Liquidity Risk Gerhard Stahl Ba Fin Agenda History

Liquidity Risk Gerhard Stahl, Ba. Fin

Agenda • History • CFI and internal models – Where we stand • Plans for the future – Where to go Liquidity Risk | Seite 2

Why Liquidity Matters Metallgesellschaft (Miller vs. Ross) S&L Crisis New Complex Instruments (IIF) => importance Central function for liquidity management (IIF) Liquidity risk is of 2 nd order (overlap to other risk categories; e. g. operational risk) => difficult to define, regulate, etc. Liquidity Risk | Seite 3

CFI and Internal Models Spot Futures, FRA‘s Swaps Options Exotics, Structured Deals Structured credit, credit derivatives Gapping & Duration Mt. M & modified duration First-order Sensitivities Volatility, delta, gamma, vega, theta Correlations, basis risk Model risk (inc. smiles, calibration) Liquidity Risk | Seite 4

Liquidity Risk – What has happened so far? History From supervisory side: • Basel paper of 2000 • Joint Forum exercise (banks, insurances, ucits) • European stock takings via the Groupe de Contact • Stock take of the ECB, via the Banking Supervision Committee, on mainly macro prudential aspects of Liquidity Risk • National authorities: OCC, FSA, Ba. Fin (internal models), … • Pillar II issue under Basel II From industry side: • IIF 44 recommendations Liquidity Risk | Seite 5

The Basel approach on liquidity • Berlin meeting in May 2006 – Committee should exercise an „intelligent“ stock take on current liquidity regimes of Members • December meeting 2006 – final agreement on establishing the Working Group on Liquidity • Tough time table – stock take to be finished until the end of 2007 • First meeting in January • Drafting session for the Questionnaire Ø Questionnaire fully taken over by Groupe de Contact Ø Questions of other groups considered No double work Liquidity Risk | Seite 6

A brief outline of the work • Objectives – what do the standards seek to achieve: level of resilience to risk Ø Externalities/market failures addressed • Outreach of the G 10: Australia, China, Hong-Kong, Singapore • Practice – what standards are applied and how Ø ‘Pillar 1 approaches’ – quantitative standards Ø ‘Pillar 2 approaches’ – qualitative standards Ø Validation of firms risk management/modeling Ø ‘Pillar 3 approaches’ – Disclosure requirements Ø Interaction with capital requirements Liquidity Risk | Seite 7

A brief outline of the work cont. • Experience with application of standards Ø For domestic firms Ø For branches, subsidiaries, and cross-border firms • Relationship with other financial infrastructure (“context”) Ø General supervisory approach Ø Central bank operations and policies Ø Payment system design Ø Collateral management Ø Capital requirements Ø Structure of domestic and (relevant parts of) international banking system Ø Asset market dynamics Ø Credit risk transfer markets Liquidity Risk | Seite 8

Deliverables • Better understanding of the outcome delivered by current liquidity regimes for domestic and cross-border firms • To provide the Committee with an analysis of: Ø the reasons for the current diversity of approach Ø the advantages and disadvantages of diversity Ø an assessment of options for future work Liquidity Risk | Seite 9

Work streams and literature survey • What are the diverse standards trying to achieve? How much underlying uniformity is there? • How is context (e. g. structure of banking sector, central bank policy, design of payment system) influencing regimes? • How has the changing financial system affected liquidity risk? • Analysis of consequences of diversity Ø For firms Ø For ‘day-to-day’ supervision (resilience to mild stress) Ø For crisis management (resilience to extreme stress) • Literature survey to complete the picture from the scientific point of view Liquidity Risk | Seite 10

Why principles based regulation is non-trivial Definition of Li. R and RMP definitions on Li. R are broadly consistent to meet obligations when they fall due at reasonable costs embedding in the RMP However: even if def. are app. the same, details are treated differently; Liquidity Risk | Seite 11

Example quant. regimes • Six countries do not apply quant. Regimes • Those who utilize ratios 1. all countries use different ratios 2. Sig. difference in terms of behavioral ass. for savings 3. Differences in treatment of committed facilities 4. Only a few countries incorporated margin calls 5. Differences in valuation methods, accounting, mtm 6. Different haircuts 7. Etc…. Liquidity Risk | Seite 12

Timeline Work on Liquidity Risk 9 April deadline for the responses to the questionnaire April - June evaluation of the responses June - October drafting of the report December delivery to the Basel Committee nearly parallel timetable of Gd. C‘s Liquidity Task Force The Basel Committee has to decide, whether further work on liquidity risk will be treated within the Basel context. Liquidity Risk | Seite 13

Basel II & Solvency II: Similarities and Differences Similarities / Synergies similar products: similar tools and models: • structured products • market risk (Black-Karasinski) • interest rate and credit derivatives • credit risk (Credit. Metrics) Banks / Basel II insurers / Solvency II • input-oriented • output-oriented • partial models (market and ratings) • holistic modeling • shorter horizons • longer horizons • aggregation of risk numbers • aggregation of distributions • in market risk: thousands of risk drivers or simple „earnings at risk” • King’s road: small number of accumulation events, which explain losses at the group level • absolute risk measure • risk relative to a benchmark (RNP) Liquidity Risk | Seite 14

Li. QR and the Risk Management Process Board sponsor Risks ERM/CRSA Risk policy Risks CRO Review TIME Threats Identification COST OBJECTIVES Strategy and KPIs EMBED Management VALUES Assessment Impact Liquidity Risk | Seite 15 Opportunities People buy-in

Liquidity Risk and models Data quality (better then CR worse then MR) Cash Flow is a output-oriented approach; no exploratory variables => principles not rules, uncertainty about model error, close to Solvency II Different FX regimes => no single numeraire => liq. Assumption in Va. R models CFI call for centralization => pooling, Liquidity Risk | Seite 16

Variable of interest: FLE-CBC LIq. Va. R: reluctance of the industry ARIMA modeling unscheduled payments Liquidity Risk | Seite 17