which does not necessarily mean that it has externally match-funded its own position 17 Free limit for investment in HLA2 must be available 18 In reality, the risk-adjusted return of the “risk-free” bond can even be higher than that of the risky bond, as banks that try to generate higher term income (for accounting purposes, not on a value basis) gauge their risk adjustments in such a way that they “can accept” the yield of the risky bond A non-ambiguous method to determine the expected return of a bond would be to deduct the costs of a credit insurance (CDS) from its yield (assuming that the CDS price is quoted in the market and not made up internally) This method also highlights that the “risk-free” bonds are not risk-free (their CDSs not come a zero cost) but are only the best approximation that can be found in the market 19 In fact, we need €33.33, as the 25% additional HLA is not sufficient as its funding is also detrimental for the TNCO If we purchase a 100%/3 = 33.33% new HLA and match-fund it, we get LRC = 100% 20 Deutsche Bank reported end-of-2008 assets of €2,202 billion and a capital of €31.9 billion, which is less than 1.5% 21 Unless the borrowing is prolonged 279 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 280 — #294 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 281 — #295 ✐ ✐ Index (page numbers in italic type relate to tables or figures) A asset flows, cashflows and inventories, 105–7 asset and option inventories, interaction between, 104–5 assets and liabilities, yield curves for, 223–4 B banking crisis 2008, 39 Basel’s initial reaction to, 249 historical risk models fail during, see also Basel III banks: assets of, capital agglutinated to cashflows of, 33 balance sheet of, described, 35–41 cashflows, 36–7 financial transactions, payments and nostro accounts, 35–6 forecasts and scenarios, 38–41 uncertainty and risk, 37–8 critical question for, 12 and financial transactions and balance sheets, 11–12 liquidity’s importance to, 11–18 and income, expense and earnings, 12–13 and time value of payments, 13–14 “base case”, 39 Basel Committee on Banking Regulation, 209 Basel Committee on Banking Supervision (BCBS), 249 Basel III, 249–79 available stable funding 273, 273 CBC in, 160 liquidity coverage ratio (LCR), 251–72 bad, reasons for, 257–60 examples of improvements to 264, 265, 266 idea and realisation of, 252–7 improvements to, by bank, 257–72 instantaneous improvements to, 261–72 possible strategies to comply with, 260–72 stock of high-quality liquid assets, 251–2 strategies for future improvement to, 268–72 tactical improvements to 260 total net cash outflows, 252 liquidity related part of 251 liquidity risk in, 250 and net stable funding ratio (NSFR), 272–6 idea and realisation of, 274–5 required stable funding, 274 steering of, by bank, 275–6 structure of 250 bid–offer spread, 24–5 widening of, increasing illiquidity reflected by, 25 bilateral interbank clearing, 207 blocked securities, 136–7 bootstrapping algorithm, 58, 224 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 282 — #296 ✐ ✐ LIQUIDITY MODELLING breach of contract, 170 by correspondent bank, 202–3 distorted payments due to, 198 wilful, distortion by, 199 breach options, 66–9 breach-of-covenant transactions, 96–8 C capital: cashflows agglutinated to, 33 and liquidity’s importance to banks, 15–17 as opaque concept, 15 and value and risk, 16–17 as buffer for liquidity risk, 32–3 cashflow(s): agglutinated to capital, 33 and asset flows and inventories, 105–7 capital agglutinated to, 33 of conditional transactions, 89 contingent, 56, 59–60, 89, 111–12, 187–8, 189–90 from contractual transactions, 89 deterministic, 55, 82 discussed, 36–7 external and internal, 112 as forecast of future payment, 46 as function of time, 112–13 generated by rejectable liquidity options, 89 non-deterministic, 56–60 at risk, 60 stemming from short selling, remark on, 158 taxonometry of, 110–13 time-correlated, 113 timelines of contracts and 177 of unenforceable transactions, 89 variable, 56–7 CBC, see counterbalancing capacity (CBC) central banks, liquidity of markets for funds of, 26–8 collateral and securities flows and inventories, 107 conditional transactions, 62 contingent cashflows, 59–60 contingent transactions and contractual