Course Overview

This course focuses on the best practices in measuring, managing and controlling liquidity risk undertaken by leading financial institutions. Proven and tested methods to identify, measure, understand and manage liquidity risk are deduced and explained.

The attendees are lead through all relevant liquidity risk measures that allow to understand and measure the illiquidity risk of the company. Current regulatory requirements for the financial industry are explained and their implementation is described. The course will also cover funds transfer pricing, stress testing, contingency planning as well as intraday liquidity risk and securities management (Target2Securities).

Key Objectives and Learning Outcomes:

  • Learn from the best practice within leading international banks
  • Identify the nature of liquidity risk and how to distinguish its different types
  • Develop an economic methodology to measure, monitor and manage illiquidity risk
  • Learn to model liquidity risk exposures and their mitigating strategies
  • Understand, implement and learn how to manage the impacts of regulatory liquidity related requirements such as Basel III, BCBS 248, CEBS’ Guidelines on Liquidity Cost Benefit Allocation
  • Understand the role of liquidity risk in the bank’s transfer pricing process and quantify its direct and indirect costs

Course Content

Day 1

The Financial Crisis of 2007­2009

What happened?

  • Unrealistic business models and the resulting balance sheets
  • The eternal money generating machine: lend long and borrow short
  • Inadequately transfer pricing methods
  • Insufficient risk management
  • Deficient regulation and supervision
  • Collapse of money and repo markets
  • Fragile payment operations

Case studies: Northern Rock, German Landesbanks, Fortis and Dexia

Lessons from the crisis: learnt and forgotten

The Big Picture: Money Generation, Supply and Liquidity

  • Central banks and ‘fiat money’
  • Open market operations of the central bank
  • List of eligible assets
  • Money generation of commercial banks
  • Quantitative easing and its possible passing

Case studies: ‘Herstatt’, ‘ECB during the 2008 crisis’

The View of an Individual Bank

Financial transactions and their cash flows

The central bank nostro

Direct and indirect payments

The risks of the payment process

The risks of providing payment services for others

What is Liquidity? What is Liquidity Risk?

  • Key concepts: illiquidity and insolvency
  • Different types of liquidity risk

­ 1st degree liquidity risk: illiquidity risk

­ 2nd degree: liquidity induced value / earnings risks

  • Liquidity by term­structures: intra­day / short­term / long­term
  • Cash management vs. liquidity risk management

Liquidity Risk Exposure

Measuring Illiquidity Risk: The Forward Liquidity Exposure (FLE)

  • Starting with a static balance sheet
  • Forecasting of the bank’s nostro
  • Simulating the balance sheet as set of transactions

­ The bank’s complete set of transactions

­ External transactions

­ Internal & quasi­external transactions

  • The future payments of a transaction
  • Future payments with cash flows

Capturing Uncertainty with Cash Flows

  • Expected cash flows (ECF)
  • Deterministic / non­deterministic cash flows
  • Floating cash flows (market simulations)
  • Conditional cash flows (client decision simulations)

Stochastic Concepts

  • Liquidity­at­Risk (LaR)
  • Cash­Flow­at­Risk (CFaR)
  • Value­Liquidity­at­Risk (VLaR)

Day 2

Liquidity Risk Mitigation

Why Capital is not a Buffer against the Lack of Liquidity

  • Capital and value risks (credit & market risk)
  • Shortness of funds: what can be done?

­ The bank’s ability to attract new funds

­ Creation of cash inflows through repo and sales of liquid assets

Liquid Assets

  • Characteristics of liquid assets
  • Eligibility: available for the desired liquification process?

­ Encumberedness of assets

­ Liquification channels

  • Possession and ownership in time: the Forward Asset Inventory
  • Classification of liquifiability: the LiX of an asset

Liquidity Generation Strategies: The CounterBalancing Capacity (CBC)

  • Liquification classes
  • Liquification haircuts, value decays and upper limits
  • The liquification algorithm and its parameters
  • Scenarios for the CounterBalancing Capacity
  • Embedment of the CBC into the Gap Analysis (FLE)
  • Related Liquidity Generation concepts:

