Ch6 Liquidity and Operational Risk

Liquidity risk In finance, 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).

Types of liquidity risk Market 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:  Widening bid/offer spread  Making explicit liquidity reserves  Lengthening holding period for VaR calculationsVaR Funding liquidity – Risk that liabilities:  Cannot be met when they fall due  Can only be met at an uneconomic price  Can be name-specific or systemic

Liquidity crises Liquidity problems can have an adverse impact on a bank’s earnings & capital &, in extreme circumstances, may even lead to the collapse of a bank which is otherwise solvent. A liquidity crisis be setting individual banks may have systemic consequences for other banks & the banking system as a whole. A liquidity crisis could also affect the proper functioning of payment systems & other financial markets.

Liquidity crises When a bank in difficulty fails to honour its obligations to other banks, thereby causing difficulties for those banks in turn. Sound liquidity management is therefore pivotal to the viability of every bank & the maintenance of overall banking stability.

6 Liquidity crunch can be a real problem Example of Financial Crisis in Turkey  Islamic financial institutions there faced sever liquidity problems  One Islamic institution Ihlas Finans was closed during the crisis Example of the 2007–08 financial crisis  Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.=>funding liquidity risk  Lehman brothers are unable to meet their payment obligations, borrow funds in the market at a good price on a regular basis, to fund actual or proposed commitments or to liquidate assets.=>funding liquidity risk

Measures of liquidity risk Liquidity gap  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. Liquidity risk elasticity  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.  For banks, it would be measured as a spread over LIBOR

Measures of asset liquidity Bid-offer spread  is also known as bid–ask or buy–sell spread  For example, if the bid price is $20 and the ask price is $21 then the "bid-ask spread" is $1.  The size of the spread from one asset to another will differ mainly because of the difference in liquidity of each asset.  The smaller the ratio the more liquid the asset is.  Currency is considered the most liquid asset in the world (the bid-ask spread in the currency market is one of the smallest)  On the other hand, less liquid assets such as a small-cap stock may have spreads

Measures of asset liquidity Market depth  the amount of an asset that can be bought and sold at various bid-ask spreads.  Market depth is closely related to liquidity and volume within a security Immediacy  the time needed to successfully trade a certain amount of an asset at a prescribed cost.

Managing liquidity risk Liquidity-adjusted value at risk  Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk (VaR).  It can be defined at VaR + ELC (Exogenous Liquidity Cost).  The ELC is the worst expected half-spread at a particular confidence level.

Operational Risk

12 Basle Operational Risk Definition/ Framework The Basel II Committee defines operational risk as: The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events  This definition includes legal risk  Strategic and reputational risk are excluded

13 Basle Operational Risk Definition/ Framework The following lists the Basel II defines the seven event types with some examples for each category: Operational Risk is not:  All risk other than credit and market  Only systems & IT related

14 Examples of Operational Loss Events in Banking Internal Fraud:  misappropriation of assets, tax evasion, intentional mismarking of positions, bribery  Allied Irish Bank, Barings, and Daiwa Bank Ltd - $691 million, $1 billion, and $1.4 billion, respectively - fraudulent trading. External Fraud:  theft of information, hacking damage, third-party theft and forgery  Republic New York Corp. - $611 million - fraud committed by custodial client.

15 Examples of Operational Loss Events in Banking continued... Employment Practices and Workplace Safety: discrimination, workers compensation, employee health and safety Merrill Lynch - $250 million - legal settlement regarding gender discrimination. Clients, Products & Business Practices: market manipulation, antitrust, improper trade, product defects, account churning Household International - $484 million- improper lending practices Providian Financial Corp. - $405 million- improper sales and billing practices.

16 Examples of Operational Loss Events Damage to Physical Assets:  natural disasters, terrorism  Bank of New York - $140 million - damage to facilities related to September 11, Business Disruption and System Failures:  utility disruptions, software failures, hardware failures  Solomon Brothers - $303 million - change in computer technology resulted in “unreconciled balances”

17 Examples of Operational Loss Events continued... Execution, Delivery & Process Management:  data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets  Bank of America and Wells Fargo Bank - $ 225 million and $150 million, respectively - systems integration failures/failed transaction processing.

18 Bank’s Recognize the Significance of Operational Risk More than 100 losses exceeding $100 Million over the last decade Large banks recognize the importance/ magnitude of operational risk:  Based on recent Basle survey, on average they hold 15% of their capital for Operational Risk.  Per their Annual Reports, Deutsche Bank and JPM are holding €2.5B and $5.8B for operational risk.

19 Rationale Banks Cite for Quantifying Operational Risk Operational failures negatively impact profitability  Banks that measure and manage operational risk can reduce earnings volatility  Banks that measure and manage operational risk can reduce likelihood of an operational event becoming a “capital event” Businesses are more complex, changing rapidly, operationally intensive, and technology reliant

Methods of operational risk management Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk Basic Indicator Approach - based on annual revenue of the Financial Institution Standardized Approach - based on annual revenue of each of the broad business lines of the Financial Institution Advanced Measurement Approaches - based on the internally developed risk measurement framework of the bank adhering to the standards prescribed

Methods of operational risk management