Liquidity Risk in the Finance and Banking Sector Finance Essay

I would like to choose liquidity risk for my assignment. Why I have selected liquidity risk? It is because there are some points or question I would like to understand. First reason is about the financial crisis. At 2007, the financial crisis interpreted how quickly and severely liquidity risk can crystallize and certain sources of funding can disappear. It shows the need for the valuation of assents and capital adequacy. The emergence and development of the financial crisis was fully exposed that the banking regulatory system had many deficiencies exist. At the old rules of banking supervision, the core capital adequacy ratio requirements was too low, the banking system is difficult to resist the sudden risk of global financial system. The derivatives in this crisis were failed to achieve "spread the risk" effectiveness, even expand the risk. For this crisis, we can learn that the liquidity risk is a serious problem and need the new rules of banking supervision. Secondly, the Basel III Accord (BIS, 2010) aimed for the capital problems because of financial crisis at 2007. The inaccurate and ineffective management of liquidity risk was a key characteristic of the financial crisis. They identified the banks must improve their liquidity risk management and control their liquidity risk exposures. So the Basel Committee on Banking Supervision (BIS) has issued for a package of proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector (BIS, 2010). Basel III greatly improves the core capital adequacy ratio requirement. The bank should increase their ordinary share capital adequacy ratio to 7% in 8 years. And then they are required to hold capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. If failing to meet requirements, the bank dividend, stock repurchase, bonuses payments and other act will be strictly limited. As the result of this, we clear know that the importance of liquidity risk management in the future. The last reason, I am interested some characteristic about liquidity risk. First of all, liquidity risk has the close relationship with the other risks, such as market risk or credit risk. Market risk always is the main reason of liquidity reason. The market risk and liquidity risk should be an independent measurement or market risk including liquidity risk still is no consistent conclusion. Moreover, other risks have a relationship with fair value. However the fair value often does not exist at liquidity risk. For banks, how to consider liquidity risk for the fair value adjustment is a very important issue. Finally, liquidity risk seem is a very important risk. However it is difficultly divides into market risk and credit risk. This part of the theoretical development and practical application of the subject should be clarified in the future. And it is absolute that cannot ignore in risk management. In conclusion, we know that liquidity risk is a very important for nearer future financial development, we should deeply understand its measurement and management. That why I choose liquidity risk for my assignment.

A full paper to be included in the special issue critically evaluating the main issues associated with the measurement and management of ONE only of either: interest rate risk, liquidity risk, or operational risk. Your writing must be supported by reference to appropriate theoretical and empirical literature. You should ensure that you include discussion of the appropriate regulatory framework. (2500 words) (70 marks)

1. Introduction

Figure 1.1 Different meanings of liquidity (Source: Adapted from Bartetzky, 2008 page 9) What is liquidity? 'Liquidity represents the capacity to fulfill all payment obligations as and when they fall due- to their full extent and in the currency required. Since it is done in cash, liquidity relates to flows of cash only. Not being able to perform leads to a condition of illiquidity (Duttweiler, 2009). In other words, it is a flow concept. In the framework, liquidity will refer to unhindered flows among the agents of the financial system. Liquidity refers to 'ability' of realizing these flows (ECB, 2009). These flows can be hindered when there are asymmetries in information and incomplete market exist. What is liquidity Risk? The potential that an institution will not be able to meet its cash flow needs as they arise in a cost effective manner (ECCB, 2006). Liquidity risk is often called a "consequential risk." it seems that is secondary risk in the sense that it always follows one or more other financial risks. Usually, a bank's main function is to provide liquidity to the economy and not to generate a liquidity crisis. It is hard to imagine that a bank can have a liquidity problem without having incurred earlier severe losses due to market, credit or operational risk (Neu, 2007). The liquidity risk can distinguish between market liquidity risk and funding liquidity risk. Funding Liquidity risk is a trader cannot fund his position and is forced to unwind. It involve a time horizon, the probability of becoming illiquid is typically measured for a given period ahead and can differ significantly according the length of the period (Matz el al, 2006) Market liquidity risk is the market liquidity worsens when one needs to unwind a position. It relates to the inability of trading at a fair price with immediacy. It composes by systemic and non-diversifiable risk. It suggests commonalities in liquidity risk across market and it should be priced.

