1. LIQUIDITY STRESS TESTING Prepared for COMESA Workshop on Financial Stability 24 th August to 1 st September 2015

2. Session Objectives Understand key drivers of liquidity stress Provide an overview of liquidity risk measurement indicators Identify issues that are important for liquidity stress design 8/28/2015 Liquidity Stress Testing 2

3. INTRODUCTION Liquidity stress testing has become very important tool for the Supervisor in recent times Case studies have shown that it can materialize very fast and translate into solvency risk Northern Rock (2008) Lehman Brothers (2008) The Basel Committee on Banking Supervision responded by introducing two new ratios The Liquidity Coverage Ratio (LCR) The Net Stable Funding Ratio (NSFR) 8/28/2015 Liquidity Stress Testing 3

4. INTRODUCTION Computation of these ratios provides a better understanding of key drivers of liquidity stress Some of the tests being designed will address major sources of funding in banking sector. Retail Funding Simulated Bank run test Withdrawals by large depositors Wholesale Funding Non-Resident Funding Non Bank Financial Institutions 8/28/2015 Liquidity Stress Testing 4

5. SOURCES OF LIQUIDITY STRESS Scheduled contractual gross cash outflows Counterparty runs (deposit runs, cash hoarding) Lost access to funding Run off Haircut increases Closure of interbank market credit Failure in payment systems settlement 8/28/2015 Liquidity Stress Testing 5

6. SOURCES OF LIQUIDITY STRESS Correlation shocks to prices and bid-ask spreads Signaling Discretional cash flows to customers Requirement to always pass liquidity stress test! 8/28/2015 Liquidity Stress Testing 6

7. TIERED LIQUIDITY SOURCES Unencumbered assets (cash, pledge able assets)Rolled over and new fundingEmergency cash capital infusionsFire sales 8/28/2015 Liquidity Stress Testing 7

8. TIERED LIQUIDITY SOURCES Merger NationalizationFailure resolution liquidity 8/28/2015 Liquidity Stress Testing 8

9. LIQUIDITY ALERTS Unencumbered assets may be false Funding markets can close due to adverse selection Contractual claims to cash can fail Cash hoarding has network externalities 8/28/2015 Liquidity Stress Testing 9

10. LIQUIDITY COVERAGE RATIO Cash Inflows Loans and advances maturing in 30 days Due from Financial Institutions Cash outflows Demand and savings deposits Time deposits Due to Financial Institutions Stock of High Quality Liquid Assets Cash, balances with Central Bank, government securities 8/28/2015 Liquidity Stress Testing 10

11. LIQUIDITY COVERAGE RATIO Total net cash outflows = Total cash outflows minus min [total cash inflows, 75% of gross outflows] Liquidity coverage ratio = (Total value of stock of high quality liquid assets / Net cash outflows) Check LCR by significant currency 8/28/2015 Liquidity Stress Testing 11

12. LIQUIDITY COVERAGE RATIO LCR ALERTS LCR test is done on over 30 day period not before Nor hair cut on “liquid” government securities Run off rate for stable deposits is small Repos are assumed not to fail 8/28/2015 Liquidity Stress Testing 12

13. NET STABLE FUNDING RATIO Available Stable Funding (Sources) Capital and Reserves (100%) Demand and savings deposits (95%) Time deposits with maturity greater than one year (90%) Balances due to banks greater than one year (90%) Balances due to Central Bank greater than on year (90%) Required Stable Funding (Uses) Marketable securities maturing in less than one year (5%) Investment securities maturing in less than one year (15%) Loans and advances maturing in less than 6 months (15%) 8/28/2015 Liquidity Stress Testing 13

14. Required Stable Funding Due from banks and non banks with maturity greater than one year (50%) Loans and advances with maturity of 6 months to one year (50%) Other assets with maturity less than one year (50%) NSFR = Total Available Stable Funding/Required Stable Funding 8/28/2015 Liquidity Stress Testing 14 NET STABLE FUNDING RATIO

15. FRAMEWORK Objective of a liquidity stress test is to: Identify key risk factors affecting assets and liabilities Design scenarios which align with assets and liabilities Test the resilience of funding sources under idiosyncratic and systemic events Framework suggested by Tata Consultancy Services (TCS) consists of four stages: Assess Identify Build and execute Quantify and control 8/28/2015 Liquidity Stress Testing 15

16. FRAMEWORK 8/28/2015 Liquidity Stress Testing 16 Source: Tata Consultancy Services (2013)

17. FRAMEWORK Assess Understand composition of balance sheet Assets and liabilities differ for each institution Concentration of funding sources needs to be analyzed Retail Funding Wholesale funding Structured funding Larger haircuts may be required for sensitive and more complex funding sources 8/28/2015 Liquidity Stress Testing 17

18. FRAMEWORK Identify What are the key liquidity risk drivers affecting the balance sheet? Risk factors to be considered for liquidity crisis are many Market risk Credit risk Operational risk Choose factor that explains most of the historically observed liquidity risk scenarios 8/28/2015 Liquidity Stress Testing 18

19. FRAMEWORK General Market Factors GDP Inflation Interest rates Exchange Rates Credit Spreads Bank Specific Factors Increase in roll over of loans Impairment in roll over of liabilities Reduced funding sources Change in behavior profile of assets and liabilities Systemic Disruptive events Full blown recession Fall of government Major devaluation of currency Failure of large institutions Historic market disruptive events Build and Execute Consider both idiosyncratic and system wide stress 8/28/2015 Liquidity Stress Testing 19

20. Quantify and control Apply different scenarios and identify those that produce negative cashflows Need for plan of action to counterbalance these actions Banks should have sufficient High Quality Liquid Assets (HQLA) to counter each scenario FRAMEWORK 8/28/2015 Liquidity Stress Testing 20

21. REFERENCES BCBS (2013), “Liquidity Stress Testing: A survey of theory, empirics and current industry and supervisory practices”, Working Paper No.24 Darrell Duffie (2012), “Liquidity and stress testing”, Financial Advisory Round Table, Federal Reserve Bank of New York Tata Consultancy Services (2013), “A stress testing framework for liquidity risk” 8/28/2015 Liquidity Stress Testing 21