A Stress Testing Framework for Liquidity Risk

Transcription

1 White Paper A Stress Testig Framework for Liquidity Risk Oe of the most importat lessos leared from the recet fiacial crisis is that liquidity risk is fudametally differet from other forms of risk such as market risk ad credit risk. Liquidity risk, viewed earlier as a secod order risk, is ow cosidered a major risk class. The crisis showed us how quickly a risk which starts as a market or credit risk trasforms ito a liquidity evet ad how rapidly it develops ito a systemic issue. The dryig out of liquidity from the market results i the collapse of traditioally strog istitutios. Sice liquidity risk is a key risk class, it eeds its ow risk measures such as Net Stable Fudig Ratio (NSFR) ad Liquidity Coverage Ratio (LCR) as prescribed by the Basel Committee o Bakig Supervisio (BCBS). It should also have some commo measures which baks across the globe use such as gap ratios based o structural ad tactical liquidity, cocetratio metrics ad others. Sice liquidity risk measures are uique, it would be logical to create a stress testig framework desiged to suit the eeds of liquidity risk The curret ecoomic eviromet is oe wherei ucertaity ad volatility have become the New Normal. Fiacial istitutios have to devise techiques to cotiuously uderstad ad aalyze the factors that affect their busiess ad develop strategies to esure busiess-as-usual whe thig go wrog.

2 A well desiged Stress Testig Framwork provides the ability to desig forward lookig extreme, yet plausible scearios ad strategies to couter the effects of a extreme evet. This paper proposes a Stress Testig Framework desiged to hadle liquidity risk. 2

3 About the Authors Zeesha Rashid Zeesha Rashid is a seior cosultat i the Risk Maagemet Practice of Tata Cosultacy Services (TCS). He has more tha 11 years of experiece i bakig ad cosultig. He has worked with baks across the globe i the area of risk cosultig ad as a derivatives trader with a global bak before joiig TCS. He holds a master s degree i busiess admiistratio. A.N. Jayarama A.N. Jayarama is the head of the Ceter of Excellece (CoE) for the Bakig ad Fiacial Services Risk ad Compliace Practice at Tata Cosultacy Services. He has over 17 years of experiece i the bakig idustry ad over 9 years of experiece i the IT idustry coverig bakig, risk maagemet, assurace, ad compliace. His curret resposibilities iclude maagemet of the CoE, developmet of solutios ad offerigs, pre-sales, ad cosultig i the risk maagemet space. He is a certified associate of the Idia Istitute of Bakers ad a graduate i commerce. 3

4 Table of Cotets Itroductio 5 The Lifecycle of a Liquidity Crisis 5 Liquidity Risk Stress Testig Framework 6 Coclusio 11 Referece Ackowledgemets 12 4

5 Itroductio Stress tests have traditioally bee associated with market risk ad credit risk., Liquidity risk had bee cosidered a secodary risk ad clubbed with Asset Liability Maagemet (ALM). However, liquidity risk took ceter stage durig the recet fiacial crisis. It was observed how quickly a cotagio ca dry up liquidity from the market, makig eve strog istitutios ru for cover. Bakig behemoths such as Bear Sters ad Lehma Brothers collapsed as a result of liquidity mismaagemet ad too much reliace o short term fudig. I the case of Lehma Brothers, it was also observed that if liquidity is maaged at the paret compay level, it puts subsidiaries at risk, promptig regulators to cosider liquidity rigfecig, a widely debated topic today. As a result, regulators are emphasizig the importace of liquidity risk maagemet ad liquidity risk stress testig more tha ever before. Previously, liquidity risk stress testig was ever a part of ay bak s stress testig framework(some baks ra some tactical scearios uder ALM). Hece, the magitude of a idiosycratic or market wide liquidity stress evet was always uderestimated. Besides, historically, there has bee o icidece of liquidity evets to make the case for liquidity risk stress testig stroger. This paper proposes a Liquidity Risk Stress Testig Framework. The framework begis with idetifyig the compositio of the balace sheet, uderstadig factors which affect the balace sheet the most, ad the moves o to desig scearios based o the idetified factors. The aalysis of the stress tests feeds the cotigecy pla esurig that all the extreme but plausible material scearios are idetified ad a pla of actio defied. The Lifecycle of a Liquidity Crisis Bak Fiacial Markets Govermet I Cotagio Hedge Fuds A Fudametals B C Evet Q-o-Q Credit ratig Bak D E F G H Fudig Cost Short Term Stress Log Term Stress Fire Sale Ru o the Bak AMCs Pesio Fuds Other Corporates Isurace Compaies Figure 1: Life Cycle of a Liquidity Crisis 5

