The most severe liquidity crises occur when we have “liquidity black holes”. In a normal market, when prices fall, some people will want to buy. During a serious crisis, many people may want to sell simultaneously. A liquidity black hole results when virtually everyone wants to sell in a falling market.
The crash of October 1987, on the New York Stock Exchange is a good example. Many traders followed a strategy of selling immediately after a price decline and buying back immediately after a price increase. As a result of this strategy called portfolio insurance, the initial decline in prices fuelled off further rounds of price declines and the market plunged sharply. In fact, the market declined so fast and the stock exchange systems were so overloaded that many portfolio insurers were unable to execute the trades generated by their models.
Herd behaviour, which lies at the heart of liquidity black holes, can cause the market to move completely to one side. Hull[1] has listed some of the reasons for herd behaviour:
Different traders use similar computer models and as a result pursue the same strategy. This can create tremendous selling pressure at the same time.
Because they are regulated in the same way, banks respond to changes in volatilities and correlations in the same way.
People start imitating other traders thinking there “must be something in it.”
Let us understand briefly how a uniform regulatory environment, i.e., similar rules for all market participants, may accentuate a liquidity crisis. When volatility increases, value-at-risk (VaR) will increase. Consequently, all banks will be forced to increase their capital.
Alternatively, they will have to reduce their exposure in which case many banks will try to do similar sell trades. In both situations, liquidity needs will suddenly shoot up and a liquidity black hole may result.
For black holes not to happen, at least some of the market participants should pursue contrarian strategies. Investors can often do well by selling assets when most people are buying and by buying assets when most people are selling. One reason for Goldman Sachs’ seemingly smart recovery from the sub prime crisis in the early part of 2009, seems to be this kind of an approach.
Volatilities and correlations may increase but over time, they get pulled back to the long term average. As such, there is no need for long term investors to adjust their positions based on short term market fluctuations. One way forward is for regulators to apply different rules to asset managers and hedge funds. If regulations are different, there will be diversity in the thinking and strategies of different market participants. Consequently, there is less likelihood of black holes developing.
[1] Risk management and Financial Institutions
Showing posts with label Liquidity Risk Management. Show all posts
Showing posts with label Liquidity Risk Management. Show all posts
Saturday, 2 January 2010
Factoring liquidity risk into VAR
Instead of considering liquidity risk separately, it often makes sense to integrate it with market and credit risk. In simple terms, adverse market movements can lead to liquidity problems in terms of funding. If this triggers off asset sales, it leads to asset liquidity problems. Similarly, a lowering of the credit rating may result in the need to deposit more collateral or margin. This in turn may lead to liquidity problems. So liquidity risk must be integrated into VAR models so that risk measures pay sufficient attention to liquidity. A simple way to do this is by looking at a bid-ask spreads.
Bid – ask spreads are driven by:
Order processing costs, which tend to decrease with volumes
Asymmetric information costs
Inventory carrying costs.
High spreads often mean the markets are shallow and liquidity is lacking.
Liquidity adjusted VAR can be calculated by adding sa/2 for each position in the book, where a is the dollar value of the position and s is defined as (offer price – bid price) / mid-price.
Liquidity risk can also be factored into VAR measures by ensuring that the horizon is at least greater than an orderly liquidation period. Generally, the same horizon is applied to all asset classes, even though some assets may be less liquid than others. Alternatively, by increasing the time horizon, the capital requirement can be enhanced. Thanks to more capital, a financial institution will be better placed to deal with a severe liquidity crisis. Sometimes, longer liquidation periods for some assets are taken into account by artificially increasing the volatility. This again leads to a higher capital buffer.
Bid – ask spreads are driven by:
Order processing costs, which tend to decrease with volumes
Asymmetric information costs
Inventory carrying costs.
High spreads often mean the markets are shallow and liquidity is lacking.
Liquidity adjusted VAR can be calculated by adding sa/2 for each position in the book, where a is the dollar value of the position and s is defined as (offer price – bid price) / mid-price.
Liquidity risk can also be factored into VAR measures by ensuring that the horizon is at least greater than an orderly liquidation period. Generally, the same horizon is applied to all asset classes, even though some assets may be less liquid than others. Alternatively, by increasing the time horizon, the capital requirement can be enhanced. Thanks to more capital, a financial institution will be better placed to deal with a severe liquidity crisis. Sometimes, longer liquidation periods for some assets are taken into account by artificially increasing the volatility. This again leads to a higher capital buffer.
Containing liquidity risks: Recommendations of the UK Financial Services Authority
The UK Financial Services Authority has recently come out with detailed guidelines for managing liquidity risk. Measuring and managing bank liquidity risk must receive as much attention as capital/solvency risk management. In the years running up to the recent financial crisis, this was not the case.
