Liquidity risk: how to calibrate liquidity buffers under normal and stressed conditions Walter Mathian 1 2 1. DEFINING, MEASURING AND MANAGING LIQUIDITY RISK ...................................................................... 5 1.1. HOW TO DEFINE LIQUIDITY RISK? ................................................................................................................. 5 1.2. LIQUIDITY RISK FOR INSURANCE COMPANIES ................................................................................................... 6 1.3. HOW TO MANAGE LIQUIDITY RISK? ............................................................................................................... 7 1.3.1. Standards for managing liquidity risk .......................................................................................... 7 1.3.2. Different strategies to reduce structural liquidity sources and contingent liquidity risk ............... 9 1.3.3. The crucial role played by the counterbalancing capacity (CBC) and liquid buffers .................... 10 1.3.3.1. The counterbalancing capacity: from the short term horizon to the long term horizon ........................ 10 1.3.3.2. The liquid buffer ..................................................................................................................................... 10 1.3.4. Contingency planning ............................................................................................................... 14 1.4. HOW TO MEASURE LIQUIDITY RISK UNDER NORMAL CONDITIONS? ..................................................................... 14 2. A CONCEPTUAL FRAMEWORK TO ANALYSE THE MATURITY MISMATCH ............................................... 19 2.1. THE APPROACH DEFINED BY ROBERT FIEDLER ................................................................................................ 19 2.1.1. Description of the conceptual framework ................................................................................. 19 2.1.1.1. Introduction of a few basic concepts...................................................................................................... 19 2.1.1.2. Characterisation of cash flows based on their uncertainty .................................................................... 21 2.1.1.3. Defining the forward looking exposure .................................................................................................. 22 2.1.1.4. The main aim of liquidity management: ensure a possible excess of liquidity at any time .................... 23 2.1.1.5. Defining scenarios and strategies to compute the FLE ........................................................................... 25 2.1.2. Main liquidity drivers to be taken into consideration when modelling future cash flows ........... 25 2.2. BEHAVIOURAL MODELS AND SPECIFIC EXAMPLES ON SOME LIQUIDITY DRIVERS ...................................................... 26 2.2.1. General introduction to behavioural models ............................................................................. 26 2.2.2. The specific issue of assets and liabilities without a maturity, NoMALs, and some examples of approaches used to model their maturity................................................................................................... 28 2.2.2.1. Replicating portfolio models (e. g. Bardenhewer). ................................................................................. 28 2.2.2.2. The option adjusted spread (e.g. Jarrow‐van Deventer) ........................................................................ 29 2.2.2.3. Using a parametric survival model (Musakwa) ....................................................................................... 30 2.2.3. Some more specific examples of NoMALs ................................................................................. 31 2.2.3.1. Sight deposits ......................................................................................................................................... 31 2.2.3.2. Assets with prepayment option ............................................................................................................. 33 2.2.3.3. New production modelling ..................................................................................................................... 34 3. THE SUPERVISORY APPROACH OF LIQUIDITY AND ITS LATEST UPDATE, BASEL III .................................. 34 3.1. A HISTORY OF THE SUPERVISORY APPROACH REGARDS LIQUIDITY ....................................................................... 34 3.2. NEW RATIOS: LCR AND NSFR .................................................................................................................. 35 3.2.1. Description of both metrics ....................................................................................................... 35 3.2.1.1. LCR .......................................................................................................................................................... 35 3.2.1.2. NSFR ....................................................................................................................................................... 36 3.2.2. Some thoughts around LCR and NSFR ....................................................................................... 38 3.2.2.1. The debates around the choice of the supervisory reference metrics ................................................... 38 3.3. NEW MONITORING AND REPORTING REQUIREMENTS ...................................................................................... 40 4. GOING FURTHER: CALIBRATING SUPERVISORY MEASURES, NOTABLY IN THE FORM OF A LIQUIDITY BUFFER ....................................................................................................................................................... 41 4.1. THE NECESSITY TO DEFINE ADDITIONAL SUPERVISORY MEASURES AND THE USE OF STRESS TESTS IN THIS CONTEXT ......... 41 4.2. OUR METHODOLOGY FOR STRESS TESTING A BANK’S POSITION ON THE MID AND LONG TERM ................................... 43 4.2.1. Some basic steps when stress testing and some methodological requirements......................... 43 4.2.2. Steps for stress testing .............................................................................................................. 45 4.2.2.1. Getting the unstressed cashflow data .................................................................................................... 45 4.2.2.2. The global outline of our scenarios ........................................................................................................ 48 4.2.3. Outcome of our stress tests and way forward ........................................................................... 50 4.2.3.1. The use of a stylised balance sheet as an input ...................................................................................... 50 4.2.3.2. Detailed analysis of the stress tests ........................................................................................................ 52 4.2.3.3. A few methodological challenges and possible refinements in the stress testing approach ................. 54 3 4.2.3.4. Calibrating the counterbalancing capacity ............................................................................................. 55 5. THE SPECIFIC ISSUE OF INTRA‐DAY LIQUIDITY RISK .............................................................................. 56 5.1. A SUBCATEGORY OF LIQUIDITY RISK: INTRA‐DAY LIQUIDITY RISK ......................................................................... 56 5.1.1. Introduction .............................................................................................................................. 56 5.1.2. The sources of uncertainty for intraday liquidity risk ................................................................. 57 5.1.3. How to manage intraday liquidity risk? Some basics ................................................................. 58 5.2. HOW TO CALIBRATE THE LIQUIDITY BUFFER TO COVER INTRADAY LIQUIDITY RISK .................................................... 61 5.2.1. A framework to perform simulations: extending the Fiedler approach to intraday payments ... 61 5.2.2. How to calibrate the level of the liquidity buffer ....................................................................... 62 5.3. SOME SIMULATIONS ................................................................................................................................ 63 5.3.1. Specification of the model ......................................................................................................... 63 5.3.1.1. Generating payments ............................................................................................................................. 64 5.3.1.2. Executing payments ............................................................................................................................... 65 5.3.1.3. Some tests on the model / sensitivity analysis ....................................................................................... 67 5.4. STRESS TESTING INTRADAY LIQUIDITY RISK .................................................................................................... 73 5.5. ENSURING CONSISTENCY IN THE USE OF THE LIQUIDITY BUFFER TO COVER INTRADAY LIQUIDITY RISK AND LONGER TERM RISKS 74 6. CONCLUSION ....................................................................................................................................... 74 ANNEX 1 : THE