Appropriate regulatory framework

Figure2: Elements of a liquidity risk management framework (Source: Liquidity risk management: A Practitioner's Perspective) As figure2, it shows a complete liquidity risk management framework must have three parts, governance, measurement & management and public disclosure. First, the sound corporate governance and organizational provide the ability of risk framework, risk tolerance, liquidity oversight and funds transfer pricing. Second, the measurement & management should have cash flows and data, group management, funding diversification, intraday liquidity, collateral management, stress testing, contingency planning and liquid assets. The last, the public should have liquidity position disclosure. The banks should fit their operations strategy and clear know that their role of the financial system. They should clearly define their degree of liquidity risk tolerance. The banks management should be based on the degree of liquidity risk tolerance to develop their strategy, policies and practices. It ensures that banks maintain sufficient liquidity. The managements should continually review the information of banks liquidity development and periodical report to the board of directors. The board of directors should be reviewed and approved on the liquidity management strategy, policies and practices at least once a year and confirm the managements effectively mange the risk. The banks should actively track and control (single/ cross) legal regulation, (single/ cross) industry and (single/ cross) currency, related to liquidity risk exposure and funding requirement. Also it should consider the legal, regulations and operational constraints of liquidity transactions. The last, the banks must periodical provide the public disclosure information to achieve the market participants to judge the risk management framework and the soundness of liquidity.

Liquidity risk measurement

It is extremely important on the liquidity management process that has the proper identification and measurement. Liquidity is dynamic, and as such, it requires regular and intense monitoring (ECCB, 2006). To assess a liquidity level, one has to evaluate cash flowing into and out of a financial institution and demands for funds to finance obligations outside the balance sheet (Bank of Thailand, 2003). It can identify the possibility of liquidity crisis in the future. Liquidity risk measurement can be done an easy calculation of the current position without further adjustment. The financial institutions would like to use the measurement toot to estimate of cash flow and liquidity position as well as an analysis of financial ratios. The selection of which method or tool used is based on the complexity of structure and management of assets, liabilities and off balance sheet transactions. There are three ways of liquidity risk measurement. First, the management must do a cash flow estimate to assess the demand for liquidity. And then if they deeply understand their cash flow, it will enable them have a level of liquidity appropriately and adequately. A contingency funding plan is an example of the cash flow estimate. When estimating cash flow, they should assess the possibility of the customers renew their contract instead of depending on maturity period of the contract alone. Cash flow may uncertain in different products because of the uncertain factors about interest rates or customer behavior. Moreover it may have a seasonal or business cycles fluctuate. The management should consider that increase or decrease the liquidity when during the business cycles forecast. Also the institutions need a funding source to protect the volatility of the loans and deposits. It also maintains a liquidity excess for safety. Second, use the ratios can help measure the level of liquidity and ensure the risk limits. However there are some factors need to consider when using the ratios. These factors may consider the qualitative information regarding the depositor's borrowing ability and other behaviors. When the management make decision depends on financial ratios, they should understand what the ratios are and find which can be adjusted. Also they should know how to make the conclusion from these financial ratios. The last, the financial institutions must have prepared and already to manage the liquidity under irregular circumstances or crisis. They should consider both positive and negative of the liquidity change in each situation. It includes the external and internal factors.

