Risk Europe April 2011

BCM International Regulatory Analytics LLC

Barbara C. Matthews
www.bcmstrategy.com
April 2011
p


Overview
The Basel framework: summary & short political
history
Liquidity & Cross Border Resolution: charting the
intersections
Liquidity Risk Regulation beyond the banking
sector: who falls within the framework?
Liquidity Risk Regulation & the Trading Book:
charting the feedback effects

www.bcmstrategy.com ©2011 all rights reserved


Main themes
g
The measurement and management of bank funding g
liquidity risk is not merely a quantification challenge
Shifts in the cost structure of bank funding will have
p
profound effects on how economic growth is managed,
g g ,
how sovereign debt management functions are
executed, and how monetary policy will be formed.
Public policy interests in the liquidity profile of
sovereign debt will affect (i) the shape and contours of
bank liquidity risk management and (ii) the cost of
corporate finance for the foreseeable future.
Are your risk management systems ready to
incorporate these non quantitative risk factors?



The Basel Framework
Summary & Short Political History



G20 Members
19 Sovereign States
S i S 1 International Grouping
I i lG i
Argentina European Union (Council Presidency) + ECB
Australia
Brazil 4 Ex Officio Participants
Canada Managing Director, International Monetary
China Fund
France President, World Bank
Germany Chair, International Monetary and Financial
India Committee (IMF)
Indonesia Chair, Development Committee (World
Bank)
Italy
Japan
J
Mexico
Russia
Saudi Arabia
South Africa BUT NOT
South Korea Financial Stability Board
Turkey BIS
United Kingdom Basel Committee
United States of America IOSCO
IAIS
IASB



Basel 1 2 3
Early 1970s: Basel Committee created to address
FX settlement/Herstatt risk
1980s: Latin American debt crisis (“sovereigns
9 ( g
don’t go bankrupt”; TBTF; Continental Illinois)
1988: Basel 1 (OECD sovereigns don’t go bankrupt;
risk is mostly in the assets)
i ki tl i th t )
2000s: Basel 2 (AAA rated entities don’t go
bankrupt; risk is mostly in the assets)
2010: Basel 3 (Liquidity & high reg cap can help a
bank avoid bankruptcy; return of ALM)
p y; )



The Great Dollar Shortage

“Taken together, Graphs 2 and 3 thus show that several European
banking systems expanded their long US dollar positions
significantly after 2000 and funded them primarily by
2000,
borrowing in their domestic currency from home country
residents. This is consistent with European universal banks
using their retail banking arms to fund the expansion of
investment banking activities, which have a large dollar
component…In aggregate, European banks’ combined long US
dollar positions grew to more than $800 billion by mid 2007
(Graph 5, top left hand panel), funded by short positions in
pounds, sterling, euros and Swiss francs.”
BIS Quarterly Review (
l (March 2009), p. 52 53.
h )




“ In sum, the run on US dollar money market funds after the Lehman
I h d ll k f d f h L h
failure stressed global interbank markets because the funds bulked so
large as suppliers of US dollars to non US banks. Public policies
stopped the run and replaced the reduced private supply of dollars
with public funding…European banks increased their dollar assets
sharply (from 1999 to 2008). Since this growth outran that of their
retail dollar deposits, they bid for dollars from nonbanks and
banks…As
banks As European banks relied more on the foreign exchange swap
market to obtain dollars against European currencies, they did not
meet US banks with a complimentary need for European currencies.
Under these circumstances, this asymmetry led to skewed foreign
exchange swap prices that hiked the cost of raising d ll well above
h i h hik d h f i i dollars ll b
an already elevated Libor dollar rate.”
BIS Quarterly Review (March 2009), p. 65 66.



