Liquidity Risk Management - Good Practices for Broker Dealers

Transcription

1 White Paper Liquidity Risk Maagemet - Good Practices for Broker Dealers Liquidity is essetial to the viability of broker dealer firms. Ay risk to the timely ad cost-effective supply of liquidity ca be disruptive i may ways. Therefore, it is crucial for broker dealers to devise ad implemet appropriate liquidity risk maagemet practices ad strive to create a risk sesitive culture across their orgaizatio. Liquidity maagemet has become eve more importat for broker dealers due to: Icreasigly cocetrated umber of broker dealers who provide market volume ad liquidity Extesive globalizatio of the fiacial system Higher reliace o secured fudig Lack of sychroizatio of global liquidity stadards To prudetly mitigate liquidity risks, it is essetial that liquidity risk maagemet practices are icorporated withi a itegrated, eterprise-wide riskmaagemet framework that icludes market, credit, ad operatioal risks. The risk mitigatio approach eeds to take ito cosideratio diverse orgaizatioal ad owership hierarchies, the complexity of busiess ad variace i the coformace of legal ad regulatory stadards across the globe. This paper details good liquidity practices i the broker dealers cotext.

2 About the Author S. K. Rao S. K. Rao is a Seior Busiess Cosultat with the Global Cosultig Practice of Tata Cosultacy Services. Prior to joiig TCS, Rao garered extesive experiece as a ivestmet baker. Rao has bee associated with both Idia ad iteratioal securities markets for more tha two decades ad has played key roles i implemetig busiess solutios for firms i the securities market space. 2

3 Table of Cotets Liquidity Risk 4 Liquidity Risk Maagemet Paradigm 5 Major Sources of Liquidity Risk 5 Liquidity Risk Maagemet issues i Broker Dealer Cotext 6 Soud Practices for Maagig Liquidity 7 Coclusio 12 3

4 Liquidity Risk Liquidity as defied by the Bak for Iteratioal Settlemets i 2000 is the ability to fud icreases i assets ad meet obligatios as they come due. I geeral, liquidity meas to have adequate fuds to meet obligatios wheever they arise without sellig assets. Broadly, it refers to havig sufficiet, cost-effective fudig through log-term fiacig ad a improved asset mix, to implemet the orgaizatio s busiess strategy. Liquidity risk ca be defied as a critical situatio where a firm is uable to meet its curret ad future cash flow ad collateral requiremets, both expected ad uexpected, without materially affectig its daily operatios or overall fiacial coditio. It is importat to ote that liquidity is ot syoymous with capital. Capital adequacy requiremets are commo to may coutries. The ability of a firm to bear liquidity risk is liked to the amout of capital it possesses ad the losses it icurs. However, the assets o a firm s books may ot be sufficiet to provide liquid cash i case of exigecies. Similarly, a firm may have liquid assets that are readily available but it may be low o regulatory capital. As such, capital itself may ot be a appropriate buffer i a demadig liquidity eviromet. This is a critical risk maagemet issue ad ot strictly a treasury issue. Most failures of fiacial istitutios have occurred i large part due to isufficiet liquidity resultig from adverse circumstaces. All firms, be it fiacial istitutios or broker dealers require access to borrowed fuds to carry out their operatios, from settlig immediate paymets to makig log-term strategic ivestmets. The iability to acquire the required fudig withi a reasoable timeframe ad budget could pose a huge risk, as is evidet from the recet dowfall of certai ivestmet baks ad fiacial istitutios. Such risks are embedded i the very ature of the operatios that broker dealers udertake. The developmet of iovative fiacial istrumets ad the volatile macroecoomic coditios have accorded a reewed importace to the measuremet ad maagemet of liquidity risk. Broker dealers are especially sesitive to fudig risk sice they use leverage to fud hedge fuds ad their cliets. A importat poit to remember is that baks ejoy a relatively stable source of core fudig i the form of usecured customer deposits ulike securities firms, which are ot deposit-takig istitutios. Broker dealers rely o their ow capital ad ability to raise fuds from exteral sources. This leaves them relatively more exposed to the price ad credit risk sesitivities of fud providers. Ulike baks, broker dealers do ot have access to cetral bak fudig o a daily basis or as leder of last resort. Stad-aloe securities firms must be self-sufficiet i terms of their liquidity eeds, requirig a high degree of rigor ad vigilace i their liquidity risk maagemet practices, sice fudig cliet positios is oe of their key busiess areas. To mitigate this risk effectively, broker dealers establish liquidity maagemet systems to assess their future fudig requiremets ad try to esure the availability of fuds accordig to the requiremets. The prime focus of liquidity maagemet systems is moitorig ad assessig the firm's curret ad future debt obligatios ad plaig for ay uexpected fudig requiremets, cosiderig specific factors such as, a drop i the firm's collateral value, cliet defaults or systemic factors. Brokers meet their liquidity requiremets through several sources ragig from operatig cash flows, service fees, debt obligatios, ad equity. For example, active maagemet of the timig ad maturity of firms' assets ad 4