6 The Liquidity Risk Life Cycle depicted i Figure 1 traces the evolutio of a liquidity crisis from oe that is limited to a bak (idiosycratic) to a systemic oe that affects the etire market. Such a crisis ca be triggered by a evet which is iteral to a bak (huge tradig loss, big couterparty default, fraud ad so o) or exteral (market collapse, sub-prime crisis ad so o). The evet is big eough to affect the fudametals of the bak ad egatively impact the sequetial quaterly umbers (top lie ad bottomlie). Over a period of time, this brigs dow the credit ratig of the istitutio. This chai of evets affects fudig cost, which starts goig up, resultig i short term stress. If the bak does ot have measures i place to cotai short term stress, it trasforms ito log term stress resultig i drastic shrikig of fudig sources to the poit where there are oe left. This creates stress i the markets ad the liquidity ad marketability of assets is greatly reduced. The bak may try to couterbalace the effect through fire sale of assets. However, distress sellig ca ever make up for the gap created by log term stress, ad the bak may evetually face liquidatio ( Liquidatio occurs i a worst case sceario; ormally there is a elogated period of stress with depressed asset prices ad marketability ad reduced fudig sources which severely affect the istitutio s health). Whe a bak eters ito log term stress, the tremors are felt i larger markets where they affect other players as well. Whether it trasforms ito a cotagio or ot is depedet o factors such as the size of the istitutio affected, the severity of the evet, cetral bak itervetio ad couplig of istitutios. Liquidity Risk Stress Testig Framework Give the balace sheet compositio, behavioral profile, cocetratio of the assets ad liabilities, ad orgaizatioal strategy, the objective of a liquidity risk stress test is to: Idetify key risk factors ad drivers affectig assets ad liabilities Desig scearios( extreme yet plausible) which alig with assets ad liabilities Test the resiliece of fudig sources ad alteratives uder idiosycratic ad systemic disruptive evets It is importat to uderstad that stress testig is ot just about idetifyig the breakig poit. It is also about uderstadig a istitutio s iteral compositio, how it would react to the vagaries of the iteral ad exteral eviromet ad what measures ca be proactively built i to act as shock absorbers to keep it afloat i a worst case sceario. The stress testig framework should evolve from a uderstadig of the fudametals of the bak. This will help the bak react proactively as soo as a evet which might develop ito a crisis is idetified. Figure 2 charts out a Liquidity Risk Stress Testig Framework. This framework comprises four stages: Assess Idetify Build ad execute Quatify ad cotrol 6

7 Build & Execute Quatify & Cotrol Balace Sheet Compositio Cocetratio Behavioral Assess Asset Liability Idetify Liquidity Risk Drivers Idiosycratic Systemic Historical Simulated Hybrid Idetify Outflows ad Iflows uder each sceario Defie a Pla of Actio Icorporate it i the Cotigecy Pla Figure 2: Liquidity Risk Stress Testig Framework Assess Uderstadig the compositio of the balace sheet is crucial to desigig relevat stress scearios. Each istitutio will have a uique balace sheet hece the compositio of assets ad liabilities will differ from istitutio to istitutio. A uderstadig of the behavioral characteristics of assets ad liabilities is oe of the most crucial elemets i desigig relevat stress scearios. This ca be aalyzed i terms of: Pre-paymet characteristics - The pre-paymet characteristics of ad drivers for a mortgage loa are differet from that of a commercial loa, although there are commo drivers such as age of the facility, charges ad iterest rate cycle. Liquidity risk typically occurs whe there is a mismatch i terms of the fudig ad the teor of the loa or mortgage, ad the issue becomes complicated as pre-paymet eeds to be icluded i the model Determiistic ad o-determiistic cash flows It is importat to gauge the compositio of such cash flows ad their proportio i fuded ad o fuded products ad maturity based ad perpetual products. Models based o idetifyig core ad volatile parts of such cashflows are key i obtaiig a view of the behavior of o-determiistic cashflows. The cocetratio of assets ad liabilities ad the correspodig sources ad alteratives of fudig play a crucial role i desigig relevat stress scearios. It is crucial to uderstad the cocetratio of fudig sources retail, wholesale, structured ad fudig alteratives call moey, commercial paper, iterbak, certificate of deposit, structured alteratives ad so o. Each source behaves differetly uder differet busiess scearios as its sesitivity varies. For example, i terms of icreasig sesitivity ad complexity, the order will be retail- wholesale structured, hece, the haircuts required for structured sources are higher tha the other two. 7

