The financial turmoil of 2007 has once again underscored the importance of liquidity to the functioning of both the financial markets and the banking sector. A cataclysmic change from buoyant, liquid markets just before the crisis, to an extended period of illiquidity put the global banking system under severe stress. In February 2008, the Basel Committee noted that many banks had failed to follow some basic principles of liquidity management during times of abundant liquidity. In its paper titled ‘Liquidity risk management and supervisory challenges’,36 the Basel committee pointed out that:
Simply stated, liquidity is a bank’s ability to generate cash quickly and at a reasonable cost. Liquidity risk is the risk that the bank may not be able to fund increases in assets or meet liability obligations as they fall due without incurring unacceptable losses. The problem may lie in the bank’s inability to liquidate assets or obtain funding to meet its obligations. The problem could also arise due to uncontrollable factors such as market disruption or liquidity squeeze. Figure 12.3 illustrates how a bank’s inability to generate cash is a manifestation of more serious problems.
FIGURE 12.3 ANATOMY OF LIQUIDITY RISK
Liquidity problems can have an adverse impact on the bank’s earnings and capital, and, in extreme circumstances, may even lead to the collapse of the bank itself, though the bank may otherwise be solvent. A liquidity crisis in a large bank could give rise to systemic consequences impacting other banks and the country’s banking system as a whole. Liquidity problems can also affect the proper functioning of payment systems and other financial markets.
Sound liquidity risk management is, therefore, essential to the viability of every bank and for the maintenance of overall financial stability.
Recent trends in the liability profiles of banks pose further challenges to the industry and have made it increasingly important for banks to actively manage their liquidity risk. Some of these developments are: (a) the increasing proportion in bank liabilities of wholesale and capital market funding, which are more sensitive to credit and market risks; (b) the increase in off-balance sheet activities such as derivatives and securitization that have compounded the challenge of cash flow management; and (c) the speed with which funds can be transmitted and withdrawn, thanks to advanced technology and systems.
Why do banks need liquidity? They need liquidity in order to meet routine expenses, such as interest payments and overhead costs. More importantly, as financial intermediaries, they need liquidity to meet unexpected ‘liquidity shocks’, such as large deposit withdrawals or heavy loan demand. The most extreme example of a liquidity shock is a ‘bank run’.37 If all depositors attempt to withdraw their money at once, almost any bank will be unable to cover their claims and will fail—even though it might otherwise be in sound financial condition. However, individual institutions are rarely allowed to fail, thanks to the safety net existing in most countries in the form of deposit insurance, the central bank’s role as lender of last resort, and stringent capital requirements. Poor liquidity may, therefore, lead to outright failure only in exceptional cases. However, if a bank does not plan carefully, it may be forced to turn to high-cost sources of funding to cover liquidity shocks, thus cutting into profitability, and ultimately, into its very existence.
It is also evident that to manage liquidity risk at the basic level, two sources of liquidity are equally important. One is the liquidity generated from liquidation of assets—this implies that in an adverse situation the bank needs excess liquidity from assets. The second is the funding liquidity—raised through liabilities.
Of the four specific forms of risk that impact banking operation—credit risk, market risk, operational risk and liquidity risk—the first three have been extensively studied and commonly incorporated into existing capital allocation frameworks. However, at present, there is no technique for modelling liquidity risk that has wide acceptance.
Though its importance is well recognized, at present there is no coherent definition of liquidity risk. This comes as no surprise. The term liquidity is used across the market for different purposes, which means that liquidity risk itself is defined differently and depends very much on the context in which it is used. For example, one quite popular definition of liquidity risk is the risk that a particular banking asset cannot be converted into cash within a specific time frame and at a specific price level. It refers directly to the ‘liquidity’ of this particular asset and yet this risk impacts the bank. Literature contains many more such contextual definitions.
Again, no single balance-sheet category or ratio is sufficient to assess liquidity risk. It involves the entire balance sheet and off-balance sheet activity as well. Liquidity management is largely about being sure that adequate, low-cost sources of funding are available on short notice. This might include holding a portfolio of assets that can easily be sold, acquiring a large volume of stable liabilities or maintaining lines of credit with other financial institutions. However, this effort must be balanced against the impact on profitability. In general, more liquid assets earn lower rates of return and certain types of stable funding may cost more than those that are more volatile. A bank can be perfectly liquid by holding only cash as an asset, but this would be an unprofitable strategy because cash does not earn any income.
