Some Thoughts on Liquidity Scenarios

Some Thoughts on Liquidity Scenarios

Liquidity Risk Measurement Is VERY Scenario Specific LIQUIDITY RISK STRESS SCENARIO Events triggered by changes in other financial risks Events triggered by changes in customer behaviour Events triggered by changes in business strategy Events triggered by changes in macro or economic factors Events triggered by no change at all (public misinformation or market perception) Source: Jaqui Outram 2

Eleven Scenarios Mentioned in the Basel II Document 1. Credit risk 415 adverse economic conditions and unexpected events 2. Credit risk 415 range or economic conditions likely to occur over a business cycle 3. Credit risk 434 economic or industry downturns 4. Credit risk 434 market-risk events 5. Credit risk 434 liquidity conditions 6. Credit risk 435- mild recession scenarios, (e.g., two consecutive quarters of zero growth) 7. Credit risk 436 changes in the bank s rating 8. Credit risk in equities 527(j) hypothetical or historical scenarios that reflect worst case losses 9. Operations Risk 665 bank specific business environment 10.Operations Risk 665 scenario analysis defined in 675 to be statistical loss analysis 11.Interest Rate Risk 826 (6) upward and downward rate shocks 3

Three More in Sound Practices for Managing Liquidity in Banking Organizations, February 2002 1. Principal 1: ability to withstand stressful events in the market place as part of day-to-day management. 2. Principal 6: internal (bank-specific) what if scenarios {also required by Basel II for operations risk}. 3. Principal 6: external (market related) what if scenarios {also required by Basel II for credit risk}. 4

Market experience in the form of Systemic Crises A Wide Variety of scenarios have occurred over time 1987 1990 1991 1992 1994 1995 1997 1998 1999 2000 2001 2002 2007 U.S. stock market crash Collapse of U.S. high yield (junk) bond market Oil price surge ERM (European Exchange Rate Mechanism) crisis U.S. bond market crash Mexican Crisis Asian crisis Russian default, Ruble collapse. LTCM Gold prices TMT (telecommunications, media & technology ) sector collapse September 11 payments system disruption Argentine crisis U.S. sub-prime mortgage collapse 5

Risk equals the product of probability and severity. HIGH S E V E R I T Y MEDIUM Catastrophic Painful ($) Normal LOW LOW MEDIUM HIGH PROBABILITY 6

Scenario Selection and Application 1. Use at least three: normal, bank specific and systemic. 2. Define three characteristics for each: business and market characteristics, duration and stress level. 3. Use at least three stress levels for all nonnormal scenarios. 31

Testing Should Reflect Both Internal and External Scenarios Capital markets disruptions Systemic shocks Payment system disruptions Prolonged global recession External Internal Credit losses Operational losses Problem merger or acquisition 8

What is Marketable? A 2005 survey of large U.S. and Canadian banks found that only 4 out of 17 reported that they varied the projected quantity of liquid assets to fit the scenario. 9

Liability Rates Counter Party Confidence Access to New Unsecured Borrowings Access to New Secured Borrowings Ordinary course of business scenario No stress Unimpaired Unimpaired Unimpaired Level 1 Mildly impaired Diminished Unimpaired No current funding problem, but an elevated level of risk Bank specific crisis scenario Level 2 Severely impaired None Some funding problems Diminished Level 3 Severely impaired None Serious funding problems Until we run out of collateral Systemic Crisis scenario Level 1 Level 2 Up 100 Unimpaired No current funding problem, but an elevated level of risk Same quantity / higher cost Some funding problems Same quantity / higher cost Level 3 Serious funding problems 10

Asset Rates Draws Under Commitments Other Changes in Loan Volume Changes in Credit Quality Ordinary course of business scenario No stress Bank specific crisis scenario Level 1 Level 2 Level 3 Mildly impaired No current funding problem, but an elevated level of risk Slight increase Little growth Severely impaired Some funding problems Significant increase No growth Severely impaired Serious funding problems Systemic Crisis scenario Level 1 Level 2 Level 3 Up 100 No current funding problem, but an elevated level of risk Some funding problems Serious funding problems 11

Perception Risk The Southdown Building Society suffered abnormal withdrawals of 35 million during three eventful days in August 1991, owing to unfounded rumors of links with the failed Bank of Credit and Commerce International, which led to a pre-tax loss of 9.8m in 1991. The members of Southdown were consulted and, at a Special General Meeting in March 1992, voted in favor of a merger with the Leeds Permanent. FURTHER GLOOM IN THE BUILDING SOCIETIES' CHALLENGING NEW WORLD, Magazine: Management Accounting, January, 1994, vol. 72 Issue 1, p28, 4p, 6 12