ALDO SOPRANO is Head of Group Price Control at Unicredit and prior to that was in charge of Short Term Liquidity Risks and Operational Risk Management. He worked at Barclays Capital in London, served on the board of Pioneer Alternative Investments and Chaired the IIF working group on operational risks and is Board member of UniCredit Bank Ireland. He is the author of articles on risk management and presents at international conferences.
Funding liquidity risk differs at a glance from the more generic liquidity risk, for it is intended as a measurement of immediate survival risk, the possibility that in the days or weeks to come a company might fail in its financial payment obligations. It is a kind of binary risk, and is mostly focused on the closest time maturities. This chapter is thus central for understanding and assessing funding liquidity risk. It presents the cash flow ladder, the survival method applied by treasuries to check inflows and outflows. It moves on to Basel 3's Liquidity Coverage Ratio analysis, also meant for shortest term control. Then, different indicators or sensors of liquidity are presented, taken from internal and external market sources, aiming to measure the temperature of funding liquidity and possibly anticipate anomalies and future difficulties in refinancing. Such exposures are mostly driven by intraday payment flows, and this is covered in a dedicated section. This chapter on funding liquidity risk management closes with an analysis of sources of liquidity and their concentration.
2.1 CASH FLOW LADDER
Liquidity risk measurement can be split into two components: the short-term one for refinancing contractual obligations up to one year and which is focused on the most immediate of those - overnight, one week or 30 days, or two or three months - is the focus of this chapter as the risk measurement methodologies differ substantially from those for long-term liquidity, discussed in Chapter 3. The long-term liquidity risk must consider and measure the sustainability of a bank over a longer time frame of five to ten years, thus giving consideration and actions a more strategic stance. Short-term liquidity risk of up to one year and mostly focusing on three months will deal with the immediate necessity of raising funds to meet contractual obligations maturing in such limited time available and typically will require the warehousing of securities or of other emergency funding.
Cash flows are therefore crucial to control and manage short-term liquidity risk. Contractual maturity mismatch identifies the gaps between the contractual inflows and outflows of liquidity for given time bands. The maturity gaps indicate how much liquidity a bank would have to ensure in each of these time bands if all outflows occurred at the earliest possible date. In managing short-term liquidity risk, commonly a bank treasury uses the cash flow ladder, or just simply the liquidity ladder (see Figure 2.1), where contractual cash and security inflows and outflows from on- and off-balance-sheet items are mapped to set time buckets.
Figure 2.1 Liquidity ladder structure.
Source: The author.
Some indications of the ladder components are provided in the new Basel accord and other regulatory documents, as presented in Chapter 1. There isn't a definitive structure and methodology, however some core elements are the same and are held in common among different approaches. Given the scope of the short-term ladder to allow treasury and risk management a view on the next payments due or expected, in order to address adequate funding needs our approach is to identify all the key elements one needs to take into account; thus, we present and describe how to model:
- Contractual maturing obligations, in and out cash flows.
- Rules for mapping flows on the maturity ladder.
- Flows without contractual certainty.
- Unexpected cash flows.
- Funds available for refinancing.
- Fund transferability.
- Total ladder construction.
The short-term ladder components are presented in Figure 2.1. I suggest that the cash flow ladder should be updated at least daily, possibly at same-day closing. Intraday updates may be beneficial, especially in difficult market conditions.
A bank should report contractual cash and security flows in the relevant time buckets based on residual contractual maturity. A more articulated and detailed time bucket structure will provide a precise cash flow position; given the daily or intraday monitoring required by the treasury, one should have a granular representation for the closest maturity (one or two weeks). A detailed interval structure up to one year, updated daily, will be important for monitoring and managing flow dynamics. One could possibly include cash flows for overnight and for each day until the end of the week, then two weeks and monthly to half year; then a quarterly bucketing would be sufficient.
Instruments that have no specific maturity, such as share capital, should be reported separately, with details on the instruments and no assumptions applied to maturity. Information on possible cash flows arising from derivatives such as interest rate swaps and options should also be included to the extent that their contractual maturities are relevant. Some additional accounting information, such as capital or non-performing loans, may be reported separately. An exemplificative ladder is presented in Table 2.1.
Table 2.1 Mapping cash flows into the liquidity ladder. Data in millions - imaginary Bank Alpha T+1 T+2 1W 2W 1M 2M 3M 4M 5M 6M 12M Primary Gap
2.82 3.80 -0.25 -9.18 -27.30 -37.82 -42.51 -43.77 -42.02 -42.68 -45.41 Eligible Securities
55.02 53.17 55.13 55.38 64.14 64.26 66.18 65.84 63.54 61.95 48.64 Marketable Securities
8.22 7.94 8.24 8.28 9.58 9.60 9.89 9.84 9.49 9.26 7.27 Cumulative Gap 66.07 64.91 63.11 54.48 46.42 36.05 33.56 31.90 31.01 28.53 10.50
Source: The author.
2.1.1 Contractual cash flows
Contractual cash flow mapping rules are the foundations of the ladder, whether assumptions of rollover are accepted or hindered (Basel 3 proposals allow liability but hamper the assets, therefore considering term deposits beneficial and renewal of financing uncertain).
Contingent liability exposures - such as contracts with triggers based on a change in price of financial instruments or a downgrade in credit rating - need to be individually assessed. The cash flow ladder is preferably built on contractual maturities for operative reasons, so the treasury can precisely manage funding. Contractual maturity mismatches do not capture outflows that a bank may make in order to protect its franchise, even where contractually there is no obligation to do so. Banks should conduct their own maturity mismatch analyses, based on assumptions of the inflows and outflows of funds in both normal and stress conditions.
When there are material changes to the company or to the business models, it is crucial to forecast cash flow reports as part of the assessment (i.e. in the case of major acquisitions or mergers or the launch of new products).
2.1.2 Rules for mapping flows on the maturity ladder
The ladder will have a substantially different shape depending on the set time buckets' granularity. For funding liquidity, greater attention should be paid to the closest deadlines, such as overnight and one day to one week. We might find it useful to maintain such a daily breakdown for ten working days and then move onto a week to one month, and from then onwards have a monthly bucket ladder. Indications have been given by regulators and most banks tend to follow a ladder with buckets daily to one week, then on to a monthly one until three months, and from there quarterly until one year - considered the separating point of short to medium long-term funding profiles. Such a decision is often driven by data availability, as per the representation this is also a matter of managerial needs: so whether one keeps a monthly deadline to one year or quarterly will not make a great difference. I prefer and suggest a daily bucket until ten working days and then monthly until eighteen months: this way the rollout dynamic is easier to monitor. One important aspect is the flow mapping when this falls between set time buckets: as an interpolation will not be needed for short-term funding risk control and management, unlike interest rate risk sensitivity, we can follow the rule of assigning the flow to the nearest next maturity interval in full.
2.1.3 Flows without contractual certainty
In banks there are flows with contractual maturity, such as term deposits or repos, addressed in previous sections. There are also cash flows that will occur with certainty and need the bank's timely forecast and planning (e.g. tax payments, predictable but not easily allowing a certain ex/ante flow placing in the...