options, 71–4 contractual liquidity options, 74 contractual options, and contingent transactions, 71–4 contractually contingent transactions, 98 counterbalancing capacity (CBC), 117–65 in Basel III, 160 basic, forward cashflows and inventories establishing 128 basis of, for a single security, 126 and building blocks of a technical solution, 126–37 admissible portfolio of securities, determining, 126 blocked securities, 136–7 for single security, 126–36, 131, 132, 133, 134, 135 and classes of securities, solving problem for, 137–57 implementation, 138 liquifiability classes/liquidity units, 137–8 stepwise solution, 138 components of, 121–4 concept, extension of, 160–1 contractual elements of, 121–2 defining strategy for, 139–42 disjunct liquidity units for 125 and European Central Bank (ECB) open market operations, 156–7 282 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 283 — #297 ✐ ✐ INDEX and forward liquidity exposure (FLE), 124–5, 157 further issues regarding, 157–62 future cashflow (FCF) of, for individual securities, 155 and liquidity buffers, reduction to, 161–2 and liquidity risk requirements, 118–19 and liquification, 142–3 null scenario before, 143 and measuring illiquidity risk, 45–6 and mitigation of account balances, 212 in narrower sense, 125–6 practical considerations of, 123–4 problem of, discussed, 119–26 rejectable liquidity options in, 122–3 specific transactions, treatment of, 155 strategy, definition of, 120–1 covenants: breach of, 96–8 liquidity-option, 75 option, inventories and flows of, 99–107, 100, 101 as options on options, 69 taxonometry of, 107–13 credit facility, simplified data model of 71 credit risk: of correspondent bank, 201–2 distortion of payments by, 198 currencies, forward liquidity exposure in, 44 D discount factors, (net) present values and internal rates, 225–6 disjunct and complete hierarchies of liquidity units, 84–5, 85 dynamic modelling, 61–3 and conditional transactions, 62 and endogenous transactions, 62 and exogenous transactions, 63 and hypothetical transactions, 61 and replacement transactions, 62 and unenforceable transactions, 62–3 E Einstein, Albert, 53 endogenous transactions, 62–3 and dynamic modelling, 62 parent and child, 62 European Central Bank (ECB), 49 open market operations of, 156–7 example bond, forward asset flows and inventories of 127 excess liquidity, 27, 28 exogenous transactions, 63 exposure and strategy scenarios, 88–91 exposure, risks stemming from uncertainty about, 38 F financial and liquidity options, 65–6 financial crisis, 2, 3, 39, 44, 62 financial instruments and markets, liquidity risk of, 22–5 forecast-at-risk, 57–9 forecasting process, risks stemming from uncertainty about, 38 forecasts, and scenarios, 38–41 283 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 284 — #298 ✐ ✐ LIQUIDITY MODELLING forward asset flows and inventories of an example bond 127 forward liquidity exposure (FLE), 41–6, 50 continuous/enhanced, 175–8 and counterbalancing capacity (CBC), 124–5 and deterministic cashflows, 55 enhanced, intra-day liquidity risks (ILRs) that go beyond, 191–7 and payments with very short notice, 191–2 and uncertainty about payments already received, 193–5 and uncertainty about payments not yet received, 192–3 enhanced, measurement of intra-day liquidity risk (ILR) with, 189–91 intra-day liquidity risk (ILR) that can be captured with, 177–8 intra-day liquidity risk (ILR) that cannot be captured with, 178 TNCO versus 255, 256 unequivocal determination of, 53 forward rate and forecast at risk, 57–9 G Group of Ten (G10), 208–9 Group of Twenty (G20), 249 H Herstatt risk, 208–9 high-quality liquid assets (HLA), 23, 160 hypothetical transactions: and dynamic modelling, 61–3 types of, 61 I IKB, illiquidity: and insolvency, 20–2 time dimension lacked by, 20 illiquidity inequality: first, 45 second, 50 illiquidity risk, 1–4, 33, 45 additional considerations concerning, 47–50 as “consequential risk”, and foundations of modelling, 35–52 measuring, 3–4, 41–50 and counterbalancing capacity, 45–6 forward liquidity exposure, 41–4, 42, 43 illiquidity risk solution, template for, 79–116 and inventories and flows, 99–107, 100, 101 of option covenants, 99–102 of transactions, 103–7 and liquidity (risk) drivers, 86–7 and taxonometry, 