5 liabilities ca ehace liquidity. The recet evets i the fiacial markets clearly demostrated the sigificace of liquidity maagemet. Failure to gauge cotractio of liquidity i certai structured products ad iterbak markets paved the way for demise of well kow ivestmet bakig etities. Liquidity Risk Maagemet Paradigm Liquidity risk has little visibility whe times are good but its high-severity ature makes it potetially devastatig durig extreme liquidity evets. Whe ecoomic ad fiacial eviromet flourished with abudat access to fudig sources, liquidity risk attracted less attetio. Rarely has liquidity bee cosidered a core risk maagemet fuctio as there have bee o regulatory capital requiremets for liquidity. Broker dealers may ot ecessarily geerate specific capital attributios for liquidity risk; that is, they may ot iterally quatify liquidity risk i capital terms as they do for market or credit risk. The recet subprime mortgage-iduced crisis thrust liquidity risk to the forefrot of every fiacial itermediary. Risk maagemet has traditioally bee reactive; implemetig chage after the impact of the fallout rather tha mitigatig risks proactively. The dyamic eviromet of a broker dealer s tradig operatios demads a proactive, holistic approach to risk maagemet. Employees ad shareholders have a vested iterest i esurig that adverse liquidity evets do ot result i massive losses. The lack of awareess of liquidity risks by the powerful frot office results i poor liquidity risk maagemet processes. This is further augmeted by approaches ad methodologies that are isufficietly embedded i the broker dealer frot office decisio makig process. As a result, risk ad reward perspectives were ot itegrated i a way that could have eabled a more accurate, eterprise-wide uderstadig of liquidity risks. This lack of uderstadig of the true magitude of credit ad liquidity risks laid the groudwork for failure. Major Sources of Liquidity Risk Liquidity risk ca arise wheever the quatum of liquidity obtaied from either the asset or the liability side of the balace sheet, is less tha the aticipated liquidity requiremets, or liquidity requiremets are greater tha that aticipated. O accout of this, liquidity risk may arise where ay of the followig risks or combiatio of risks, occur: Market risk: the risk of loss due to variaces i the value or price of a asset resultig from fluctuatios i stock prices, iterest rates, currecy exchage rates, ad commodity prices. Credit risk: the risk of loss whe the couterparty fails to hoor its fiacial obligatios. It icludes the risk of default o a loa or bod obligatio, as well as the risk of a guarator or derivative couterparty failig to meet its obligatios. Operatioal risk: is the risk of loss from iadequate or failed iteral processes, people ad systems or from exteral evets. 5