8 Idetify The ext step after assessig ad uderstadig the DNA of the balace sheet is to figure out which liquidity risk factors or drivers affect the balace sheet the most. I most cases, the geesis of liquidity risk lies withi a market risk, credit risk ad/or a operatioal risk evet or a combiatio of these risk classes. The cavas of liquidity risk is therefore larger tha ay other form of risk ad hece the risk factors to be cosidered for desigig scearios is also larger. The aalysis of the cocetratio of assets ad liabilities ad their behavioral profile will aid i idetifyig the mai risk factors from the larger populatio. Techiques such as Pricipal Compoet Aalysis (PCA) ca help i reducig the umber of factors to be cosidered for desigig stress scearios, by choosig those which explai 95% or 99% of historically observed variatios. Build ad Execute The previous two steps (Assess ad Idetify) esure that the scearios which are built to perform stress tests are i syc with the ature of the balace sheet ad the factors affectig it. We also have to cosider a cocetrated set of factors from the larger populatio by usig techiques such as PCA. The Build ad Execute phase of the framework is more computatioally itesive. Regulators eed baks to desig scearios takig ito cosideratio both idiosycratic stress ad system wide stress. The scearios ca be built by adoptig Historical, Simulated ad Hybrid methods. A comparisio of the three methods is depicted i Table 1 below: Parameter Methods Historical Simulated Hybrid Historical Data Reliace o judgmet Ease to desig build ad execute Probability of over/uder estimatio High Medium Low Table 1: Methods to Desig Scearios 8

9 Geeral Market Factors: Equity FX Iterest Rates Credit Spreads GDP Iflatio Bak Specific Factors: Icrease i the roll over of loas Impairmet i the rollover of liabilities Reduced fudig sources Chage i the behavioral profile of assets ad liabilities Ratig dowgrade Shock poits i bps Terror 1D 1W 1M 3M 6M 1Y 3Y 5Y 7Y Systemic Disruptive Scearios Full blow recessio Fall of Govermet Major devaluatio of currecy Failure of large Istitutios War, act of terror Historic Market disruptive evets Ratig dowgrade Bad Severe Catastrophic Shock Grid Figure 3: Buildig Blocks of Stress Scearios Figure 3 shows the Buildig Blocks of Stress Scearios ad cosolidates the factors (sample) which affect liquidity risk uder three headigs: Geeral market factors such as chages i iterest rates, spreads ad currecy rates Bak specific factors such as adverse chages i assets ad liabilities, fudig sources, cotiget claims, ratig dowgrade ad large couterparty default Systemic disruptios such as coutry risk, war ad collapse of a large istitutio. Historic systemic disruptive evets such as the Russia crisis, the Log Term Capital Maagemet (LTCM) crisis ad the 2008 fiacial crisis ca be good sources to build scearios. It has to be oted that systemic disruptive evets cause chages i the market factors ad bak specific factors, from which scearios ca be built. 9