Why is it so difficult to isolate and study liquidity risk?
First, unlike the other three risks that are bank-specific, liquidity risk can transcend the individual bank—liquidity shortfall at a single bank can have repercussions on the entire banking system of a country.
Second, liquidity risk is partly confounded with market risk as depositor behaviour can arise from perceptions of the market state.
Third, liquidity risk cannot be eliminated or transferred, as can be done with say, credit risk. It has to be borne and managed by the individual bank.
Fourth, liquidity risk can occur in perfectly normal times—as when a large number of depositors withdraw their deposits within a short period of time—or in crisis times when the most severe outcomes can be expected.
Fifth, liquidity risk can affect both the profitability of the bank in the short term, as well as the very survival of the bank in the long term.
A bank that plans well can anticipate many of its internal liquidity needs (such as funding loan growth, meeting depositor demands and paying operating expenses) and structure its balance sheet accordingly. If the bank knows its market, it can plan for many external events (such as seasonal borrowing patterns, deposit run-off and business practices requiring bank funds).
Apart from such anticipated needs, unforeseen events can have serious implications for a bank’s liquidity position. For example, frauds, natural disasters or resources malfunction could unexpectedly affect liquidity. Even with the most careful planning, banks need to maintain reserves of liquidity to sustain them when the unexpected occurs.
In general, factors that can influence bank liquidity include the following:
Historically, better practices for liquidity measurement and management focused on the use of liquidity ratios. These were static ratios, calculated from the bank’s balance sheet. The thinking then welcomed the use of more and more such ratios.
Use of these ratios presupposed that past performance was a realistic indicator of the future. Banks discovered that this assumption may not be valid in a dynamic environment when bank failures happened, triggered by liquidity risk. For example, a large regional bank in the US, Southeast Bank, used over 30 liquidity ratios to manage its liquidity. When it failed in 1991, the second largest failure of the previous two decades in the US, the reason cited was ‘liquidity risk’. It, therefore, became obvious that calculating more or different ratios was not the solution, since historical ratios, however well conceptualized, could say little about the future.
Now, better practices of liquidity measurement and management are evolving. These approaches focus on prospective liquidity, diversified funding and contingency planning. Such approaches can be used by all banks, irrespective of size and geographical area of operation.
The adage ‘you manage what you measure’ has been recognized by the regulators, as evidenced by the Basel III requirements for liquidity management, spelt out by the Basel Committee on Banking Supervision.38 It is noteworthy that the principles for liquidity management as spelt out by the committee have undergone substantial changes and have taken into account lessons from the financial crisis of 2007.
The Basel document of 2000 and 2008 specifically mentions the key areas (quoted below) where more detailed guidance has been provided39:
The Basel document mentions two kinds of liquidity risk—funding liquidity risk and market liquidity risk. It defines the two kinds of risk as follows: (page 1) ‘Funding liquidity risk is the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption.’ The guidance in the document focuses primarily on ‘funding liquidity risk’.
However, these two risks are not independent of each other. For example, under conditions of stress, investors in capital market instruments may demand higher compensation for increased risk, or simply refuse to lend. The need for funding liquidity may then increase, since the illiquidity in the market may make it difficult for banks to raise funds by selling-off assets.
In addition, Basel III has proposed liquidity coverage ratios described later in this section.
It is evident that liquidity risk is closely linked to the nature of banking assets and liabilities. The assets and liability positions of a bank, in turn, are affected by the bank’s investment and financing decisions, irrespective of whether they have short- or long-term implications.
It follows that banks should be able to manage their liquidity position both on an everyday basis as well as in the long term, to ensure that liquidity risk is effectively mitigated. This implies that a bank should preferably have two approaches to managing short-term and long-term liquidity.
Choosing the appropriate approach would depend on the bank management’s ‘liquidity policy’. What is important here is that board-approved policies address liquidity in some manner and that the board monitors both compliance with these policies and the need to change them as necessary.
