Liquidity Risk Stress Testing

Transcription

1 Liquidity Risk Stress Testing White Paper Liquidity Risk Stress Testing

2 In this White Paper A financial world under transformation...4 Characteristics of liquidity risk management...5 New regulation and standards...6 The BearingPoint response...8 Implementation project Outlook Early Warning Indicators Liquidity reserve Modeling cash flows Concentration risks Funds transfer pricing Contact... 14

3 Liquidity risk has just recently emancipated itself as a significant risk type. Prior to the 2007 financial crisis, liquidity was considered only as a part of the regulatory reporting process for financial institutions and did not constitute a risk type requiring thorough risk management. In order to respond to the increased importance of liquidity risk and its role as a full-fledged risk factor, regulators introduced stress testing as the primary technique for identifying, measuring and limiting liquidity risk vulnerabilities and exposures. BearingPoint presents a solution for complying with the regulatory requirements for liquidity risk stress testing, which can be applied in various banking environments. We offer a tailored step-by-step approach to identify institutespecific, extreme yet plausible, idiosyncratic and market-wide liquidity stress scenarios, allowing for the consistent management of liquidity risks. Liquidity Risk Stress Testing White Paper 3

4 A financial world under transformation Liquidity risk became a major concern for banks and financial institutions after the recent financial and economic turmoil. During the 2007 crisis, even well-capitalised institutions were unable to acquire funding to refinance their operations and short term obligations due to the collapse of the unsecured interbank lending market. The failure of Lehman Brothers, and the difficulties experienced by major financial institutions 1 pinpointed a serious soft spot in the existing risk governance and management frameworks of banks and other financial institutions. The system-wide effects of the crisis, such as the systemic liquidity shortages, liquidity hoarding 2 and inability of institutions to acquire funding and thereby collapsing as a result, exposed the interdependencies between different risk factors. The lack of liquidity contributed significantly to the problems experienced by financial institutions 3, with some market analysts speculating that Lehman Brothers might have survived, if the bank had been provided with further liquidity 4. In the real world, information frictions and imperfections in capital markets can make it difficult for financial institutions to acquire liquidity in extreme situations, thus making the handling of liquidity risks an essential part of the management of a bank. Liquidity risk gained increased importance during the 2007 crisis due to the systemic impact of liquidity risk related events such as liquidity shortages. While the main point of concern for asset and liability risk managers over the past decades has been interest rate risk, the importance of liquidity management has until recently been underestimated and neglected in the overall context of asset and liability management for financial institutions. Based on past experiences 5, the active management of the balance sheet had its focus on managing exposures to interest rate risks, and considered liquidity of importance solely from the regulatory reporting point of view. The effective steering and management of the newly acknowledged risk type requires new or enhanced governance and risk management processes, methods and techniques. Liquidity risk management needs to be successfully incorporated into the already existing asset and liability management framework. Furthermore, a regular update and independent assessment of the effectiveness of liquidity risk management is required. This presents a challenge for banking institutions, due to the specific nature of liquidity risk and its relationships to other risk types. 1 Such as most notably Bear Stearns, Wachovia, Merrill Lynch, AIG, HBOS, Washington Mutual. For a detailed timeline of problems experienced by major institutions, please refer for example to Federal Reserve Bank of St. Louis, The Financial Crisis: A Timeline of Events and Policy Actions. 2 Liquidity hoarding occurs when banks prefer withholding cash instead of lending it out, causing in effect a dry up of the interbank market. 3 As was, for example, the case with Bear Stearns: The institution was unable to acquire liquidity on the interbank market and was offered a bailout package by the Federal Reserve. The bank was ultimately bought by J.P.Morgan at a staggering loss for Bear Stearns shareholders. 4 A statement most notably expressed by Richard S. Fuld, Jr. former CEO of Lehman in front of the Financial Crisis Inquiry Commission. 5 The increased volatility of interest rates was one of the causes of the system shock in the US in the early 1980s and which resulted in numerous bank failures. 4 Liquidity Risk Stress Testing White Paper

