Liquid Asset Buffer Management Stephen Temple January 2019
Key Themes 1. Where have we come from 2. Evolution of Liquid Asset Buffers post crisis 3. Constructing a Liquid Asset Buffer (LAB) 4. Conclusion The destruction of the inducement to invest by an excessive liquidity-preference was the outstanding evil, the prime impediment to the growth of wealth, in the ancient and medieval worlds. John Maynard Keynes 2
The Evolution of Liquidity Risk Regulation July 2008: Deterioration in wholesale funding markets for UK Oct 2014: banks Final European Sep - Dec LCR rules 2021: NSFR is 2008: HBOS Dec 2009: Apr 2007: Oct 2015: LCR expected to be published experiences Basel First signs of becomes the implemented in significant consultation stress in the PRA’s regulatory Europe outflows LCR and US sub- liquidity stress test NSFR begins prime market (Basel 3) 2008 2009 2010 2015 2016 2017 2021 2007 Sep 2008: Lehman Sep 2007: Northern Brothers collapse Rock emergency liquidity assistance made public leading Dec 2009: to a run on deposits FSA liquidity stress tests introduced (ILG) 3
What Has New Regulation Meant for Bank Balance Sheets? Sterling liquid assets relative to total asset holdings of UK banking sector – Liquidity management existed before the crisis 30% but in a very different form 27% 24% – Liquid Asset Buffer requirements are driven by 21% 18% internal and regulatory liquidity stress tests 15% 12% – Now a meaningful part of a bank balance 9% sheet 6% 3% 0% – Funding costs associated with liquidity buffer Year 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017 needs are high % of Total Assets Source: Bank of England – Emergence of a dedicated investment function UK Bank 5 Year CDS Spreads (funding cost 450.0 to manage liquid assets and associated market proxy) 400.0 liquidity 350.0 300.0 – Activities governed by specific legislation but 250.0 200.0 also firm specific risk appetite leading to 150.0 unique, proprietary approaches 100.0 50.0 0.0 RBS BARCLAYS LLOYDS SANUK Source: Bloomberg 4
Evolution of Eligible Assets EBA’ LCR EBA’s PRA ILG LCR delegated Asset type BCBS LCR empirical LCR recommendat act (BIPRU 12) findings ion 2010 Jan-13 Dec-13 Dec-13 Oct-14 � Central bank reserves 1 1 1 1 � Notes and coins 1 1 1 1 � Government debt 1 1 1 1 � Central bank debt 1 - 1 1 � Supranational/Sub-Sovereign/Agency 1 2A 1 1 Regional govt. / local authority debt backed by � 1 2A 2A 1 central govt. � Covered bonds > €500m, AA-, OC 2% 2A 1 2A 1 � Covered bonds > €250m, A-, OC 7% - 2A 2A 2A � RMBS 2B 2B 2B 2B � Auto-loan ABS - - - 2B � Consumer lending / credit card ABS - - - 2B � Corporate bonds - - - 2B � Equities - - - 2B � Restricted-use central bank facilities - - - 2B – Range of assets has broadened over time – some super equivalence in the UK initially – Risk appetite means that the majority of liquidity pools are concentrated in Level 1 assets. More limited investment in level 2A and 2B assets – Risk appetite, return and liquidity haircuts drive portfolio mix decisions 5
Liquid Asset Buffer Construction – Confluence of Risk Appetites Price Price Stability Stability Market Market Haircuts Haircuts Depth and Depth and Liquidity Liquidity Liquidity Risk Capital Capital Minimum Minimum Appetite Committe Committe Rating Rating d (VaR) d (VaR) Criteria Criteria Capital Capital Market Risk Credit Risk Risk Risk Ratio Ratio Appetite Appetite Weighted Weighted Volatility Volatility (AFS (AFS Assets Assets reserves) reserves) Other Other Asset Asset considerations: considerations: Portfolio Portfolio Class Class • Environmental, • Environmental, Diversifica Diversifica Restrictio Restrictio Social and Social and tion tion ns ns Governance Governance (ESG) (ESG) • Geopolitical • Geopolitical Risks Risks 6
Liquidity Risk: Liquid Asset Buffer Construction is not only about return Rank on Rank on Return over Liquidity Indicative Return LCR RoC (%) Return Rank on Asset SONIA (bps) Haircuts (%) Capital Reqt. (%) on Category (A-B(D))/C on Liquidity* A B C Leverag Capital e UK Gilt 9y 1 10 0 1.34 7 5 5 2 US Treasury 7y 1 32 0 1.36 23 3 3 1 European SSA 1 20 0 1.19 33 1 4 3 7y European Covered Bond 1/2A 69 7-15 1.75 32 2 2 4 7y D = Cost of funding UK Prime Worst outcome 2B 100 25 3.38 23 3 1 5 *Cost of immediate liquidation RMBS 3y Best outcome 0.60 Gilt 0.50 SSA 0.40 Covered Liquidity Cost Cost of liquidation 0.30 highly correlated to size of holding for 0.20 SSAs and secured assets 0.10 0.00 0.5 0.75 1.5 3 5 8 15 30 50 80 Size of holding (m) 7
