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Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

See also bank capital, Basel Committee on Banking Supervision and capital adequacy.


Global liquidity efforts

Basel to review new rules prior to implementation

Global bank regulators are preparing to ease new rules that would require banks to hold more liquid assets to withstand a funding crunch in a crisis.

The move follows complaints from banks that the new Basel III standards on liquidity – the first international rules of their kind – would force them to sharply curtail lending to consumers and businesses.

The new measure, known as the “liquidity coverage ratio”, will require banks to hold enough easy-to-sell assets to withstand a 30-day run on their funding, similar to the crisis that engulfed Lehman Brothers in 2008. While the ratio does not formally take effect until 2015, banks were already struggling to amass enough cash and government bonds to meet the requirements, said analysts.

A new report by JPMorgan estimates that 28 European banks faced a total liquidity shortfall of €493bn ($695bn) at the end of 2010 under the ratio’s current framework. Only seven of the 28 banks tested met the enhanced standards, with the leading French banks – BNP Paribas, Société Générale and Crédit Agricole – among the least prepared, with a combined shortfall of €173bn.

Basel agrees on liquidity rules

Global banking supervisors agreed on Tuesday to phase in the introduction of a key new global standard on lenders' minimum short-term funding cover, handing further relief to a sector facing a hefty funding gap.

The Basel Committee of banking supervisors and central bankers from 27 countries met on Tuesday in South Korea, which is hosting the Group of 20 leading countries that had called for tougher capital and liquidity requirements in response to the financial crisis.

The committee had already agreed to a soft phase-in for its net stable funding ratio, which covers a bank's longer-term liquidity. That measure will be tested from 2012 and become mandatory in January 2018.

On Tuesday the committee said it would also have a softer phase-in for its liquidity coverage ratio (LCR), which will require a bank to hold enough highly liquid assets, mainly government bonds, to cover 30 days of net cash outflows.

The LCR observation period will start next year but the committee still wants the rule to become a minimum global standard in January 2015.

Introducing an observation period and review clauses gives the committee more leeway to make big changes on the way.

Exemptions for financial systems with minimum sovereign issuance

On 16 December, the Basel Committee on Banking Supervision (Basel Committee) announced its global framework for promoting stronger liquidity buffers at internationally active banking institutions. The centrepiece of this framework is a new standard for liquidity risk that aims to ensure that banking institutions have sufficient high-quality liquid assets to survive an acute stress scenario lasting for one month. The standard will come into effect on 1 January 2015. Under the new Liquidity Coverage Ratio (LCR) requirement, the bulk of high-quality liquid assets in most jurisdictions will take the form of holdings of government debt.

Fiscal prudence by a succession of governments means that the supply of government securities in Australia is relatively limited. A second level of eligible liquid assets that includes certain non-bank corporate debt is also in short supply in Australia. A small number of other jurisdictions are in a similar position. To address this situation, the Basel Committee's framework incorporates scope for alternative treatments for the holding of liquid assets. One alternative treatment is to allow banking institutions to establish contractual committed liquidity facilities provided by their central bank, subject to an appropriate fee, with such facilities counting towards the LCR requirement.

The Reserve Bank of Australia (RBA) and the Australian Prudential Regulation Authority (APRA) have agreed on an approach that will meet the global liquidity standard. Under this approach, an authorised deposit-taking institution (ADI) will be able to establish a committed secured liquidity facility with the RBA, sufficient in size to cover any shortfall between the ADI's holdings of high-quality liquid assets and the LCR requirement. Qualifying collateral for the facility will comprise all assets eligible for repurchase transactions with the RBA under normal market operations. In return for the committed facility, the RBA will charge a market-based commitment fee.

The commitment fee is intended to leave participating ADIs with broadly the same set of incentives to prudently manage their liquidity as their counterparts in jurisdictions where there is an ample supply of high-quality liquid assets in their domestic currency. Detailed work on determining an appropriate fee based on this principle is currently underway. A single fee will apply to all institutions accessing the facility.

The approach will be applicable only to the larger ADIs (around 40 in number). APRA does not intend to apply the LCR requirement to ADIs that are currently subject to a simple quantitative metric, the minimum liquid holdings (MLH) regime. In APRA's view, the MLH regime is working effectively in delivering an appropriate degree of resilience for ADIs with simple, retail-based business models. Accordingly, APRA intends to retain the current approach for these ADIs.

For its part, APRA will require the larger ADIs to demonstrate that they have taken all reasonable steps towards meeting their LCR requirements through their own balance sheet management, before relying on the RBA facility.

The details of the RBA liquidity facility and APRA's prudential standard on liquidity risk management, which will give effect to the global liquidity framework in Australia, will be subject to consultation during 2011 and 2012.

Proposed Basel 3 standards on liquidity

Global Liquidity Standards

The December 2009 Proposal set out proposals for two liquidity ratios: a short-term liquidity cover ratio aimed at ensuring banks maintain 30 days' liquidity coverage for extreme stress conditions and a longer-term net stable funding ratio by reference to the amount of "longer-term, stable sources of funding" (at least one year) relative to the "liquidity profiles" of the assets funded and the off-balance sheet exposures.

Liquidity coverage ratio

Various changes to the detailed calculation of "liquid assets" and other elements of the ratio have been proposed. These changes include treating commitments of sovereigns and central banks in a manner similar to non-financial corporates and requiring that all assets in the liquidity pool for the definition of liquid assets be managed as part of the pool and be subject to operational requirements (to be finalised by the end of this year) and introducing a "level 2" of liquid assets which can comprise up to 40% of the pool.

Net stable funding ratio

BSBC states that it remains committed to introducing a net stable funding ratio but that the proposals for its calibration set out in the December 2009 Proposal require significant modification. It states that it is considering, in particular, amending the calibrations relating to retail and SME deposits, mortgages and off-balance sheet commitments. A modified proposal will be produced for consultation by the end of 2010.

It also states that it will carry out an "observation phase" to test the effect of the ratio and that its current timetable for introducing the ratio as a minimum standard is 1 January 2018.

IMF on financial stability and liquidity

Key points
  • Financial institutions and regulators failed to account for rising liquidity risks during the global crisis that were caused by increased reliance on short-term wholesale funding.
  • Collateral valuation practices in the repurchase markets need to be improved. Greater use of central counterparties for repurchase transactions should also be encouraged.
  • The recent proposals by the Basel Committee on Banking Supervision will help enhance liquidity cushions and lower banks’ exposures to maturity mismatch risk.
  • The liquidity guidelines should, in some form, include non-bank financial institutions that contribute to maturity transformation.
  • Cross-border, cross-currency dimension of funding risks should be accounted for in the new liquidity regulations. The inability of multiple financial institutions to roll over or obtain new short-term funding was one of the defining hallmarks of the crisis. Banks and non-banks financial institutions, in particular in advanced countries, increased their reliance on short-term markets for funding, exposing them to significant risks when these markets dried up. Secured lending through repurchase operations grew immensely, greasing the funding markets. Perhaps insufficiently recognized was that the wholesale providers of funds had changed—instead of banks playing a central role in intermediating unsecured funds where needed, others, such as money market mutual funds, were growing suppliers of funds while traditional more stable depositors were not. Underestimated were also the risks associated with the greater use of low quality securities as collateral for secured funding. Moreover, the crisis demonstrated that regulators, and banks themselves, had underestimated the risks emanating from the reliance on cross-border funding. This chapter outlines a comprehensive approach for dealing with systemic liquidity risk.
Policy proposals

A number of policy proposals arise from the chapter, including the following:

  • Policymakers should strengthen collateral valuation and margin practices in the secured funding markets. Important would be to have more realistic assumptions about how long it might take to sell the collateral, more frequent adjustments to collateral to avoid the problem of abrupt shortfalls in cash. Supervisors should also encourage markets to value collateral through a full credit cycle so to discourage excessive funding when values are high. Moreover, financial supervisors should periodically validate the models banks use to price collateral used to secure funding.
  • Market regulators should advocate greater use of central counterparties to lower operational and counterparty risk associated with repo transactions. Central counterparties serving repo markets should be subject to minimum regulatory requirements to ensure safety and soundness. Central bank emergency liquidity should be made available to well-run central counterparties in times of systemic liquidity crisis.
  • Over time, money market mutual funds should have to choose to either become mutual funds whose net asset value fluctuates, or be regulated as banks. Ensuring that investments in such funds are regularly valued at market prices would enhance investors’ awareness that they bear investment risks and that their funds are different from a bank deposit in that the principal is not guaranteed and not backed by a public deposit insurance scheme.
  • The agreement reached to implement the quantitative liquidity requirements as proposed by the Basel Committee on Banking Supervision in September 2010 is a significant step towards lowering liquidity risk. The rules will encourage banks to hold higher liquidity buffers and reduce the mismatch between the cash flows of their assets and payment obligations of their liabilities.
  • Policymakers should also consider extending the Basel quantitative rules, in some form, to other financial institutions that, as the crisis demonstrated, can contribute to maturity transformation and a buildup of systemic risk. This would help mitigate the buildup of liquidity risks in the less-regulated ”shadow banking” system.
  • Policymakers should consider ensuring that foreign exchange swap facilities of central banks are readily available in the future in times of stress. This should be complemented by placing greater emphasis on the cross-border, cross-currency dimension in the new liquidity regulations.
  • Finally, closer international coordination is called for to improve the collection of financial information on relevant funding markets and institutions to allow for an adequate assessment of buildup of liquidity risks in the financial system.

