Liquidity RiskA challenging issue for the supervisory community

Gerhard Stahl, BaFin

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Agenda

• History

• CFI and internal models – Where we stand

• Plans for the future – Where to go

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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

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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

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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

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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 II insurers / 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)

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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

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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,….

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What is Risk Management Process about?

OBJECTIVESStrategy and KPIs

TIME COST

EMBED VALUES

Impact

Risks

ERM/CRSA

Threats Opportunities

Management

Identification

Assessment

Review

Risks

Riskpolicy

Peoplebuy-in

CRO

Boardsponsor

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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

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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

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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

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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

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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

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9 Aprildeadline for

the responses to the questionnaire

April - Juneevaluation ofthe responses

December delivery to the

Basel Committee

June - Octoberdrafting 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.

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All models are wrong but some are useful