6 These risks are ofte iter-related ad their crystallizatio, either i isolatio or i combiatio, ca gravely impact a firm's liquidity risk profile. Total elimiatio of liquidity risk would be too costly ad hece, liquidity risks eed to be effectively addressed by adherig to prudet limits ad good liquidity risk maagemet practices. Liquidity Risk Maagemet issues i Broker Dealer Cotext Iteral Goverace A key factor i liquidity maagemet is the role of the seior maagemet. Uless the seior maagemet is well iformed of the risks embedded i tradig various asset classes icludig structured products, risk goverace loses its efficacy. The lack of seior maagemet oversight o tradig operatios of broker dealers ad iheret risks i the products results i a delayed respose to the icreasig exposure to risks. Although seior maagemet of broker dealers set detailed limits o the tradig, there is obscure articulatio ad measuremet of risk appetite ad risk retur. Moreover, quite ofte the likage of the risk appetite to the actual toleraces ad limits are imprecise. Powerful Frot Office Ifluece The frot office exerts immese ifluece o seior maagemet o accout of their reveue cotributio. This reders the positio of risk maagemet persoel/ Chief Risk Officers (CROs) ieffective quite ofte. This cocer is best addressed oly whe CROs have veto power over trade positios, couterparties, ad other key risk-related decisios, icludig the ability to recommed cuttig positios or hedgig, with a appropriate escalatio ad resolutio process i place. Fragmeted Risk Orgaizatio Structure Risk maagemet persoel do ot ofte get a itegrated, real-time perspective of all positios across all asset classes ad geographies of cash ad derivative trasactios. Risk groups are structured primarily by risk type, such as, market risk, couter party risk/credit risk ad they do ot have a true eterprise-wide view of risk. This fragmeted risk structure cotributes to the limited sharig of kowledge ad evetually leads to suboptimal mitigatio of risk. Elimiatig these orgaizatioal silos of specific risk disciplies of liquidity, market, credit, ad operatioal risk will address the risks of broker dealers i a itegrated maer. Lack of a Clear Methodology for Assessmet of Liquidity Risk Recet turmoil i credit markets highlighted the fact that lack of a clear liquidity risk assessmet methodology cotributed sigificatly to delays i maagemet s respose to the credit cruch. For example, cocetratios ad correlatios betwee differet credit products, uderlyig collaterals, couterparties, credit providers, ad other factors specific to cotiget liquidity evets were isufficietly modeled or aalyzed. Some risk models used historical default experiece ad ot curret spread iformatio; as a result movemets i related credit spreads were ot captured. Other models wrogly assumed cotiued availability of cheap fudig. 6

7 Overlooked Exposures I a axiety to geerate a cotiuous stream of reveues from securities tradig, broker dealers quite ofte igore the risks associated with off-balace-sheet structures, cotiget liquidity risks from structured products, correlatio ad cocetratio risks ad cotagio risks. As such, there is a gap i the curret liquidity aalytical systems to capture cotiget ad liquidity risk measures at a product level ad broker dealer istitutio fudig level. Icosistet Set of Models, Data ad Related Systems It is importat to ote that liquidity risks caot be aggregated across the broker dealer firm if the related systems do ot work i syc ad use differet types ad formats of data. For systems to be compatible with each other, broker dealers should deploy a cosistet set of models, data, ad related systems across the firm to completely capture relevat drivers of value ad risk. Oly i the light of recet evets has the importace of the system compatibility become evidet. It is difficult to overestimate the value of complete, compatible, cosistet data for effective maagemet of liquidity risks. Soud Practices for Maagig Liquidity Followig are some of the good practices that broker dealers must follow to complemet effective liquidity risk maagemet: Desig ad Implemet a Robust Liquidity Framework A robust liquidity framework, to keep risks uder cotrol, should cover: Goverace ad the articulatio of liquidity risk tolerace across the firm Liquidity risk measuremet Measuremet ad moitorig of et fudig requiremets Asset-liability maagemet Iteral cotrols for liquidity risk maagemet icludig the role of risk supervisors Cotigecy liquidity plaig Role of disclosure i improvig liquidity 7

8 Liquidity Risk Maagemet Balace Sheet Structure Cotiget Risk Maagemet Tactical Liquidity Risk Maagemet Balace sheet size Balace sheet forecasts Fudig Mix Securitizatios Liquidity reserve Exteral ad iteral pricig policies Margi call procedures for differet simulated scearios Iitial margis Limits to cotrol liquidity risk exposure ad vulerabilities Cotigecy Fiacig Plas Stress tests Compositio of the offbalace sheet portfolio ad its probable impact o fudig Crisis Maagemet Collateral maagemet Fudig diversificatio Cash flow forecasts Valuatio framework for firm s propriety positios Early warig idicators to idetify icreased liquidity risk Policy ad limit compliace Maagemet iformatio system for providig timely liquidity iformatio Formulate Appropriate Liquidity Risk Strategy Figure 1: Liquidity Risk Maagemet Framework Firms eed to formulate their liquidity risk strategy, appropriate to the firm s fudig profile, its curret ad prospective activities, cosiderig all liquidity risks, icludig itra-day ad cotiget risks as well as potetial costraits. Appropriate resposibilities ad icetives, i lie with log-term objectives must be set by seior maagemet. The liquidity risk strategy should cover: Cosolidatio ad aggregatio of data across the firm to provide a holistic view of liquidity risk. Aligmet of the risk-takig iitiatives of idividual busiess uits ad traders with the liquidity risk exposures that their activities create for the firm. This ivolves allocatig liquidity costs, beefits ad risks to busiess activities. Aligig the cost of fudig with performace metrics esures that appropriate icetives are i place for efficiet maagemet of liquidity. Additioally, this provides a mechaism to alter the pricig based o market coditios i a liquidity evet. Regular update of liquidity profile of cliets/hedge fuds. This should form the basis for coductig stress tests ad margi call simulatios as well as for determiig margi call procedures uder adverse market coditios. A clearly articulated liquidity risk tolerace that is appropriate for the busiess strategy of the broker-dealer cosiderig its complexity, busiess mix, liquidity risk profile. Policies should also cotai provisios for documetig ad periodically reviewig assumptios used i liquidity projectios. Both quatitative targets ad qualitative guidelies. Specified ature ad frequecy of maagemet reportig. 8