5 Characteristics of liquidity risk management Liquidity risk is a black swan a high impact, low frequency event. Liquidity risk relevant events occur with extreme rarity, and are therefore difficult to account for using traditional statistical techniques. The scarcity of historical information and statistics, both bank-specific as well as market wide, suggests that these cannot be considered a reliable source of data for modeling liquidity risk directly. Furthermore, liquidity risk is a derivative risk stemming from other risk factors it highly depends on the impacts and severities of risk types such as market, credit and operational risk. Liquidity risk is a low frequency high severity risk, making it difficult to manage. Regulators have assigned a central role to stress testing as an appropriate technique for the management and modeling of liquidity risk due to its economic significance and since it incorporates extreme events and accounts for the specifics of the considered bank. Stress testing is a balanced combination of historical as well as forward looking knowledge, such as statistical data, empirical observations and expert judgment. It exploits quantitative methods, but it is also subjective by depending on the input of the risk management of the bank. Of utter importance when designing stress tests is the identification of the liquidity stress scenarios and liquidity risk relevant stress events, as well as the institute-specific liquidity vulnerabilities. During the analysis of the causes of the recent financial crisis and while on the lookout for new management solutions, supervisors observed that stress testing did not appear to be sufficiently integrated into the institutions risk management frameworks or senior management decision-making. In general, where stress testing was used, scenarios were not sufficiently extreme nor were there appropriate considerations given to the potential crystallization of confluences of events. As a result new regulation and standards emerged 6. 6 For a report on the range of bank practices before the crisis, please consider (2008) ECB, EU Banks Liquidity Stress Testing and Contingency Funding Plans. Best practices guidelines for stress testing are described in the (2010) CEBS, Guidelines on Stress Testing. Liquidity Risk Stress Testing White Paper 5

6 New regulation and standards Having acknowledged the importance of liquidity risk as well as the domino effects of liquidity shocks during the 2007 financial crisis, regulators systematically developed new standards and regulations for its successful management. The Bank for International Settlements published its Principles for Liquidity Risk Management 7 and introduced two regulatory minimum liquidity standards the LCR and the NSFR 8 with deadlines for the implementation of the LCR from 2015 until The European Banking Authority 9 published a series of guidelines on liquidity and stress testing 10 which constitute an important part of the currently discussed proposition on new EU wide regulation the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) intended to govern, among others, liquidity risks. The German regulatory authorities consider the overall management of risk, including liquidity risks in their Mindestanforderungen an das Risikomanagement (MaRisk) requirements, which implement the EU regulatory framework. The MaRisk regulation requires an integrated consideration of liquidity risk into the whole risk governance and process framework of banking institutions. Regulators introduced stress testing for identifying, measuring and limiting liquidity risk vulnerabilities. Regulators use a twofold approach towards the governance of liquidity risk management: Firstly, system-wide risk stability is addressed by requiring the adherence to minimum liquidity standards such as the LCR and NSFR. Secondly, the specific vulnerabilities and liquidity risk exposures are taken into account by requiring the introduction of institute-specific stress tests as well as the adherence to the sound liquidity risk management practices. FIGURE 1: REGULATORY REQUIREMENTS AND THE LIQUIDITY RISK MANAGEMENT Governance MaRisk AT 4.2 Z2 Risk Strategy Processes MaRisk AT MaRisk BTR 3.1 Z11 MaRisk BTR 3.1 Z2 Risk Steering Liquidity Risk Reporting Risk Interdependencies Methods MaRisk BTR 3.1 Z2 Early Warning Indicators MaRisk BTR 3.1 Z3 Liquidity Gap Analysis MaRisk BTR 3.1 Z5-7 Fund Transfer Pricing MaRisk AT 4.3.3, BTR 3.1 Z8, BTR 3.2 Z3 Stress Testing MaRisk BTR 3.2 Z2 Liquidity Reserves MaRisk BTR 3.1 Z1 Intraday Liquidity MaRisk AT 2.2 Z1, BTR 3.1 Z1 Concentration Risk IT-Architecture (Data, Systems) MaRisk AT 7.2 IT Systems, IT Processes and Data 7 (2008) BCBS, Principles for Sound Liquidity Risk Management and Supervision 8 LCR and NSFR were first introduced by the BCBS in (2010) International framework for liquidity risk measurement, standards and monitoring. An update to the LCR and monitoring tools was issued in (2013) BCBS, The LCR and liquidity risk monitoring tools. 9 The European Banking Authority (EBA) was founded after the crisis with the main aim of maintaining the future stability of the financial system and has taken over all existing and ongoing tasks and responsibilities from the Committee of European Banking Supervisors (CEBS). 10 Such as the (2009) CEBS, Guidelines on Liquidity Buffers and (2010) CEBS, Guidelines on Liquidity Cost Benefit Allocation, (2010) CEBS, Revised Guidelines on stress testing etc. 6 Liquidity Risk Stress Testing White Paper

