Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 9. Liquidity Stress Testing

Presented by: Sudhanshu

Module 1. Types of Liquidity and Contingent Liquidity

Module 2. Liquidity Stress Test Design Issues

Module 1. Types of Liquidity and Contingent Liquidity

Topic 1. Types of Liquidity

Topic 2. Estimating Contingent Liquidity

Topic 1. Types of Liquidity

• Funding Liquidity: The core ability of a financial institution to satisfy its liabilities without suffering excessive losses. There are four categories of funding liquidity: operational, contingent, strategic, and restricted.

  • Operational Liquidity: The funds required to cover the firm's regular, day-to-day operational needs, such as clearing payment transactions. Operating cash flow may sometimes fluctuate dramatically and as a result, a buffer of additional cash would be required. Such funds cannot be used for nonoperational liabilities.

  • Contingent Liquidity: A buffer of high-quality liquid assets and credit facilities meant to satisfy general liabilities during stressed situations. Contingent liquidity is estimated through the liquid asset buffer. The main goal of a stress test is to determine the required size of this buffer.

  • Strategic Liquidity: Funds held by a firm for potential investment opportunities such as like fixed asset purchases or mergers/acquisitions. These funds are not intended for stress events, but the most liquid portions can be reallocated to meet contingent liabilities if needed.

  • Restricted Liquidity: Liquid assets that have pre-determined operational uses such as collateralization. They are not available for general operational needs.

Practice Questions: Q1

Q1. Which type of liquidity is meant specifically to fund capital asset purchases?
A. Contingent.
B. Funding.
C. Restricted.
D. Strategic.

Practice Questions: Q1 Answer

Explanation: D is correct.

Strategic liquidity comprises the funds that the firm maintains to satisfy potential investment opportunities such as fixed asset purchases or mergers/acquisitions.

Topic 2. Estimating Contingent Liquidity

• Contingent liquidity is estimated through the stressed liquidity asset buffer.

  • Stressed liquidity asset buffer = (normal) liquidity asset buffer - stressed cash outflow + stressed cash inflows

• Components:

  • Normal Liquidity Asset Buffer: The amount of contingent liquidity currently held

    • The assets must be able to withstand the most extreme stressed situations.

    • Assets typically have little or no credit and market risk, easy to value, and actively traded.

  • Stressed Outflows: Early settlement of liabilities or inability to roll over debt.

    • Examples: retail deposit withdrawals, loss of funding sources, and early settlement of derivatives transactions and early repayments of debt.

  • Stressed Inflows: Cash coming into the firm during a stress event, such as maturing investments or customer debt repayments.

    • ​It serves as an offset to stressed outflows and can be lowered depending on market conditions.

Practice Questions: Q2

Q2. Firm A has $1 billion in highly liquid assets. In a sudden stressed scenario, it estimates that retail customers will withdraw $150 million in deposits, and retail customers will be able to make $80 million of loan repayments. Firm A must deal with $60 million of margin and collateral calls on its derivatives transactions due to falling collateral values and greater volatility of the underlying assets. In addition, the firm has utilized $90 million of its available $100 million liquidity facility.

What is the estimate of Firm A’s stressed liquidity asset buffer?
A. $0.80 billion.
B. $0.88 billion.
C. $0.90 billion.
D. $0.96 billion.

Practice Questions: Q2 Answer

Explanation: D is correct.

The margin and collateral calls on the derivatives transactions are considered stressed outflows. The stressed liquidity asset buffer of $0.96 billion is calculated as $1B (highly liquid asset) − $150M (retail deposit outflow) + $80M (stressed inflow) − $60M (stressed outflow) + $90M (stressed inflow).

Module 2. Liquidity Stress Test Design Issues

Topic 1. Scope of Liquidity Stress Testing

Topic 2. Scenario Development

Topic 3. Assumptions

Topic 4. Outputs

Topic 5. Governance

Topic 6. Integration with Other Risk Models

Topic 1. Scope of Liquidity Stress Testing

• Consolidated View: The process begins with a consolidated, firm-wide liquidity stress test.

• Individual Entity Testing: Stress testing should also be performed on specific parts of the organization:

  • Parent company

  • Subsidiary companies

  • Business lines and individual business units

• Liquidity Transfer Restrictions: Crucial to consider any restrictions that prevent liquidity from being transferred freely within the organization, such as between a parent company and its foreign subsidiary.

  • ​Therefore, looking at consolidated liquidity may be misleading.

  • The restrictions should be considered in both regular and stressed scenarios.

• Foreign Currency & Regulation: The test must account for differences in foreign currency settlement procedures and the need to perform separate tests for entities operating in different regulatory environments.

Topic 2. Scenario Development

• Benchmark: The first step is to establish a benchmark level of funding and liquidity. This benchmark provides a starting point for comparison, making it easier to evaluate the impact of a stress event and the effectiveness of any mitigation strategies.

• Types of Scenarios: A combination of historical scenarios, hypothetical scenarios and reverse stress testing is used to test a firm's resilience.