9 Moitor the Iitial Margis ad Portfolio Risk o a Regular Basis It is essetial to moitor the iitial margis ad portfolio risk o a regular basis. Alig the uderlyig compoets of risk assessmet with busiess specifics, risk tolerace ad prevailig market realities. I particular, VaR-based iitial margis should be regularly stress tested; that is, they should be compared to the potetial credit exposure that could surface i stress situatios. Note that VaR calculatios do ot estimate the extet of losses that could occur whe the probability parameters are exceeded. Thus, it is vital that securities firms cosider appropriate back testig of their liquidity policies over a sufficiet rage of time horizos to validate the robustess of their system. Set Margi Call Procedures for Differet Simulated Scearios Work out clear terms to determie margi call procedures for differet simulated scearios assumig exteded adverse market coditios. This will ehace predictability i the credit relatioship betwee prime broker dealers ad their hedge fud cliets. Such predictability mitigates the risk of disorderly uwidig of positios/credit lik. It is also ecessary to coduct margi call simulatios o a aggregate basis. This would eable a particular prime broker dealer to assess the impact of simultaeous margi calls of all prime broker dealers exposed to oe or several hedge fuds. Establish Robust Collateral Risk Maagemet Systems Collateral risk maagemet systems esure adequate liquidity buffers to meet ay cotigecy fudig. As a good practice, dealers secure sufficiet collateral from cliets o that day s closig market value of outstadig positios ad for margi loas ad short sales. Brokers who use derivatives should also cosider the potetial for cotractually specified additioal collateral requiremets due to chages i market positios. Securities firms geerally keep sufficiet margis o the collaterals of cliets: a) to provide protectio agaist bad debt, b) to have ample margi so that the firm ca re-hypothecate the securities if ecessary. Broker dealers should have the ability to calculate all collateral positios, icludig assets curretly pledged relative to the amout of security required ad uecumbered assets available for pledge. The maagemet of haircuts ad collateral levels, icludig daily ad itra-day valuatios ad margi calls is labor-itesive; however, this challege ca be overcome through sophisticated IT/operatioal ifrastructure. Set Limits to Cotrol Liquidity Risk Exposure ad Vulerabilities Broker dealers should review exposure limits ad correspodig risk escalatio procedures regularly. The defied limits should be relevat to the busiess i terms of the complexity of activity, ature of products ivolved, markets serviced ad volatility of prices. These limits should be used for maagig daily liquidity withi ad across lies of busiess. It is ecessary to emphasize that the broker dealer should employ a rage of customized metrics as there is o sigle metric that ca comprehesively quatify as liquidity risk. A broker should have metrics that assess the structure of the balace sheet (that is, static ratios) as well as metrics that provide foresight of liquidity risk exposures. These metrics should spa vulerabilities across busiess-as-usual ad stressed coditios over various time horizos. 9