Key considerations in liquidity risk management.
§ Liquidity risk has inherently systemic characteristics. The simultaneous attempt by multiple banks to improve their liquidity position can contribute to a generalised collapse of liquidity.
§ Liquidity management has become increasingly complex over time. There is increased reliance on ‘liquidity through marketability’ alongside traditional liquidity through funding access. This makes it difficult to base good liquidity regulation primarily on one or a few standard ratios.
§ There is a tradeoff to be struck. Increased maturity transformation delivers benefits to the non bank sectors of the economy and is favourable to long-term investment. But the greater the aggregate degree of maturity transformation, the more the systemic risks and the more difficult for central banks to address liquidity crises.
Recommendations to deal with liquidity risk:
• There is a need for greater disclosures. For example, firms must be required to provide, for example, detailed maturity ladders, analysis of the assumed liquidity of trading assets, and analysis of off-balance sheet positions with liquidity implications.
• Individual Liquidity Adequacy Assessments (ILAAs) must be carried out for different assets.
• A liquid assets buffer must be maintained, whose minimum value (defined relative to balance sheet size) will be determined for each bank in Individual Liquidity Guidance.
• Firms must quantify and reflect in internal costing systems the liquidity risk created by participation in different categories of activity.
• Regulators must specify some stress tests, rather than leave it entirely to bank internal decisions. Stress tests must consider market-wide events as well as firm specific events.
• There must be a strong focus on the analysis of cross-system liquidity trends, with the publication of a periodic system-wide report.
A new regime
There can be considerable risk both for individual banks and for the system as a whole, if rapid asset growth is funded through increased reliance on potentially unstable funding sources. In the UK, between 2002 and 2007, growth of bank balance sheets was significantly correlated with the % of funding derived from short-term wholesale deposits. The new liquidity regime, should ideally result in:
• less reliance on short term wholesale funding,
• greater emphasis on retail time deposits;
• a higher amount and quality of stocks of liquid assets, including a greater proportion of those assets held in the form of government debt;
• a check on the unsustainable expansion of banking lending during favourable economic times.
These measures will naturally involve a trade off between a cost to the economy during ‘normal times’ and the benefits of the reduced probability of extreme adverse events. Given the scale of the economic fallout from the financial crisis, such a trade-off is justified in order to safeguard future financial stability.
A ‘core funding ratio’ as a prudential and macro-prudential tool.
The FSA has proposed a core funding ratio. Most developed countries have not used standard funding ratios (e.g. loans to deposit ratios) as regulatory tools for many years: but several emerging countries (e.g. Hong Kong and Singapore) have continued to apply regulatory constraints of this nature.
Key considerations in liquidity risk management.
§ Liquidity risk has inherently systemic characteristics. The simultaneous attempt by multiple banks to improve their liquidity position can contribute to a generalised collapse of liquidity.
§ Liquidity management has become increasingly complex over time. There is increased reliance on ‘liquidity through marketability’ alongside traditional liquidity through funding access. This makes it difficult to base good liquidity regulation primarily on one or a few standard ratios.
§ There is a tradeoff to be struck. Increased maturity transformation delivers benefits to the non bank sectors of the economy and is favourable to long-term investment. But the greater the aggregate degree of maturity transformation, the more the systemic risks and the more difficult for central banks to address liquidity crises.
Recommendations to deal with liquidity risk:
• There is a need for greater disclosures. For example, firms must be required to provide, for example, detailed maturity ladders, analysis of the assumed liquidity of trading assets, and analysis of off-balance sheet positions with liquidity implications.
• Individual Liquidity Adequacy Assessments (ILAAs) must be carried out for different assets.
• A liquid assets buffer must be maintained, whose minimum value (defined relative to balance sheet size) will be determined for each bank in Individual Liquidity Guidance.
• Firms must quantify and reflect in internal costing systems the liquidity risk created by participation in different categories of activity.
• Regulators must specify some stress tests, rather than leave it entirely to bank internal decisions. Stress tests must consider market-wide events as well as firm specific events.
• There must be a strong focus on the analysis of cross-system liquidity trends, with the publication of a periodic system-wide report.
A new regime
There can be considerable risk both for individual banks and for the system as a whole, if rapid asset growth is funded through increased reliance on potentially unstable funding sources. In the UK, between 2002 and 2007, growth of bank balance sheets was significantly correlated with the % of funding derived from short-term wholesale deposits. The new liquidity regime, should ideally result in:
• less reliance on short term wholesale funding,
• greater emphasis on retail time deposits;
• a higher amount and quality of stocks of liquid assets, including a greater proportion of those assets held in the form of government debt;
• a check on the unsustainable expansion of banking lending during favourable economic times.