US banking regulators policy statement on liquidity/funding risks

The federal banking agencies,1 in conjunction with the Conference of State Bank Supervisors (CSBS), released a policy statement today on their expectations for sound funding and liquidity risk management practices. This policy statement, adopted by each of the agencies, summarizes the principles of sound liquidity risk management issued previously and, when appropriate, supplements them with the "Principles for Sound Liquidity Risk Management and Supervision" issued in September 2008 by the Basel Committee on Banking Supervision.

Given the recent market turmoil, the agencies are reiterating the importance of effective liquidity risk management for the safety and soundness of financial institutions. This policy statement emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets, and a formal, well-developed contingency funding plan as primary tools for measuring and managing liquidity risk. The agencies expect each financial institution to manage funding and liquidity risk using processes and systems that are commensurate with the institution's complexity, risk profile, and scope of operations.

BIS consultative paper on liquidity

Issued for comment by 16 April 2010

Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks in order to sustain the financial system and even with such extensive support a number of banks failed, were forced into mergers or required resolution.

These circumstances and events were preceded by several years of ample liquidity in the financial system, during which liquidity risk and its management did not receive the same level of scrutiny and priority as other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.

2. A key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk. In recognition of the need for banks to improve their liquidity risk management and control their liquidity risk exposures, the Basel Committee on Banking Supervision1 (“the Committee”) issued Principles for Sound Liquidity Risk Management and Supervision in September 2008. These sound principles provide consistent supervisory expectations on the key elements of a robust framework for liquidity risk management at banking organisations. Such elements include:

  • board and senior management oversight;
  • the establishment of policies and risk tolerance;
  • the use of liquidity risk management tools such as comprehensive cash flow forecasting, limits and liquidity scenario stress testing;
  • the development of robust and multifaceted contingency funding plans; and
  • the maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs.

CEBS guidelines on bank liquidity buffers

"Yesterday, the Committee of European Banking Supervisors (CEBS) released its “Guidelines on Liquidity Buffers & Survival Periods,” which are the result of a four-month public consultation period and public hearing. These guidelines build on CEBS’s “Recommendations on Liquidity Risk Management,” which discussed the optimal size and composition of liquidity buffers to allow banks to withstand liquidity stress for a period of at least one month without changing their business models. Specifically, the guidelines call for banks to hold buffers of cash and highly liquid assets in the private markets to allow them to meet their payment obligations for one week and a broader set of instruments to last at least one month.

The report highlights six guidelines which were developed by reviewing a range of liquidity buffer approaches and views from a broad range of market participants. The CEBS provided draft guideline recommendations in June and a public hearing was held in September 2009. In drafting yesterday's guidelines, the CEBS considered feedback received and sought to address the primary issues raised by market participants.

Giovanni Carosio, Chairman of CEBS, stated that “[t]hese guidelines address the flaws in the liquidity risk management practices revealed during the crisis and are expected to represent a significant enhancement of institutions’ liquidity.”

Swiss liquidity standards

UBS AG and Credit Suisse Group AG may have to almost triple the amount of cash they hold in relation to customer deposits under new proposals from Swiss regulators, two people familiar with the matter said.

The two largest Swiss banks may be required to hold 45 percent of customers’ demand deposits in cash or easy-to-sell securities such as government debt, almost three times as much as under current rules, said the people, who declined to be identified because the proposals haven’t been made public. The banks, which are in talks with the regulators, are seeking to soften the requirements, the people said.

Switzerland may be the first country to introduce rules requiring banks to keep more liquid assets on hand following the global credit crisis. Forcing Zurich-based UBS and Credit Suisse to hoard more cash and low-yielding securities against a possible bank run would make them less profitable and may lead them to curb lending, analysts and bank officials said.

“Switzerland has always been stricter with its rules for the banks than other countries,” said Dirk Becker, a Frankfurt- based analyst at Kepler Capital Markets. “Stricter liquidity rules take away the flexibility of the banks in lending. That may lead to fewer loans being made and lower profitability as less interest income is generated.”

FSA on liquidity standards

requirements in liquidity regime] FSA, December, 2010

"The Financial Services Authority (FSA) has today published its final rules on the liquidity requirements expected of firms.

The far-reaching overhaul, designed to enhance firms’ liquidity risk management practices, is based on the lessons learned since the start of the credit crisis in 2007. The new rules will require changes to firms’ business models and will bring about substantial long-term benefits to the competitiveness of the UK financial services sector.

London’s competitive position depends on counterparties’ perception of the financial soundness of the firms that operate in the UK. Low-levels of financial soundness cannot provide sustainable long-term competitive advantage. The FSA’s new requirements are designed to protect customers, counterparties and other participants in financial services markets from the potentially serious consequences of imprudent liquidity risk management practices.

Specifically, the rules include:

  • An updated quantitative regime coupled with a narrow definition of liquid assets;
  • Over-arching principles of self-sufficiency and adequacy of liquid resources;
  • Enhanced systems and controls requirements;
  • Granular and more frequent reporting requirements; and,
  • A new regime for foreign branches that operate in the UK.

Paul Sharma, FSA director of prudential policy, said:

"The FSA is the first major regulator to introduce tighter liquidity requirements for firms. We must learn the lessons of the financial crisis and we believe that implementing tougher liquidity rules is essential to ensure we are in a better position to face future crises.

"In the current crisis some firms weathered the storm better than others. These firms tended to be those that had policies that were similar to those that we are introducing today - including holding assets that were truly liquid, such as government bonds. Phasing the period in which firms will build up their liquidity buffers should mitigate the knock-on effects to bank lending."

The FSA will not tighten quantitative standards before economic recovery is assured. It plans to phase in the quantitative aspects of the regime in several stages, over an adjustment period of several years. This is to take into account the fact that all firms at present are experiencing a market-wide stress.

The precise amount of liquidity that each firm will need to hold will be refined over time to ensure that the combined impact of higher capital and liquidity standards is proportionate.

The qualitative aspects of the regime will be put into place by December 2009.

The FSA strongly supports the liquidity workstreams that are underway internationally although recognises that it may be some time before there is international agreement on specific proposals, Therefore, the structure of the new regime is sufficiently flexible to allow the FSA to amend it through time to reflect any new international standards.

"UK banks and investment firms would have to increase their holdings of cash and government bonds by £110bn and cut their reliance on short-term funding by 20 per cent in the first year of tough liquidity standards put forward by the Financial Services Authority on Monday.

If the FSA ramps up the requirements in subsequent years, as expected, banks and investment firms could have to increase their holdings of easily saleable assets by a total of £370bn or cut their reliance on short-term funding by 80 per cent from today’s levels and boost their cash and bonds by a total of £170bn.

The FSA has promised the regime will not take effect until regulators are confident the recession is over. Regulators are likely to begin considering a timetable for implementation from the middle of next year.

The liquidity rules put the FSA at the forefront of efforts to prevent a repeat of the collapses of Lehman Brothers and Northern Rock. The UK is the first leading country to impose new liquidity requirements, although Group of 20 countries have all pledged to follow suit.

“We thought it was very important to put in place a strong regime in place in time for the end of the recession. You can’t wait six months or a year or two years because then you don’t have enough time before the next recession,” said Paul Sharma, FSA director of prudential policy.

FSA implements liquidity standards

"...Unsurprisingly, commentary on the new regime has largely been directed at the requirement that banks hold appropriate levels of liquid assets. So, I should say a little about our approach to setting, and managing through time, the calibration of liquidity buffer requirements. The Policy Statement sets out the radical new architecture of the future regime, but explicitly reserves for further consideration and separate decision the level of liquidity buffers we would be expecting to prevail system-wide. That level will emerge from a disciplined and consistent approach to setting Individual Liquidity Adequacy Standards (ILAS) for firms on the standard ILAS quantitative regime. For various reasons the path observed will not be a straight line.

First, we have highlighted in the Policy Statement a welcome strengthening in the short-term liquidity position of what are currently the sterling stock banks. However, we are looking for our new regime to produce a significant further strengthening over coming years. In the long term, the system certainly needs to become more liquid and so less leveraged.

Second, the rate at which we shepherd the system towards higher levels of liquidity will depend on the macroeconomic context.

Third, if and when the system as a whole comes under liquidity pressure, in the future, it is logical then to allow firms to draw on the buffers they have been carrying to help deal with just such stresses.

So, while we need to drive up overall liquidity to distinctly higher levels than we have seen through recent years, the outcome in any particular time period could depend on the interplay of all these factors.

I should emphasise of course that for any particular firm on the standard ILAS regime our liquidity guidance will be tailored to its specific risks, including the kind of business it does and the quality of its risk management. So any given firm may see us looking for an increased buffer even at a time when system-wide we may be content to see some overall reduction, and vice versa.

That conceptual perspective will, I hope, help firms to appreciate why it is that, although we are deadly serious about seeing liquidity levels rise over the years, we are not in a hurry to do that through the next few quarters. Until economic recovery is robustly established we must be patient about the rate at which we expect liquidity levels to increase, otherwise we could threaten levels of bank lending and jeopardise that recovery. There is sense in making haste towards the long-run goal at a measured pace.

Looking to what that long-run goal should be, we say in the Policy Statement that the secular level of liquidity is something to be assessed carefully in the light of costs and benefits. And, as The Turner Review Feedback Statement also acknowledged last month, the Policy Statement noted the need to consider the joint impact of both the liquidity calibration and of tighter capital requirements expected to emerge from current international work in the Basel Committee and within Europe.

So, both because we have not set the appropriate long-term calibration and because of the need to be patient in making progress towards that target given the current macroeconomic context, the aggregate position is not likely to shift radically overnight. We expect liquidity levels to rise further at only a gentle pace through coming quarters.