10 The Shock Grid i Figure 3 defies the severity of movemets i risk factors over differet time periods. This is a simplistic represetatio of a grid, the actual grid that a bak desigs will be much larger ad graular i terms of teor coverage ad shock poits.the severity, i terms of Bad, Severe ad Catastrophic o the Shock Grid, helps i sortig out the scearios for each ru. It is importat to cosider that the timig of the cashflows as well as the settlemet cycles of currecies ad markets ca differ resultig i a severe strai o the liquidity positio. Sice the grid charts out the shock poits across teors ( short term ad log term), it would aid i the fial calculatio of Liquidity Coverage Ratio (LCR) ad Net Stable Fudig Ratio (NSFR). The biggest challege a bak is likely to face while buildig ad executig scearios is availability of quality data. Well established frameworks for market ad credit risk still face hurdles due to uavailability of correct data. As such, the challege for liquidity risk will be more proouced. Quatify ad Cotrol After developig the scearios based o the buildig blocks show i Figure 3, each sceario is executed. The scearios which produce egative et cash flows are studied carefully ad probabilities of occurece assiged accordigly. Based o the bak s priorities ad policies, each of the idetified egative cash flow scearios uder Bad, Severe ad Catastrophic are mapped. A pla of actio should be defied to couterbalace the effects of these cash flows. Oe of the stadard methods of couterbalacig is to use the uecumbered asset pool. Guidelies prescribed by the Basel Committee o Bakig Supervisio (BCBS) for the classificatio of High Quality Liquid Assets (HQLA) should be cosidered for assessig the meas available for couterig liquidity stress uder differet scearios. The board should be regularly iformed of the results of the stress testig exercise, which should also be used to set limits, allocate capital, provide iputs for risk appetite defiitio ad prepare cotigecy plas. The scearios should be reviewed periodically to esure suitability to market dyamics ad the geo-political eviromet. All couterbalacig strategies alog with the related stress scearios should the be fed ito the Cotigecy Fudig Pla, which becomes the master documet at a eterprise level, to chalk out the followig: How does a liquidity crisis evolve ad how might it affect the bak? What are the risk factors which affect the balace sheet the most, give the compositio, cocetratio ad the behavioral profile of its assets ad liabilities? What are the early warig idicators? What actio should get triggered uder various stress scearios short term, log term, idiosycratic, market wide? What are the couterbalacig strategies (primary pla A, secodary pla B) ad whe do they get triggered? 10

11 Which team is resposible for dealig with stress uder differet coditios ad what should be their commuicatio pla with iteral ad exteral stakeholders? What is the system to icorporate a feedback mechaism? A cotigecy pla has to be dyamic i ature. Hece, it should be liked to the stress testig framework ad derive cotiuous iputs from each phase of the framework. It is advisable to have dry rus at pre-defied itervals to esure the efficacy of the cotigecy fudig plas. A dry ru should iclude a simulatio of a evet across the orgaizatio icludig commuicatio plas, assumptios o haircuts, validity of the sesitivity of risk factors ad alterate sources of fudig. The goverace of the framework should be uder the cotrol of the board, but it is equally importat to have a structure for the orgaizatio with clear represetatio of all lies of busiesses ad geographies to make the framework operatioal Coclusio Stress Testig for Liquidity Risk is extremely essetial to uderstad the behavior of the balace sheet ad its compoets durig extreme scearios, which are ow becomig more frequet. Stress tests, whe properly desiged ad executed, eable the maagemet to have cotigecy plas i place. These plas allow the maagemet to take ito cosideratio scearios where thigs could go wrog ad the resultig impact. Stress testig results are also icreasigly beig used by baks for strategic decisio makig ad capital allocatio. The process should become a part of busiess-as-usual for the istitutio as it is more tha just protectio agaist the ukow it is about better maagemet, which is reassurig to all stakeholders. However, it is very importat to uderstad that i the case of stress scearios, oe size does ot fit all. Each bak is uique ad therefore the scearios desiged to execute stress tests have to be i lie with the bak s profile. Demads from regulators will keep icreasig with the passage of time ad the more prepared a bak is, the better its ability to garer ad retai goodwill i the market place. 11

12 Referece Ackowledgemets IMF Workig paper,next Geeratio System-Wide Liquidity Stress Testig, Jauary 2011 GARP, A New Regulatio for Liquidity Risk, Garp December 2011 Ja Willem va de Ed, Liquidity Stress-Tester- A model for stress-testig baks Liquidity Risk, February 2009 Chris Matte, PRMIA Members Meetig, Stress testig liquidity ad the cotigecy fudig pla, 24 February 2009 Bak for Iteratioal Settlemets (BIS), Basel Committee o Bakig Supervisio- Iteratioal framework for liquidity risk measuremet, stadards ad moitorig, December 2010 Bak for Iteratioal Settlemets (BIS), Basel III: Iteratioal framework for liquidity risk measuremet, stadards ad moitorig, December 2009 Bak for Iteratioal Settlemets (BIS), Basel Committee o Bakig Supervisio- Priciples for Soud Liquidity Risk Maagemet ad Supervisio, September 2008 Bak for Iteratioal Settlemets (BIS),Basel III: A global regulatory framework for more resiliet baks ad bakig systems, December 2010 Richard Barfield ad Shyam Vekat, Liquidity risk maagemet, The Joural -Global perspectives o challeges ad opportuities, (2008) Europea Cetral Bak, EU Baks Liquidity Stress Testig ad Cotigecy Fudig Plas, November

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