The Liquidity Policy Similar to a bank’s ‘loan policy’, which we saw in an earlier chapter, many banks have the practice of formulating a ‘liquidity policy’ for the bank.
Policies on liquidity are likely to vary from bank to bank based on individual operating environments, customers and needs. Also, policies will be subject to change over time as a bank’s situation and environment change.
An illustrative list of typical features of a sound liquidity and funds management policy and some symptoms of potential liquidity problems are provided in Annexure III.
It should be noted here that the involvement of a bank’s top management is extremely important in the process of ‘liquidity risk management’.
Since the bank’s long-term survival and growth are the driving factors, this approach tries to mitigate long-term liquidity risk by strategically controlling the bank’s asset and liability positions. This could be achieved by (a) aligning the maturity of assets and liabilities so that cash flow timing risks are eliminated, or (b) diversifying the funding sources so that liquidity availability is ensured.
The alternative approaches prevalently used by banks are:
Asset Management All bank assets are a potential source of liquidity. The asset portfolio of a bank can provide liquidity in the following circumstances—(a) on maturity of the asset; (b) on sale of the asset; and (c) the use of the asset as collateral for borrowing or repo transactions.
Typically, banks hold liquid assets such as money market instruments and marketable securities to supplement the conventional funding sources such as deposits and other liabilities. When the cash inflows from asset realization, either on maturity or through sale, are less than anticipated due to default risk or price volatility, the bank incurs liquidity risk. Similarly, secured funding, such as repos, may be affected if counterparties seek larger discounts on the collateral provided or demand better quality collateral. Additionally, concentrated exposure of the asset portfolio to specific counterparties, instruments, economic activity or geographical location, may heighten the level of liquidity risk.
We have seen in earlier chapters that the typical bank has very few fixed assets. Most of its assets are in the form of loans and investments. Though, theoretically, in an extreme situation, even the bank’s building can be sold to provide funds, banks generally use shorter-term or readily marketable assets for liquidity purposes.
Of course, when the bank needs cash, the best thing to have on hand is cash. That is the reason vault cash, deposits at banks and other cash items are considered a bank’s primary reserve. The problem with cash is that it does not earn a return. Therefore, banks often hold relatively little vault cash, keeping their liquidity reserves in assets that earn some interest.
We have also seen in an earlier chapter that many central banks insist on creating secondary liquidity reserve for banks through investing in approved securities. Securities can be liquidated quickly and at relatively little cost. Also, they provide interest income to the bank.
Secondary reserve securities used for asset management would typically exhibit the following characteristics: (a) they will be short-dated, with maturity periods below 1 year, (b) they will be high quality instruments with low default risk, (c) they will be highly marketable, and (d) have a low conversion cost.
For a bank resorting to ‘asset management’ as a strategy to mitigate liquidity risk, its investment portfolio is looked upon as a liquidity shock absorber. However, there is a trade off between asset liquidity and profitability for the bank, since short-term, liquid, risks-free assets yield relatively low returns.
How much of liquid assets should a bank maintain? The level of liquid assets is generally a function of the stability of the bank’s funding structure and the potential for rapid expansion of its loan portfolio. Generally, if a bank has stable sources of funds and predictable loan demand, a relatively low allowance for liquidity may be required.
However, it is prudent to maintain higher allowance for liquidity to offset the factors described in the following illustrative list:
Hence, to balance liquidity and profitability, management must carefully evaluate the full return on liquid assets against the expected (risk-adjusted) return associated with less liquid assets. Adverse balance sheet fluctuations may lead to a forced sale of securities, in which case the potential higher income from securities may be lost.
Liability Management Liability management has been popular with larger banks since 1960s and 1970s. As the name suggests, the strategy focuses on sources of funds to mitigate liquidity risk.
Contrary to the practice in ‘asset management’, where surplus funds of the bank are parked in cash or near cash assets like readily marketable securities, a bank resorting to ‘liability management’ would invest its surplus funds in long-term assets. When there is a need for liquidity, the bank raises funds from external sources. Typically, the ‘liability-managed’ bank would manage its deposits and other borrowings judicially to meet its funding obligations.