We plan to publish shortly further research on the macro-economic impact of liquidity calibration. We need to share that, and take account of the potential effects of higher capital requirements, before setting out in the first quarter of 2010 our proposed long-run calibration for system-wide liquidity and our initial pathway towards it. Meanwhile, look out for the further Turner Review discussion paper, due out by the end of October, which will set out some of the key issues in more depth."

The regulator may be trying to enhance banks’ liquidity — but it is doing so oh so sensitively. In fact, it will wait for the economy to turn before it actually starts making banks’ follow its new guidelines on liquidity standards. From the FSA policy statement:

"We have already said we would not seek to tighten quantitative standards before economic recovery is assured. We will therefore notify firms individually of the prospective impact on them of the new quantitative requirements, assuming they are fully implemented.We will then agree with each firm other than those operating under the simplified regime a timetable of potentially some years for completing transition to the new quantitative requirements. Because of the long transitional period, we do not expect that our policy will, in the short term, put significant downwards pressure on levels of bank lending."

And those liquidity requirements include — as speculated — a buffer of government bonds:

"On liquid assets our final policy is that firms need to hold buffers comprising highquality government bonds. This represents prudent liquidity risk management practice as demonstrated by the significantly advantageous position through the past two years of those firms which had maintained higher proportions of their liquid assets in that form. In fact, some firms with very sound approaches to liquidity risk management have even more conservative definitions of liquid assets than we have proposed. The Bank of England strongly endorses our position. Its view is discussed in Chapter 8."

In practice, that will include debt from any European Economic Area central bank, or those of Japan, Switzerland, the US, Canada and Australia.

And what’s more — banks will actually be forced to use that liquidity:

"8.14 In CP08/22 we proposed that firms should be required to turn over their liquidity buffers regularly in private markets. By this we meant that firms would regularly need to generate liquidity from their liquidity buffers through sale or repo.We received few comments on this proposal, but the feedback received was not supportive of the approach. For example, one respondent said:

Testing the market … may be dangerous, sending the wrong signal to other market participants. … [F]irms who are seldom active in markets should only be required to research market prices periodically rather than actually executing trades.

8.15 We believe that the respondent’s concern over the existence of a turnover requirement justifies the need for such a provision. If generating liquidity from a firm’s buffer gives negative signals about its financial health it cannot serve the purpose for which it is designed. If a firm regularly and randomly turns over its liquid asset buffer the signalling effect will be reduced, as the markets will not be able to link the act of accessing the repo markets with signs of stress. We will continue with this approach.

All this is good news for the British government, of course.

But not so good news, perhaps, for the banks themselves:

The cost to firms will depend upon how we calibrate Individual Liquidity Guidance (ILG) relative to the stress tests set out in BIPRU 12.5 and the actions firms choose in response to our new regime. For example, many firms will lengthen the maturities of their short-term wholesale funding; whilst some firms will restructure their balance sheets. Given the degrees of freedom involved it is hard to be definitive on the exact costs.

However, if during the first year of the application of the new regime we assume a calibration of ILG where the firm would need to cover 60% of outflows under the Individual Liquidity Adequacy Assessment (ILAA) stresses and that firms were to lengthen the maturity of 20% of their short-term wholesale funding then we estimate that firms would need to increase their holdings of high-quality government bonds by £110bn.This would give rise to an annual cost of £2.2bn (see later tables).

"The most (popularly) insensitive quote of the year award goes to the FSA’s liquidity manager, David Morgan.

In a Friday speech on the FSA’s new liquidity rules for banks, which will see them buying more government bonds, he said:

Oct. 9 (Bloomberg) — British banks may pass on more than 2 billion pounds ($3.2 billion) in fees to customers to make up for the costs of implementing tougher liquidity rules, a U.K. regulatory official said.

Banks can charge retail and corporate customers higher rates and fees to maintain profit margins after implementing the rules, David Morgan, liquidity policy manager at the Financial Services Authority, said in London today. The cost to financial firms of using more expensive funding, such as government bonds, may reach 2.2 billion pounds a year under the proposals, according to FSA data.

“This is not a cost to your shareholders in the long term, this is a cost to your customers,” Morgan said in a speech. “You will pass these costs on to your customers.”

ECB: Balance sheet interlinkages

"The financial crisis has highlighted the need for models that can identify counterparty risk exposures and shock transmission processes at the systemic level. We use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system.

We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes.

High financial leverage and high asset volatility are found to increase a sector’s vulnerability to shocks and contagion.

Senior Supervisors Group on the '08 crisis

The events of 2008 clearly exposed the vulnerabilities of financial firms whose business models depended too heavily on uninterrupted access to secured financing markets, often at excessively high leverage levels. This dependence reflected an unrealistic assessment of liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction in the availability of secured funding to support these assets under stressed conditions.

A major failure that contributed to the development of these business models was weakness in funds transfer pricing practices for assets that were illiquid or significantly concentrated when the firm took on the exposure. Some improvements have been made, but instituting further necessary improvements in liquidity risk management must remain a key priority for financial services firms.

In the attached report, we identify various other deficiencies in the governance, firm management, risk management, and internal control programs that contributed to, or were revealed by, the financial and banking crisis of 2008. Our report highlights a number of areas of weakness that require further work by the firms to address, including the following (in addition to the liquidity risk management issues described above):

  • the failure of some boards of directors and senior managers to establish, measure, and adhere to a level of risk acceptable to the firm;
  • compensation programs that conflicted with the control objectives of the firm;
  • inadequate and often fragmented technological infrastructures that hindered effective risk identification and measurement; and
  • institutional arrangements that conferred status and influence on risk takers at the expense of independent risk managers and control personnel.

In highlighting the areas where firms must make further progress, we seek to raise awareness of the continuing weaknesses in risk management practice across the industry and to evaluate critically firms’ efforts to address these weaknesses. Moreover, the observations in this report support the ongoing efforts of supervisory agencies to define policies that enhance financial institution resilience and promote global financial stability.

Federal Reserve on global liquidity in the crisis

"... The way the problems in the U.S. subprime mortgage market spread illustrated the interconnections. Underwriting standards for U.S. subprime mortgages had weakened at the same time that non-U.S. investors, including many non-U.S. financial institutions, had eagerly invested in the subprime mortgage market by purchasing subprime-backed securities. When house prices leveled out and then began to decline, default rates on subprime mortgages started to rise rapidly. Both U.S. and foreign banks suffered losses, along with other investors.

Many of those losses affected asset-backed commercial paper (ABCP) conduits and similar structures that had invested in subprime-backed securities. Many of these conduits were sponsored by non-U.S. entities. The conduits had funded illiquid long-term assets with short-term liabilities, creating a substantial maturity mismatch. When a few of these conduits began to report subprime-related losses, investors ran from many conduits. The flight was broadly based because investors were uncertain about the incidence of losses and liquidity pressures arising from nontransparent and poorly understood exposures.

Integrated bank funding markets were an important source of contagion. Short-term funding markets in both the United States and Europe were disrupted when conduits drew on bank lines of credit to replace maturing ABCP, and banks turned to dollar-denominated money markets to raise the needed funds. As the financial crisis deepened, banks hoarded liquidity and became concerned about the exposure of their counterparties in the interbank market to losses from subprime mortgages. Spreads between the London interbank offered rate and the overnight index swap rate, a measure of interbank market stress, widened in dollars, euro, sterling, and other currencies.

To be sure, the mispricing of assets and risks was not confined to the U.S. subprime mortgage market. Many credit risk spreads across the globe were at historic lows in the period before the crisis, after several decades of mostly mild, infrequent recessions in the industrial economies. The broad incidence of narrow spreads in part reflected the activities of investors and intermediaries who were facing the same perceived incentives in many different markets. And asset prices--especially real estate prices--were unsustainably high in a number of countries.

Liquidity risk had also been mispriced. Investors had paid insufficient attention to the maturity mismatch present in a number of investment vehicles, including ABCP conduits and money funds. And both investors and intermediaries had assumed that the exceptionally liquid conditions in many markets of the pre-crisis period were a permanent part of the financial landscape. Again, with hindsight, we can see that these vehicles were vulnerable to runs once the crisis hit, and these runs did not stop at national borders.

Moreover, even countries where assets weren't obviously mispriced felt the effects of the growing dislocations when global banks were forced to deleverage and conserve liquidity. Their pullback from lending was broad-based and eventually affected many emerging market economies. And the adverse feedback loop between world financial markets and the real economy was exacerbated by the greater global integration of markets for goods and services. Trade and industrial output plunged everywhere as consumers and businesses pulled back from spending.

Notably, although financial institutions in some countries seemed to be more resilient to the growing turmoil than in other countries, all were affected to a degree, and no particular type of regulatory or supervisory system proved itself clearly superior to other designs--either in the buildup or the crisis-response phase. Problems afflicted both the fragmented system of the United States and the unified systems of other countries. They cropped up where the central bank was deeply involved in regulation and where it played only a consultative role. And it occurred both in systems that were principles-based and those that had thick rule books. Clearly, the deficiencies in both private behavior and public oversight were widespread, and both needed to be addressed.

The Response to the Crisis Was Global

Given the global factors that helped spread the crisis, the response to the crisis needed to be global as well. And many of the responses were indeed global--or at least were quite similar across various jurisdictions. Everyone was reacting to the same types of problems, but the similarities also reflected a high degree of global consultation and collaboration.