This vulnerability highlights why the IMF reform (especially
SDR reform) issues are at the top of the French Presidency
f )i h f h F h P id
agenda for the G20 and why the Basel Committee went
forward with the liquidity risk framework over the objection
of European banks
banks.
However, global monetary reform requires long timeframes
and implies significant shifts of economic policy sovereignty.
Current experience in Europe suggests this is not likely to
occur quickly, if at all. These issues and their implications for
the global economy are beyond the scope of today’s
p
presentation.
As the eurozone and its banks continue to experience stress
in the near term, an alternative framework is needed to
decrease European banks’ reliance on short term dollar
funding. Enter Basel 3 and the liquidity risk framework.
f d l d h l d kf k



The Liquidity Risk Framework – The Big Picture

Underlying Premise: “During the early ‘liquidity’
phase of the financial crisis that began in in 2007,
many b k – d
banks despite adequate capital l l – still
it d t it l levels till
experienced difficulty because they did not manage
their liquidity in a prudent manner.” Para. 2
(emphasis added).
Focus: Funding Liquidity Risk
Short t
Sh t term f di risk (Liquidity C
funding i k (Li idit Coverage R ti ) +
Ratio)
Longer term (1 year) funding risk (Net Stable Funding
Ratio)



Liquidity Coverage Ratio (LCR): An Overview

Stock of high quality unencumbered liquid assets
Total cash outflows for 30 days (stress scenario) =100%
100%

PER CURRENCY

Goal: Identify and segregate assets that can be
y g g
converted into cash to support a firm under severe
stress assumptions to avoid emergency government
liquidity support



Liquidity Coverage Ratio (LCR)
What = “high quality liquid asset ?
high asset”?
Low credit & market risk
Easy, reliable valuation
E li bl l ti
Low correlation w/risky assets
Listed
Li d on a d l
developed & well recognized market
d ll i d k
Active & sizeable market/low market concentration
Flight to quality beneficiary
Committed market makers
What besides cash could fit these parameters?


Rhetorical Question:
Do eurozone sovereign bonds and/or bonds issued by
EU entities (e.g., EFSF; ESM) fit these parameters ?
( g, ; ) p



Tier 1 Tier 2
Cash (40% cap; 15% haircut)
Central Bank reserves Marketable sovereign
Marketable
M k t bl securities
iti debt that attracts a 20%
issued or guaranteed by a risk weight
government Corporate and covered
Anything with a 0% RW bonds rated at least AA
Local sovereign debt of (
(or with an equivalent PD
q
any rating or currency if using IRB)
NO financial firm debt



Liquidity Coverage Ratio (LCR)
Stress Scenario
Regulator determined run off rates for specific liabilities
(See Annex A) over a 30 day period
The short version:
Limited (5 10%) runoff: retail deposits if deposit insurance exists
and unsecured wholesale deposits
p
High (75% 100%) runoff: deposits from clearing, correspondent
banking, custody, cash management, financial institution,
derivatives, ABCP or other asset backed instruments & any
, y
instrument with a ratings based downgrade trigger
No (0%) runoff: reverse repos & securities borrowing with
maturities in excess of 30 days; lines of credit; operational
3 y p
deposits.



Net Stable Funding Ratio (NSFR)

Goal: Limit or eliminate reliance on short term wholesale
funding
Mechanism: Instrument specific “required stable funding”
required funding
(RSF) coverage/haircuts based on liquidity profile of the
instrument. The higher the liquidity profile, the lower the RSF:
RSF buckets: 0%, 2%, 5%, 20%, 50%, 65%, 85%, 100%
b k t % % % % % 6 % 8 % %
Instruments with maturity less than one year: RSF buckets structured
across 4 maturity buckets (one per quarter), with shorter maturities
attracting a higher RSF factor
National discretion applies for setting RSF amounts on most off balance
sheet instruments, including letters of credit and trade finance.
Preference for capital and preferred stock with maturities in excess of
365 days.


Additional “Tools” (just regulatory reporting – for now)

Contractual Maturity: Regulators to identify maturity
C lM i R l id if i
mismatches/gaps using standardized raw data from banks plus
regulatory assumptions regarding behavioral components (e.g.,
outlays to promote going concern operation and franchise protection
payments

Funding Concentration: Regulatory reporting regarding funding
g g y p g g g g
from significant counterparties (over 1% of balance sheet), significant
products/investments (over 1% of balance sheet), and significant
currencies (over 5% of total liabilities) across four quarterly maturity
buckets

Unencumbered Assets: Reporting of non client assets not otherwise
pledged as collateral that are eligible at the central bank by asset and
with any applicable haircuts



Regulatory Compliance Parameters

Reporting Frequency
LCR: monthly (but can increase to weekly, daily, etc. as needed)
NSFR: quarterly

Scope: All internationally active banks on a consolidated basis
+ all individual legal entities, foreign branches and subsidiaries
g g
“taking into account legal, regulatory and operational
“
limitations to the transferability of liquidity” in the local
jurisdiction such as: ring fencing requirements; currency
convertibility restrictions; foreign exchange controls

Home State rules apply extraterritorially: except regarding
retail & SME d
t il deposits if th H t state h more stringent
it the Host t t has ti t
standards


Liquidity and Cross border Resolution
Charting the Intersections



Liquidity: Preventing Cross Border Resolution Problems?