In almost all banks, deposits constitute the largest component of liabilities. Of these, ‘core deposits’40 are generally the lowest-cost funding source because the presence of deposit insurance almost eliminates depositor concerns about the repayment of their funds.
Banks typically employ different liability funding strategies to manage liquidity risk. Those with large branch networks find it easier to garner relatively low-cost retail deposits. Banks concentrating on wholesale business may find borrowing in the money market the most efficient way of obtaining short-term liquidity. Others may issue medium-term certificates of deposit (CDs) or prefer term deposits with a spread of maturities to reduce liquidity risk.
Generally, banks that have a large and ready source of core deposits find liability management an easier task than those that must rely on more volatile, non-core deposits. Unfortunately, few banks have a large base of core deposits in the present competitive environment where investors are constantly seeking more profitable avenues to park their savings. Consequently, many banks now rely more heavily on non-core deposits and other non-deposit sources for funding. The greater volatility associated with these funds increases the rigour needed in a bank’s liquidity management.
The underlying implication of this approach is that a bank will not depend on its liquidity position for credit commitments, since it intends raising the required funds from external or market sources. While the approach would benefit large, growth-oriented, aggressive banks by way of higher returns, it also involves greater risk for the bank.
One risk would be the sustenance of high spreads—while the yields could be high, the cost of borrowing could also be high and in some cases, out of the bank’s control, since borrowing depends on market conditions.
The second would be the asset liability risk. Making long-term investments or loans also requires liabilities of matching maturity. It is likely that at the time the bank wants to source funds of a specific maturity, such sources may not be available, or available at a very high cost, or with embedded options.
The above factor would lead to a third risk—refinancing risk. If liabilities of shorter maturities are deployed in longer-term assets, the liability would fall due for payment before the asset flows come in completely. The bank would then have to seek more liabilities to match the remaining maturity of the assets. If interest rates are rising, there is likelihood that the new source of funds is priced much higher than the earlier one, which might render the transaction unviable.
A fourth risk—a critical one—cannot be ruled out. As the bank borrows more and more, it is vulnerable to credit risk. If a bank defaults on repayment of liabilities, it also runs a reputation risk.
Asset Management or Liability Management? Choosing between the strategies of ‘asset management’ and ‘liability management’ depends to a large extent on not only the size and nature of operations of a bank, but also expectations of how interest rates are going to move in the foreseeable future.
For example, consider a bank whose proportion of retail customers, both depositors and borrowers, is large. Though the amount per transaction, whether deposit repayment or loan disbursement, would be low, the volumes are likely to be large, and the payments would mostly be on demand. The surplus and deficits that arise on a periodic (depending on the liquidity planning horizon that the ‘liquidity policy’ has recommended) basis due to mismatch in cash inflows and outflows will have to be closely monitored. Surpluses, when they occur, will have to be accumulated carefully to take care of times of deficit, to ensure that the bank’s liquidity is not impaired. Instead of maintaining the surplus inflows in the form of cash, the bank would find it more profitable to invest them in short-term securities that can be liquidated at short notice to yield cash. Such a bank, therefore, would prefer the asset management strategy.
On the other hand, the large bank with a substantial proportion of wholesale customers, typically also has large volatile deposits as liabilities. The need for funds would arise in this case for payment of balances in demand deposit accounts and large volatile accounts, as well as for the expected and unexpected needs of its large borrowers. The bank is also likely to have good credit rating in the market due to its large-scale lending and investing activities. In the case of this bank too, periodic mismatches in cash inflows and outflows are likely to arise. However, this bank, unlike the predominantly retail bank discussed above, would be more likely to invest its surplus in long-term loans or investments. The deficits would be met by borrowing in the market, which is facilitated by its market reputation.
Due to the short-term investment strategy, the bank opting for asset management may have to forego higher yields. An alternative this bank has is to invest in long-dated securities and liquidate them in the secondary market as and when the need arises. However, the transaction costs and characteristics of the secondary markets will play a major role in deciding for this alternative. In any case, marketable securities that are relatively risk-free do not yield high returns.