7 The new regulation intends to identify and constrain the liquidity risk exposure of financial institutions by setting limits on the funding structure of banking institutions, especially on the maturity, stability and reliability of the different funding sources and by assuring adequate liquidity reserves and counterbalancing capacities. Financial institutions are required to test their ability to cover unexpected liquidity requirements and to maintain their refinancing sources on a frequent basis and pay special attention to the stock of highly liquid assets with which liquidity shocks are to be accounted for (MaRisk BTR 3.1.2). MaRisk BTR 3.2 further requires liquidity reserves of highly liquid assets to be kept, which can be used to cover short-term funding gaps. Since liquidity risk is considered a derivative risk type, MaRisk requires that the effects on liquidity risk of other risk types, such as reputation risks, are also accounted for. For capital market oriented institutions the German regulation imposes additional and stricter measures regarding the testing of extreme scenarios (MaRisk BTR 3.2). Three general types of scenarios ought to be considered: idiosyncratic, market-specific as well as a combination of both. Furthermore, financial institutions need to analyze and integrate into their stress testing framework extreme, yet plausible stress scenarios and consider hypothetical as well as historical crises (MaRisk AT 4.3.3). By using Early Warning Indicators (EWI), financial institutions should identify liquidity shortages early on (MaRisk BTR 3.1). Banks are required to maintain a diversified structure of their funding sources as well as the diversified nature of their assets (MaRisk AT 2.2, BTR 3.2). Liquidity Risk Stress Testing White Paper 7

8 The BearingPoint response After a detailed, in-depth analysis and step-by-step consideration of the regulatory requirements, BearingPoint has conceptually developed and applied into practice a target architecture for the management of liquidity risks. Stress testing and institute specific stress tests in particular, are the centerpiece of the liquidity risk management framework, since stress tests and their results constitute major inputs for the other liquidity risk management components. Stress testing is the centerpiece of liquidity risk management, and its successful implementation is crucial for other elements of the liquidity risk architecture. BearingPoint offers a proven step-by-step approach for identifying institute-specific, extreme yet plausible liquidity stress scenarios. The proposed solution for defining liquidity risk stress tests is compliant with the newest national and supranational regulatory requirements, recommendations and guidelines. One of the challenges financial institutions are expected to face in the setup of the stress testing framework is the definition of stress test scenarios which appropriately capture the institute-specific liquidity risk vulnerabilities. For the definition of liquidity stress scenarios, we suggest the integrated, sequential approach displayed in Figure 3. There are two major components of the approach the structured description of scenarios and the definition of liquidity events, which serve as building blocks for the scenarios description. These building blocks are determined through the simultaneous formulation of historical liquidity events and institute-specific liquidity events. The institute-specific liquidity events are viewed from two angles: they are either mapped to an already identified historical liquidity event or, if no appropriate historical event has been identified, to a hypothetical liquidity event. Liquidity events are economic or other occurrences which have an effect on the liquidity position of the bank. For the purpose of successful liquidity risk management, these need to be extreme, yet plausible with typical examples being a funding shock, deposit run-off or stock crash. Defining a plausible event is a challenge due to the inherent subjectivity: therefore the use of a liquidity event needs to be rationally explained and be easily understandable in order to assure its real world relevance. Banks ought to define an institute-specific list of liquidity events in order to account for their specific vulnerabilities. FIGURE 2: STRESS TESTING AS A CENTERPIECE OF THE LIQUIDITY RISK MANAGEMENT TARGET ARCHITECTURE Stress Testing FTP EWI Stress Tests Liquidity Reserve FTP Scenarios/Generation indirect Liquidity Gap Analysis (stressed) EWI Stress Tests Liquidity Reserve FTP Liquidity Gap Analysis Asset Concentration direct Cash Flows normal Concentration Intraday Liquidity Cash Flows normal Funding Concentration Concentration Cash Flow Modeling Concentration Risk 8 Liquidity Risk Stress Testing White Paper