• Historical Scenarios: These are based on past liquidity crises or market events. They are valuable because they reflect real-world outcomes and dependencies. However, their drawback is that there are very few examples with limited data and they might not capture new or evolving risks that didn't exist in the past.

• Hypothetical Scenarios: These are forward-looking and use the best available information to model potential future events. Scenarios should be developed for systemic only, idiosyncratic only, and combined systemic and idiosyncratic.

  • Systemic risks: Broad, market-wide events that affect all financial institutions, such as a credit market freeze.

  • Idiosyncratic risks: Firm-specific events that are unique to the institution, such as a major ratings downgrade or a reputational crisis.

  • Combined Scenarios: Testing a combination of systemic and idiosyncratic risks helps in understanding how the firm would perform in a complex, multi-faceted crisis.

• Hypothetical Scenarios normally look like:

  • Overall stress level (e.g., low, medium, and high), taking into account the state of the

    economy and credit markets

  • State of secured and unsecured funding markets.

  • Haircut changes for each type of collateral.

  • For a given sale, the impact of liquidity on the sale prices of investments in the liquidity buffer.

  • Occurrence of credit downgrades.

  • Assumptions regarding the acceleration of deposit withdrawals.

  • Impact of rating changes on derivatives margin and collateral calls.

  • Estimated drawdowns on unfunded credit and liquidity sources.

  • Estimated debt calls and buybacks.

• Reverse Liquidity Stress Tests: These tests are a useful supplement to hypothetical scenarios.
  • They assume the end result of a business failure and work backward to determine the specific sequence of events and the most crucial factors that would lead to that failure.
  • This helps identify vulnerabilities that might be missed in forward-looking scenarios.

Topic 2. Scenario Development

Practice Questions: Q1

Q1. Which liquidity stress impact factor would generally be the largest threat to a bank’s liquidity?
A. Deposit run-off.
B. Derivatives cash flows.
C. Loss of secured funding.
D. Loss of wholesale funding.

Practice Questions: Q1 Answer

Explanation: A is correct.

Deposit run-off in the form of depositors withdrawing their demand deposits immediately or suddenly and term depositors withdrawing their investments early (assuming such rights exist) are generally the largest threat to liquidity to banks. Therefore, they are the most important customer behavior to attempt to model.

Topic 3. Assumptions

• The principle of "garbage in, garbage out" applies for LST assumptions validation. Ideally, assumptions must be backed by sufficient historical or market data.

• There are some basic guidelines in formulating assumptions in this context:

  • For each cash flow type, conduct separate qualitative analyses of expected liquidity behavior to identify major liquidity risks.

  • For each risk, estimate the optimal segmentation level based on behavioral differences, subject to data availability constraints.

  • Perform qualitative analyses and rank each segmentation factor in terms of liquidity risk.

  • Create assumptions (e.g., using historical data) for use in quantitative analysis.

  • Create matrices of model assumptions using scored risk levels.

  • Update assumption matrices as needed based on the stress scenario.

• Investment Portfolio Haircuts:

  • Haircuts widen during a systemic crisis and the widening depends on security type and its liquidity traits, providing few plausible assumptions

  • A liquidity ranking system can be established using segmentation features such as secured versus unsecured or government versus non-government.

  • Liquidity haircut calibration should compare normal market conditions with financial crisis periods.

Topic 3. Assumptions

• Deposit Outflows: 

  • ​Model sudden and early withdrawals of deposits and time deposits due to their severe liquidity impact.
  • Use behavioral segmentation to capture depositor behavior under stress, despite data limitations.
  • Segment below portfolio level and down to the account level.
  • Key behavioral factors across all depositor types include relationship tenure and deposit interest rates.
  • Consider deposit insurance coverage for individuals and small businesses, and credit usage behavior for small businesses and larger commercial clients.
• ​Unsecured Wholesale Funding: 
  • ​In severe scenarios, banks can assume little to no unsecured wholesale funding availability.
  • Banks should assess the impact of stress on all funding sources, especially overnight and term funding.
• ​Collateral Requirements: 

  • Assumptions should account for the need for significantly more collateral due to reduced values and additional calls on derivatives positions.

  • Historical data can be used to estimate additional collateral requirements (e.g., collateral call levels).

Topic 3. Assumptions

• Other Contingent Liabilities: 

  • Model cash outflows from contingent liabilities (e.g., credit lines, letters of credit, trade finance) using historical data where available.

  • Apply conservative assumptions when reliable historical data is unavailable.

  • Consider noncontractual obligations that may be honored to protect the firm’s reputation.

  • Account for reputation-driven cash outflows, such as security buybacks to shield counterparties from losses.

• Business Reduction: 

  • ​Assumptions should also reflect the bank’s ability to limit liquidity-draining activities, such as issuing new customer loans.

  • This requires input from business unit leaders to identify reductions that preserve the bank’s reputation.

Practice Questions: Q2

Q2. In the context of deposit outflows, which behavioral assessment factor is relevant for individual, small business, and commercial/institutional customers of the bank?
A. Credit usage.
B. FDIC coverage.
C. Industry segment.
D. Relationship tenure.

Practice Questions: Q2 Answer

Explanation: D is correct.