On the other hand, the bank opting for liability management may be looking for higher returns, which do not come without the attendant risks. First, the bank will have to access various types of lenders and markets in its bid to raise funds. Interest rate fluctuations in any of the instruments or markets increase interest rate risk. Second, the bank will have to operate in well-organized markets with credit rating capabilities. A default by the bank in any of these markets would lead to a downgrade of the bank by the rating agencies, which, in turn, would push up the bank’s cost of borrowings. If the bank is not able to pass on the increased cost to its borrowers, its spreads weaken.
Off-balance sheet items, depending on the nature and size of transactions, can either supply or use liquidity. The following examples illustrate the effect of such items on a bank’s liquidity:
Given the customized nature of the contingent contracts illustrated above, it is evident that triggering events for these contingent liquidity risks would be quite difficult to predict or model. Therefore, liquidity risk management in these cases would have to be based on analysis of assumptions and scenarios on the behaviour of both banks and counterparties under various conditions, even if there had been no adverse liquidity events in the past.
We have been discussing the risks arising from balance sheet assets and liabilities of banks. What are the risks inherent in off-balance sheet activities (contingent liabilities) of banks? Box 12.12 outlines some of the liquidity risks in off-balance sheet activities.
A single measurement of liquidity risk rarely suffices in the short term. Banks basically use two kinds of tools used by banks to measure liquidity risk—forward-looking and retrospective—since sound liquidity management requires a complement of measurement tools.
Forward looking or prospective tools project funding needs in the foreseeable future—the planning horizon in such cases could range from daily to quarterly to half yearly and so on. When based on sound assumptions, these tools provide a good basis for liquidity planning in the short term.
Retrospective tools analyze historical behaviour and try to draw inferences for the future, though this may not necessarily prepare the bank for the future.
Some of the forward-looking tools prevalently used by banks include:
A few typical retrospective tools include:
As opposed to managing the asset and liability positions for long-term liquidity management, the short-term approach manages the actual cash flows.
A few of the above approaches are discussed as follows:
1. The Working Funds Approach The working funds typically constitute bank’s capital and outside liabilities, such as deposits and borrowings as well as float funds.
In this approach, liquidity is assessed based on the working funds available with the bank. ‘Liquidity needs’ are typically estimated as a proportion of the working funds.
There are two ways in which a bank can estimate its liquidity requirements—one, as a proportion of total working funds. For example, the bank can decide to maintain 5 per cent of the total working funds as cash or near cash instruments for its liquidity requirements. A second approach is to segment the working funds and maintain separate liquidity limits for each segment.
In one commonly used segmentation approach, the bank classifies its liabilities based on their maturity profiles as follows:
Based on the above allowances for components of its working funds, the bank would assess its desired liquidity levels at any point in time during the planning period. The bank, again depending on its risk-return characteristics, would determine the allowable variance over the desired liquidity levels. The variance is called the ‘acceptance range’. As long as the average cash or near cash balances fall within this acceptance range, the bank’s profitability and liquidity would fall in line with its expectations. Any surplus or deficit over this range would be compensated by investing or borrowing. It is to be noted that both actions of the bank would have a potential impact on its profitability. However, the acceptance range changes along with the liability profile of the bank.
For example, if a bank’s total working funds are ₹1,000 crore and the bank needs to maintain liquidity of 1 per cent on the working funds, the cash requirement would be ₹10 crore. In this case, an acceptance range of ±5% would imply that the cash balance can vary between 10 ±0.5 crore, i.e., between ₹9.5 crore and ₹10.5 crore.
The limitations of the approach are as follows:
2. The Ratios Approach Table 12.6 describes some key ratios and limits that could be employed by banks to assess and manage liquidity risk. The applicability of these ratios to a specific bank would depend on the nature of business and risk profile of the bank. For example, a ratio considered relevant for a predominantly retail bank would be less meaningful to a predominantly wholesale bank.
More liquidity ratios (with their significance) can be found in RBI’s (2009) “Committee on Financial Sector Assessment” Report, pages 91–92.
Can different banks have different liquidity positions despite having similar liquidity ratios? They can be due to the following factors:
All the above factors could dramatically affect the liquidity/cash flow of individual banks.
