Liquidity Management: A Self Study Guide Advanced course. Integrating Liquidity into the Risk Management Framework

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1 Lesson 8: Liquidity Management: A Self Study Guide Advanced course Integrating Liquidity into the Risk Management Framework Learning Objectives When you have studied this lesson you should be able to: identify the main categories of risks facing a financial institution, distinguish between the transaction risk and the portfolio risk in the lending business, develop strategies for diversifying the portfolio risk of a micro-lending operation, explain the interaction between interest rate risk and liquidity risk, use the yield-curve to predict future interest rates, define foreign exchange risk and explain its connection to credit risk and liquidity risk. Pre-Test (Solutions are at the end of the lesson) P1 A well managed bank A) does not take on financial risks B) minimizes financial risks at all cost C) seeks an efficient trade-off between financial risks and profit opportunities P2 Which of the following might reduce the credit portfolio risk? D) In addition to making loans to farmers you also lend to farm equipment vendors in the same area. E) You specialize in loans to fruit growers. F) You diversify your lending operations by providing not only agricultural loans but also loans for off-farm activities. P3 Interest rate risk is A) the risk of your borrowers not paying the interest due B) the risk of negative changes in the value of your assets and liabilities following a change in the market interest rate C) the risk that your organization might not be able to pay the interest on its commercial bonds GTZ 1

2 8.1 Overview Risk taking is the business of banking. It is the conscious engagement in risks that constitutes the economic value of financial intermediation. Banks convert financial claims with short maturity into long-term loans and vice versa. A bank may borrow at variable rates, but make 30-year fixed-rate commitments to its loan customers. Banks also take on foreign exchange risk by funding themselves in one currency and lending out in another. And finally, banks bridge the size difference between small deposits and large assets, or wholesale refinancing and microcredit. All of these financial transformations are risky. The key to successful bank management is not to entirely avoid the risks, but to properly balance the risks against the rewards from potential profits. A bank can only be sure to realize efficient trade-offs between risk and return, if it has the instruments in place to measure and manage the risk exposure. The first step towards this goal is to structure and classify the many risks a bank faces. Operational versus Financial Risks Banks face many risks. There are legislative, regulatory and competitive risks. There are management risks in the possibility that bank staff is incompetent or involved in fraud. Finally, the services the bank provides are affected by delivery risks such as technology risks, new-product risks, and cash-handling risks. We propose combining all the above risks into one broad category that we will call operational risk. For the rest of this chapter, we will neglect such operational risks and concentrate on the specific risks that apply to the intermediation function of a bank. These are financial risks in a narrower sense. Components of Financial Risk The financial risks of a bank consist of: liquidity risk, credit risk, market risk. Components of Market Risk Market risk is often further broken down into: interest rate risk, foreign exchange risk, equity price risk. We already have a good understanding of liquidity risk. Let's look at the other risk categories in as far as they apply to the microfinance environment and discuss how they interact with the liquidity position of the bank. Since MFIs generally do not hold trading positions in equity securities, equity price risk is not an important concern. In the following, we will focus on the interface between liquidity and the three other major financial risks: credit, interest rate and foreign exchange risk. GTZ 2

3 Comprehension Check (Please refer to the text to find the answers) i. Is risk bad for a financial institution? ii. Give five examples of operational risks in a MFI. iii. Your MFI holds a 25% stake in a regional cooperative that provides services to microlenders. Should your MFI be concerned about equity price risk? 8.2 Credit Risk Credit risk has two important dimensions: transaction risk and portfolio risk. Transaction risk refers to individual loans and essentially measures two aspects: (1) the probability that the borrower will be able to repay, and (2) the quality of procedures, such as borrower selection and loan administration, which should maximize the likelihood of repayment. This is the core business of the micro-finance movement and most MFIs have good credit risk assessment and loan loss mitigation strategies in place. GTZ 3

