- BearingPoint Deutschland

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Liquidity Risk
Stress Testing
White Paper | Liquidity Risk Stress Testing
In this White Paper
A financial world under transformation...........................................................4
Characteristics of liquidity risk management................................................5
New regulation and standards.............................................................................6
The BearingPoint response....................................................................................8
Implementation project....................................................................................... 12
Outlook........................................................................................................................ 13
Early Warning Indicators................................................................................ 13
Liquidity reserve................................................................................................. 13
Modeling cash flows......................................................................................... 13
Concentration risks........................................................................................... 13
Funds transfer pricing...................................................................................... 13
Contact............................................................................................................................... 14
Liquidity risk has just recently emancipated itself as a
significant risk type. Prior to the 2007 financial crisis,
liquidity was considered only as a part of the regulatory
reporting process for financial institutions and did not
constitute a risk type requiring thorough risk management. In order to respond to the increased importance
of liquidity risk and its role as a full-fledged risk factor,
regulators introduced stress testing as the primary
technique for identifying, measuring and limiting
liquidity risk vulnerabilities and exposures. BearingPoint
presents a solution for complying with the regulatory
requirements for liquidity risk stress testing, which can
be applied in various banking environments. We offer a
tailored step-by-step approach to identify institutespecific, extreme yet plausible, idiosyncratic and
market-wide liquidity stress scenarios, allowing for the
consistent management of liquidity risks.
Liquidity Risk Stress Testing | White Paper
3
A financial world under transformation
Liquidity risk became a major concern for banks and financial institutions after the
recent financial and economic turmoil. During the 2007 crisis, even well-capitalised
institutions were unable to acquire funding to refinance their operations and short
term obligations due to the collapse of the unsecured interbank lending market. The
failure of Lehman Brothers, and the difficulties experienced by major financial
institutions1 pinpointed a serious soft spot in the existing risk governance and
management frameworks of banks and other financial institutions.
The system-wide effects of the crisis, such as the systemic liquidity shortages, liquidity
hoarding2 and inability of institutions to acquire funding and thereby collapsing as a
result, exposed the interdependencies between different risk factors. The lack of
liquidity contributed significantly to the problems experienced by financial institutions3, with some market analysts speculating that Lehman Brothers might have
survived, if the bank had been provided with further liquidity4. In the real world,
information frictions and imperfections in capital markets can make it difficult for
financial institutions to acquire liquidity in extreme situations, thus making the
handling of liquidity risks an essential part of the management of a bank.
Fast Fact
Liquidity risk gained increased
importance during the 2007 crisis
due to the systemic impact of
liquidity risk related events such as
liquidity shortages.
While the main point of concern for asset and liability risk managers over the past
decades has been interest rate risk, the importance of liquidity management has until
recently been underestimated and neglected in the overall context of asset and
liability management for financial institutions. Based on past experiences5, the active
management of the balance sheet had its focus on managing exposures to interest
rate risks, and considered liquidity of importance solely from the regulatory reporting
point of view.
The effective steering and management of the newly acknowledged risk type requires
new or enhanced governance and risk management processes, methods and techniques. Liquidity risk management needs to be successfully incorporated into the
already existing asset and liability management framework. Furthermore, a regular
update and independent assessment of the effectiveness of liquidity risk management
is required. This presents a challenge for banking institutions, due to the specific
nature of liquidity risk and its relationships to other risk types.
1
2
3
4
5
4
Such as most notably Bear Stearns, Wachovia, Merrill Lynch, AIG, HBOS, Washington Mutual. For a detailed timeline of
problems experienced by major institutions, please refer for example to Federal Reserve Bank of St. Louis, The Financial Crisis: A
Timeline of Events and Policy Actions.
Liquidity hoarding occurs when banks prefer withholding cash instead of lending it out, causing in effect a dry up of the
interbank market.