“taking into account legal, regulatory and operational
limitations to the transferability of liquidity” in the local
j
jurisdiction such as: ring fencing requirements; currency
g g q ; y
convertibility restrictions; foreign exchange controls
Vickers Report (UK)/subsidiarization?
IMF sanctioned FX controls
Vienna Initiative
Dodd Frank resolution authority at FDIC (wind up
y p
activities should seek to maximize the value of the entity
in administration)
EU Commission resolution proposals (going
p p (g g
concern/stability priorities)


A Few Questions for CROs & Scenario Analysis Designers

1.
1 How do you adjust your liquidity risk models and scenario analysis for the
possibility that access or distribution of liquidity within your firm or
counterparties could be constrained due to political or economic policy priorities?

2.
2 How do you track regulatory and economic policy trends that will impact the
ability of governments to implement the Basel framework for the flow of liquidity
support within a financial firm? Are you evaluating the impact that a tradeable
SDR could have on (i) liquidity profiles and/or (ii) the performance of existing
sovereign debt?
g

3. Have you simulated the market impact of a bank tapping its liquidity reserves to
avoid a bail out or other government support? Would reliance on the liquidity
cushion require y to restrict credit or trading relationships with that bank even
q you g p
if no resolution activity were triggered?

4. Have you simulated potential differences in path dependencies and correlations
in interest rate inputs if a firm (a) begins to stockpile sovereign debt to meet Basel
p ( ) g p g
standards and/or (b) begins to liquidate sovereign debt in order to meet the Basel
standards? In other words: are you ready for sovereign debt market dynamics to
shift based on different demand profiles?


Mapping Liquidity & Cross Border Resolution
Timing & Behavioral Considerations

Government Policies

• Cash • Short term?
• Gov’t securities • Competition • Going Concern?
• Fiscal Policy • CP
• Monetary Policy relationships?
• Macroprudential
d l
Policy
Liquidity support • FX Controls Liquidity Needs



Liquidity Risk Beyond the Banking Sector:
Who Falls Within the Framework?



p
Focus: INDIRECT Impacts

Winners Losers
Issuers of S
I f Sovereign D bt (d ’t
i Debt (don’t CCPs, Custodians, and C h
CCP C t di d Cash
worry; supply will be plentiful for Managers
years to come)
Any company requiring short term
y p y q g
Niche (non bank) financial firms (below 365 days) funds
specializing in short term lending
Banks seeking to serve as market
Maybe the covered bond market
market, makers
but only up to a point

Exchanges



Liquidity Risk and the Trading Book



Feedback Effects Point to Longer Maturities
g p
And Higher Costs for Corporates

Increased cost
and maturity
d t it
structure for
Bank demand corporate debt
for corporate
p
debt limited to
Disincentives for the banking
banks to hold book (hold to
corporate bonds maturity), and
in the liquidity then subject to
cushion = fewer LCR and NSFR
Shorter bank purchases coverage;
maturities Disincentives
generate higher for banks to
LCR and NSFR serve as market
k
requirements makers.



Rhetorical Question:
Why bother with the Volcker Rule when the Basel
liquidity framework exists?



Timeframe

Currently: QIS
January 2012: first reporting starts
J fi t ti t t
Mid 2013: LCR revisions
Mid 2016: NSFR revisions
6 i i
1 January 2015: LCR final
1 January 2018: NSFR final



Conclusion
The debate regarding appropriate bank funding models
is only just starting.
Changes to bank funding models will profoundly
impact the shape and cost of corporate finance….and,
finance and
thus, the scale and scope of economic recovery.
A broader range of policymakers will have a voice in
defining banks functions and f di structures going
d fi i b k f i d funding i
forward given the fiscal and monetary policy
implications of new funding liquidity profiles for banks.
The definition , measurement, and application of
liquidity risk standards will be driven as much by non
quantitative and economic policy priorities as by formal
risk measurement processes. Are you ready?
i k A d ?



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Risk Europe April 2011

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