107–13 of covenants, 107 of transactions, 108–10 scenarios, 80–91 comprehensiveness, 81–2 dependency, 83–4 and disjunct and complete hierarchies of liquidity units, 84–5 exposure and strategy, 88–91 how realistic?, 87–8 liquidity units, 82 null, 82 and simulations, 80–1 uniqueness and consistency, 81 and technical implementation, 91–9 284 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 285 — #299 ✐ ✐ INDEX and example of credit facility, 98 and hierarchies of bank, 94 and portfolios, selections, inventories and flows, 91–3 and selections and hierarchies, 93 and transactions, 94–9 incorrectly captured deals, 190 individual securities, liquification of, 149 initial value, risks stemming from uncertainty about, 38 insolvency, and illiquidity, 20–2 interest-rate effects, in forward liquidity exposure, 44 interest-rate hedging, 231–2 intra-day deals, 190 intra-day liquidity risk, 167–217, 169 and bank’s incorrect payments, 195–7 and bilateral interbank clearing, 207 and breach of contract by correspondent bank, 202–3 and clearing that is effective only at end of day, 207 and continuous/enhanced FLE, 175–8, 177 and credit risk of correspondent bank, 201–2 and credit risk, distortion of payments by, 198 and direct debit, 208 and distorted payments due to breach of contract, 198 and distortion by wilful retention of payments, 199 and financial risk 172, 172–3 going beyond enhanced FLE, 191–7 and Herstatt risk, 208 and incorrectly captured deals, 190 and intra-day deals, 190 and late deals, 190 measurement of, with enhanced FLE, 189–91 measurement of, within an enhanced FLE or separately, 188–9 and minimum reserve, role of, 209–10 and non-financial transactions, 190–1 and nostro, insufficient coverage of, 200–1 and operational risk, distortion by, 198–200 other issues concerning, 197–200 and payment process, 178–88 and payment process, idiosyncratic risks of, 206–10 and payments to correct beneficiary bank, 197 and payments to wrong beneficiary bank, 196 and real-time gross settlement systems, 207 and risk as result of uncertainty, 173–4 and risks related to correspondent banks, 200–6 and time splinter risk, 202 and time-zone splinter risk (Herstatt), 208–9 and timed payments, 208 and vostro risk, 203–6, 204 and wilful breach of contract, distortion by, 199 inventories and flows, 99–107, 100, 101 collateral and securities, 107 of transactions, 103–7 and asset and cashflows, 105–7 assets and liabilities, 103–4 and interaction between asset and option, 104–5 L late deals, 190 Lehman Brothers, 199 285 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 286 — #300 ✐ ✐ LIQUIDITY MODELLING liquidity: contractual options, 74 excess, 27, 28 forward exposure of (FLE), 41–6, 50 and deterministic cashflows, 55 unequivocal determination of, 53 importance of, in a bank, 11–18 and capital, 15–16 of markets, for central bank funds, 26–8 importance of, to banks, 11–18 and income, expense and earnings, 12–13 and time value of payments, 13–14 of markets for funds of central banks, 26–8 option covenants, 75 rejectable options, 75–6 units, 82 disjunct and complete hierarchies of, 84–5 example of possible hierarchy, 85 value risk induced by, 28–32 liquidity-at-risk (LaR), liquidity buffers, reduction to, 161–2 liquidity coverage ratio (LCR), 251–72 bad, reasons for, 257–60 examples of improvements to 264, 265, 266 idea and realisation of, 252–7 improvements to, by bank, 257–72 instantaneous improvements to, 261–72 costs of, 263–72 possible strategies to comply with, 260–72 stock of high-quality liquid assets, 251–2 strategies for future improvement to, 268–72 tactical improvements to 260 total net cash outflows, 252 liquidity option covenants, 75 liquidity risk: in Basel III, 250; see also Basel III; regulation capital as buffer for, 32–3 explained and discussed, 19–34 of financial instruments and markets, 22–5 and illiquidity, 19–22 intra-day, 167–217, 169 and bank’s incorrect payments, 195–7 and bilateral interbank clearing, 207 and breach of contract by correspondent bank, 202–3 and clearing that is effective only at end of day, 207 and continuous/enhanced FLE, 175–8, 177 and credit risk of correspondent bank, 201–2 and credit risk, distortion of payments by, 198 and direct debit, 208 and distorted payments due to breach