These measures will naturally involve a trade off between a cost to the economy during ‘normal times’ and the benefits of the reduced probability of extreme adverse events. Given the scale of the economic fallout from the financial crisis, such a trade-off is justified in order to safeguard future financial stability.
A ‘core funding ratio’ as a prudential and macro-prudential tool.
The FSA has proposed a core funding ratio. Most developed countries have not used standard funding ratios (e.g. loans to deposit ratios) as regulatory tools for many years: but several emerging countries (e.g. Hong Kong and Singapore) have continued to apply regulatory constraints of this nature.
Types of liquidity risk
There are two types of liquidity risk :
a) Asset Liquidity Risk
b) Funding liquidity risk
Asset liquidity risk is the risk that the liquidation value of the assets may differ significantly from the current mark-to-market values. When unwinding a large position or when the market circumstances are adverse, the liquidation value may fall well below the fair or intrinsic value.
Asset liquidity is low when it is difficult to raise money by selling the asset. This typically happens when selling the asset depresses the sale price. Asset liquidity depends on the relative ease of finding somebody who takes on the other side of the trade. When it is difficult to find such counterparties, liquidity is low. There are three forms of asset liquidity:
v the bid–ask spread, which measures how much traders lose if they sell one unit of an asset and then buy it back right away;
v market depth, which shows how many units traders can sell or buy at the current bid or ask price without moving the price;
v market resiliency, which tells us how long it will take for prices that have temporarily fallen to bounce back. While a single trader might move the price a bit, large price swings occur when “crowded trades” are unwound—that is, when a number of traders attempt to exit from identical positions together.
Funding liquidity risk refers to the inability to meet payment obligations to creditors or investors. Funding liquidity risk can thus take three forms:
v margin/haircut funding risk, or the risk that margins and haircuts will change;
v rollover risk, or the risk that it will be more costly or impossible to roll over short-term borrowing;
v redemption risk.
Most financial institutions fund long term assets with short term sources of funds. This maturity mismatch can lead to problems if depositors/investors start withdrawing their money simultaneously.
Funding liquidity problems also arise because most trading positions are leveraged. Traders post collateral in exchange for cash from a broker. The value of the collateral is constantly marked to market. If this value falls, the market participant may be asked to deposit some additional payment called the variation margin to keep the total amount held above the loan value. Without adequate liquidity to make these margin payments, market participants can find themselves in trouble.
Typically, when a trader, purchases an asset, the trader uses the purchased asset as collateral and borrows (short term) against it. However, the trader cannot borrow the entire price. The difference between the security’s price and its value as collateral is called the margin or haircut. The haircut must be financed by the trader’s own equity capital. Haircuts are adjusted to market conditions on a daily basis. Since traders are leveraged and carry little capital in relation to their assets, increasing the haircut may force them to sell part of their assets when liquidity dries up in the market.
Financial institutions that rely substantially on short-term (commercial) paper or repo contracts have to roll over their debt. An inability to roll over this debt is equivalent to margins increasing to 100 percent, because the firm becomes unable to use the asset as a basis for raising funds. Similarly, withdrawals of demand deposits from an investment fund have the same effect as an increase in margins. When the time is due for redemption or if investors want to make premature withdrawals, banks can find themselves in serious trouble if they do not have adequate liquidity.
a) Asset Liquidity Risk
b) Funding liquidity risk
Asset liquidity risk is the risk that the liquidation value of the assets may differ significantly from the current mark-to-market values. When unwinding a large position or when the market circumstances are adverse, the liquidation value may fall well below the fair or intrinsic value.
Asset liquidity is low when it is difficult to raise money by selling the asset. This typically happens when selling the asset depresses the sale price. Asset liquidity depends on the relative ease of finding somebody who takes on the other side of the trade. When it is difficult to find such counterparties, liquidity is low. There are three forms of asset liquidity:
v the bid–ask spread, which measures how much traders lose if they sell one unit of an asset and then buy it back right away;
v market depth, which shows how many units traders can sell or buy at the current bid or ask price without moving the price;
v market resiliency, which tells us how long it will take for prices that have temporarily fallen to bounce back. While a single trader might move the price a bit, large price swings occur when “crowded trades” are unwound—that is, when a number of traders attempt to exit from identical positions together.
Funding liquidity risk refers to the inability to meet payment obligations to creditors or investors. Funding liquidity risk can thus take three forms:
v margin/haircut funding risk, or the risk that margins and haircuts will change;
v rollover risk, or the risk that it will be more costly or impossible to roll over short-term borrowing;
v redemption risk.
Most financial institutions fund long term assets with short term sources of funds. This maturity mismatch can lead to problems if depositors/investors start withdrawing their money simultaneously.