We can see this in the actions of many central banks. Beginning in late 2007, central banks generally reacted to funding problems and incipient runs with similar expansions of their liquidity facilities. They lengthened lending maturities, in many cases broadened acceptable collateral, and in several instances initiated new auction techniques for distributing liquidity to overcome the inertia from stigma. Central banks were in constant contact through this period, although they arrived at many of these actions separately.

However, we did explicitly coordinate to address problems in dollar funding markets. The Federal Reserve entered into foreign exchange swaps with a number of other central banks to make dollar funding available to foreign banks in their own countries. By doing so, we reduced the pressure on dollar funding markets here at home.

Governments also reacted similarly when in late 2008 the turmoil deepened and many countries saw a need to provide broad support to their banking systems. The rescue plans in different countries contain similar elements: expanded deposit insurance, guarantees on nondeposit liabilities, and capital injections. Although most countries wound up in a similar place, the process was not well coordinated, with action by one country sometimes forcing responses by others.

Many countries also took measures to deal with financial distress at systemically important firms. Efforts in this area were much messier. The failure of Lehman Brothers highlighted the lack of a framework that would allow for the orderly resolution of a systemically important nonbank financial institution in the United States. Even where formal crisis-management frameworks existed, such as within the European Union, they were not always used in the heat of the crisis. The reality is that the resolution of failing firms is still a national responsibility, even for institutions that operate globally.

Early on in the crisis, authorities recognized that addressing the deficiencies made apparent by the crisis required an international effort. Many of those deficiencies--for example, in bank capital and liquidity requirements and in accounting systems--were embodied in internationally agreed regulations, standards, and codes of conduct. Addressing them would require working through global bodies of national and international standard setters and they would require broad agreement among national authorities. The Financial Stability Forum (now renamed the Financial Stability Board) brought central banks, regulators, and finance ministries together to identify the problems, suggest avenues for addressing those problems, and push for timely solutions.

Federal Reserve definition of "liquid assets"

“Liquid assets” are defined to include:

  • cash or cash equivalents;
  • an asset that is traded on a recognized, established exchange, trading facility or other market on which there exist independent, bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined for the asset almost instantaneously;
  • an asset for which there are bona fide, competitive bid and offer quotations in a recognized inter-dealer quotation system or similar system or for which multiple dealers furnish bona fide, competitive bid and offer quotations to other brokers and dealers on request;
  • an asset the price of which is quoted routinely in a widely disseminated publication that is readily available to the general public or through an electronic service that provides indicative data from real-time financial networks;
  • an asset with an initial term of one year or less and the payments on which at maturity may be settled, closed-out, or paid in cash or one or more other liquid assets described above; and
  • any other asset that the Board determines, based on all the facts and circumstances, is a liquid asset.30

The standards contained in the second, third, and fourth standards above are based on existing standards in the Federal banking and securities laws that are designed to identify securities that are liquid and may be sold promptly at a price that is reasonably related to its fair value.

Specifically, the second standard above is based in part on the SEC’s definition of securities for which a “ready market” exists for purposes of the net capital rules applicable to broker-dealers under the Securities Exchange Act of 1934 (“Exchange Act”).31

Similarly, the third standard above is based, in part, on the actions regularly taken by a “qualified OTC market maker” as defined in the SEC’s Rule 3b-8, with respect to securities under the Exchange Act.32

The fourth standard above is based, in part, on the criteria used to identify whether a security or other asset is a “marketable security” or a “liquid asset” for purposes of the Board’s Regulation W governing transactions between member banks and their affiliates.33

In each instance, the proposal represents a modification of the standards to reflect the broader range of financial instruments (including derivatives) or other assets that may be held by a hedge fund or private equity fund and that should be considered “liquid” if traded or quoted in the manner described. The Board has proposed using these standards (which are generally understood within the banking and financial services industries) to help promote ready and measurable compliance with the requirements of the Volcker Rule.

These standards are designed to capture the wide range of instruments and assets (or their equivalents) that one actively or routinely trades on markets or trading facilities, as for which bid, offer or price quotations are widely available, and that, therefore, should be considered as liquid assets for purposes of the Volcker Rule’s provision regarding illiquid funds.

For example, these standards would treat as a liquid asset:

  1. equity and debt securities, derivatives, and commodity futures traded on a registered securities exchange, board of trade, alternative trading system, electronic trading platform or similar market that provides independent, bona fide offers to buy and sell;
  2. assets traded on an electronic inter-dealer quotation system, such as OTC Bulletin Board or the system maintained by PINK OTC Markets, Inc., as well as over-the-counter derivatives, debt securities (such as corporate bonds), and syndicated commercial loans for which active inter-dealer markets exist; and
  3. financial instruments for which indicative price data is supplied by an electronic service, such as Markit Group Limited.

The fifth standard is designed to capture instruments with a relatively short-term duration and that can be monetized or converted at maturity into a liquid asset. The Board recognizes that there may be situations where other, non-enumerated assets may be liquid even though they are not included in the standards contained in sections 225.181(h)(1) – (5) of the proposed rule. In order to address these situations, the Board has expressly retained the ability to determine that any other asset is a liquid asset, based on all the facts and circumstances.

On the other hand, consistent with the purpose of the Volcker Rule, this proposed approach to defining illiquid assets should include as illiquid assets investments in portfolio companies, investments in real estate (other than those made through publicly traded REITs), venture capital investments, and investments in other hedge funds or private equity funds that both are not publicly traded and invest in illiquid assets.

The proposed rule also provides that an asset – including a liquid asset such as a security – may be considered an “illiquid asset” if, because of statutory or regulatory restrictions applicable to the hedge fund, private equity fund or asset, the asset cannot be offered, sold, or otherwise transferred by the hedge fund or private equity fund to a person that is unaffiliated with the banking entity.

This approach recognizes situations where, for example, a security held by a fund is subject to one or more statutory or regulatory restrictions under the Federal securities laws (such as under Rule 144A of the Securities Act of 1933 regarding private resales of securities to institutions) that temporarily prohibit the transferability or resale of the security.34 However, the proposed rule expressly provides that an asset may be considered an illiquid asset under this provision only for so long as and to the extent that the relevant statutory or regulatory restriction is effective.35

Regulators actions on Lehman prior to collapse

"...As part of this scrutinizing of Lehman’s secured funding activities, the SEC and the Fed encouraged the establishment of additional term funding arrangements and a reduced dependence on "open" transactions, which must be renewed as often as daily. This process also focused on the so-called matched book, a significant locus of secured funding activities within Lehman and other investment banks, to guard against potential mismatches between the "asset side," where positions were financed for customers, and the "liability side," where positions were financed by other financial institutions and investors.

The SEC staff obtained expanded funding and liquidity information for Lehman on a continual basis, and monitored the amount of excess secured funding capacity for less-liquid positions. The additional stress scenarios that were developed with the Federal Reserve were layered on top of the existing scenarios as a basis for sizing more stringent liquidity pool requirements. Also, the SEC discussed with Lehman’s senior management their longer-term funding plans, including plans for raising new capital by accessing the equity and long-term debt markets.

Since Lehman’s management had by this time been made fully aware of their need for more capital, greater liquidity, and reduced leverage, the focus of both the SEC and Fed staff was on Lehman’s working toward these objectives more deliberately and urgently. These strong messages were presented jointly by the SEC and the Fed to Lehman’s management..."

Federal Reserve on financial amplification and liquidity

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system.

The authors review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. They interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices.

By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones.

Finally, Sarkar and Shrader provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Their analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

SEC on liquidity disclosures

On September 17, 2010, the SEC issued an Interpretive Release intended to improve discussion of liquidity and capital resources in MD&A in order to facilitate the understanding by investors of the liquidity and funding risks facing companies.1 In particular, the Interpretive Release provides guidance on the presentation of liquidity, leverage ratio and contractual obligations table disclosures within MD&A. The Interpretive Release is the latest in a series of SEC releases on improving the quality of specific aspects of MD&A.2 Concurrently, the SEC also issued proposed amendments which would require both financial and non-financial companies to disclose additional information in registration statements and periodic reports about intra-period short-term borrowings as a supplement to disclosure about period-end amounts.3 The proposed rule changes contained in this Companion Release would require a registrant to provide, in a separate MD&A subheading, a comprehensive explanation of its short-term borrowings, including both quantitative and qualitative information for short-term borrowings during the interim period, instead of simply disclosing material changes since the previous balance sheet date.4


In the Interpretive Release, the SEC acknowledges that companies have undertaken increasingly diverse and complex types of financing activities, and have expanded the kinds of funding methods and cash management tools they use. Accordingly, the Interpretive Release not only revisits prior guidance and rulemaking initiatives that the SEC has issued in the past with respect to MD&A – such as the importance of discussing trends and analyzing the business from management's perspective – but also provides new guidance with respect to the following areas of liquidity disclosure within MD&A:

  • trends and uncertainties relating to liquidity;
  • intra-period variations in liquidity;
  • repurchase agreements that are accounted for as sales; and
  • cash management and risk management policies.

Although this guidance has not been codified per se within SEC rules, it is nevertheless important for companies as they prepare MD&A because it highlights certain SEC concerns. As many of our clients know from their SEC comment letters, liquidity has been a key focus of the SEC comment process in the past several years.

FINRA on broker dealer liquidity

Executive Summary

In adverse circumstances, whether the result of firm-specific events or systemic credit events, the cost of funding a broker-dealer’s operations could become prohibitively expensive; in extreme cases funding could become unavailable. FINRA expects broker-dealers to develop and maintain robust funding and liquidity risk management practices to prepare for adverse circumstances. Further, FINRA expects broker-dealers affiliated with holding companies to undertake these efforts at the broker-dealer level, in addition to their planning at the holding-company level. We are publishing this Notice to provide guidance in this effort.