3.1 Liquidity risk measurement on Principles

According to Principles for Sound Liquidity Risk Management and Supervision (BIS, 2008), there are some principles about liquidity risk measurement. Firstly, Banks on all important business activities, in house pricing, performance measurement and new product approval process should be composing with liquidity costs, profits and risk. It can take the long-term and short-term risk cost and benefits into the internal pricing and performance measurement. Secondly, Banks should have an integrity procedures to confirm, measure, track and control liquidity risk. This process should include an integrity framework to be in the proper period, estimated the cash flows from assets, liabilities and off-balance sheet activities. It is including establish the liquidity risk ratio, A/D ratio and early warning indicators. I will talk about the early warning indicators as follow. Thirdly, banks should periodically do the stress test to test a variety of short-term or long term related organizations specific or market in common of the individual or combination pressure situations. For identify the sources of potential stress and confirm the current risk exposure is higher than the banks liquidity risk tolerance level. The banks should use the result of stress test to adjust its liquidity risk management strategies, policies and positions, and develop effective contingency plans. I also talk about the important of stress test as follow. Fourthly, banks should actively manage its liquidity position and risk, to be in peacetime and emergency time, can immediate achieves the payment and settlement obligations. And thus it can promote the payment and settlement systems operating smoothly. Fifthly, banks should actively manage its collateral positions, the differences between restricted and non-restricted assets. The bank shall pay attention of the legal regulatory who keep the collateral and how it operation. The last, banks should have a formal contingency funding plan (CFP), set its clear strategy to cope with the liquidity shortage under the contingency conditions. CFP should outline the policies to manage the specific range of stress environments, establish clear responsibility. It is including the clear procedures for launching and expanded, and should be periodically test and update, in order to confirm the integrity operation.

3.2 Early warning indicators (EWI)

After the financial crisis, it is more highlight the importance of early warning indicators. Early warning is very useful. It can provide the following information to do the reference: Rapid growth assets Enhance the concentration of assets or liabilities distribution Currency mismatch increase Decline the weighted average maturity date of liabilities In specific product lines, have a negative trends or risk increase Deteriorated significantly of bank earnings, asset quality and overall financial statement. Negative public events Decline credit rating Stock price decline or borrowing cost increase The risk of debt or credit default swap increase Wholesale or retail funding costs rise Counterparties inquiring or request additional collateral for the credit exposure, even refuse the new transaction. The loss of retail deposits increased The issue of CDs called for redemption prior the maturity increase Increase the difficulty of long-term funding Difficult to issue short-term liabilities.

3.3 Stress test

For running the stress test, it need some assume information. There are some examples as the followings: Reduce the market liquidity, the value of current assets decrease The loss of retails funding The correlation between financial market sources or the effectiveness of financial diversification Additional collateral The funding period The loss of liquidity about the off balance street business Possibility of contingency funding amount in bank Impact of credit rating adjustment Foreign exchange convertibility and the use of foreign exchange market Central bank mechanism Capacity of the bank selling cash assets Forecast growth of the balance sheet