As was, for example, the case with Bear Stearns: The institution was unable to acquire liquidity on the interbank market and
was offered a bailout package by the Federal Reserve. The bank was ultimately bought by J.P.Morgan at a staggering loss for
Bear Stearns’ shareholders.
A statement most notably expressed by Richard S. Fuld, Jr. former CEO of Lehman in front of the Financial Crisis Inquiry
Commission.
The increased volatility of interest rates was one of the causes of the system shock in the US in the early 1980s and which
resulted in numerous bank failures.
Characteristics of liquidity risk management
Liquidity risk is a “black swan” – a high impact, low frequency event. Liquidity risk
relevant events occur with extreme rarity, and are therefore difficult to account for
using traditional statistical techniques. The scarcity of historical information and
statistics, both bank-specific as well as market wide, suggests that these cannot be
considered a reliable source of data for modeling liquidity risk directly. Furthermore,
liquidity risk is a derivative risk stemming from other risk factors – it highly depends on
the impacts and severities of risk types such as market, credit and operational risk.
Fast Fact
Liquidity risk is a low frequency
high severity risk, making it
difficult to manage.
Regulators have assigned a central role to stress testing as an appropriate technique
for the management and modeling of liquidity risk due to its economic significance
and since it incorporates extreme events and accounts for the specifics of the
considered bank. Stress testing is a balanced combination of historical as well as
forward looking knowledge, such as statistical data, empirical observations and expert
judgment. It exploits quantitative methods, but it is also subjective by depending on
the input of the risk management of the bank. Of utter importance when designing
stress tests is the identification of the liquidity stress scenarios and liquidity risk
relevant stress events, as well as the institute-specific liquidity vulnerabilities.
During the analysis of the causes of the recent financial crisis and while on the lookout
for new management solutions, supervisors observed that stress testing did not
appear to be sufficiently integrated into the institutions’ risk management frameworks
or senior management decision-making. In general, where stress testing was used,
scenarios were not sufficiently extreme nor were there appropriate considerations
given to the potential crystallization of confluences of events. As a result new
regulation and standards emerged6.
6
For a report on the range of bank practices before the crisis, please consider (2008) ECB, EU Banks Liquidity Stress Testing and
Contingency Funding Plans. Best practices guidelines for stress testing are described in the (2010) CEBS, Guidelines on Stress
Testing.
5
New regulation and standards
Having acknowledged the importance of liquidity risk as well as the domino effects of
liquidity shocks during the 2007 financial crisis, regulators systematically developed
new standards and regulations for its successful management. The Bank for International Settlements published its Principles for Liquidity Risk Management7 and
introduced two regulatory minimum liquidity standards – the LCR and the NSFR8 –
with deadlines for the implementation of the LCR from 2015 until 2018. The European
Banking Authority9 published a series of guidelines on liquidity and stress testing10
which constitute an important part of the currently discussed proposition on new EU
wide regulation – the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) – intended to govern, among others, liquidity risks. The
German regulatory authorities consider the overall management of risk, including
liquidity risks in their Mindestanforderungen an das Risikomanagement (MaRisk)
requirements, which implement the EU regulatory framework.
The MaRisk regulation requires an integrated consideration of liquidity risk into the
whole risk governance and process framework of banking institutions.
Fast Fact
Regulators introduced stress
testing for identifying, measuring
and limiting liquidity risk
vulnerabilities.
Regulators use a twofold approach towards the governance of liquidity risk management: Firstly, system-wide risk stability is addressed by requiring the adherence to
minimum liquidity standards such as the LCR and NSFR. Secondly, the specific
vulnerabilities and liquidity risk exposures are taken into account by requiring the
introduction of institute-specific stress tests as well as the adherence to the sound
liquidity risk management practices.