4 Figure 8.1 Components of Credit Risk Credit Risk Transaction risk Portfolio Risk Portfolio Risk The critical area where many MFIs can still make improvements is loan portfolio risk. The risk of the entire loan portfolio is not simply the summation of all individual loan risks. Portfolio risk assessment must take into account the effects of diversification. Simply put, diversification is about having many different types of loan clients whose payment behavior is independent from each other. If all your clients are providing tourist services, then a decline of tourism due to bad weather or unfavorable exchange rates may lead to a wave of loan losses. The same exchange rate problem that keeps foreign tourists away, however, may make it more lucrative to import the food products that possible street vendor clients are selling to local customers. Diversification of your client base thus allows you to offset losses in one area with an improved outlook in another. Diversification There are several key components to a comprehensive diversification strategy. First, one must avoid concentrating on a few large borrowers, who would risk bringing the whole bank down if they failed. This is usually not a problem for a MFI because of its mission to provide microcredit to small entrepreneurs. Secondly, a MFI should try to diversify the sectors of activity that it finances. One should avoid a mono-culture of only tea farmers or only rickshaw drivers, for example. And thirdly, it is important to diversify across geographic regions. This is in part linked to the second issue of industry diversification. In a region where coffee plantations are the economic backbone, it is not enough to diversify by lending to small restaurants in the same area. If the coffee business goes downhill so will the rest of the services and small merchants in the region. Geographic diversification thus facilitates effective industry diversification. In addition, it also provides protection against the effects of large natural disasters, which might impact the entire economy of a region. The problem with diversification across industries and geographic areas is that microlending has often been successful, precisely because the institutions know their local customers personally and understand their business and their economic environment. A MFI that ventures outside its home market and industry expertise will risk losing loans because it lacks information about the area and the creditworthiness of clients. A simple solution to this dilemma is to cooperate with MFIs in other geographic areas. MFIs could exchange loan participations or swap parts of their loan portfolios to give each other access to the earning potential and credit risk of their client base. The individual loans would still be screened and serviced locally by the originating institution. A more sophisticated variation of this same idea is to buy formally securitized loan portfolios from MFI issuers in other regions 1. 1 See lesson 7, Box 7.2 for MFI loan securitization. GTZ 4

5 Connection with Liquidity Risk How is credit risk linked to liquidity risk? The most important connection is obvious. A loan that is not repaid when it is due is a loss of liquidity. You will recall how we accounted for "cash attrition from loan loss" in the cash flow charts in lesson 4. The second connection is that potential lenders to a microfinance organization have a keen interest in the quality of the loan portfolio as an indicator of its financial viability. If nonrepayment rates increase, you will find it much harder to borrow liquidity from the banking system. Eventually, word of your troubles with loan collections will get around to the retail depositors, who will lose confidence and begin to withdraw deposits and thus further drain liquidity. Box 8.1 Risk Management at the Fédération des Caisses d'epargne et de Crédit Agricole Mutuel du Bénin (FECECAM) FECECAM has already been introduced in Box 7.8. The federation has devised standards that apply to the risk management of every individual credit union in the FECECAM network: (1) A credit ceiling of 1 million in the local currency (FCFA) applies to all members of the credit union, in order to avoid a loan concentration with certain powerful members. (2) The network attempts to diversify its operations by welcoming new groups of clientele (urban and women customers). Regional diversification outside of the cotton zone is encouraged. Cotton farmers are the traditional core of the banking business and represented more than half of the credit unions' clients in Since then, their share of the loan business has been reduced to only one third. The cotton sector is prone to cyclical problems that can affect the economy of the entire region. (3) The federation imposes limitations on the individual credit union's business volume depending on its management capacities. The maximum authorized level of loan operations for a credit union is 70% of the savings book accounts of the previous quarter. If the credit union has more than 5% in arrears, the coefficient is lowered to 60%. In addition to on-lending their collected savings, well managed credit unions can apply for internal refinancing lines from their regional union and can thus increase their transformation rate to 85%. Source: Christine Westercamp in: Challenges of Microsavings Mobilization. A. Hannig / S.Wisniwski (eds), Comprehension Check (Please refer to the text to find the answers) i. How can diversification reduce credit portfolio risk? ii. Why is it often difficult to diversify across industries without diversifying geographically? iii. Is there a possibility that reducing the portfolio risk via diversification might actually increase credit transaction risk? iv. What is the link between credit and liquidity risk? GTZ 5

