Stress Testing Liquidity Risk. Ming Soong Tham Adjunct Professor Risk Management Institute National University of Singapore

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1 Stress Testing Liquidity Risk Ming Soong Tham Adjunct Professor Risk Management Institute National University of Singapore

2 What Will be Flowing Through Your Mind Understanding your liquidity risk levers Incorporating environmental inputs Integrating stress test results into liquidity management framework

3 What Will be Flowing Through Your Mind The risk drivers and scenarios Building scenarios to cover liquidity How to Collect Data Backward Looking vs Forward Looking Scenarios Regulatory requirements Establishing a contingency funding plan and early warning indicators

4 Basel III Scenarios The stress scenario applicable to LCR must include: Run-off of a portion of retail deposits Partial loss of unsecured wholesale funding Partial loss of secured short term funding Contractual outflows resulting from a 3 notch credit downgrade

5 Basel III Scenarios Increase in market volatility impacting collateral haircuts and values Unexpected draws on undrawn commitments Need for debt buy-backs and honouring of noncontractual obligations to mitigate reputation risk These are minimum requirements.

6 Liquidity Risk Interconnections

7 Comparison of Prudential Requirements Jurisdiction Key Liquidity Ratio(s) Requirement China Loans/Deposits Liquid Asset Ratio 75% 25% Hong Kong Liquefiable Assets/Qualifying Assets 25% India Liquid Assets/Demand and Time Liabilities 25% (40% max) Japan No Specific Ratio None Malaysia Minimum Net Asset Requirement Philippines No Specific Ratio None Singapore South Korea Liquid Assets/Qualifying Liabilities Current KRW Assets/Current KRW Liabilities KRW Loans/KRW Deposits (Effective 2014) Bank Specific 10 15% Bank General 16% Bank Basic 18% 100% 100% Taiwan NTD Liquid Assets/NTD Liabilities 7% Thailand Liquid Assets/Deposits and Borrowings 6% United States No Specific Ratio None NOTE: Table is not comprehensive and includes only the most common liquidity ratios. Source: FRB San Francisco, Asia Focus March 2011

8 Dynamic Cash Flow Analysis To enhance the organisation s preparedness in handling funding requirements under most circumstances, it must be able to understand how its cash flows are likely to change Covers Wholesale and retail funding Off Balance Sheet Commitments Option Risk Development of assumptions need to Encompass a sufficiently wide range of interest rate scenarios Adequately modify or vary assumptions for embedded options Periodic Assessment of assumptions Models to provide a range of outcomes

9 Dynamic Cash Flow Analysis Model assumptions could include Level of interest rates Shape of yield curve Quality of credit portfolio Asset price volatility Accounting volatility

10 Trigger Ratios EWI may be tracked using ratios already being produced and monitored. These can be calculated from existing and projected balance sheets Examples: Loan Deposit Ratio (LDR) Wholesale deposits/total Assets Non-current loans/gross loans and Non-current assets and Other Real Estate/Total Assets Return on Assets

11 Contingency Funding Plan Sets out the organisation s strategy for handling liquidity crises Describes procedures for managing cash flow shortfalls Builds upon the outputs of stress tests and scenario analyses An integral part of Business Continuity Management (BCM) Practices range from simple procedures to fullfledged war plans

12 Contingency Funding Plan Outlines a list of potential risk factors, key reports and metrics that must be reviewed on an ongoing basis Details potential responses, including pre-funding as well as utilisation of secondary liquidity sources Describes mitigants and action items, assigned to individuals for execution Details the responsibilities of groups and individuals, including the making and dissemination of decisions, coordinating all activities throughout the duration of the market stress or crisis period

13 Action Plans

14 Liquidity Management Strategies The regulatory liquidity framework does seem punitive in terms of additional cost to financial institutions. The increase in cost is likely to be transferred to borrowing customers with potentially adverse broader consequences. To be successful, banking institutions need to review their management and business strategies/models An effective liquidity risk management strategy involves a process that is more than the simple increase in the quantity of HQLA, or reducing cash outflows or increasing cash inflows.

15 Liquidity Management Strategies Diversification is key Diversification of liquidity providers Diversification of HQLA Use of derivatives for assuming interest rate risk Possible use of derivatives for hedging liquidity

16 Reverse Stress Testing Reverse stress tests identifies the point at which a business model becomes unviable. Identifies the scenarios that could lead to a business model becoming unviable Creates better understanding of vulnerabilities beyond capital, losses or liquidity Incorporates other risk levers such as loss of confidence, reputation, concentration, etc. Going beyond manageable impacts

17 Reverse Stress Testing Challenges What kind of losses will cause a decline below the minimum capital requirements; What event or business could cause such a loss; What factors could cause such losses; What are the hidden vulnerabilities; Difficulty in envisioning the future Ignorance Surprise Volition Intensity of stress testing process places significant demands on current systems

18 Worksheet What am I doing now? Why am I doing what I am doing?

19 Worksheet What should I doing? How do I get to do what I should do?

Basel Committee on Banking Supervision

Basel Committee on Banking Supervision Liquidity coverage ratio disclosure standards January 2014 (rev. March 2014) This publication is available on the BIS website (www.bis.org). Bank for International