Funding liquidity problems also arise because most trading positions are leveraged. Traders post collateral in exchange for cash from a broker. The value of the collateral is constantly marked to market. If this value falls, the market participant may be asked to deposit some additional payment called the variation margin to keep the total amount held above the loan value. Without adequate liquidity to make these margin payments, market participants can find themselves in trouble.
Typically, when a trader, purchases an asset, the trader uses the purchased asset as collateral and borrows (short term) against it. However, the trader cannot borrow the entire price. The difference between the security’s price and its value as collateral is called the margin or haircut. The haircut must be financed by the trader’s own equity capital. Haircuts are adjusted to market conditions on a daily basis. Since traders are leveraged and carry little capital in relation to their assets, increasing the haircut may force them to sell part of their assets when liquidity dries up in the market.
Financial institutions that rely substantially on short-term (commercial) paper or repo contracts have to roll over their debt. An inability to roll over this debt is equivalent to margins increasing to 100 percent, because the firm becomes unable to use the asset as a basis for raising funds. Similarly, withdrawals of demand deposits from an investment fund have the same effect as an increase in margins. When the time is due for redemption or if investors want to make premature withdrawals, banks can find themselves in serious trouble if they do not have adequate liquidity.
Understanding liquidity risk
Liquidity risk and other financial risks go together. For example, market risk is the possibility of losses due to fluctuations in interest rates, commodities, stocks and currencies. Managing market risk calls for ongoing adjustments of the exposure depending on the performance of the portfolio. But this adjustment is possible only when a liquid market exists where assets can be bought and sold easily.
Liquidity risk emanates from the liability side when creditors or investors demand their money back. This usually happens after the institution has incurred or is thought to have incurred losses that could threaten its solvency. Problems arise on the asset side when the forced liquidation of assets at distress prices causes substantial losses.
Liquidity risk is more complex than we think. Understanding liquidity risk involves knowledge of market microstructure, which is the study of market clearing mechanisms; optimal trade execution (e.g., minimising trading costs) and asset liability management (matching the values of assets and liabilities on the balance sheet).
Liquidity is crucially dependent on the market conditions and the prevailing sentiments. As Paul McCulley of the CFA Institute ( CFA Institute Reading 53, “The Liquidity Conundrum.”) mentions, “Liquidity is the result of the appetite of investors to underwrite risk and the appetite of savers to provide leverage to investors who want to underwrite risk. The greater the risk appetite, the greater the liquidity and vice versa. Put another way, liquidity is the joining or separating of two states of mind – a leveraged investor who want to underwrite risk and an unleveraged saver who does not want to take risk and who is the source of liquidity to the leveraged investor. The alignment or misalignment of the two investors determines the abundance or shortage of liquidity.”
In his very insightful book, “The Partnership,” consultant Charles Ellis has given an excellent example of liquidity by quoting Bob Mnuchin, a senior leader of Goldman Sachs: “When you can get out a stock that you’re long at a small loss and buy back a stock you’re short at a small loss, that’s an easy decision. It is painful when there isn’t an apparent opportunity to unwind a position or the price moves farther and faster away. Then you hesitate. Then you pray.”
Liquidity risk emanates from the liability side when creditors or investors demand their money back. This usually happens after the institution has incurred or is thought to have incurred losses that could threaten its solvency. Problems arise on the asset side when the forced liquidation of assets at distress prices causes substantial losses.
Liquidity risk is more complex than we think. Understanding liquidity risk involves knowledge of market microstructure, which is the study of market clearing mechanisms; optimal trade execution (e.g., minimising trading costs) and asset liability management (matching the values of assets and liabilities on the balance sheet).
Liquidity is crucially dependent on the market conditions and the prevailing sentiments. As Paul McCulley of the CFA Institute ( CFA Institute Reading 53, “The Liquidity Conundrum.”) mentions, “Liquidity is the result of the appetite of investors to underwrite risk and the appetite of savers to provide leverage to investors who want to underwrite risk. The greater the risk appetite, the greater the liquidity and vice versa. Put another way, liquidity is the joining or separating of two states of mind – a leveraged investor who want to underwrite risk and an unleveraged saver who does not want to take risk and who is the source of liquidity to the leveraged investor. The alignment or misalignment of the two investors determines the abundance or shortage of liquidity.”
In his very insightful book, “The Partnership,” consultant Charles Ellis has given an excellent example of liquidity by quoting Bob Mnuchin, a senior leader of Goldman Sachs: “When you can get out a stock that you’re long at a small loss and buy back a stock you’re short at a small loss, that’s an easy decision. It is painful when there isn’t an apparent opportunity to unwind a position or the price moves farther and faster away. Then you hesitate. Then you pray.”
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