Many of the practices outlined in this Notice were identified through FINRA examinations and a survey of 15 mid-sized and large broker-dealers that hold inventory positions and carry customer accounts. This Notice does not provide a comprehensive description of all appropriate funding and liquidity risk management practices. Each broker-dealer should determine which practices are best suited to its particular business, whether or not they are mentioned in this Notice. While much of the content in this Notice is directed to broker-dealers that carry inventory positions, other brokerdealers may also find it to be a valuable resource.

Australian prudential regulation and liquidity

"... The Basel Committee is also promoting the development of stronger liquidity buffers in the global financial system. And for obvious reasons! As I have noted, years of apparently abundant liquidity in global funding markets lulled banks and prudential supervisors alike into a false sense of security. The speed with which that supposed liquidity evaporated during the traumatic events of September and October last year was the rudest of awakenings. Central bank support, unprecedented in its scale and the creativeness of some of the support mechanisms, was required to restore liquidity to domestic financial systems, and those actions were reinforced by governments in over a dozen countries providing guarantees of wholesale funding. Australia’s experience over this period was no exception, although the Reserve bank did not need to resort to unconventional monetary measures.

As a matter of principle, liquidity buffers would be made up of high-quality assets that are liquid in private markets during a time of stress. That is, a liquid asset must be liquid when it is needed. Hardly a controversial proposition! Almost any financial asset is liquid during a boom; the test is whether assets are reliably liquid — without large fire-sale discounts or haircuts — under conditions of severe market stress. Sovereign bonds most clearly meet this test and this reality is shaping the thinking of global policymakers.

Some would argue, however, that liquidity buffers need only include assets that can be used (repoed) to obtain liquidity from the central bank. That brings me to the matter of principle. Global policymakers are concerned about ‘moral hazard’ – the incentive that banks would have to take excessive liquidity risks if they know that central banks are standing ready to provide insurance. Market discipline would be much stronger if, on the contrary, banks hold strong cushions of high-quality liquid assets as the first line of insurance against severe liquidity stress and do not turn to the central bank at the first whiff of gun-smoke.

APRA shares this concern about ‘moral hazard’. At the same time, we are able to perform simple arithmetic. We are well aware of the need for an operational definition of high-quality liquid assets that make sense for Australia. We are currently working with the industry and the Reserve Bank to find a pragmatic solution that reconciles the concern with the realities of Australia’s relatively small Government bond market..."

How stable are bank deposits?

Ric Battellino, Deputy Governor, Remarks to the 22nd Australasian Finance & Banking Conference Sydney – 16 December 2009

How Stable are Bank Deposits?

"...Assessing the relative stability of banks’ various funding sources is not straightforward, as there can be significant variation even within each category of funding. For example, government-guaranteed deposits are ‘stickier’ than non-guaranteed deposits, household deposits tend to be stickier than corporate and institutional deposits, while internet deposits are less stable than other at-call deposits. Deposits from corporates and other financial institutions are unlikely to be much more stable than short-term debt, particularly in a crisis. Offshore capital market funding can be less stable than domestic capital market funding, as during crises investors often have a strong home bias.

The behavioural maturity of a given funding source can also be very different from the contractual maturity, especially during financial crises. It is the behavioural maturity that matters most, and during a severe crisis this can shorten significantly for many funding sources. This is because banks can come under pressure to allow term deposits to be redeemed early and to buy back short-term capital market debt. While a bank could try to enforce the contractual maturity on its funding, the reality is that, unless the bank is already in great difficulty, this could draw attention to itself and accentuate its problems.

Another issue is that the behaviour of new depositors attracted through more competitive pricing may also be very different from that of existing depositors. These new deposits are likely to be more price sensitive and less stable. The benefit, in terms of funding stability, which comes from increasing deposits through competitive pricing, may therefore be somewhat illusory..."

Australian banks show "hubris" over liquidity buffers

"THE nation's top bank regulator has warned that the hubris starting to stir in the banking sector needs to be quashed despite Australia's lenders emerging from the global financial crisis relatively unscathed.

Australian Prudential Regulation Authority chairman John Laker has also hit out against banks that have been campaigning against global efforts aimed at making banks safer by bolstering capital buffers.

Top bank executives have argued that rules on liquidity proposed by APRA would be likely to force bigger banks to set aside billions of dollars in largely unproductive assets such as cash and government bonds that cannot be lent out, hurting their profitability.

But speaking at an Australian British Chamber of Commerce lunch yesterday, Dr Laker said Australian lenders would be required to fall into line with what was emerging as a consensus on global banking standards.

If you don't want to play by those standards, then you've got to have a very careful explanation to the market, Dr Laker said.

In recent weeks executives ranging from ANZ boss Mike Smith to Westpac's Gail Kelly have warned that increasing banking regulation in Australia may have a negative effect on the economy.

Analysts, including Jarrod Martin, from brokerage RBS, have estimated that the planned changes to liquidity could cost each of the banks about $500 million a year - or add 15 to 20 basis points to the cost of borrowing. In some cases, the costs could be as high as $1 billion, he said.

Mr Martin said liquidity was one of the larger regulatory risks. If regulations were not uniformly enacted, bank shareholders could bear the costs.

However, the APRA chairman seemed to leave the door open on a planned measure requiring banks to increase their holdings of government bonds substantially. Lenders, including the big four banks, have claimed this would be unworkable given Australia's relatively shallow sovereign bond market.

On a simplistic view, we know the government bond market at the moment may not generate the volumes that would be available for banks to hold as a first line of defence, he said. So we are are talking to the industry over what other assets might provide confidence for liquidity and what role they may play as lines of defence.

But as a matter of principal, liquidity buffers should be made up of high-quality assets that were liquid in private markets in times of stress, Dr Laker said.

He also acknowledged that the sum of planned reforms should not strangle the banking system.

However, with the global economic recovery not firmly established, Dr Laker sounded a warning over the dangers of complacency stirring among Australia's banks.

Some say global reform initiatives will go too far given how well Australian financial institutions performed through the crisis, he said. Any self-congratulatory tone here needs to be curbed - after all, many hands were involved in the lifting.

ONLY months after the financial crisis, Australian banks say the banking regulator is taking too hard a line in proposed measures to improve confidence.

Some of Australia's biggest banks have begun an intensive, behind-the-scenes campaign, arguing against an idea from the regulator that all banks have available cash on hand to fund 30 days of operations. The current level is five days.

Banks argue this might force bigger banks to set aside billions of dollars in largely unproductive assets such as cash and government bonds that cannot be lent out, hurting their profitability.

One bank executive said a tough, prescriptive approach to liquidity was largely unnecessary given the relative health of the banking sector, even through the crisis.

He said Australian banks were well capitalised and had pumped up liquidity as the crisis deepened.

Bernanke on modern day bank runs

"...I'll conclude with the cautionary fourth lesson--history is never a perfect guide. It is a principle acknowledged by the words etched on the wall of the Center's conference room, attributed to Mark Twain, "History does not repeat itself, but it can rhyme."

As an example, bank runs in many countries, including the United States, were common in the Depression. In the most recent crisis, retail runs--depositors lining up in the streets--were thankfully rare because of deposit insurance and other changes in our financial system.4

Although ordinary small depositors by and large did not run, we nevertheless experienced the equivalent of runs on the network of nonbank financial institutions that has come to be called the shadow banking system.

In the shadow banking system, loans, instead of being held on the books of banks as was virtually always the case in the 1930s, were packaged together in complex ways and sold to investors. Many of these complex securities were held in off balance sheet vehicles financed by short-term funding.

When the housing slump shook investors' faith in the values of the loans underlying the securities, short-term funding dried up quickly, threatening the banks and other financial institutions that explicitly or implicitly stood behind the off-balance-sheet vehicles.

This was a new type of run, analogous in many ways to the bank runs of the 1930s, but in a form which was not well anticipated by financial institutions or regulators. In an additional variation on the theme of the bank run, in September 2008 money market mutual funds saw massive outflows after one prominent fund suffered losses related to the failure of Lehman Brothers."

Fed could offer ‘liquidity backstop’

"Federal Reserve Bank of New York President William Dudley said the central bank could curtail the risk of future liquidity crises by providing a “backstop” to solvent firms with sufficient collateral.

“The central bank could commit to being the lender of last resort” to such firms, Dudley said in a speech yesterday in Princeton, New Jersey. This would reduce “the risk of panics sparked by uncertainty among lenders about what other creditors think.”

Dudley said he’s confident regulators can create policies to reduce the risk of future liquidity runs like the ones that struck Bear Stearns Cos., Lehman Brothers Holdings Inc. and American International Group Inc. The international Basel Committee on Banking Supervision is reviewing ways to require banks to hold more and higher-quality capital, he said.

The New York Fed chief’s comments coincide with consideration by Fed officials of ways to withdraw a record $1 trillion of liquidity channeled into the financial system to avert a depression. The New York Fed said last month it’s working with market participants on using reverse repurchase agreements to drain cash from the banking system.

“Liquidity risk will never be eliminated, nor should it,” the bank president said. “However, we can do better to make our system less prone to the types of liquidity runs that we have experienced.”

‘Remain Committed’

“If we remain committed to implementing the reforms that are already under way, I am confident that we can dramatically reduce the risks of the type of liquidity crises that we experienced all too recently,” the New York Fed chief said at a Center for Economic Policy Studies symposium...