10 Esure Fudig Diversificatio Esure fudig diversificatio to address iheret fudig risk. Securities firms diversificatio policies etail creditor diversificatio (for example, baks, isurace compaies, mutual fuds ad so o) icludig limitig the amout held by ay oe ivestor, spreadig debt maturities, diversifyig the fudig istrumets (secured ad usecured) ad market geographies (for example, U.S., Europe, ad Asia). Brokers should regularly gauge their capacity to raise fuds quickly from each source. They should idetify the mai factors that affect the ability to raise fuds ad moitor these factors closely to esure that estimates of fud raisig capacity are accurate. Moitor Compositio of the Off-Balace Sheet Portfolio ad its Probable Impact o Fudig Maagig cash flow risks ca be effective oly with accurate cash flows. Lack of a thorough uderstadig of the cash flow profile of off-balace sheet istrumets ad other remote vehicles ad cotigecies is a major cocer i the maagemet of liquidity risk. A robust framework ca be created for projectig the potetial cosequeces of udraw commitmets udertake, cosiderig the ature of the commitmet ad credibility of the couterparty. A broker dealer should also icorporate cash flows related to the re-pricig ad maturity of fiacial derivatives cotracts i its liquidity risk aalysis, icludig the possibilities like couterparties demadig additioal collateral i a evet such as, a declie i the brokers credit ratig or credibility or a declie i the price of the uderlyig asset. Timely cofirmatio of over-the-couter derivatives trasactios is fudametal to such aalyses; ay ucofirmed trade questios the accuracy of a broker s measures of potetial exposure to risks. Coduct stress tests Esure that stress tests iclude a variety of istitutio-specific ad market-wide scearios. Perform adequate stress ad sceario testig for potetial asset expasios ad arisig liquidity shocks. Itegrate cotigecy plas with risk tolerace ad stress testig of the preparedess for ay liquidity evet. Broker dealers should use stress test results to modify the liquidity risk maagemet strategies, policies ad positios ad to develop effective cotigecy plas. The extet ad frequecy of testig depeds o the size of the broker dealer firm ad its exposure to liquidity risk. Stress tests should reflect accurate time frames for the settlemet cycles of assets that might be liquidated, ad the time required for trasfer of liquidity across systems/asset classes. If the firm relies o liquidity outflows from oe system to meet obligatios i aother, it should cosider the delay that operatioal or settlemet disruptios may cause to the expected flows across systems/asset classes. This is particularly relevat for brokers relyig o cetralized liquidity maagemet. To idetify ad aalyze factors that could have a sigificat impact o its liquidity profile, broker dealers must coduct a aalysis of the sesitivity of stress test results to certai key assumptios. Such sesitivity aalysis ca provide additioal idicatios of a broker s degree of vulerability to certai factors. The broker dealer s choice of scearios ad related assumptios must be documeted ad reviewed alog with the stress test results. Seior maagemet must itegrate the results of the stress testig process ito the broker s strategic plaig process ad the firm's risk maagemet practices. The results of the stress tests should be explicitly cosidered i the settig of iteral tradig limits. The ability ad willigess of firms to thik imagiatively ad creatively about a umber of plausible scearios ad icorporate the results ito strategic decisios equip broker dealers to face liquidity risks more effectively tha otherwise. 10

11 Establish a Comprehesive Valuatio Framework for the Firm s Propriety Positios There is a compellig case for establishig a comprehesive valuatio framework to evaluate the firm s propriety positios alog with collateral. Brokers should establish a goverace fuctio, such as a valuatio committee, with the ultimate resposibility of drivig compliace of the documeted valuatio policies. Idepedet persoel must be resposible for the valuatio of the dealers ivestmet positios. Devise Cotigecy Fiacig Plas It is importat to devise fudig actio plas or cotigecy fiacig plas detailig the key tasks that eed to be performed withi stipulated time lies to meet cotigecies effectively. The tasks would deped o the severity of the crisis as outlied i a variety of scearios. It may ot be feasible to pla for every evetuality but absece of thoughtful plaig ca severely ihibit the ability of securities firms to respod appropriately i the evet of a liquidity crisis. The cotigecy plas must be reviewed ad periodically updated i light of market evets ad their impact o the firm s liquidity. Desig ad Implemet Early Warig Idicators to Idetify Icreased Liquidity Risk Effective liquidity risk maagemet ivolves idetifyig the emergece of icreased risk or vulerabilities i its liquidity risk positio. These early warig idicators must idetify ad idicate ay egative tred, so that appropriate actio ca be take to mitigate the ascet risk. Early warig idicators ca be qualitative or quatitative i ature ad may iclude but are ot limited to: Rapid asset growth, especially whe fuded with potetially volatile liabilities Growig cocetratios i assets or liabilities Decrease of weighted average maturity of liabilities Repeated icidets of trader positios approachig or breachig iteral limits Negative publicity; a credit ratig dowgrade Risig debt costs Couterparties requestig additioal collateral for credit exposures Difficulty i accessig loger-term fudig Implemet Reliable Maagemet Iformatio System for Providig Timely Liquidity Iformatio It is ecessary to esure that the maagemet iformatio system is reliable ad has bee desiged to provide the seior maagemet ad risk supervisors with timely iformatio o the liquidity positio of the firm. The maagemet iformatio system should have the ability to calculate liquidity risks emaatig from all the ope positios across the firm, icludig all the asset classes ad dealers i all the markets i which the firm operates both o a subsidiary/brach/ sub broker basis ad o a aggregate group basis. To effectively maage ad moitor its et fudig requiremets, broker dealer firms should also have the ability to calculate liquidity 11

