Liquidity Risk A challenging issue for the supervisory community 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 Liquidity Risk – What happened so far? History From supervisory side: Basel paper of 2000 Joint Forum exercise 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 banking side: IIF 44 recommendations

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 Modeling Liquidity Risk Metallgesellschaft (Miller vs. Ross) S&L Crisis Liquidity risk is of 2nd order Data quality (better then CR worse then MR) LIqVaR ARIMA modeling unscheduled payments

Liquidity Risk | Seite 6 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 7 What is a good measure of risk? 1.SM are weakly coherent 2.Backtest-ability 3.Clear substantial meaning 4.Robustness 5. good scaling behavior (time, level of significance, portfolios,...) - risk silos, different users 6.Valuation of assets is key (marked to market, marked to model, best estimate,…) 7.Multi-period vs. one-period models 8.USE TEST

Liquidity Risk | Seite 8 Economic Capital – Stakeholders Bondholders Shareholders Regulators Rating agencies Managers - different time horizons(!!) - different levels of significance (!) - complexity of the firm, e.g. a holding (!!!) => copula, consistent modeling,….

Liquidity Risk | Seite 9 What is Risk Management Process about? 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 10 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 11 A brief outline of the work I Objectives – what do the standards seek to achieve:  Level of resilience to risk  Externalities/market failures addressed 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 12 A brief outline of the work II 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 13 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 14 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 15 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 16 All models are wrong but some are useful