The limitations of balance sheet ratios are as follows:
Apart from the above ratios, some banks fix limits for their volatile borrowings, in individual or all currencies, to reduce their dependence on market funding. Similarly, limits can also be fixed for unutilized commitments of customers. In this manner, banks use both the retrospective and prospective tools for liquidity management.
3. Cash Flow Approach This forward-looking approach forecasts the cash flows of the bank over a specified planning horizon, and estimates liquidity needs by identifying the likely gaps between sources and uses of funds. The bank then makes a decision on investing surplus funds and borrowing in case of a deficit.
The approach works well when two potentially conflicting parameters are reconciled—the planning horizon and the costs of forecasting. The shorter the desired planning horizon, the more will be the cost of forecasting.
The forecasting could be done in a format as follows:
The ending cash balance could be a surplus or deficit at the end of the planning period.
What does the bank do in case of a surplus cash balance?
In case of a surplus, the bank has two options—(a) retain the surplus as cash; or (b) invest these funds in securities/loan assets. Though holding the surplus as cash would substantially reduce liquidity risk, the option would erode the bank’s profitability. Hence, the bank should be investing the surplus funds.
Here again, the bank has two alternatives. In the first alternative, the surplus can be invested in short-term assets, so that liquidity is not impaired, and yet the bank would be able to earn a small return on the funds invested. In the second alternative, the surplus can be invested in long-term assets, and the bank would borrow when the need for liquidity arises.
The bank’s decision would depend on whether it is an ‘asset-managed’ or a ‘liability-managed’ bank. An asset-managed bank would prefer to invest the surplus in low-yielding short-term assets, so that it can easily fund the liquidity deficits when they arise. A liability-managed bank would prefer to invest the surplus in high-yielding long-term assets and borrow to fund the liquidity deficit when it arises.
Illustration 12.11 will serve to clarify this.
Bank A wants to plan its liquidity, and has arrived at the cash inflows and outflows for the next 6 months as follows: (cash flows in ₹ crore).
Assumption:
Period (in months) | Yield (% per annum) |
1 | 6% |
2 | 6.25% |
3 | 6.75% |
4 | 7.25% |
5 | 8% |
6 | 8.75% |
Case 1 The bank chooses to adopt asset management strategy.
It would, therefore, invest the surplus after meeting the deficit as follows:
The bank’s total returns would amount to
Case 2 The bank chooses to adopt liability management strategy
It would invest the surplus as and when it arises as follows:
It would also have to borrow to meet the deficits as follows:
The Bank’s net returns would amount to ₹0.53 crore, calculated as follows:
Interpretation of the Result The above comparison seems to show that the bank benefits more by liability management. However, in reality, the decision will depend on the following:
It should also be noted that the cost of borrowing is assumed to be equal to the yield for the same period, a situation that may not be realistic in practice. Further, in a rising interest rate environment, the cost of borrowing may outpace the yield rate that has been locked in, thus, leading to refinancing risk for the bank.
In two documents published in December 2010 and January 2013 as part of the Basel III reforms described in earlier chapters, the Basel committee has presented reforms to strengthen liquidity risk management in banks. The latest documents build upon the Basel II framework for liquidity management as given in the ‘Principles for Sound liquidity risk management and Supervision’ (September 2008, accessed at www.bis.org) mentioned in an earlier paragraph.
The document published in December 2010, titled “Basel III: The International Framework for liquidity risk measurement, standards and monitoring”, (accessed at www.bis.org), the Committee mentions that the objective is to set rules and timelines to implement the liquidity portion of the Basel III framework (which we have described in the earlier chapter). The document published in January 2013, titled “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” (accessed at www.bis.org), describes in detail the Liquidity Coverage Ratio (LCR) and its implementation timelines.
To recap from the earlier chapter, the LCR is a short term measure of the liquidity profile of banks and is measured as:
The Committee states that this ratio should be more than 100%. This implies that banks should hold High Quality Liquid Assets (HQLA) to more than compensate for liquidity outflows expected over a 30 day period. HQLA should comprise of unencumbered cash and assets that can be converted into cash with little or no loss of value to meet the liquidity needs of the bank over a 30 day period.
Specifically, the LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.