6 8.3 Interest Rate Risk We briefly touched on interest rate risk in connection with asset-liability management in lesson 2 and more recently in lesson 7, when discussing how the market price of fixedincome securities changes with variations in the current interest rates. Definition Usually, interest rate risk is defined as the possibility of a change in the value of assets and liabilities in response to changes in the prevailing interest rate. So, both assets and liabilities can be affected by interest rate changes. And, somewhat counter-intuitively, not just variable rate instruments are exposed to risk. A long-term loan from a donor agency with a fixed interest rate is also subject to significant interest rate risk. This is easy to see if you consider that interest rates might fall after the MFI takes out the loan. It is now tied to paying the high interest rate, even though it could get the money cheaper in the current market. This is not just a mere loss on paper. Competitors who can take advantage of the lower funding cost can offer cheaper loans and will take business away from the long-funded MFI. Example Now, imagine a bank that only lends overnight with daily interest rate adjustments and only borrows overnight, also with daily interest adjustments. In this extreme example, there would be no liquidity risk and no interest rate risk. The bank would try to lend out for a little bit more than it borrows. This interest margin would be independent of the absolute level of interest rates, and both asset and liability interest rates would move up and down in parallel. The problem is that the bank will probably not be able to earn enough of a margin to cover its operating expenses. That is rightfully so, because nobody needs such a bank. It is not adding value through financial intermediation. In order to provide a useful service, a bank must to some extent transform short-term liabilities into long term assets (and vice versa) and convert between fixed and variable interest rates. The most important open flank in this risky business is the future development of interest rates. Connection between Interest Rate Risk and Liquidity Liquidity risk and interest rate risk come together where maturities of assets and liabilities are mismatched. Liquidity risk refers to the diverging timing of the asset and liability cash flows. Assume that you lend to a farmer for six months with weekly interest payments and a principal payment at the end. You fund this loan with a three-month time deposit. You have to repay or roll-over the deposit at least once, before the loan is paid back. Imagine that you cannot generate enough other cash flow to repay the deposit and that there is a disruption in the financial market, which prevents you from bringing in new deposits or purchasing funds at a reasonable rate. This is the liquidity risk component of maturity mismatching. The maturity mismatch also has an interest rate risk dimension, because along with the diverging cash flow timetable, there will always be differences in the re-pricing intervals of the interest rate charge. For example, a variable-rate loan may allow for interest rate adjustments according to market conditions every month or once a year, while the overnight money that is used to fund these loans re-prices every day. If interest rates rise quickly, the asset rate adjustments will lag the funding cost increase and the interest margin will be reduced. The most outstanding example of such a re-pricing mismatch would be a 30-year fixed-rate mortgage funded by hot money deposits. GTZ 6

7 Re-Pricing Gap Whether a bank that makes only long-term fixed-interest loans and refinances them with money market deposits will go bankrupt or make a large profit is ultimately determined by the future course of interest rates. While such a large gamble is unthinkable for any prudent banker, all banks maintain a certain re-pricing gap 2 and speculate on future interest rate scenarios within reasonable limits. It is therefore important to invest some effort into developing a well-founded expectation about future interest rates. The interest rate forecast is not only essential for the asset-liability strategy it also has important implications for liquidity management. When interest rates are expected to rise, the liquidity manager should preferably purchase funds for longer terms and delay the cost increase by slowly ratcheting up the interest rates. Conversely, if the expectation leans towards falling interest rates, then the MFI should cover liquidity needs with the shortest maturities possible in order to take advantage of falling funding costs in a timely manner. Yield Curve As a general rule, the longer the loan or deposit commitment, the higher the annualized interest rate is likely to be. The extended time commitment normally commands a premium for bearing the risk of future adverse changes in interest rates. This relationship is often illustrated with a yield curve, which plots the annualized interest rate against the length of the time commitment. 8 Effective interest rate % 7 6 Figure 8.2 Yield Curve Month 6-Month 1-Year 2-Year 3-Year 5-Year 7-Year 10-Year 30-Year Time until maturity A yield curve is a snapshot of current market conditions at one point in time. It compares effective interest yields for debts of the same borrower quality for different maturities. A normal yield curve slopes upwards and an inverted (abnormal) yield curve slopes downward. An inverted yield curve can be observed during times when the central bank tightens short-term liquidity in order to cool down a booming economy, while the expectation remains that the current high interest rate levels will soon fall back to normal. 2 The re-pricing gap is defined as the difference between the assets and the liabilities that will be subject to a rate adjustment during a specified time horizon. GTZ 7

