Liquidity Risk Gerhard Stahl, BaFin

Liquidity Risk | Seite 2 Agenda History CFI and internal models – Where we stand Plans for the future – Where to go

Liquidity Risk | Seite 3 Why Liquidity Matters Metallgesellschaft (Miller vs. Ross) S&L Crisis New Complex Instruments (IIF) => importance Central function for liquidity management (IIF) Liquidity risk is of 2nd order (overlap to other risk categories; e.g. operational risk) => difficult to define, regulate, etc.

Liquidity Risk | Seite 4 Spot Futures, FRA‘s Swaps Options Exotics, Structured Deals Structured credit, credit derivatives Gapping & Duration MtM & modified duration First-order Sensitivities Volatility, delta, gamma, vega, theta Correlations, basis risk Model risk (inc. smiles, calibration) CFI and Internal Models

Liquidity Risk | Seite 5 Liquidity Risk – What has happened so far? History From supervisory side: Basel paper of 2000 Joint Forum exercise (banks, insurances, ucits) European stock takings via the Groupe de Contact Stock take of the ECB, via the Banking Supervision Committee, on mainly macro prudential aspects of Liquidity Risk National authorities: OCC, FSA, BaFin (internal models), … Pillar II issue under Basel II From industry side: IIF 44 recommendations

Liquidity Risk | Seite 6 The Basel approach on liquidity Berlin meeting in May 2006 – Committee should exercise an „intelligent“ stock take on current liquidity regimes of Members December meeting 2006 – final agreement on establishing the Working Group on Liquidity Tough time table – stock take to be finished until the end of 2007 First meeting in January Drafting session for the Questionnaire  Questionnaire fully taken over by Groupe de Contact  Questions of other groups considered  No double work

Liquidity Risk | Seite 7 A brief outline of the work Objectives – what do the standards seek to achieve: level of resilience to risk  Externalities/market failures addressed Outreach of the G10: Australia, China, Hong-Kong, Singapore Practice – what standards are applied and how  ‘Pillar 1 approaches’ – quantitative standards  ‘Pillar 2 approaches’ – qualitative standards  Validation of firms risk management/modeling  ‘Pillar 3 approaches’ – Disclosure requirements  Interaction with capital requirements

Liquidity Risk | Seite 8 A brief outline of the work cont. Experience with application of standards  For domestic firms  For branches, subsidiaries, and cross-border firms Relationship with other financial infrastructure (“context”)  General supervisory approach  Central bank operations and policies  Payment system design  Collateral management  Capital requirements  Structure of domestic and (relevant parts of) international banking system  Asset market dynamics  Credit risk transfer markets

Liquidity Risk | Seite 9 Deliverables Better understanding of the outcome delivered by current liquidity regimes for domestic and cross-border firms To provide the Committee with an analysis of:  the reasons for the current diversity of approach  the advantages and disadvantages of diversity  an assessment of options for future work

Liquidity Risk | Seite 10 Work streams and literature survey What are the diverse standards trying to achieve? How much underlying uniformity is there? How is context (e.g. structure of banking sector, central bank policy, design of payment system) influencing regimes? How has the changing financial system affected liquidity risk? Analysis of consequences of diversity  For firms  For ‘day-to-day’ supervision (resilience to mild stress)  For crisis management (resilience to extreme stress) Literature survey to complete the picture from the scientific point of view

Liquidity Risk | Seite 11 Why principles based regulation is non-trivial Definition of LiR and RMP definitions on LiR are broadly consistent to meet obligations when they fall due at reasonable costs embedding in the RMP However: even if def. are app. the same, details are treated differently;

Liquidity Risk | Seite 12 Example quant. regimes Six countries do not apply quant. Regimes Those who utilize ratios 1. all countries use different ratios 2.Sig. difference in terms of behavioral ass. for savings 3.Differences in treatment of committed facilities 4.Only a few countries incorporated margin calls 5.Differences in valuation methods, accounting, mtm 6.Different haircuts 7.Etc….

Liquidity Risk | Seite 13 9 April deadline for the responses to the questionnaire April - June evaluation of the responses December delivery to the Basel Committee June - October drafting of the report nearly parallel timetable of GdC‘s Liquidity Task Force Timeline Work on Liquidity Risk The Basel Committee has to decide, whether further work on liquidity risk will be treated within the Basel context.

Liquidity Risk | Seite 14 Basel II & Solvency II: Similarities and Differences Similarities / Synergies similar products: structured products interest rate and credit derivatives similar tools and models: market risk (Black-Karasinski) credit risk (CreditMetrics) Banks / Basel IIinsurers / Solvency II input-oriented partial models (market and ratings) shorter horizons aggregation of risk numbers in market risk: thousands of risk drivers or simple „earnings at risk” absolute risk measure output-oriented holistic modeling longer horizons aggregation of distributions King’s road: small number of accumulation events, which explain losses at the group level risk relative to a benchmark (RNP)

Liquidity Risk | Seite 15 LiQR and the Risk Management Process OBJECTIVES Strategy and KPIs TIMECOST EMBEDVALUES Impact Risks ERM/CRSA Threats Opportunities Management Identification Assessment Review Risks Risk policy People buy-in CRO Board sponsor

Liquidity Risk | Seite 16 Liquidity Risk and models Data quality (better then CR worse then MR) Cash Flow is a output-oriented approach; no exploratory variables => principles not rules, uncertainty about model error, close to Solvency II Different FX regimes => no single numeraire => liq. Assumption in VaR models CFI call for centralization => pooling,

Liquidity Risk | Seite 17 Variable of interest: FLE-CBC LIqVaR: reluctance of the industry ARIMA modeling unscheduled payments