Liquidity risk management

Liquidity and solvency are the twins that are no different in banking. The illiquid problem can lead to a bank rapidly go into bankruptcy. The global financial crisis, which began in 2007, exposed the fact many banks most adversely affected by the crisis have a range of deficiencies in the liquidity risk management systems. They are failure to properly allocated liquidity cost and risk to their business activities and products, lead to misalignment of risk-taking incentives and take excessive liquidity risk. They are failure to adequately identify and account the liquidity risk arising from non-contractual obligations or off balance sheet exposures. They also are failure to maintain sufficient high quality liquid assets to withstand pressure arising from the loss of normal funding source in the crisis. The last, the stress test and contingency financing plan are not included in the overall market, lead to the possibility of the severe and long term liquidity assets shortage situation. Now, we should understand what risk management is. The risk management is classified two roles, the micro role and macro role. In micro role, first is creating a sound governance framework. The liquidity risk management process should be surrounded by independent controls capable of regularly analyzing and auditing aspects of measurement, monitoring and management. The process should be examined by directors and executives at least annually to make sure that it remains consistent with the firm's mandate, structure, and growth plans, and is relevant in the market and regulator environment. Second is implementing proper measures and reporting. The firm should develop and use robust liquidity risk measures that are applicable to its business. While balance sheet measures can provide useful point-in-time stock measures, these should be supplemented by dynamic flow measures that take account of gaps, durations, probabilities of draw-down, disposal discounts, and loss of market access. Third is using tactical controls. Limits should be created to control all relevant aspects of liquidity exposure, and should relate directly to the firm's liquidity risk mandate. Fourth is developing a crisis management process. A centralized crisis management program, that is regularly tested and updated, must be a management priority. Knowing when to invoke the program is absolutely essential, as any unnecessary delay can prove costly. The last is performing ongoing reviews. A Firm's liquidity risk process should be thoroughly vetted by internal and external auditors to ensure that it meet necessary governance and regulatory standard. Auditors should verify proper independence and segregation of duties between those generating and controlling liquidity risks. In macro role, first is conducting regular inspections. Regulatory and industry bodies should regularly examine the liquidity practices of institutions operating in their jurisdictions. Authorities should insist on the creation and use of contingency programs, as these can help minimize instances of systemic dislocation. Second is promoting competition. It is clear that market makers, dealers, and exchanges have a central role to play in the provision of financial asset liquidity. They must be allowed to operate in a competitive and efficient manner, and regulators should promote and prudent deregulation measures that allow for greater competition. Third is avoiding fragmentation. Regulators must avoid actions that lead to market fragmentation. This represents a balancing act, as it is generally beneficial to promote alternatives in order to keep competition strong. Fourth is minimizing costs. It is well established, theoretically and empirically, that measures that reduce the cost burden of participating in a trading, investment, or funding market lead to an increase in activity. Fifth is harmonizing accounting treatment. Firms are periodically precluded from participating in a market or transaction as a result of accounting rules. The last is reinforcing proper capital allocations. Global financial regulators have generally done a creditable job in ensuring that financial institutions preserve sufficient capital for core market and credit risks.

4.1 Liquidity risk management on Principles

Take a lesson learned from the crisis, the Basel Committee issued the Principles for Sound Liquidity Risk Management and Supervision (BIS, 2008) to improve the international standards on liquidity risk. There are some principles used for manage and monitor the liquidity risk. Firstly, banks should continuously maintain non-restricted, high-quality liquidity assets as a buffer, to do insurance for the specific range of liquidity stress situation. Buffer on the use of these assets to obtain funding, should not be legally, regulations and operating restrictions. Secondly, banks should establish a funding strategy to provide the effective diversification of funding source and tenor. The bank should maintain an ongoing presence in its chosen funding markets and strong relationships in funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates o fund raising capacity remain valid. Those two principles are that the banks should follow. Furthermore, there also are some principles that the supervisors should follow. Firstly, supervisors should regularly perform the overall liquidity risk management framework and liquidity position for a comprehensive assessment. It determines supervisors deliver an adequate level of resilience to liquidity stress given the bank's role in the financial system. Secondly, supervisor should follow the bank internal reports, monitoring a combination of internal reports, prudential reports and market information, to supplement its banking liquidity risk management framework and liquidity position of the periodic assessments. Thirdly, Supervisors should require the banks have an effective and timely remedial action to address deficiencies in its liquidity risk management processes or liquidity position. The last, supervisors should communicate with other relevant supervisors and public authorities, both within to enhance the effective cooperation regarding the supervision and oversight of liquidity risk management. In normal times, they should have regularly communication with the nature and frequency of the information sharing increasing as appropriate during times of stress.

A concluding section that reflects upon what you consider to be the main challenges to both banks and regulators with regard to either interest rate, liquidity or operational risk in the coming few years. (1000 words) (20 marks)