FIGURE 1: REGULATORY REQUIREMENTS AND THE LIQUIDITY RISK MANAGEMENT
Governance
Processes
Methods
IT-Architecture
(Data, Systems)
7
• MaRisk AT 4.2 Z2
Risk Strategy
• MaRisk AT 4.3.2
• MaRisk BTR 3.1 Z11
Risk Steering
Liquidity Risk Reporting
Risk Interdependencies
• MaRisk BTR 3.1 Z5-7
• MaRisk AT 4.3.3,
BTR 3.1 Z8, BTR 3.2 Z3
• MaRisk AT 2.2 Z1,
BTR 3.1 Z1
Early Warning Indicators
Liquidity Gap Analysis
Fund Transfer Pricing
• MaRisk AT 7.2
Stress Testing
Liquidity Reserves
Intraday Liquidity
Concentration Risk
IT Systems, IT Processes
and Data
(2008) BCBS, Principles for Sound Liquidity Risk Management and Supervision
LCR and NSFR were first introduced by the BCBS in (2010) International framework for liquidity risk measurement, standards
and monitoring. An update to the LCR and monitoring tools was issued in (2013) BCBS, The LCR and liquidity risk monitoring
tools.
9 The European Banking Authority (EBA) was founded after the crisis with the main aim of maintaining the future stability of the
financial system and has taken over all existing and ongoing tasks and responsibilities from the Committee of European
Banking Supervisors (CEBS).
10 Such as the (2009) CEBS, Guidelines on Liquidity Buffers and (2010) CEBS, Guidelines on Liquidity Cost Benefit Allocation,
(2010) CEBS, Revised Guidelines on stress testing etc.
8
6
The new regulation intends to identify and constrain the liquidity risk exposure of
financial institutions by setting limits on the funding structure of banking institutions,
especially on the maturity, stability and reliability of the different funding sources and
by assuring adequate liquidity reserves and counterbalancing capacities. Financial
institutions are required to test their ability to cover unexpected liquidity requirements
and to maintain their refinancing sources on a frequent basis and pay special
attention to the stock of highly liquid assets with which liquidity shocks are to be
accounted for (MaRisk BTR 3.1.2). MaRisk BTR 3.2 further requires liquidity reserves of
highly liquid assets to be kept, which can be used to cover short-term funding gaps.
Since liquidity risk is considered a derivative risk type, MaRisk requires that the effects
on liquidity risk of other risk types, such as reputation risks, are also accounted for. For
capital market oriented institutions the German regulation imposes additional and
stricter measures regarding the testing of extreme scenarios (MaRisk BTR 3.2). Three
general types of scenarios ought to be considered: idiosyncratic, market-specific as
well as a combination of both. Furthermore, financial institutions need to analyze and
integrate into their stress testing framework extreme, yet plausible stress scenarios
and consider hypothetical as well as historical crises (MaRisk AT 4.3.3). By using Early
Warning Indicators (EWI), financial institutions should identify liquidity shortages
early on (MaRisk BTR 3.1). Banks are required to maintain a diversified structure of
their funding sources as well as the diversified nature of their assets (MaRisk AT 2.2,
BTR 3.2).
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The BearingPoint response
After a detailed, in-depth analysis and step-by-step consideration of the regulatory
requirements, BearingPoint has conceptually developed and applied into practice a
target architecture for the management of liquidity risks. Stress testing and institute
specific stress tests in particular, are the centerpiece of the liquidity risk management
framework, since stress tests and their results constitute major inputs for the other
liquidity risk management components.
Fast Fact
Stress testing is the centerpiece of
liquidity risk management, and its
successful implementation is
crucial for other elements of the
liquidity risk architecture.
Fast Fact
BearingPoint offers a proven
step-by-step approach for
identifying institute-specific,
extreme yet plausible liquidity
stress scenarios.
The proposed solution for defining liquidity risk stress tests is compliant with the
newest national and supranational regulatory requirements, recommendations and
guidelines. One of the challenges financial institutions are expected to face in the
setup of the stress testing framework is the definition of stress test scenarios which
appropriately capture the institute-specific liquidity risk vulnerabilities.