Liquidity Risk: Asset Buffer Construction – Immediacy of Liquidation • Liquidation of LAB is driven by liquidity stress test outflows • Portfolio construction should ensure rate of asset liquidation at least matches expected outflows Resource Notional Highly Liquid Level 1 (cash) Highly Liquid Level 2 A (sovereign Covered Level 2B assets bonds and Bonds Supras) Stressed outflow period Cumulative Stressed Liquidity Outflows Notional Outflow Surplus Liquidity Aggressive Liquidity Risk Conservative Level 2A assets High Grade Sovereign Level 2B assets Bonds 8
Market Risk: Capital Allocation and Risk Management • Returns dictate Pillar 1 and 2A capital allocations. These define risk appetite and portfolio composition • Volatility of asset valuations in the AFS also impacts CET1 resources – requires risk management (or different accounting treatment) • Risk and capital to be modelled, measured and managed Risk Appetite Setting Risk Management Return Return on on Capital/ Capital/ Leverag Leverag e e PV01/ PV01/ AFS AFS Early Early Capital Capital Optimal Portfolio Nominal Nominal Reserve Reserve Warning Warning Allocatio Allocatio Allocatio Allocatio Composition s s QVaR QVaR n n n n Volatility Volatility Value at Value at Risk Risk Risk Risk Risk Risk Appetit Appetit Modellin Modellin Management Management e e g g 9
Market Risk: Risk Appetite and Available for Sale Reserves Volatility £10m swapped 10 year gilt MTM 2 £m 0 -2 -4 -6 -8 -10 -12 Source: Bloomberg Gilt MTM Swapped gilt MTM Aggressive Market Risk Conservative Asset Swap Spread Risk High volatility assets Open IR01 Position 10
Market Risk: Liquid Asset Buffer – Portfolio Diversification Benefits £10m equiv 10 year Portfolio MTM 2 £m 1 0 -1 -2 -3 Swapped gilt MTM Swapped bund MTM Swapped treasury MTM Scaled portfolio MTM Source: Bloomberg Aggressive Market Risk Conservative Asset Swap Spread Risk High volatility assets Open IR01 Position 11
Credit Risk: Liquid Asset Buffer Construct Considerations • Credit Risk should be considered in the context of the firm's overall risk governance framework - under supervision of Credit Committee • Primary risk considerations include: - Jurisdiction - Emerging risks and market developments - Issuer credit ratings - Rating agency assessments Top 15 Govt. Bond Markets (excl. Covered Bond Market Share by US & Japan) Australia, Jurisdiction 4% Korea, 5% Switzerland, 5% Greece, 1% New UK, 16% Zealand, 1% Spain, Portugal, 1% Nether, 4% 8% Canada, Denmark, 17% Spain, 9% 2% Finland, 1% Italy, 5% Ireland, 1% Belgium, 2% France, 18% France, 13% Italy, 19% Austria, 2% Australia, 7% Germany, Germany, 16% 9% UK, 5% Argentina, Sweden, 5% Nether, 4% 2% Canada, 4% Norway, 7% Finland, 1% Belgium, 4% Austria, 2% 12
Accounting For a Liquidity Portfolio: Classification of Bonds The accounting for financial instruments is governed by IFRS9 (introduced 2018), which allows three possible classifications: 1.Amortised Cost: Bonds are not fair valued after initial purchase, hence there is no MTM volatility in the financial statements. MTM gains and losses are only recognised in P&L at the point of sale. Interest is accrued in P&L as normal. 2. Fair Value through Other Comprehensive Income (FVOCI) : Bonds are fair valued, but the MTM volatility is held in a reserve within equity until sale. Used to be called ‘AFS’. Accruals continue to be recognised in P&L. 3. Fair Value through Profit and Loss (FVTPL) : MTM gains/losses affect P&L daily, which can make earnings volatile and treasurers unpopular! The classification above is determined by a combination of two tests: • 1. An assessment of the contractual terms of the bond • 2. An assessment of the business model the bond is held in 13
Conclusion • Constructing a liquid asset buffer requires a multi dimensional approach, giving consideration to: –Turning assets into cash in a timely manner (Liquidity Risk) –Buying assets that fit the organisations overall credit risk appetite –Optimising capital consumption and minimising ratio volatility (Market Risk) • Return is not always the abiding consideration but portfolio optimisation is required to maximise it • The regulatory framework means there is a commonality to portfolio constituents but individual firm risk appetites will drive end state portfolio asset allocations 14
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