8 Even though the yield curve only summarizes observations of current market yields, it contains important indications for the future direction of interest rates. The yield curve, indeed, implies aggregate market expectations about forward rates, i.e. an interest rate for a future time interval that is contracted today. For example, it is possible to arrange in advance for a three-month loan that starts in 3 months and is repaid in 6 months from today. The interest rate that applies to this loan is the forward rate in three months for three months time. Forward Rate Example Let's show how we can extract this three-month forward rate from the data of the yield curve. We will use the upper, steeply normal yield line in figure 8.2. One can borrow at 5.53% for three months or at 6.22% for six months. As an alternative to the six-month loan with the exact same financial outcome, you should be able to borrow for three months now and contract a follow-up loan for three months in three months time. The current three-month rate and the forward rate combined should be exactly equivalent to the sixmonth rate. The interest multiplier for the six-month loan at 6.22% p.a. is /2 = The multiplier for the three-month loan at 5.53% is /4 = The forward rate is therefore given by: x (1+ forward rate for three months in three months) = This comes out to a forward rate of or 6.89% on an annualized basis. We can now see that the market expects a strong increase in short-term interest rates. The same three-month loan we can get today for 5.53% is expected to cost 6.89% in three months. It is important to remember that such an expectation about future interest rates only represents the current consensus of market participants based on the information available today. New information or subsequent economic events can change these expectations instantly. Thus there is no guarantee that the actual three-month interest rate in three months will correspond to the forward rate quoted today. Comprehension Check (Please refer to the text to find the answers) i. Is it safe to say that a 30-year loan with a fixed interest rate taken out by your institution is free of interest rate risk? ii. What is the liquidity risk aspect of maturity mismatching? GTZ 8

9 iii. What is the effect on the net interest margin of a drop in interest rates on deposits for a MFI that lends at fixed interest rates for an average duration of two years and funds itself mainly with retail deposits that have monthly interest rate adjustments? iv. Why is a yield curve with negative slope abnormal (inverted)? v. In the above example, we calculated an implied forward rate for three months in three months of 6.89%. Three months later you realize that the current three-month interest rate is actually 5.3%. Does this mean that the yield curve was incorrect? 8.4 Foreign Exchange Risk Definition Foreign exchange (forex) risk is the possibility of a loss or a gain from varying exchange rates between currencies. In addition to the risk in changing rates, foreign exchange risk also includes the danger that it might become impossible to carry out currency transactions because of government interventions or a market disruption. Importance for MFIs One might expect MFIs to ignore forex risk, because their mission does not require them to deal in foreign currency. It seems unlikely that the poor clientele of MFIs would be engaged in international commerce or foreign travel. However, in many countries where MFIs operate, the local currency is weak and prone to erratic swings in external value. In such a situation, it is common to use a parallel currency system, where a strong foreign currency is employed for domestic transactions. It is helpful for understanding the nature of forex risk to look at two extreme, opposite examples: at one end of the spectrum would be the "local currency only" bank which does not deal in foreign exchange at all, neither for its clients nor for its own account. Obviously, in such a case, forex risk is not a concern. At the other end of the spectrum would be an offshore type bank that holds all its assets and liabilities in US dollars, including micro loans and retail deposits. The offshore bank also does not incur forex risk, even though all financial contracts are exclusively in a currency that is foreign to its place of business. The magnitude of the forex risk exposure is not determined by the proportion of business conducted in foreign currency, but by the size of the discrepancy between forex assets and liabilities and the timing of the associated cash flows. GTZ 9