of contract, 198 and distortion by wilful retention of payments, 199 and financial risk 172, 172–3 going beyond enhanced FLE, 191–7 and Herstatt risk, 208 and incorrectly captured deals, 190 and intra-day deals, 190 and late deals, 190 measurement of, with enhanced FLE, 189–91 286 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 287 — #301 ✐ ✐ INDEX measurement of, within an enhanced FLE or separately, 188–9 and minimum reserve, role of, 209–10 and non-financial transactions, 190–1 and nostro, insufficient coverage of, 200–1 and operational risk, distortion by, 198–200 other issues concerning, 197–200 and payment process, 178–88 and payment process, idiosyncratic risks of, 206–10 and payments to correct beneficiary bank, 197 and payments to wrong beneficiary bank, 196 and real-time gross settlement systems, 207 and risk as result of uncertainty, 173–4 and risks related to correspondent banks, 200–6 and time splinter risk, 202 and timed payments, 208 and time-zone splinter risk, 208–9 and vostro risk, 203–6, 204 and wilful breach of contract, distortion by, 199 measurements of, 171–8 mitigation of, 210–13 of account balances and the counterbalancing across time, 211 between multiple currencies, 210–11 between multiple nostros in one currency, 210 capacity, 212 and collateral, double counting of, 212–13 other risks compared with, 4–6 and pricing of risk transfer, 238–9 as result of uncertainty, 174 types of, 174–5 wide field, scarcely covered, liquidity transfer pricing, 219–48 basic concepts of, 220–3 for assets and liabilities, 222–3 funds pricing: flat, mixed rate, 221 individual, 221–2 methods, 220 and payments and cashflows of transactions, 223 components, summary of, 242, 243 and liquidity risk limits, 242, 244–5 regulatory requirements, 245–7 and replicating transaction, deterministic costs of, 223–36, 228, 229, 230 and assets and liabilities, yield curves for, 223–4 and changing nominal amounts, 228, 229, 230 and discount factors, (net) present values and internal rates, 225–6 and funding matrix, 232–4, 233 and funding in other currencies, 234–5 and interest-rate hedging, 231–2 and liabilities, replication of, 231 and other deterministic costs, 235–6 and risk-neutral/ structural yields, 224–5 and structural liquidity premium, 226–31 287 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 288 — #302 ✐ ✐ LIQUIDITY MODELLING of risk, 236–42 and credit, operation and market risk, 237–8 credit risk, 240 and expected and unexpected risk, and economic capital, 236–7 and liquidity risk, 238–9 and originated transaction, price of uncertainty of, 236–40 and risk mitigation, effects of, 240–2 and secondary risk types, 239 and uncertainties from unreplicated relative values, 239–40 liquidity units, 82 example of possible hierarchy, 85 liquifiability class, synthetic security of, 143–4 liquifiability classes/liquidity units, 137–8 liquification algorithm, 147–8 illustration of 154 M markets, liquidity of, for central bank funds, 26–8 modelling: dynamic, and hypothetical transactions, 61–3 foundations of, and illiquidity risk, 35–52 N net stable funding ratio (NSFR), 272–6 idea and realisation of, 274–5 required stable funding, 274 steering of, by bank, 275–6 non-deterministic cashflows, 56–60 nostro, insufficient coverage of, 200–1 null scenarios, 82, 143, 152–5, 153 O operational risk, distortion by, 198–200 optionality: modelling, 70–76 and contractual options and contingent transactions, 71–4 role of, 63–70 options: breach, 66–9 contractual, and contingent transactions, 71–4 contractual liquidity, 74 financial and liquidity, 65–6 liquidity (covenants), 75 on options (covenants), 69–70 rejectable liquidity, 75–6 typical life cycle of, 73–4, 73 P payment process and intra-day liquidity risk, 178–88, 179, 180, 182 and bank as payment agent, 183 and cashflows, 183–8, 185 internal and external, 187 from deal to cashflow to payment, 184–6 execution in a bank, 182–3 indirect, 183 processing, 180–81 settlement, 179 uncertainties, 181, 187–8 payments, time value of, 13–15 and present-value concept, implicit assumptions in, 14–15 portfolios, selections, inventories and flows, 91–3 288 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 289 — #303 ✐ ✐ INDEX present-value concept: and credit v liquidity risk, 