12 positios o a itra-day basis, for the shorter time horizos ad over a series of time itervals as required. The maagemet iformatio system should be used to moitor compliace with the broker s established risk policies, procedures ad limits. I a eviromet of rapidly chagig overall tradig ad ivestmet positios of dealers, the ultimate key still is real-time aalytics. Real-time liquidity risk maagemet would idicate whe positios eed to be squared/hedged ot oly to dealers but also to risk supervisors. Risk supervisors eed to be aware of how differet securities are budled to each other. If oe part of the broker-dealer etity has a big positio i say X compay s equities, for istace, ad aother has a big positio i X compay s bods, the two positios eed to be evaluated i tadem. This calls for stregtheig the risk tradig ifrastructure. New techologies have made it feasible for broker dealers to hadle the huge icrease i data o trades ad evaluate the chagig tradig positios costatly. Coclusio Effective liquidity risk maagemet i the cotext of a broker dealer is critical i a marketplace where complex fiacial products are icreasigly commoplace. Liquidity risk maagemet requires focused effort as well as directio ad support from the highest levels of maagemet i the orgaizatio. The seior maagemet ad board eed to effectively steer the formulatio ad compliace of risk maagemet policies ad procedures. A soud IT ifrastructure alog with cosistet ad well-defied methodologies eeds to be i place, uecumbered by risk silos of busiess uits. I a utshell, modelig liquidity maagemet imagiatively ad collectig data from across the firm will eable broker dealer firms to effectively mitigate liquidity risks. The liquidity ladscape is fluid at both a corporate ad a evirometal level. Broker-dealers liquidity profile obviously chages over time, while liquidity techiques ad combiatios thereof cotiue to evolve. Therefore, desigig ad maitaiig a broker-specific implemetatio of liquidity good practice is the proverbial challege/opportuity. It is ecessary to ote that eterprise-wide liquidity risk maagemet ca be tured to broker dealers advatage. The potetial beefits are big: Reduced cost of capital Stabilized earigs Ability to capture ew profit opportuities I fact, effective liquidity maagemet is what keeps oe i busiess. 12

13 Refereces Priciples for soud liquidity risk maagemet ad supervisio, Basel Committee o Bakig Supervisio, Jue Priciples of liquidity risk maagemet, Istitute of Iteratioal Fiace, March Soud Practices for Maagig Liquidity i Bakig Operatios, Basel Committee o Bakig Supervisio, February Soud Practices for the Maagemet of Liquidity Risk at Securities Firms, Report of the Techical Committee of the Iteratioal Orgaisatio of Securities Commissios, May Iterim Report of the IIF Committee o Market Best Practices, Istitute of Iteratioal Fiace, April 9, Fial Report of the IIF Committee o Market Best Practices: Priciples of Coduct ad Best Practice Recommedatios, Istitute of Iteratioal Fiace, July 17, Wall Street Takig a Closer Look at Collateral Maagemet, By Pey Crossma November 17, 2008, Wallstreetadtech.com. The Future State of Liquidity Maagemet Buildig a Sustaiable Respose to a Chagig Ladscape by Sea Crooks ad Herik Lag. Treasury& Securities Services; March 2010; JPMorga Chase Bak, N.A. Fiacial Idustry Regulatory Authority, Regulatory Notice 10-57; November 2010, Fudig ad Liquidity Risk Maagemet Practices 13

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