For the definition of liquidity stress scenarios, we suggest the integrated, sequential
approach displayed in Figure 3. There are two major components of the approach –
the structured description of scenarios and the definition of liquidity events, which
serve as building blocks for the scenarios’ description. These building blocks are
determined through the simultaneous formulation of historical liquidity events and
institute-specific liquidity events. The institute-specific liquidity events are viewed from
two angles: they are either mapped to an already identified historical liquidity event
or, if no appropriate historical event has been identified, to a hypothetical liquidity
event.
Liquidity events are economic or other occurrences which have an effect on the
liquidity position of the bank. For the purpose of successful liquidity risk management,
these need to be extreme, yet plausible with typical examples being a funding shock,
deposit run-off or stock crash. Defining a plausible event is a challenge due to the
inherent subjectivity: therefore the use of a liquidity event needs to be rationally
explained and be easily understandable in order to assure its real world relevance.
Banks ought to define an institute-specific list of liquidity events in order to account for
their specific vulnerabilities.
FIGURE 2: STRESS TESTING AS A CENTERPIECE OF THE LIQUIDITY RISK MANAGEMENT
TARGET ARCHITECTURE
Stress Testing
EWI
FTP
Liquidity
Reserve
FTP
Stress Tests
Scenarios/Generation
indirect
(stressed)
EWI
Stress Tests
Liquidity
Reserve
FTP
Cash Flows – normal Concentration
Asset
Concentration
Intraday Liquidity
Funding
Concentration
Cash Flows – normal
Cash Flow Modeling
8
Concentration
Concentration Risk
direct
FIGURE 3: INSTITUTE-SPECIFIC LIQUIDITY STRESS TEST SCENARIO DEFINITION
Liquidity Event Definition
(combined Top-Down/Bottom-Up Approach)
Structured Description of Scenarios
Fast Fact
A liquidity stress scenario
represents the screenplay for a
liquidity crisis.
Top-Down Analysis
wide range of historical crises
Bank-specific relevance
Select liquidity event
as trigger of scenario
Select liquidity events
describing the scenario
Order sequence of
liquidity events
List of bank-specific liquidity events
Deposit Run-Off
Market Downturn
Real EstateHerabstufung
Shock
Rating Downgrade
Cluster
Sight
deposits
Cluster
Term
deposits
Cluster
Credit lines
Cluster
Rating
triggers
Market
Downturn
…
Cluster
Commercial
papers
Liquidity Shortage
Rating Downgrade
Deposit Run-Off
Cluster
…
Pool of liquidity clusters
B/S and Off-B/S Positions
Bottom-Up Analysis
For the definition of the list of liquidity events, a combination of a Top-Down and a
Bottom-Up approach is applied. The Top-Down approach conducts an analysis of
historical crises and from these extracts relevant historical liquidity events.
Banks need to consider a wide range of crises with respect to their time of occurrence,
geography, severity, impact, etc. For example, focusing only on recent crises can ignore
relevant past occurrences, focusing only on far away crises would ignore current trends
in the market – a balanced view is deemed necessary.
Fast Fact
The liquidity events are the
building blocks for the liquidity
stress scenarios and capture the
institute-specific vulnerabilities.
The relevance of historical liquidity events for the bank and the formulation of
bank-specific liquidity events is determined after a detailed analysis of the related
risks, the portfolio structure and regional or country exposures.
Bank-specific liquidity events need to take into account the bank’s portfolio exposures
or asset/liability concentrations. Consider the example of a bank which strongly relies
on the interbank market to refinance its short-term debt. In this case, liquidity events
describing shock in the interbank market would be considered highly relevant.