10 Link between Forex Risk and Credit Risk With this offshore scenario in mind, one might be tempted to avoid forex risk by shifting all transactions to a strong foreign reference currency: since the funding is in dollars, let's also make dollar microloans. While this would reduce forex risk, credit risk would go up instead. Even though the loans are now denominated in dollars, the borrowers still plan to repay the loans with local currency revenues. Should the local money lose value against the dollar, the borrowers will have a hard time repaying the dollar loans with the shrinking counter-value of their local currency earnings. For most MFIs in countries with a weak local currency, the offshore scenario and the localcurrency-only model are not realistic options. These institutions will to some extent fund themselves in hard currency and lend in local money or convert local currency deposits into hard currency assets. Why, and to what degree, a bank enters into such currency mismatching is a question of overall risk strategy and expectations about future exchange rate developments. This is beyond the immediate scope of liquidity management. Link Between Forex Risk and Liquidity The liquidity manager will look at the profile of foreign exchange assets and liabilities as a given fact. From a liquidity perspective, it is important to capture the cash flow consequences of the forex positions, so that short-term liquidity needs and surpluses are identified for each currency. How liquidity management works across several currencies is the subject of the following lesson. Comprehension Check (Please refer to the text to find the answers) i. Why is forex risk an issue for micro-finance institutions whose clients rarely travel overseas or are engaged in international business? ii. What type of bank has more forex risk, a local-currency-only bank or a pure offshoretype bank? iii. What is the connection between forex risk and credit risk? iv. How is foreign exchange exposure captured from a liquidity management perspective? GTZ 10

11 Exercises (Solutions are at the end of the lesson) E1 Extract Forward Rates from Yield Curve From a yield curve on government bonds published in the Financial Times you obtain the following information: Two-year funds yield 7.8% p.a. and 1-year funds pay 7.1% p.a. You know that you would like to borrow $500,000 for one year in one year's time. If you go to your commercial correspondent bank today and sign a forward rate agreement for this loan, how much can you expect to pay in interest given that your institution's risk normally calls for a 4% spread over government debt? E2 Inverted Yield Curve Imagine you are an economist trying to develop a future interest rate scenario. You base your assumptions on a yield curve that you plotted yourself from published market data. Your yield curve is inverted with negative slope and indicates a two-year interest of 6% and a 3-year rate of 3.5%. You wonder what the forward rate for a 1-year loan in two years might be. How do you interpret the result? Can your yield curve be correct? GTZ 11

12 Multiple Choice Test (Solutions are at the end of the lesson) M1 M2 M3 M4 M5 M6 M7 Which of the following is not an operational risk in a financial institution? A. legislative risk B. technology risk C. fraud risk D. equity price risk Which of the following is not a market risk? A. equity price risk B. credit risk C. interest rate risk Loan diversification reduces A. credit transaction risk B. credit portfolio risk C. interest rate risk A 30-year loan with a fixed interest rate taken out by your institution is free of interest rate risk. A. True B. False What is the effect on net interest margin of a drop in interest Rates on deposits for a MFI that lends at fixed interest rates for an average duration of two years and funds itself mainly with retail deposits that have monthly interest rate adjustments? A. net interest margin decreases B. net interest margin increases C. net interest margin is unchanged A normally sloped yield curve A. shows higher interest rates for longer time horizons B. shows higher interest rates for shorter time horizons C. is always a straight line What type of bank has more forex risk, a local-currency-only bank or a pure offshoretype bank? A. The off-shore bank deals exclusively in foreign currency and therefore has the highest possible forex risk. B. Both types of bank have no forex risk. C. The local currency-only bank has the higher forex risk, because it has no foreign currency and must buy all of it on the forex market. GTZ 12

13 Solutions to Pre-Test P1 C) P3 B) P2 F) Solutions to Exercises E1 Extract Forward Rates from Yield Curve (1 forward rate) Forward rate for government risk = 8.5% Your forward rate: 12.5% E2 Inverted Yield Curve 1.06 (1 forward rate) Forward rate = -1.3% 2 3 The slope of the yield curve is so steeply inverted that the implied forward rate for one year in two years is negative. Mathematically this is correct, because the only way to bring down the "average" interest to a three-year rate of 3.5% after having paid 6% for the first two years is by incurring a negative interest rate during the third year. Economically, negative interest rates make no sense. Therefore, either something is wrong with your yield curve computation or there is a serious financial disruption in the market which prevents normal arbitrage from correcting the implausible market rates. Solutions to Multiple Choice M1 D M5 B M2 B M6 A M3 B M7 B M4 B GTZ 13