15 and time value of payments, 14–15 R reduction to liquidity buffers, 161–2 regulation: and Basel III, 249–79 available stable funding, 273, 273 and idea and realisation of NSFR, 274–5 and liquid assets, high-quality, 251–2 liquidity coverage ratio (LCR), 251–72 liquidity related part of, 251 liquidity risk in, 250 and net stable funding ratio (NSFR), 272–6 and required stable funding, 274 and steering of NSFR, by bank, 275–6 structure of, 250 counterbalancing capacity (CBC) and Basel III, 160 see also Basel III rejectable liquidity options, 75–6 replacement transactions, and dynamic modelling, 62 repoability, term structure of, 147 repos in synthetic bonds, 137 risk exposures, compensation of, 45 risk mitigation, effects of, 240–2 credit risk, 240 liquidity risk and cost thereof, 241–2 risk, transfer pricing of, 236–42 and credit, operation and market risk, 237–8 credit risk, 240 and expected and unexpected risk, and economic capital, 236–7 and liquidity risk, 238–9, 241–2 and originated transaction, price of uncertainty of, 236–40 and risk mitigation, effects of, 240–2 and secondary risk types, 239 and uncertainties from unreplicated relative values, 239–40 risks related to correspondent banks, 200–6 credit risk, 201–2 insufficient coverage of nostro, 200–1 S Sachsen LB, saleability, term structure of, 147 scenario dependency, 83–4 “scenario”, risk-management use of, 39 scenarios: and forecasts, 38–41 passive or active future behaviour modelled by, 40 scenarios for illiquidity risk solution, 80–91 comprehensiveness, 81–2 dependency, 83–4 liquidity units, 82–5 disjunct and complete hierarchies of, 84–5 null, 82 and simulations, 80–1 uniqueness and consistency, 81 securities lending, expressing blocking with, 137 Sombart, Werner, 16 structural liquidity premium, 226–31 289 ✐ ✐ ✐ ✐ ✐ ✐ “fiedler_reprint” — 2012/8/10 — 13:44 — page 290 — #304 ✐ ✐ LIQUIDITY MODELLING sub-prime securities, 2, 201 survival horizons, 158–60, 159 synthetic bonds, repos in, 137 synthetic security, 142, 145, 146 of liquifiability class, 143–4 structural position in, 145 T taxonometry, 107–13 of cashflows, 110–13 of covenants, 107–13 of transactions, 108–10 term structure of saleability, repoability, 147 “theoretical price”, 23–5 passim theory, Einstein’s stipulation concerning, 53 time-correlated cashflows, 113 time splinter risk, 202 time value of payments, 13–15 and present-value concept, implicit assumptions in, 14–15 time-zone splinter risk (Herstatt), 208–9 transactions: accumulated, across covenants, 110 active, 108–9 aggregated, with one covenant, 109 and forward asset flows and inventories of an example bond, 127 pseudo- 108 as result of options, 64 cashflow-generating function of, 39 taxonometry of, 107–13 see also conditional transactions; endogenous transactions; exogenous transactions; replacement transactions; unenforceable transactions typical life cycle of an option 73, 73 U uncertainties, 53–78 and cashflow at risk, 60 and contingent cashflows, 59–60 and forward rate and forecast at risk, 57–9 and payments already received, 193–5 and payments not yet received, 192–3 stationary modelling of, 54–60 and deterministic cashflows, 55 and non-deterministic cashflows, 56–60 and variable cashflows, 56–7 uncertainty, risk as result of, 173–4 unenforceable transactions, 62–3 uniqueness and consistency in scenarios, 81 unreplicated relative values, uncertainties from, 239–40 V value-at-risk (VaR), value-liquidity-at-risk (VLaR), 28–32, 30, 31 value, risk and capital, and liquidity’s importance to banks, 16 value risk, liquidity-induced, 28–32 variable cashflows, 56–7 vostro payments, risks stemming from, 203–6, 204 W Weber, Max, 16 290 ✐ ✐ ✐ ✐ ... 2012/8/10 — 13:44 — page iii — #3 ✐ ✐ Liquidity Modelling by Robert Fiedler ✐ ✐ ✐ ✐ ✐ ✐ ? ?fiedler_ reprint” — 2012/8/10 — 13:44 — page iv — #4 ✐ ✐ Published by Risk Books, a Division of Incisive...✐ ✐ ? ?fiedler_ reprint” — 2012/8/10 — 13:44 — page i — #1 ✐ ✐ Liquidity Modelling ✐ ✐ ✐ ✐ ✐ ✐ ? ?fiedler_ reprint” — 2012/8/10 — 13:44 — page ii — #2 ✐ ✐ ✐ ✐ ✐ ✐ ✐ ✐ ? ?fiedler_ reprint”... 19 Illiquidity Risk: The Foundations of Modelling 35 Capturing Uncertainties 53 A Template for an Illiquidity Risk Solution 79 The Counterbalancing Capacity 117 Intra-Day Liquidity Risk 167 Liquidity