Introduction.

In the wake of the financial market turmoil that arose over the last few years and which already brought  down some big financial institutions, the question remains what banks can and should do to protect themselves from the worst-case scenario.

This article describes how banks operate in time of crisis and what their instruments are in navigating in the stormy waters. 

One day in life of a Risk Manager during the crisis time.

W. is a risk manager in a large European bank. One early morning he was awaken by his mobile phone. A colleague, a treasury manager has activated the red line to inform W. that he cannot get dollars from  Asian market and that swap market is also dried up. It means that bank cannot get liquidity through the wholesale market because banks don’t trust each other anymore.

Normally at this time his bank already has few billions through the money market, but today there is nothing yet. The worst-case scenario, that the bank might not meet its obligations, which will be due today, is not to be excluded.

W. begins to call traders in other European branches, there is the same situation. Fortunately, this scenario has been already simulated several times and everybody knows what to do. Firstly, bank has a buffer to deal with such situation; so to say there is no need to ask ECB for a credit facility. Asking for a credit facility could mean severe consequences for the bank’s reputation and its credit rating  (Think about what happened with Northern Rock bank when it asked for a credit facility from Bank of England).  Treasury department around the globe works extra hours to provide dollars from different markets to the Head office, the price becomes less important. Other team members are responsible for checking  the outflow of the retail deposits. The substantial outflow could mean big problems, but luckily this is not the case.

In this situation it becomes clear why Risk management has become banks’ main business. Without clear policy and procedures, good systems and right people a bank might not survive the shocks.

How banks manage liquidity risk

Liquidity risk management is a crucial area of risk control that is not covered by the original Basel II accord. Liquidity Risk is the risk of not being able to meet obligations when they come due because it cannot:

1.      Liquidate assets or obtain adequate funding , this is called "funding liquidity risk";

or

2.      Easily unwind or offset specific exposures without significantly lowering market prices because of inadequate market depth or market disruptions, which is called "market liquidity risk".

The dual definition of the liquidity risk helps in understanding the nature of the risks; while funding liquidity risk focuses on company specific funding problems, market liquidity risk describes general market liquidity disruptions.

The core of the liquidity risk strategy of a commercial bank must include following main components;

·        Regular monitoring of net funding position and net funding gap of the bank;

The Treasury monitors all maturing cash flows, replenishes existing funds as they mature, monitors expected withdrawals from retail current and savings accounts and makes additional borrowings and regularly issues new debt.

·        Diversification of funding sources;

The bank should posses well diversified funding sources including customer current accounts credit balances, savings and retail deposits and inter-bank deposits.

·        Broad portfolio of highly liquid assets;

The bank has to maintain a broad portfolio of highly liquid or marketable assets that can be easily used to obtain cash. These assets can provide liquidity through repurchase agreements or through sale.

·        Matching long term funding (over 12 months).

Fixed rate funding over 12 months and/or interest swaps (converting fixed rate liabilities over 12 months in floating rate liabilities).

·        Set up quantitative limits and the limit structure.

·        Set up clear crisis organization structure and escalation procedure.

·        Tested and up-to-date contingency funding plans;

The contingency plans should address temporary and long-term liquidity disruptions caused by a crisis. These plans ensure that all roles and responsibilities are clearly defined.

Several scenarios should be analysed, for example, a market event, a specific bank event (think of a  downgrade by a rating agency) and a mixed event.  

The real scenarios could be taken from the real past events like:

·        Black Monday 1987 when on 19 October 1987 the Dow Jones Industrial index fell 22.6%;

·        The Bond Market crisis from 18 February until 21 February 1994 when Fed unexpectedly increased key interest rates by 300 basis points;

·        Emerging markets crisis 1997 originated in East Asia and caused global financial crisis;

·        Financial Markets crisis 1998 when Russian rouble devaluation and default on August 17, 1998, and the near collapse of LTCM triggered the Financial Market Crisis:

·        Major terrorist act scenario like on September 11, 2001 when bond and equity markets have been closed for four days. 

·        Current financial crisis has provided a wide range of information for scenario analysis ( collapse of Lehman Brothers, extensive risks taken by IAG, USB and other financial institutions)

           

How this policy works in the crisis time.

 

Scenario 1: a short-time funding crisis related to a market event.

The preferred order of generating liquidity in times of crisis is:

  1. Determine per position the financial instruments available for generating liquidity during the crisis:

An important element in this determination is the collateral position that must be held in times of crisis at the different central banks for supporting the payments system. The following trade off should be considered:

a) Putting too much collateral at Central banks solves payment system issues but limits the secured funding possibilities with the money market.

b) Putting collateral at work through repo (repurchase agreement) keeps financing secured  but risks the payment system.

DNB (De Nederlandsche Bank – the Dutch Regulator) is of the opinion that putting collateral for supporting the payment system is essential.

  1. Unsecured professional funding.

  2. Secured professional funding:

a. Non-eligible assets in the professional repo market or through sale

b. Eligible assets in the professional repo market or through sale

  1. Central Bank funding (secured) through open market transactions (if available):

a. Main Refinancing Operations (short term)

b. Longer-term Refinancing Operations.

c. Ad-hoc ‘fine-tuning’ or ‘structural operations’ of Central Banks

  1. Funding through the Standing Facilities of the Central Bank (Lombard rate)
  2. Funding through ‘emergency funding’ possibilities with the Central Bank (non-eligible collateral)

Scenario 2: In case of liquidity crisis is more severe and when it lasts for a longer banks begin to

  1. Price deposits more aggressively. (Watch out for the banks that promote their deposit products with unbelievable high interest rates)

  2. Reduce asset origination.

  3. Raise term debt.

  4. Raise equity.

Conclusion.

Right policies, timely and correct risk management reporting combined with state of the art Information systems are keys in withstanding liquidity crisis.