9 FIGURE 3: INSTITUTE-SPECIFIC LIQUIDITY STRESS TEST SCENARIO DEFINITION Liquidity Event Definition (combined Top-Down/Bottom-Up Approach) Structured Description of Scenarios Top-Down Analysis wide range of historical crises Bank-specific relevance List of bank-specific liquidity events Deposit Run-Off Market Downturn Real Estate Herabstufung Shock Rating Downgrade Select liquidity event as trigger of scenario Market Downturn Select liquidity events describing the scenario Liquidity Shortage Rating Downgrade Deposit Run-Off Order sequence of liquidity events A liquidity stress scenario represents the screenplay for a liquidity crisis. Cluster Sight deposits Cluster Term deposits Cluster Credit lines Cluster Rating triggers Pool of liquidity clusters Cluster Commercial papers Cluster B/S and Off-B/S Positions Bottom-Up Analysis For the definition of the list of liquidity events, a combination of a Top-Down and a Bottom-Up approach is applied. The Top-Down approach conducts an analysis of historical crises and from these extracts relevant historical liquidity events. Banks need to consider a wide range of crises with respect to their time of occurrence, geography, severity, impact, etc. For example, focusing only on recent crises can ignore relevant past occurrences, focusing only on far away crises would ignore current trends in the market a balanced view is deemed necessary. The liquidity events are the building blocks for the liquidity stress scenarios and capture the institute-specific vulnerabilities. The relevance of historical liquidity events for the bank and the formulation of bank-specific liquidity events is determined after a detailed analysis of the related risks, the portfolio structure and regional or country exposures. Bank-specific liquidity events need to take into account the bank s portfolio exposures or asset/liability concentrations. Consider the example of a bank which strongly relies on the interbank market to refinance its short-term debt. In this case, liquidity events describing shock in the interbank market would be considered highly relevant. FIGURE 4: TOP-DOWN: EXTRACTION OF LIQUIDITY EVENTS FROM HISTORICAL CRISES Historical Crises Liquidity Events Northern Rock bank run Lehman Brothers: ABS crisis Société Générale: Rogue trading Constrained market liquidity Retail Funding Run-Off Breakdown of a funding relevant asset class (e.g. MBS) Trader fraud scandal Restriction on unsecured and secured money-market Greece : Sovereign crisis Record yields for Italian and Portugese Government Bonds Default of a country Market turbulence with collateral repudiation Liquidity Risk Stress Testing White Paper 9

10 FIGURE 5: TOP-DOWN: IDENTIFICATION OF BANK-SPECIFIC LIQUIDITY EVENTS Identification of liquidity related risk Analysis of the bank s specific product offering Interdependencies Identification of contingent liquidity risk Analysis of specific national or geographic dependencies of the business model Bank-specific liquidity events Furthermore, country specifics are important in the analysis, due to systemic risk and the potential system wide effects of liquidity risk. For banks with strong regional dependencies, liquidity events which focus on shocks in the region should be taken into account. The Bottom-Up analysis locates positions which exhibit similar or identical liquidity effects and aggregates them in clusters. The conclusive structural analysis of these liquidity effects starts at the balance sheet level. A position s potential effect on liquidity is categorised in five groups: unexpected cash flows, unexpected collateral pledge, liquidation, risk mitigation and stable funding. When defining the liquidity clusters, different granularity levels are possible with a strong reliance on expert judgment in the matter. FIGURE 6: BOTTOM-UP: LIQUIDITY RISK EFFECTS AND THEIR RELEVANCE Assets Liabilities Liquidation Risk Mitigation Counter Balancing Capacity (e.g. Cash, Deposits, Securities) Asset used for Risk Mitigation (e.g. Loans) Funding Positions (e.g. Deposits, Issued Securities, Wholesale funding) Stable Funding Unexpected Collateral Pledge Derivatives (e.g. Options) Other Assets Other Liabilities Unexpected Cash Flow Off Balance Sheet (e.g. Letters of Credit, Liquidity support) 10 Liquidity Risk Stress Testing White Paper

11 The liquidity clusters are defined by combining dimensions, which describe the properties of a position such as the position s maturity, credit rating, currency, etc. The identification of the different liquidity clusters is necessary because each cluster requires a specific method of parameterisation (for example roll-over rate, haircut, flows). Liquidity clusters are further broken down into more granular components along each dimension through the use of liquidity value groups. These represent a very detailed look into the portfolio of the bank liquidity value groups are groupings of positions with different values of the same dimension. Consider the dimension credit rating an acceptable liquidity value group breakdown would be to group all positions with credit rating values between AAA to BBB in one liquidity value group. The liquidity events are defined after a careful analysis of historical liquidity crises and bank-specific vulnerabilities. After this, the structured description of liquidity stress scenarios takes place based on the list of institute-specific liquidity events. A liquidity stress scenario is the screenplay for the course of a liquidity crisis: it describes a trigger-event chain of liquidity events, the timing of the liquidity events occurrence and the relationships between them. The crisis is initiated by a trigger event, followed by a sequence of further liquidity events. Consider the example of the Lehman Brothers bankruptcy the particular event counterparty bankruptcy was followed by a perfect storm of distress factors which in turn had a substantial effect on systemic liquidity risk. Usually a scenario is mapped to only a limited number of liquidity events. In order to ensure the plausibility, we recommend keeping the scenarios simple. Over-fitted scenarios which are parameterised by many events are difficult to rationalise and are not intuitively interpretable. Liquidity Risk Stress Testing White Paper 11

