Some Thoughts on Liquidity Scenarios
Liquidity Risk Measurement Is VERY Scenario Specific
LIQUIDITY RISK STRESS SCENARIO
Events triggered by changes in other financial risks Events triggered by changes in customer behaviour Events triggered by changes in business strategy
Events triggered by changes in macro or economic factors
Source: Jaqui Outram
Events triggered by no change at all (public misinformation or market perception)
Eleven Scenarios Mentioned in the Basel II Document
1. Credit risk 415 adverse economic conditions and unexpected events 2. Credit risk 415 range or economic conditions likely to occur over a business cycle 3. Credit risk 434 economic or industry downturns 4. Credit risk 434 market-risk events 5. Credit risk 434 liquidity conditions 6. Credit risk 435- mild recession scenarios, (e.g., two consecutive quarters of zero growth) 7. Credit risk 436 changes in the banks rating 8. Credit risk in equities 527(j) hypothetical or historical scenarios that reflect worst case losses 9. Operations Risk 665 bank specific business environment [Link] Risk 665 scenario analysis defined in 675 to be statistical loss analysis [Link] Rate Risk 826 (6) upward and downward rate shocks
Three More in Sound Practices for Managing Liquidity in Banking Organizations, February 2002
1. 2. 3. Principal 1: ability to withstand stressful events in the market place as part of day-to-day management. Principal 6: internal (bank-specific) what if scenarios {also required by Basel II for operations risk}. Principal 6: external (market related) what if scenarios {also required by Basel II for credit risk}.
Market experience in the form of Systemic Crises A Wide Variety of scenarios have occurred over time
1987 1990 1991 1992 1994 1995 1997 1998 1999 2000 2001 2002 2007 U.S. stock market crash Collapse of U.S. high yield (junk) bond market Oil price surge ERM (European Exchange Rate Mechanism) crisis U.S. bond market crash Mexican Crisis Asian crisis Russian default, Ruble collapse. LTCM Gold prices TMT (telecommunications, media & technology ) sector collapse September 11 payments system disruption Argentine crisis U.S. sub-prime mortgage collapse
5
Risk equals the product of probability and severity.
HIGH
S E V E R I T Y
($)
Catastrophic
MEDIUM
Painful
Normal
LOW LOW MEDIUM HIGH
PROBABILITY
Scenario Selection and Application
1. 2. Use at least three: normal, bank specific and systemic. Define three characteristics for each: business and market characteristics, duration and stress level. Use at least three stress levels for all nonnormal scenarios.
3.
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Stress Testing Should Reflect Both Internal and External Scenarios Capital markets disruptions Systemic shocks Payment system disruptions Prolonged global recession
External
Internal
Credit losses Operational losses Problem merger or acquisition
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What is Marketable?
A 2005 survey of large U.S. and Canadian banks found that only 4 out of 17 reported that they varied the projected quantity of liquid assets to fit the scenario.
Liability Rates
Counter Party Confidence Unimpaired
Access to New Unsecured Borrowings Unimpaired
Access to New Secured Borrowings Unimpaired
Ordinary course of business scenario
No stress
As per budget
Stress Level 1
As per budget
Mildly impaired
Diminished
Unimpaired
No current funding problem, but an elevated level of risk As per budget Severely impaired None Diminished
Bank specific crisis scenario
Stress Level 2 Stress Level 3
Some funding problems As per budget Severely impaired None
Until we run out of collateral
Serious funding problems Same quantity / higher cost Same quantity / higher cost
Stress Level 1
Up 100
Unimpaired
Systemic Crisis scenario
No current funding problem, but an elevated level of risk ??? ??? ??? ???
Stress Level 2 Stress Level 3
Some funding problems
Serious funding problems
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Asset Rates
Draws Under Commitments As per budget
Other Changes in Loan Volume As per budget
Changes in Credit Quality As per budget
Ordinary course of business scenario
No stress
As per budget
Stress Level 1
As per budget
As per budget
As per budget
Mildly impaired
No current funding problem, but an elevated level of risk As per budget Slight increase Little growth Severely impaired
Bank specific crisis scenario
Stress Level 2 Stress Level 3
Some funding problems As per budget Significant increase No growth Severely impaired
Serious funding problems
Stress Level 1
Up 100
As per budget
As per budget
As per budget
Systemic Crisis scenario
No current funding problem, but an elevated level of risk ??? ??? ??? ???
Stress Level 2 Stress Level 3
Some funding problems
Serious funding problems
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Perception Risk
The Southdown Building Society suffered abnormal withdrawals of 35 million during three eventful days in August 1991, owing to unfounded rumors of links with the failed Bank of Credit and Commerce International, which led to a pre-tax loss of 9.8m in 1991. The members of Southdown were consulted and, at a Special General Meeting in March 1992, voted in favor of a merger with the Leeds Permanent.
FURTHER GLOOM IN THE BUILDING SOCIETIES' CHALLENGING NEW WORLD, Magazine: Management Accounting, January, 1994, vol. 72 Issue 1, p28, 4p, 6 12