...“The central bank could provide a liquidity backstop to solvent firms,” Dudley said. “If the central bank is willing to provide backstop liquidity, then a lender that judges the financial firm to be solvent should be willing to lend.”

In response to audience questions, Dudley said he expects problems in the commercial real-estate market to persist “for quite a period of time.”

“It’s quite significant for the health of the commercial banking system,” he said. “It’s going to retard the rate and speed at which the U.S. commercial banking system returns to health.”

At the same time, weakness in commercial real estate doesn’t pose a systemic risk and will probably trouble regional banks more than large ones, he said.

“The orthodoxy of the Fed” on how it should respond to asset-price bubbles “is shifting a little bit,” he said. Dudley said it’s possible to identify asset bubbles or at least the risk of asset bubbles “to some degree.”

SEC to the Basel Committee on Bear Stearns

"Securities and Exchange Commission Chairman Christopher Cox today sent the following letter to the chairman of the Basel Committee on Banking Supervision expressing strong support for their planned updated guidance on liquidity management for banking organizations in light of the recent market turmoil.

  • Dr. Nout Wellink
  • Chairman
  • Basel Committee on Banking Supervision
  • Centralbahnplatz 2
  • CH-4002 Basel
  • Switzerland

Re: Sound Practices for Managing Liquidity in Banking Organizations

Dear Dr. Wellink:

I am writing in connection with the announcement by the Basel Committee on Banking Supervision that your Working Group on Liquidity intends to update the February 2000 guidance entitled "Sound Practices for Managing Liquidity in Banking Organizations" in light of the recent market turmoil. I strongly agree with you that the events earlier this month leading up to the acquisition of Bear Stearns by JP Morgan Chase highlight the importance of liquidity management in meeting obligations during stressful market conditions.

I also strongly support your decision to update the guidance for managing liquidity in banking organizations.

To assist the Working Group in its task, this letter provides you with specific information regarding Bear Stearns' capital and liquidity positions in the days preceding its transaction with JP Morgan Chase. I hope this very recent data will prove valuable as the Working Group examines its guidance on liquidity management practices.

As you will see, the conclusion to which these data point is that the fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard.

Specifically, even at the time of its sale on Sunday, Bear Stearns' capital, and its broker-dealers' capital, exceeded supervisory standards. Counterparty withdrawals and credit denials, resulting in a loss of liquidity - not inadequate capital - caused Bear's demise.

It is worth noting, however, that net capital rules are designed to preserve investors' funds and securities in times of market stress, and they served that purpose in this case. This investor protection objective was amply satisfied by the current net capital regime, which - together with the protection provided by the Securities Investor Protection Corporation (SIPC) and the requirement that SEC-regulated broker-dealers segregate customer funds and fully-paid securities from those of the firm - worked in this case to fully protect Bear's customers.

The data above (see SEC link) show that Bear Stearns' registered broker-dealers were comfortably in compliance with the SEC's net capital requirements, and in addition that Bear Stearns' capital exceeded relevant supervisory standards at the holding company level. Specifically, throughout the week of March 10 until the closing of the JP Morgan Chase transaction on Sunday March 16, Bear Stearns had a capital ratio of well in excess of the 10% level used by the Federal Reserve Board in its "well-capitalized" standard.

The data above also reflect the fact that the holding company had a pool of high quality, highly liquid assets of over $18 billion as of the morning of March 11. This was consistent with what the SEC had seen over the preceding weeks, during which SEC staff - both on-site and at headquarters - monitored the capital and liquidity positions of all the CSEs, in the case of Bear Stearns on a daily basis.

In accordance with customary industry practice, Bear Stearns relied day-to-day on its ability to obtain short-term financing through borrowing on a secured basis. Beginning late Monday, March 10, and increasingly through the week, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns. This resulted in a crisis of confidence late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms.

This unwillingness to fund on a secured basis placed enormous stress on the liquidity of the firm. On Tuesday, March 11, the holding company liquidity pool declined from $18.1 billion to $11.5 billion. This improved on Wednesday, March 12, when Bear Stearns' liquidity pool increased by $900 million to a total of $12.4 billion. On Thursday, March 13, however, Bear Stearns' liquidity pool fell sharply, and continued to fall on Friday. The market rumors about Bear Stearns liquidity problems became self-fulfilling. On Sunday, March 16, Bear Stearns entered into the transaction with JP Morgan Chase. These events illustrate just how critical not just capital, but liquidity is to the viability of financial firms and how the evaporation of market confidence can lead to liquidity being impaired.

The SEC's Consolidated Supervised Entity Program Use of the Basel Standards

I also want to provide the Working Group with the following contextual information to provide a better understanding of how the SEC has incorporated the Basel standards into our supervision of large broker-dealers.

Under the SEC rules, a broker-dealer's holding company and its affiliates (known as consolidated supervised entities, or CSEs) may elect to be subject to group-wide SEC supervision. In electing to operate under this program, the holding company must, among other things, compute on a monthly basis its group-wide capital in accordance with the Basel standards. Further, the holding company must provide the Commission on a periodic basis with extensive information regarding its capital and risk exposures, including market and credit risk exposures, as well as an analysis of the holding company's liquidity risk.

With respect to computing capital at the holding company level, CSEs are expected to maintain an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve Bank's 10% "well-capitalized" standard for bank holding companies. CSEs provide monthly Basel capital computations to the SEC. The CSE rules also provide that an "early warning" notice must be filed with the SEC in the event that certain minimum thresholds, including the 10% capital ratio, are breached or are likely to be breached.

In addition to capital, liquidity and liquidity risk management are of critical importance to broker-dealer holding companies. Due to the importance of liquidity to the firms, CSEs have adopted funding procedures designed to ensure that the holding company has sufficient stand-alone liquidity and sufficient financial resources to meet its expected cash outflows in a stressed liquidity environment where access to unsecured funding is not available for a period of at least one year.

In evaluating the liquidity risk management processes at a CSE, the SEC staff considers not only capital but also the assets supported by the capital. Applying such a "liquidity standard" alongside a capital standard is critical to the effective supervision of a CSE. To assess the adequacy of liquid assets, the SEC staff takes a scenario-based approach. The CSEs have developed a set of scenarios for use internally in assessing liquidity. A key assumption underlying the scenario analysis is that during a liquidity stress event, the holding company would not receive additional unsecured funding but would need to retire maturing unsecured obligations.

Further, firms generally assume that during a liquidity crisis, assets would not be sold to generate cash. Another premise of this liquidity planning is that any assets held in a regulated entity are unavailable for use outside of the entity to deal with weakness elsewhere in the holding company structure, based on the assumption that during the stress event, including a tightening of market liquidity, regulators in the US and relevant foreign jurisdictions would not permit a withdrawal of capital. There are also considerations as to the degree a firm relies on overnight and other short-term funding versus long-term funding.

I hope this information will be of use to the Working Group as it revises its liquidity guidance for banks. I would be pleased to provide additional information or otherwise contribute to the examination of banks' liquidity management that the Working Group is undertaking.

ECB, ABS and repo funding

"European banks have pledged a record amount of asset-backed securities to the European Central Bank as collateral in return for temporary funds, indicating that banks remain heavily reliant on the ECB for liquidity.

A total of several hundred billion euros worth of ABS - notes backed by repayments on other debt such as mortgages or credit card loans - have been deposited with national central banks in the euro zone to use in the ECB's liquidity-providing repurchase operations, senior bankers said.

That has happened as the public ABS market remains shut, with banks keeping top-rated government bonds for use in the interbank market.

"Everybody is doing it," a Frankfurt-based banker said, estimating that banks have deposited up to EUR500 billion of ABS with the ECB.

Some experts cautioned that the EUR500 billion-figure was at the high end of estimates, but confirmed that the use of ABS in the ECB's repos has swollen massively.

The development may get critical if banks' become over-reliant on ECB funds, or abuse the ECB's generosity, bankers said.

Since the credit crunch sparked by the meltdown of the U.S. subprime mortgage market last summer, the ECB has been a key source of funding.

It currently provides about EUR430 billion liquidity through its main and long-term repos. Banks, which lodge securities, can also tap the ECB for intraday credit or use the ECB's marginal lending facility for overnight money at an expensive 5% rate - 100 basis points above the minimum bid rate that applies to the ECB's main refinancing operations. The marginal lending facility was tapped to the tune of EUR627 million Monday and for EUR129 million on Tuesday.

Other options to raise liquidity include private bond placements, or straight debt sales, such as HSH Nordbank's EUR7.6 billion sale of mortgages to BNP Paribas (BNPQY), Lehman Brothers (LEH) and Hypo Real Estate (HREHY) earlier this week. But those are difficult funding options in the current market, bankers said.

"It's a massive amount, given that the value of the underlying assets is likely to deteriorate," said Pravin Banker, director at The Financial Network, a U.S. boutique investment bank specializing in distressed debt.

If accurate, the EUR500 billion figure given by the Frankfurt banker would be well in excess of the roughly EUR272 billion in 2008 ABS issuance forecast by a European Securitisation Forum survey.

The volume of potentially ECB-eligible ABS amounted to EUR746 billion in late August 2007, or about 58% of the entire European ABS market, the ECB said in its October monthly bulletin. Banks put forward roughly EUR100 billion of ABS as collateral in 2006, the ECB's 2006 annual report showed. The central bank is expected to update this figure in its 2007 annual report due in April.

The ECB declined to comment on current data.

"I'd be cautious on the very high estimates, but in Spain you see deals being rated and retained," said an ABS banker in London. "If you extrapolate that across other jurisdictions, you quickly get to a large number."