12 Implementation project The BearingPoint approach suggests an implementation project according to the steps below. FIGURE 7: METHODOLOGICAL STEP-BY-STEP IMPLEMENTATION Determine the current situation Define the liquidity events and scenarios Model and validate scenarios Design the stress tests Implement the system and organise the reporting processes The implementation project incorporates five steps which allow for the consistent management of liquidity risk and successful integration into the client s risk framework. An important first step in the implementation project is the discovery phase, which focuses on the institute-specific analysis of policies, internal guidelines, processes and if appropriate the current implementation. The conducted gap analysis is supposed to identify any deviations with regard to liquidity risk management and stress testing by comparing the regulatory and internal to-be situation, with the present one. An overview of the bank s business model and balance sheet should identify any specifics to be taken into consideration. A detailed project approach and activity planning needs to occur depending on the discovered gaps, specifics and vulnerabilities. The second step encompasses the definition of liquidity events and the structured description of liquidity stress scenarios. The consideration of the liquidity clusters granularity is crucially important here. BearingPoint s experience suggests, that as a good starting point, the bank can consider the granularity level suggested by the LCR and NSFR regulatory ratios. The granularity, however, ultimately depends on the specifics of the bank and its business model as well as expert judgment on the matter. In the following step, the liquidity clusters are modeled and validated. Only liquidity clusters which fulfill preset materiality conditions are considered. The modeling of liquidity clusters pertains to the analysis of their time series and, if necessary, the modeling of distribution parameters. Relevant benchmarks need to be identified and analyzed by applying appropriate quantitative methods, and the results used in the modeling and validation of the liquidity clusters. A challenge in the practical implementation is the identification of quantitative models which are robust and stable over time. The potential challenge in the next step, is the correct calibration of the liquidity clusters inherent risk factors. The verification and fine-tuning of the risk factor impacts need to be conducted by expert judgment and documented in detail. Different severity levels of the stress test scenarios need to be analyzed and considered in the calibration. The last step focuses on the translation of the functional specifications defined in the previous steps into technical specifications. Implementation testing as well as user acceptance tests will take place, ensuring the robustness of the framework. 12 Liquidity Risk Stress Testing White Paper

13 Outlook Due to its relationship to other components of the governance framework for liquidity risk, stress testing represents a major and indispensable part of successful liquidity risk management. It is the centerpiece of liquidity risk management and the results of the stress tests are used in other aspects of the overall target architecture. Early Warning Indicators Stress tests are used in the calibration as well as the verification of the Early Warning Indicators. The implementation of EWIs is an essential component of the liquidity risk management target architecture EWIs are used to identify liquidity shortages early on. The usefulness and applicability of EWIs are examined under different liquidity stress scenarios. Liquidity reserve The determination of the liquidity reserve is carried out using the stress testing framework it is calculated by taking into account the need for liquidity under stressed conditions. The liquidity reserve must be adequately large to ensure the survival of the institution in various extreme situations for sufficiently long periods of time. Modeling cash flows The cash flows of products and positions are a crucial input for successful liquidity risk stress testing. By using the observed past product behaviour and applying modeling assumptions, the projected flows under business-as-usual conditions are used to parameterise the stress test scenarios and to simulate stressed conditions. Concentration risks Setting the appropriate concentration levels is an important factor in overall liquidity risk governance: the stress testing results are used in the setting of these concentration risk limits. Funds transfer pricing The MaRisk (BTR 3.1) regulation requires that large financial institutions with complex business activities maintain a liquidity transfer pricing system in order to internally assign originated costs and risks. Stress testing is important for the liquidity transfer pricing system due to the role of the liquidity reserves in the origination of indirect liquidity costs. Liquidity Risk Stress Testing White Paper 13

14 Contact Ralf Kehlenbeck Partner BearingPoint GmbH, Frankfurt/Main. All rights reserved. Printed in the EU. The content of this document is subject to copy right ( Urheberrecht ). Changes, cuts, enlargements and amendments, any publication, translation or commercial use for the purpose of trainings by third parties requires the prior written consent of BearingPoint GmbH, Frankfurt/Main. Any copying for personal use is allowed and only under the condition that this copy right annotation ( Urheberrechtsvermerk ) will be mentioned on the copied documents as well. WP_0839_EN 14 Liquidity Risk Stress Testing White Paper

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