The Principles of Banking Moorad Choudhry Chapter 12 Principles of Bank Liquidity Management WHUT Robert R. Reitano

Principles of Bank Liquidity Management One Definition of Liquidity: Liquidity for a bank means the ability to meet its financial obligations as they come due. Asset/Liability Mismatches Create Liquidity Risks Banks Require Continuous Ability to Roll-Over Funding Otherwise, long loans/investments are impossible WHUT Robert R. Reitano

Principles of Bank Liquidity Management Elements of Liquidity Risk Management WHUT Robert R. Reitano

Principles of Liquidity Management Sustainable Banking: 9 Principles Fund Illiquid Assets with Core Customer Deposits More stable than wholesale funds Lower risk of withdrawal in downturn If not Available, Fund with Long-Term Wholesale Funding Sources Minimum 1 year Ideally, Suited to maturity of asset WHUT Robert R. Reitano

Principles of Liquidity Management Sustainable Banking: 9 Principles (Cont’d) No Over-Reliance on Wholesale Funding Long-term (>1 year) preferred over short term Author suggests < 20-30% short term funding Note: Borrow Short – Invest Long WHUT Robert R. Reitano

Principles of Liquidity Management Sustainable Banking: 9 Principles (Cont’d) Maintain “Liquidity Buffers” of Instantly Liquid Assets For Firm-specific and industry-wide stresses Example: short-term government bills, CDs, FRNs Low yielding, but cost justified in crisis Establish a Liquidity Contingent Plan Establish borrowing facility at Central bank, etc. Plan must be updated and tested regularly WHUT Robert R. Reitano

Principles of Liquidity Management Sustainable Banking: 9 Principles (Cont’d) Know What Central Bank Facilities are Available Know requirements Test access periodically Be Aware of Bank Liability Exposures Be aware of reputational obligations Lines of credit, lines of liquidity, etc. Liquidity Risk is not a Single Metric Requires an array of metrics (Ch. 13) WHUT Robert R. Reitano

Principles of Liquidity Management Sustainable Banking: 9 Principles (Cont’d) Internal Funding Pricing (Ch. 15 Transfer Pricing) Framework must be set correctly and adequately Inappropriate pricing yields poor business decisions Liquidity Risk Framework “Owned” by the Group Management Board Policy is Centralized All exceptions authorized by Board Board ultimately responsible for funding WHUT Robert R. Reitano

Principles of Liquidity Management Additional Principles All Legal Entities required to be “stand-alone” w.r.t. liquidity and funding Including liquidity contingency plans Maintain high proportion of stable customer funding Understand liquidity of collateral under stressed and normal conditions Les risk if re-collateralized daily WHUT Robert R. Reitano

Principles of Liquidity Management (FSA) Liquidity Stress Tests WHUT Robert R. Reitano

Principles of Liquidity Management Liquidity Risk Drivers: Regulators Approach (FSA) Requires Stress Tests Wholesale Funding Risk Behavioral characteristics during stress test scenarios Intra-Group Funding Risk Must be “Self-Sufficient,” not reliant on Parent Intra-Day Liquidity Risk Concern: Delays from CPY’s payments when stressed Cross-Currency Liquidity Risk Split by currency and tenor WHUT Robert R. Reitano

Principles of Liquidity Management Liquidity Risk Drivers (Cont’d) Retail Funding Risk Varies by bank-customer relationship, account type, etc. Off-Balance Sheet Liquidity Risk Contingent liabilities, lines-of-credit, liquidity facilities Franchise Viability Liquidity Risk Ability of bank to delay obligations Marketable/Non-Marketable Asset Risk Ability to use as collateral, to liquidate, etc. WHUT Robert R. Reitano

Principles of Liquidity Management Liquidity Policy Governance Structure WHUT Robert R. Reitano

Principles of Liquidity Management Liquidity Policy Statement WHUT Robert R. Reitano

Principles of Liquidity Management Liquidity Policy Statement WHUT Robert R. Reitano

Principles of Liquidity Management The Liquidity Asset Buffer (“LAB”) Guidelines from European Supervisors Covers additional needs under stressed conditions Use 3 stress tests – loss of rollovers, liquidity loss Survival period >1 month Cash, core assets (CB eligible and highly liquid) Manage liquid assets to be ever available Locate and size buffers to be adequate to bank BUs WHUT Robert R. Reitano

Principles of Liquidity Management The Liquidity Asset Buffer (“LAB”) Definition of “Liquid” Convertible to Cash Quickly and Easily, With no Loss of Value Proxies: Bid-offer spread Price “error” – market versus model proce Number of market-makers Size and depth of asset class WHUT Robert R. Reitano

Principles of Liquidity Management The Liquidity Asset Buffer (“LAB”) Securities in the LAB Highly liquid, high-quality Government debt Reserves in Central Banks Bonds issued by multilateral development banks Two Tiers Recognized by UK FSA Sovereign securities Agency securities, corporates AA-/Aa3, secured bonds WHUT Robert R. Reitano

Principles of Liquidity Management The Liquidity Asset Buffer Cost Calculation WHUT Robert R. Reitano