Relationship tenure is a behavioral assessment factor to consider for all three groups of bank customers. Credit usage applies more to small business and commercial/institutional customers and not individuals. FDIC coverage applies only to individuals and small businesses but not commercial/institutional customers. Industry segment does not apply to individuals and generally only applies to commercial/institutional customers.

Topic 4. Outputs

• Outputs of LST are used to evaluate structural and tactical liquidity in the context of internal limits and regulatory requirements.

• LST should be conducted at least quarterly to provide ALCO with timely and regular insights.

• LST should produce the following four key deliverables for each entity: Stress testing assumptions, current liquidity position metrics, future liquidity position metrics, and capital and performance metrics.

• Stress Testing Assumptions: 

  • Cash flows resulting from the scenario.

  • Contribution of economic, market, and firm-specific events.

  • Systemic, idiosyncratic, or combined scenario.

  • ​General stress level.

• Current Liquidity Position Metrics: ​The main objective is to assess available liquidity relative to net cash outflows, expressed as a % or dollar amount.
  • Tactical liquidity (e.g., 30 days) vs structural liquidity (e.g., 12months) under stress, where the latter refers to a survival horizon.

Topic 4. Outputs

• Future Liquidity Position Metrics: Future refers to the assumed stress horizon.

  • Important metrics include:

    • Available liquidity in the future,

    • Level of wholesale funding dependence, and

    • Level of concentration in certain funding channels (e.g., to detect possible over-concentration).

  • It is critical to identify points in the stress horizon where survival depends on major actions such as capital infusions or complex debt financing.

• Capital and Performance Metrics: Beyond short-term liquidity horizons, long-term viability must be assessed by evaluating the bank’s capital position.

  • As banks must hold regulatory capital, investing it involves a trade-off between lower-yield, high-liquidity assets and higher-yield, lower-liquidity assets.

  • Analyzing capital measures shows the impact of supporting liquidity during stress affects the firm’s capital position.

Practice Questions: Q3

Q3. How often is it generally recommended that the liquidity stress test be done to allow review by the asset-liability management committee?
A. Monthly.
B. Quarterly.
C. Semiannually.
D. Annually.

Practice Questions: Q3 Answer

Explanation: B is correct.

At a minimum, the liquidity stress test should be done at least quarterly to allow for proper analysis by the asset-liability management committee. Some banks are able to do the test more frequently (e.g., monthly or daily) by investing in the
necessary technology and other tools.

Topic 5. Governance

• Oversight of the overall liquidity risk management process is delegated to the following roles: ALCO, treasury unit, risk management, internal audit and MRM.

• Asset-Liability Committee (ALCO): The ALCO is in charge of the LST framework. The ALCO should focus on a few key tasks:

  • Creating and finalizing a LST policy (e.g., scenarios, major assumptions, roles and responsibilities, reporting, limits).

  • Creating and finalizing liquidity risk scenarios, which includes any key changes to the scenarios and/or the underlying assumptions.

  • Determining liquidity risk policy limits based on the results of stress testing.

  • Escalating any exceptions noted.

• Treasury Unit (First Line of Defense): Manages the stress testing process and ​suggests scenarios to be used for stress testing.

  • ​Evaluates asset and liability liquidity characteristics and advises ALCO on appropriate stress-testing assumptions.

  • Reports results of stress testing.
  • Proper segregation of duties (independence) suggested in the testing process so that testing data is provided by a group outside of the treasury unit
  • Large firms with multiple treasury units require consistent stress-test scenarios and assumptions across entities.

Topic 5. Governance

• Risk Management (Second Line of Defense): An independent party in the management of LST and administers the stress testing policy.

  • ​Identifies and highlights weaknesses in proposed scenarios and assumptions.

  • Confirms that the firm’s LST process is consistent with regulations and industry practice.

  • Approves and oversees the stress test-based limits.

  • Communicates firm’s liquidity risk profile to key individuals (board, senior management, ALCO).

• Internal Audit (Third Line of Defense):  Regular checks on the stress testing process, procedures, and controls as a confirmation of adherence to regulations.

• Model Risk Management (MRM): A separate group that validates the stress testing model to ensure it is consistent with the firm’s MRM policy.

Topic 6. LST Integration with Other Risk Models

• LST should account for related risk models such as capital stress testing (CST), asset-liability management (ALM) and funds transfer pricing (FTP).

• LST and CST:

  • Liquidity stress tests should incorporate potential parent-to-subsidiary capital injections, with scenarios ranging from simple to complex based on systemic and idiosyncratic assumptions.

  • CST must assess both liquidity effects and capital impacts to evaluate how funding liquidity support affects overall capital adequacy.

• LST and ALM: 

  • ​Liquidity stress models must capture rate-driven effects—rising liability values when rates fall and disintermediation risk when rising rates prompt deposit outflows.
  • Liquidity impact analysis is traditionally separate from interest rate risk stress tests, as interest rate shocks mainly affect long-term capital rather than short-term liquidity.
• LST and FTP: The FTP framework should accurately establish the price of liquidity, ensuring that any costs arising from LST are charged to the appropriate business areas.