"Basel III" developed by Basel Committee on Banking Supervision (BCBS) is a comprehensive set of reform measures at December 2010. It aims to improve the banking sector's ability to absorb shocks arising from financial and economic stress, improve risk management and governance and strengthen banks' transparency and disclosures (BIS, 2010). It increased the capital requirements for increase the bank level which will help raise the resilience of individual banking institutions to periods of stress. The minimum common equity requirement increase from 2% to 4.5%, banks is required to hold a capital conservation buffer of 2.5%. Tier 1 capital requirements will increase from 4% to 6%. And the requirements will progressively increase in the future year. However there still have some challenges to both banks and regulators with regard to liquidity risk in the coming few years. "The Basel III process is a disaster" said by Simon Johnson who was Chief Economist of the International Monetary Fund (IMF). Some experts indicate the banks have misrepresented and the officials have misunderstood reality. According to Professor Anat Admati (Stadford University) and her colleagues, they make three main points. First, the basic economics behind official thinking is wrong. Second, the Basel process uses dysfunctional methods to adjust capital requirements to reflect the risk of various kinds of assets. Third, capital requirements should be simplified and greatly increased. It seems that Basel III still not perfect. I will talk some challenges as the follow. Firstly, small and medium banks are very difficult to implement Basel III. Nowadays, the small and medium banks average return on capital is 20%, while the capital adequacy ratio is 10%. After the implementation of the "Basel III", the capital adequacy ratio needs 13% to 14%which the capital adequacy ratio will increase 30%. Based on the present capital return ratio, the operating model remains unchanged. The return may decline to 15%. "They are going to be using in the denominator risk-weighted assets, ... So it looks like they're being realty tough on the top number, but by using risk-weighted assets most banks fall into the category already and are fine" said by Paul Miller who is FBR analyst. So many banks can fulfil the requirement and only small banks have the negative effect. Secondly, Basel III may be a difficult challenge by European banks. "It really does hurt the European banks. I would have liked to see them come out tougher, I thought they were going to come out tougher, but in reality they couldn't because of the position of the European banks" also by Miller. It is because European banking supervision rules is most loose. They do not have a large-scale supplementary capital after the financial crisis. In all European commercial banks, Deutsche bank has the highest level of capital adequacy ratio but only is 10.8%. They need to issue 9.8 billion euros of shares to avoid the negative effect of capital shortage. The new rules will undoubtedly reduce the banks profits. The liquidity risk also will increase. Thirdly, Basel rules leave banks overcapitalized. "In the next 10 years, at the end of 2019, we will have overly liquid, overcapitalized banks," said Mr. Grubel who is UBS AG Chief Executive. This may be a long term challenges but it also means the world would not have a lot of growth in the coming few years. It also affects the banks return. But the good news is that the interest rates will relatively low in the coming decade which should help stimulate economic growth. The low interest rates also mean that the banks will have strong liquidity. Fourthly, Basel rules lead to dividends reduces. Due to reduced dividends, it leads to the attractiveness of banking shares decrease. Less people invest in banking stock. The banks capital will decrease and it also affect the liquidity reduce. For avoid this situation, Federal Reserve issued guidelines on how it will decide whether large U.S. banks may increase dividends and buy back shares, requiring the lenders to submit to stress tests of capital (Bloomberg, 2010). Its guidelines show that they response to Basel III to face the challenge and meet the requirement. The last, Asian economies are in the strong rebound after the global financial crisis. However the large cash flow into Asian raises people concerns about inflation and market volatility. Because of the low interest rates policies in the America and European, many international investors invest their money into Asian market to make a higher returns. However the inflation is following the large cash flow into Asian. Second is the capital flow. If the capital flow into Asian is short term and speculative, it may disappear suddenly. It will repeat the financial crisis at 1997. It led to many countries currencies extremely devaluate. Many corporate will bankruptcy, resulting in large-scale economic loss. And it will lead to banks have a large amount of bad debts and increase the liquidity risk. In conclusion, Basel III would like strengthen the regulation, supervision and risk management of the banking sector. However it also provides more challenge to banks. BIS should keep improve the "Basel III". It is because the liquidity risk still is a serious problem in the forecasting few years. The Banks and Regulators should keep follow the principles for Sound Liquidity Risk Management and Supervision to do the measurement and management. It is very important when they face the challenges in the comings few years. That is the end of my Risk 2 assignment.

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