FIGURE 4: TOP-DOWN: EXTRACTION OF LIQUIDITY EVENTS FROM HISTORICAL CRISES
Historical Crises
2007
Northern Rock bank run
2008
Lehman Brothers: ABS crisis
Société Générale: Rogue trading
Constrained market liquidity
2009
2010
2011
Greece : Sovereign crisis
Record yields for Italian and
Portugese Government Bonds
Liquidity Events
Retail Funding Run-Off
Breakdown of a funding relevant asset class (e.g. MBS)
Trader fraud scandal
Restriction on unsecured and secured money-market
Default of a country
Market turbulence with collateral repudiation
9
FIGURE 5: TOP-DOWN: IDENTIFICATION OF BANK-SPECIFIC LIQUIDITY EVENTS
Identification of liquidity related risk
Analysis of the bank’s specific product offering
Interdependencies – Identification of contingent
liquidity risk
Analysis of specific national or geographic dependencies
of the business model
Bank-specific
liquidity events
Furthermore, country specifics are important in the analysis, due to systemic risk and
the potential system wide effects of liquidity risk. For banks with strong regional
dependencies, liquidity events which focus on shocks in the region should be taken
into account.
The Bottom-Up analysis locates positions which exhibit similar or identical liquidity
effects and aggregates them in clusters. The conclusive structural analysis of these
liquidity effects starts at the balance sheet level. A position’s potential effect on
liquidity is categorised in five groups: unexpected cash flows, unexpected collateral
pledge, liquidation, risk mitigation and stable funding. When defining the liquidity
clusters, different granularity levels are possible with a strong reliance on expert
judgment in the matter.
FIGURE 6: BOTTOM-UP: LIQUIDITY RISK EFFECTS AND THEIR RELEVANCE
Assets
Liquidation
Risk Mitigation
Unexpected
Collateral Pledge
Counter Balancing
Capacity
(e.g. Cash, Deposits,
Securities)
Asset used for Risk
Mitigation
(e.g. Loans)
Liabilities
Funding Positions
(e.g. Deposits,
Issued Securities,
Wholesale funding)
Derivatives
(e.g. Options)
Other Liabilities
Other Assets
Unexpected Cash Flow
Off Balance Sheet
(e.g. Letters of Credit, Liquidity support)
10
Stable Funding
The liquidity clusters are defined by combining dimensions, which describe the
properties of a position such as the position’s maturity, credit rating, currency, etc. The
identification of the different liquidity clusters is necessary because each cluster
requires a specific method of parameterisation (for example roll-over rate, haircut,
flows). Liquidity clusters are further broken down into more granular components
along each dimension through the use of liquidity value groups. These represent a very
detailed look into the portfolio of the bank – liquidity value groups are groupings of
positions with different values of the same dimension. Consider the dimension credit
rating – an acceptable liquidity value group breakdown would be to group all positions
with credit rating values between AAA to BBB – in one liquidity value group.
Fast Fact
The liquidity events are defined
after a careful analysis of historical
liquidity crises and bank-specific
vulnerabilities.
After this, the structured description of liquidity stress scenarios takes place based on
the list of institute-specific liquidity events. A liquidity stress scenario is the “screenplay” for the course of a liquidity crisis: it describes a trigger-event chain of liquidity
events, the timing of the liquidity events’ occurrence and the relationships between
them. The crisis is initiated by a trigger event, followed by a sequence of further
liquidity events. Consider the example of the Lehman Brothers bankruptcy – the
particular event “counterparty bankruptcy” was followed by a “perfect storm” of
distress factors which in turn had a substantial effect on systemic liquidity risk.
Usually a scenario is mapped to only a limited number of liquidity events. In order to
ensure the plausibility, we recommend keeping the scenarios simple. Over-fitted
scenarios which are parameterised by many events are difficult to rationalise and are
not intuitively interpretable.
11
Implementation project
The BearingPoint approach suggests an implementation project according to the
steps below.
FIGURE 7: METHODOLOGICAL STEP-BY-STEP IMPLEMENTATION
Determine the
current situation
Define the
liquidity events
and scenarios
Model and
validate scenarios
Design the
stress tests
Implement
the system and
organise the
reporting
processes
An important first step in the implementation project is the discovery phase, which
focuses on the institute-specific analysis of policies, internal guidelines, processes and
if appropriate the current implementation. The conducted gap analysis is supposed to
identify any deviations with regard to liquidity risk management and stress testing by
comparing the regulatory and internal “to-be” situation, with the present one. An
overview of the bank’s business model and balance sheet should identify any specifics
to be taken into consideration. A detailed project approach and activity planning
needs to occur depending on the discovered gaps, specifics and vulnerabilities.
