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Hermes’ Staff – Perspectives on Liquidity Risk

Nick Scott and Steven Claxton

Part I

Tacoma Narrows Bridge (1940)

Bridge Collapse in Minneapolis (August 2007)

Bank Balance Sheet

Notes to the Accounts

Illustrative Maturity Profile for Banks

<1 year 1 to 5 years > 5 years

Dol

lar

Val

ue

Contractual Maturity

Assets Liabilities

Source: NAB

Illustrative Maturity Profile for General Insurers

<1 year 1 to 5 years > 5 years

Dol

lar

Val

ue

Contractual Maturity

Assets Liabilities*

Source: NAB

• Liquidity resources of much of the banking system was inadequate

• Central bank backstop function was tested

• Cash rich non-financial corporates and insurers survived with no central bank support

2008-2009 Financial Crisis

• The practice of borrowing short-term and lending long-term

• Like alchemy, it doesn’t work

• Inherent Fragility: A well-capitalised firm faces a non-zero probability of ruin over a short-term horizon

“Maturity Transformation (MT)”

• Bids down the price of illiquid assets and value of economic liquidity

• Discourages economic incentives to provide more stable liquidity solutions (e.g. transfer and exchange mechanisms)

• Dampens market-based signals for controlling the credit growth cycle

Other Downsides of MT

• Liquidity assessment: strong to weak depending on need for central bank support

• Survival periods of 12-24 months

• Comprehensive stress scenarios to identify full range of contingent liabilities

Rating Agencies

-

50

100

150

200

250

300

350

400

Jun 06 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11

bps

3yr IG Corporate Loans 3yr Major Banks Bond Issuances 3yr Bank CDS Spread

Bond Markets Reaction

Source: NAB

• Liquidity ratio for 30 day stress scenario; funding ratio for 12 month period

• Hierarchy of “stickiness”: extremely favorable towards retail demand deposits

• Negative spread on government securities becomes the “regulatory cost of liquidity”

Basel Committee and APRA

Part II

Early Accounting

Modern Accounting

What Financial Reporting Misses

• Firms with high MT more risk higher capital cost lower value

• Cost of refinancing risk over mismatched periods (time value of funding shortfalls)

• Highly positive correlation between stresses on both sides of the balance sheet

Towards a New Standard

• Focus on contractual cashflows

• Unmatched assets have a liquidity-adjusted value (LAV)

• Value of liabilities includes refinancing costs

Steps

• Step 1: Plot out contractual cash inflows and outflows

• Step 2: Project contingent inflows and outflows based on legal obligations

• Step 3: Match up the inflows and outflows

• Step 4: Model the cost of matching cashflows

Model Basics

• The modeling of matched cashflows recognises contractual outflows can either be met with asset sales or refinancing

• Fire-sale asset values are a function of their market price volatility

• Cost of refinancing is a function of a credit spread curve

• Simulated random failure times for unmatched cash outflows

Model Outcomes

• Assets subject to funding gaps are adjusted below their credit risk-adjusted discounted value to account for liquidity

• Economic signal rewarding strongly matched firms

• Risk-based approach reconciles MtM and HTM accounting

Part III

• Establish and quantify firm-wide liquidity risk appetite

• Transfer funding costs internally based on matched maturity marginal (MMM) cost of funds

• Recognise profit generated from maturity mismatches (credit curve) after liquidity risk expires

Disciplined Pricing

• Banks pool credit risk, provide credit diversification and allow weaker counterparties to borrow

• Banks assist stronger firms raise capital market finance

• Specialisation of skills is productive: banks underwrite credit risk; Insurers underwrite property, casualty, mortality, morbidity, and longevity risk

What Works in Financial Services

• There are very few self-liquidating assets (Trade finance is an exception)

• Liquidity backstops are part of a firm’s capital structure

• Liquidity backstop providers are de-facto economic owners on a risk-adjusted basis

What We Know

• Growth in liquidity transfers that allow liquidity-rich and low-MT firms to provide liquidity during stress scenarios

• Banking services based on economic liquidity needs with special purpose withdrawal and call features

• Originate, distribute and mitigate (ODM) models

Towards Financial Stability