­ Liquidity Buffer, Day­Count­to­Default, Liquidity Barometer, Survival Horizon

Discussion: the Liquid Asset Buffer

  • Instruments to include
  • The right size
  • The funding
  • Optimizing costs

Integrating Dynamic Balance Sheet Behaviour

  • Why simulating a static balance sheet doesn’t make too much sense
  • Scenarios: Exposures and Strategies
  • Squaring the run­off balance sheet
  • Going­Concern and Business­As­Usual scenarios
  • l Growth­ and contraction­scenarios

Optionality

  • Real Options and Liquidity Options
  • Contractual and non­contractual options
  • Forgotten’ optionality: counterparty’s breach of contract

­ Credit risk adjustments and modelization of large defaults

­ Violation of liquidity and credit lines

Liquidity Units

  • The concept of subsets of the balance sheet which behave uniquely in a scenario

Liquidity Risk Stress Testing

  • Why stress testing is necessary for value risk (and why it is already embedded in the liquidity risk scenario methodology)
  • Overview of stress tests approaches

Workshop: Impact of various firm­specific and systematic stress events on liquidity risk metrics

Managing Liquidity Risk

  • Traffic light systems
  • Limitation
  • Unadjusted limiting
  • CBC­adjusted limiting
  • Pricing of Liquidity (Risk)
  • Funding: term structured approach

Liquidity Contingency Plan

  • Essential components:
  • Defining stages, setting triggers, identifying potential responses, reporting requirements, communications requirements, testing

Intraday Liquidity Risk

  • Distinction between real intraday liquidity risks and enhanced FLE­type risks
  • The payment process revisited
  • Risks in the bank’s proprietary payment process
  • Risks from payment services for clients
  • Risks from using payment agents
  • Double use’ of collateral

Day 3

Governance – Views of Other Stakeholders

Rating Agencies

  • Risk of insolvency or illiquidity
  • Impact of a bank’s rating on its liquidity risk
  • Impact of liquidity risk on a bank’s rating

Regulators

  • International regulations: Basel III ­ BCBS Consultative Document (Dec 2009)

­ BCBS LQR measures (liquidity coverage ratio + net stable funding ratio

­ BCBS LQR monitoring tools

  • National regulations issued by:

­ UK: FSA

­ DE: BaFin

  • Similarities and differences across regulations (stress testing assumptions such as survival horizons, definition of liquid assets,…)
  • Interrelationships between liquidity risk regulation, capital adequacy and other prudential measures
  • Other stakeholders: role of audit,..

Discussion: The Impact of liquidity risk regulation on banks’ business model

Liquidity Transfer Pricing

Best Practice (Funds) Transfer Pricing Methods and Processes

  • The purpose of Transfer Pricing: levelling the playing field or steering the balance sheet?
  • Generalized (Average Funding Rate) vs. individual (Match Funding) replication of originated transactions ­

objectives & challenges

  • The role of a central pricing department (treasury)
  • Multiple treasuries for interest rate, liquidity, collateral, credit, etc

Transfer Pricing in a World with no Uncertainty

  • What is the ‘correct’ funding curve of the bank:
  • Risk neutral interest and structural liquidity costs
  • Funding instruments and venues

Integrating the Uncertainties of the Originated Transaction

  • Costs of expected and unexpected risks: credit, market and liquidity risk
  • Cost effects of credit risk and liquidity risk mitigation
  • Dealing with non­maturing instruments (with core and volatile parts)
  • Stochastic modelling of forecast & stochastic optimization

Integrating Regulatory Cost (from Basel III)

  • Total Net Cash Outflows & Stock of Highly Liquid Assets as a simplified FLE & CBC
  • The 75% rule: a simplified measure of uncertainty and a driver of costs
  • Differences between the regulatory and economic liquidity risk
  • The costs of improving the LCR / NFSR for the bank as a whole
  • How to split these cost between treasury and originating departments

Advanced Transfer Pricing Issues

  • Asset and liability driven banks
  • Dynamic vs. Static Balance Sheet Assumptions
  • Alternative funding curves for over / under funded time intervals
  • What is the right funding tenor of transaction from the trading book
  • Can transfer pricing substitute limiting?

Discussion: How to embed liquidity risk in banks’ pricing systems?

Who Should Attend?

Trainer’s Profile

Course Curriculum

Section 1: Introduction
Section 2: Development & Testing
The Course Quiz 00:05:00

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