Fast Fact
The implementation project
incorporates five steps which allow
for the consistent management of
liquidity risk and successful
integration into the client’s risk
framework.
The second step encompasses the definition of liquidity events and the structured
description of liquidity stress scenarios. The consideration of the liquidity clusters’
granularity is crucially important here. BearingPoint’s experience suggests, that as a
good starting point, the bank can consider the granularity level suggested by the LCR
and NSFR regulatory ratios. The granularity, however, ultimately depends on the
specifics of the bank and its business model as well as expert judgment on the matter.
In the following step, the liquidity clusters are modeled and validated. Only liquidity
clusters which fulfill preset materiality conditions are considered. The modeling of
liquidity clusters pertains to the analysis of their time series and, if necessary, the
modeling of distribution parameters. Relevant benchmarks need to be identified and
analyzed by applying appropriate quantitative methods, and the results used in the
modeling and validation of the liquidity clusters. A challenge in the practical implementation is the identification of quantitative models which are robust and stable
over time.
The potential challenge in the next step, is the correct calibration of the liquidity
clusters’ inherent risk factors. The verification and fine-tuning of the risk factor impacts
need to be conducted by expert judgment and documented in detail. Different severity
levels of the stress test scenarios need to be analyzed and considered in the calibration.
The last step focuses on the translation of the functional specifications defined in the
previous steps into technical specifications. Implementation testing as well as user
acceptance tests will take place, ensuring the robustness of the framework.
12
Outlook
Due to its relationship to other components of the governance framework for liquidity
risk, stress testing represents a major and indispensable part of successful liquidity risk
management. It is the centerpiece of liquidity risk management and the results of the
stress tests are used in other aspects of the overall target architecture.
Early Warning Indicators
Stress tests are used in the calibration as well as the verification of the Early Warning
Indicators. The implementation of EWIs is an essential component of the liquidity risk
management target architecture – EWIs are used to identify liquidity shortages early
on. The usefulness and applicability of EWIs are examined under different liquidity
stress scenarios.
Liquidity reserve
The determination of the liquidity reserve is carried out using the stress testing
framework – it is calculated by taking into account the need for liquidity under
stressed conditions. The liquidity reserve must be adequately large to ensure the
survival of the institution in various extreme situations for sufficiently long periods of
time.
Modeling cash flows
The cash flows of products and positions are a crucial input for successful liquidity risk
stress testing. By using the observed past product behaviour and applying modeling
assumptions, the projected flows under business-as-usual conditions are used to
parameterise the stress test scenarios and to simulate stressed conditions.
Concentration risks
Setting the appropriate concentration levels is an important factor in overall
liquidity risk governance: the stress testing results are used in the setting of these
concentration risk limits.
Funds transfer pricing
The MaRisk (BTR 3.1) regulation requires that large financial institutions with complex
business activities maintain a liquidity transfer pricing system in order to internally
assign originated costs and risks. Stress testing is important for the liquidity transfer
pricing system due to the role of the liquidity reserves in the origination of indirect
liquidity costs.
13
Contact
Ralf Kehlenbeck
Partner
+49 172 67 67 362
[email protected]
© 2013 BearingPoint GmbH, Frankfurt/Main. All rights reserved. Printed in the EU. The content of this document is subject to copy right (“Urheberrecht”). Changes, cuts,
enlargements and amendments, any publication, translation or commercial use for the purpose of trainings by third parties requires the prior written consent of BearingPoint GmbH,
Frankfurt/Main. Any copying for personal use is allowed and only under the condition that this copy right annotation (“Urheberrechtsvermerk”) will be mentioned on the copied
documents as well. WP_0839_EN
14
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www.bearingpoint.com

- BearingPoint Deutschland

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