Volumes in the Spanish securitization market hit an all-time high of EUR142.8 billion in 2007, up 55% from 2006, Moody's estimated.

"The market for these bonds closed...but many institutions had deals in the pipeline, so instead of postpone them, many of them went ahead, issued the bonds and used them as collateral to get ECB liquidity," Moody's analyst Sandie Fernandez said.

Demand for ECB funding from Spanish banks also hit record highs in December, as banks drew roughly EUR52 billion in main and longer-term refinancing operations, official numbers showed.

Recent data highlight how important a source of funding the ECB has become for European banks and that timely access to liquidity, particularly in greater volumes, remains a concern.

As well as Spain, "anecdotally, we hear that Greek banks are doing it, and I'm fairly confident there's a lot of German paper (being pledged)," a London-based bank analyst said. Bankers also flagged up activity by banks in Belgium, the Netherlands and Luxembourg.

Rabobank of the Netherlands, for example, has turned EUR30 billion of its mortgage book into asset-backed bonds to guard against a sudden need for funding from the ECB. Chief Financial Officer Bert Bruggink said the bank formed the paper in late December.

Total issuance in the European ABS market, including retained deals and tranches, has amounted to about EUR250 billion since mid-2007, according to information from Dealogic.

The ECB's acceptance of a broad range of collateral in its repos has also helped to avert a deeper credit crisis in Europe, bankers said, but cautioned that banks cannot stay on the ECB's drip forever.

In euro terms, the Eurosystem has the largest amount of eligible collateral, at EUR10.8 trillion, compared with the Federal Reserve System at EUR8.3 trillion and the Bank of Japan at EUR7.2 billion, the ECB said in its October monthly bulletin, using exchange rates from the end of 2005.

"The fact that the ECB accepts asset-backed securities as eligible collateral for repo financing has helped European banks transition to the tougher environment after the onset of the credit crunch," said Nitesh Shah, an economist in the Moody's Investors Service's structured-finance team.

The ECB lent its support at a time when private investors withdrew their backing.

Moody's said last month that European ABS issuance - excluding mortgage-backed deals, structured credit, structured covered bonds, asset-backed commercial paper and some other instruments - grew 19% in 2007 to EUR120.3 billion. But of deals not placed in the public market since the onset of the credit crunch, some were used to provide collateral for repo transactions with the ECB.

"We believe a large portion of ABS issuance (as defined above by Moody's) - maybe more than 50% - has gone to the ECB for repo since September," said Benedicte Pfister, a managing director at Moody's responsible for ABS in Europe, the Middle East and Africa. Total residential mortgage-backed issuance in 2007 was EUR383.6 billion, Moody's said.

The growing use of ABS as collateral in ECB repos isn't too alarming, as long as the underlying assets maintain their credit ratings and remain repo-eligible, bankers said. A drop in the credit quality could prompt the ECB to apply a greater valuation haircut, meaning that it would subtract a greater percentage from the asset's market value to reflect the higher risk associated with the paper. The ECB applies a haircut of up to 12% of the ABS's market value, depending on the type of the collateral and its maturity date, although in most cases the haircut lies under 5%, bankers said.

"The collateral pool is likely to include some bad paper, and nobody knows the size of it," The Financial Network's Banker cautioned. "But the ECB cannot just stop accepting ABS paper, even though nobody knows the true value of the underlying assets. That would exacerbate the crisis."

There is also a concern that banks may get over-reliant on the ECB, or may start abusing the situation. "If a bank grows its balance sheet at 10% per annum and uses the ECB to fund that growth, there is a moral hazard," the bank analyst said. "But using the ECB to refinance debt coming due on static assets and a static balance sheet is the sensible thing to do. It needs to be monitored, but the ECB is doing the right thing in the right way."

How CDS can magnify liquidity constraints in financial crisis

"...But I think [Felix] Salmon all too often misses the forest for the trees on credit default swaps. He extols them for supplying liquidity, and that has informational value for the larger bond market and contributes to efficiency in pricing. But, at least in my reading of him, he doesn't step back and look at the big picture. Namely, if financial bust-and-boom cycles are inevitable (and yes, they are), then it behooves us to look at what exacerbates and ameliorates them. And there is good evidence, from this last crisis, that a huge CDS market (that's now shrunk to $25 trillion notional from $50 to $60 trillion), changes a garden-variety financial crisis to a financial crisis on steroids.

Think of what happens in a financial crisis: credit tends to freeze or contract, making liquidity scarce. Now think of what happens right at the same time in the CDS market: there's a large hoovering up of liquidity. You have CDS writers scrambling to post collateral or make good on their bets on the debt of failed companies. They need money and tap available cash and sell assets, just when the economy needs more liquidity. Credit swaps are cyclical enhancers, in a bad way.

And there's more: default swaps are highly leveraged and become highly volatile in times of economic distress. So a CDS on Bank of America trades at 80 basis points, nice and steady, for four or five years, then boom -- all of a sudden Bank of America takes a huge writedown and the swap is zooming back and forth between 600 and 900 basis points. Multiply this by a handful of companies -- you can be assured in a downturn that others will be revealed to be on thin ice -- and now you've got large amounts of money sloshing back and forth, even before a default has been declared, as swap writers try to meet collateral obligations.

All this volatility is not what the distressed financial system needs at this time, but that's what swaps contribute. As they add to systemic volatility, they can feedback-loop in an unpleasant way -- the posters of collateral, if they are not well hedged, can begin adding strains of their own in unexpected places.

And then, because our modern financial system is so interconnected, at some point the very interlaced network of swap sellers and buyers will expose a weak point. AIG was a big weak point last time -- and it was engaged in an undeniably stupid activity. But next time there will be another weak point, probably more subtle. We're not dumb enough, hopefully, to let another AIG write swap protection ad nauseum until the house burns down. But when the markets grow more volatile, and money is shifting back and forth to cover the multi-trillion-dollar exposures on credit default swaps, you can bet that there will be a weak point again -- it could be a hedge fund, a small one that goes down, that leads to cascading failures and, at some point, another giant bailout.

So all that -- the macro, systemic stuff -- is what I'm surprised Salmon doesn't spend more time thinking about because he's a really smart guy.

The suggestion right now is to put credit default swaps on exchanges for trading, to increase transparency and make exchanges the backstop for failure (and who backstops the exchanges? Three guesses and one hint: it rhymes with "shmaxpayers.") It may be worth trying that. But I think we also should look hard at the alternative: even though credit swaps do some micro-good for the market (pricing efficiency on little-traded bonds) they may do too much macro-bad to be allowed to exist."

Markit to offer "liquidity" ratings

Investors will have new tools to assess the trade-ability of their holdings in corporate bonds and credit default swaps following the launch of “liquidity scores” by Markit, the financial data provider.

The move comes as regulators are forcing traders and investors to pay more attention to liquidity following the severe problems caused by the freezing of various credit markets during the financial crisis.

Markit will score bonds and CDS on a scale of one to five, with five being the least liquid (based on the spread between the bid and offer prices, the number of dealers who have provided the data and the number of price points it has been given).

The scores are new for the corporate bond world but other providers produce something similar for CDS.

Markit will also provide liquidity measures for the 6,500 loans that it offers pricing data on and is looking at developing a similar score for European asset-backed securities.

The score will indicate liquidity relative to other securities in that asset class but it will not be possible to consider a bond and a CDS contract with the same score as equally liquid, owing to the different trading conditions of those markets. The measures are expected to prove popular with investors and product control teams in banks, who can use the data to challenge traders’ prices.

“Irrespective of regulation, banks and ‘buy’ side companies are seeking better views of liquidity for managing risk and their portfolio,” said David Austin, director of the credit products group at Markit, who said clients had shown interest in the new scores.

Types of liquidity risk

  1. Asset Liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:
    1. Widening bid/offer spread
    2. Making explicit liquidity reserves
    3. Lengthening holding period for VaR calculations
  2. Funding liquidity - Risk that liabilities:
    1. Cannot be met when they fall due
    2. Can only be met at an uneconomic price
    3. Can be name-specific or systemic

Causes of liquidity risk

Liquidity risk' arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found higher in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.

Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle.

Futures were used to hedge an OTC obligation.

It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk.

A simple test for liquidity risk is to look at future net cash flows day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.

Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis.

A general approach using scenario analysis might entail the following high-level steps:

  • Construct multiple scenarios for market movements and defaults over a given period of time
  • Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.

Regulators are primarily concerned about systemic implications of liquidity risk. [1]

US banks increase liquidity

"Citigroup Inc. and JPMorgan Chase & Co. are hoarding cash as if another crisis were on the way.

Citigroup has almost doubled its cash to $244.2 billion in the year since Lehman Brothers Holdings Inc. filed for bankruptcy, the biggest such stockpile of any U.S. bank. The lender, which last year came so close to a funding shortfall it had to get a $45 billion government infusion, is under pressure from the Treasury Department and regulators to keep more money on hand for emergencies, even as markets improve.

The caution, which may help restore confidence in the financial system, offers little comfort to shareholders, who can expect to see shrinking returns as banks put money into liquid investments that yield one-twelfth the interest rates of loans.

“It’s a smart longer-term move, but it will take down the rates of returns these companies can generate,” said Eric Hovde, chief executive officer of Washington-based Hovde Capital Advisors LLC, a hedge fund with $1 billion of financial-industry and real estate investments. “If you start to see more economic stabilization, then liquidity levels would start dropping, but they’ll never go back to the insane level they were pre- crisis.”

Regulators say banks got too aggressive in the years leading up to last year’s credit-market seizure, operating with too little equity capital and putting too much money into illiquid investments such as loans and complex, hard-to-trade securities and derivatives.

‘Core Principles’

A lack of funds “can contribute as much or more to the firm’s failure as insufficient capital,” the Treasury Department said in a Sept. 3 statement of “core principles” on financial regulation. Lehman, the New York-based securities firm that declared bankruptcy on Sept. 15, 2008, after losing access to its funding, had said in a statement five days earlier that it had a “strong capital base.”

Banks should “hold a pool of unencumbered, liquid assets sufficient to cover likely funding shortfalls in the event of an acute liquidity stress scenario,” the Treasury said. Such a scenario might occur when depositors rush to pull their money, companies suddenly draw down credit lines or trading partners unexpectedly demand additional collateral, the department said.

Banks worldwide have raised $1.4 trillion of capital since the start of the credit crisis in mid-2007, diluting shareholders’ stakes while shoring up the buffer that insulates depositors in the event of a failure.

Increasing Liquidity

The four largest U.S. banks by assets -- Bank of America Corp., JPMorgan, Citigroup and Wells Fargo & Co. -- have increased their combined liquidity by 67 percent to $1.53 trillion as of Sept. 30 from $914.2 billion in June 2008, before Lehman’s collapse, according to the companies’ third-quarter reports. The amount equals 21 percent of the banks’ total assets, up from 15 percent.

Liquidity includes cash, deposits at other banks and debt securities that can be pledged as collateral in exchange for overnight borrowings from the Federal Reserve or other banks.

Citigroup’s total liquidity as of Sept. 30 was $450.3 billion, or 24 percent of assets, up from 16 percent in June 2008. The shift was reflected in the bank’s third-quarter results, when interest income fell by $1.4 billion from a year earlier and pushed New York-based Citigroup, headed by CEO Vikram S. Pandit, to an operating loss of $750 million.

‘No Choice’

The $244.4 billion Citigroup holds in cash and deposits is $131.4 billion more than it had as of June 30, 2008. That’s five times as much as the $47.1 billion cash hoard Warren Buffett’s Berkshire Hathaway Inc. had at its peak in the third quarter of 2007. Financial firms typically keep more liquid assets than other companies to comply with regulatory requirements.

“In my 44 years in the business, I have never seen a company with remotely as much cash as this,” said Richard X. Bove, an analyst at Rochdale Securities in Lutz, Florida.

If Citigroup’s cash and deposits, which earn 0.63 percent, had been put into loans, which fetch 7.2 percent, the bank would be getting at least $8.65 billion more in annual interest revenue. The risk is that some of those loans go bad, and the bank ends up losing more than the incremental revenue.

In the third quarter, the four biggest U.S. banks posted a combined 2.1 percent decline from the previous quarter in net interest revenue -- what they earn on loans and investments minus what they pay out on deposits and borrowings.

“Even though it makes no sense for a bank to have $245 billion in cash, Pandit has no choice,” said Bove, who rates Citigroup “buy.” “I don’t think it’s something to either praise him for or criticize him for. That’s simply the fact. You either keep that cash or you’re dead.”

Measures of liquidity risk

Liquidity Gap

Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.

As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.

Liquidity Risk Elasticity

Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.

Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.

Measures of asset liquidity

Bid-Offer Spread

The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid price can be used. The smaller the ratio the more liquid the asset is.

This spread is comprised of operational costs, administrative and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

Market Depth

Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.


Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.


Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.

Managing liquidity risk

Liquidity at Risk

Greenspan (1999)[2] discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered.

It might be possible to express a standard in terms of the probabilities of different outcomes.

For example, an acceptable debt structure could have an average maturity--averaged over estimated distributions for relevant financial variables--in excess of a certain limit.

In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.[3]

Scenario analysis-based contingency plans

The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.". [4] Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.

Diversification of liquidity providers

If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit.

The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed."[5]


Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.:

  • Withdrawal option: A put of the illiquid underlying at the market price.
  • Bermudan-style return put option: Right to put the option at a specified strike.
  • Return swap: Swap the underlying's return for LIBOR paid periodicially.
  • Return swaption: Option to enter into the return swap.
  • Liquidity option: "Knock-in" barrier option, where the barrier is a liquidity metric

Against liquidity

"Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it’s a good idea for government policy to “nudge” financial institutions away from it.

That’s something that opponents of the Miller-Moore amendment should bear in mind, when they complain that it could hit the repo market hard.

Here’s Agnes Crane:

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to.

The problem is that we don’t want to encourage the use of leverage to finance short-term trading positions. Indeed, from a public-policy point of view, we’d ideally want to discourage it.

Would a less liquid repo market mean, in turn, a less liquid Treasury market? I daresay it would. But that’s no bad thing: the more liquid the Treasury market, the more that investors flock to it in times of crisis, exacerbating the systemic downside of the flight-to-quality trade, and reducing the amount of liquidity elsewhere in the markets, especially among credit instruments.

There are serious systemic consequences to living in a world where a Treasury bond — or any asset, for that matter — is considered a safe haven from all possible harm. Investing shouldn’t be about safety: it should be about calculated risk. Excess demand for triple-A-rated risk-free assets, as we’ve seen over the past couple of years, can be much more systemically damaging than excess demand for risky assets like dot-com stocks. So yes, let’s throw some sand into the wheels of the repo market, either through a Tobin tax or through the Miller-Moore amendment or both. Because liquidity is not ever and always a good thing."

Modeling collective market behavior as risk

That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.

“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University, told The Times. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”

In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.

The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.

Much of the early work has been done tracking online behavior. The Web provides researchers with vast data sets for tracking the spread of all manner of things — news stories, ideas, videos, music, slang and popular fads — through social networks. That research has potential applications in politics, public health, online advertising and Internet commerce. And it is being done by academics and researchers at Google, Microsoft, Yahoo and Facebook.

Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets. A team of six economists, finance experts and computer scientists at Cornell was recently awarded a grant from the National Science Foundation to pursue that goal.

Foreign exchange liquidity

"... Lower turnover in the foreign exchange market does not appear to be linked to any problems with market function. Indeed, throughout the financial crisis, the foreign exchange market has tended to function better than most other markets. Liquidity has improved in the spot market over recent months, with the bid-ask spread currently approaching pre-crisis levels (Graph 6), although market participants report the market remains prone to episodes of reduced liquidity.

This is in stark contrast to October and November last year, when at times the daily average of the bid-ask spread widened to as much as US0.07 cents, relative to a precrisis level of US0.02 cents. At that time, risk retrenchment and the unwinding of leveraged position were generating one-sided markets. As an example, one group of participants reportedly contributing to one-sided markets were fund managers adjusting the foreign currency hedges on their foreign equity investments. The 2009 hedging survey found that Australian investors hedge around 50 per cent of the currency risk on their foreign portfolio equity investments. As global equity markets fell sharply late last year, the size of these hedges became too large relative to the value of the equity portfolio. In order to correct the hedge, fund managers needed to sell Australian dollars either in the spot or forward markets. Although this sort of hedge adjustment is occurring all the time, the extent of the falls in equity markets meant these flows were much larger than usual, and the trades were being executed in much thinner markets.

In this environment the Bank entered the market to support liquidity and reduce the size of ‘gaps’ in the exchange rate that occurred as the large Australian dollar flows were digested by the interdealer market. The Bank’s interventions were not designed to target any particular level of the exchange rate, but rather to enhance the functioning of the market. Net sales of foreign exchange by the RBA in the market totalled just under A$3½ billion in October and November. Because of the nature of the transactions which were going through the market, the size of the Bank’s individual transactions were generally very small, in contrast to our intervention in the market in 2001."

Collapses caused by liquidity problems

Lehman - 2008

"...Onaran: How about liquidity risk? That wasn’t incorporated into the rest of the risk-management function, was it?

Williams: Exactly. Liquidity is a big risk especially if you’re relying very heavily on overnight borrowing. Lehman was borrowing $180 billion a day on the repo market. Bear Stearns Cos. was knocking on the repo door for about $50 billion every day, assuming it was going to be open for them.

Discount Window

Onaran: Why did the Fed decide not to lend to Lehman from its discount window when its overnight lenders balked? Wouldn’t opening the window to investment banks have prevented such a liquidity crisis? Did the Fed decide Lehman was insolvent and not just illiquid?

Williams: The Fed had more insights into Lehman’s collateral and refused to lend against it. Then a few days later, when Barclays Plc came in and bought Lehman’s U.S. businesses, the Fed accepted that same collateral to lend to Barclays. It wasn’t good enough collateral for Lehman, but it was for Barclays.

The Fed decided Barclays was going to be around, but Lehman wasn’t. So it looks like they decided it was insolvent."

Northern Rock - 2007

Northern Rock suffered from funding liquidity risk back in September 2007 following the subprime crisis.

The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets [6].

In response, the UK Financial Services Authority now places greater supervisory focus on liquidity risk especially with regard to "high-impact retail firms". [7]

Amaranth - 2006

Amaranth Advisors lost roughly $6bn in the natural gas futures market back in September 2006.

Amaranth had a concentrated, undiversified position in its natural gas strategy.

The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures.[8]

Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions.[9]

Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity.

Regression analysis on the 3 week return on natural gas future contracts from August 31st 2006 to September 21 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.[10]

LTCM - 1998

Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls.

The fund suffered from a combination of funding and asset liquidity.

Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable (as it did following the crisis).

Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor. [11]

LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, haircuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securities. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans.

Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk. (Markus Brunnermeier, Market Liquidity and Funding Liquidity,Review of Financial Studies, Volume 22, Issue 6, pages 2201–2238)


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