2015 | 2016 | 2017 | 2018 | 2019 | |
Minimum LCR requirement | 60% | 70% | 80% | 90% | 100% |
A study of the components of the ratio as described in the document would show that the LCR builds on traditional liquidity coverage ratios and methodologies used internally by many banks (that have been outlined in earlier paragraphs of this section). However, the differences lie in the rigour of supervision by the regulator and the uniform definition for various classes of assets as well as cash inflows and outflows, taking into account off balance sheet items.
The summarized table given here (Basel III document of January 2013–Annexure IV) presents an illustrative list of the components of the numerator and denominator of the LCR.
The Numerator of the LCR – HQLA (The individual components of HQLA are to be multiplied by the factors given in the table)
The noteworthy feature of the above definition of HQLA is the recognition of the fact that all assets considered ‘liquid’ may not get converted to cash quickly without loss of value, due to their inherent risk and volatility factors. The Basel document contains detailed explanations of each of the above components.
The denominator of the LCR–net cash outflows over a 30 day period (The individual components of cash outflows and inflows are to be multiplied by the factors given in the table.)
It can be seen that the net cash outflows takes into consideration the possible cash outflows from off balance sheet commitments. Detailed definitions and explanations for each line item can be found in the Basel document of January 2013.
Some points to be noted are:
The Group of Governors and Heads of Supervision (GHOS) is the oversight body of the Basel Committee on Banking Supervision (BCBS). The above proposals for regulating the short term liquidity of banks through the LCR is an outcome of its long standing deliberations on Basel III reforms and liquidity risk management. Following the successful agreement of the LCR, the Committee has launched the implementation of the Net Stable Funding Ratio (NSFR), which is a medium term measure of liquidity. This is a crucial component in the new framework, extending the scope of international agreement to the structure of banks’ debt liabilities.
To recap from the previous chapter:
NSFR will be a required standard from January 1, 2018, and the reporting will be not less than quarterly. The NSFR final standard was published by BCBS in October 2014. This document, titled Basel III: The net stable funding ratio can be accessed at http://www.bis.org/bcbs/publ/d295.pdf
The salient features of the calculation of available stable funding (ASF – the numerator of the ratio), and required stable funding (RSF- the denominator of the ratio) are given below.
TABLE 12.7 LIABILITY CATEGORIES AND RELATED ASF FACTORSA SUMMARY
TABLE 12.8 ASSET CATEGORIES AND RELATED RSF FACTORSA SUMMARY
The BCBS has also published extensive explanations to frequently asked questions on the NSFR in February 2017, which can be accessed at http://www.bis.org/bcbs/publ/d396.pdf
Annexure IV summarizes the key findings of a research conducted in May 2006 by the Bank for International Settlements42 and the lessons flowing from the financial crisis of 2007 manifested as principles for measurement and management of liquidity risk by the BIS.43
Indian participation in the derivative markets has accelerated only since the late 1990s. After the introduction of currency forwards in the 1980s, the Indian banking system saw no new instruments till 1997 when long-term foreign currency swaps began trading in the OTC markets.
Thereafter, the rise of derivatives in India has been swift—Interest rate swaps and FRAs were introduced as OTC products in July 1999, followed by several exchange-traded derivatives such as equity index futures (2000), equity index options (June 2001), stock options and stock futures later in the same year, and interest rate futures in June 2003.
In India, the different derivatives instruments are regulated by various regulators, such as Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Forward Markets Commission (FMC). Broadly, RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives.
There are two distinct groups of derivative contracts:
Typically, participants in this market are broadly classified into two functional categories, namely, market-makers and users.
At least one party to a derivative transaction is required to be a market-maker. (It is to be noted that the definition is purely functional. For example, a market making entity, undertaking a derivative transaction to manage an underlying risk, would be acting in the role of a user.)
In India, all commercial banks (excluding Regional rural banks) and primary dealers can act as market makers. They are governed by the regulations in force. The users are typically business entities with identified underlying risk exposures.
At present, the following types of derivative instruments are permitted, subject to conditions and regulations in force:
OTC Derivatives in India Conventionally, OTC derivative contracts are classified based on the underlying into (a) foreign exchange contracts, (b) interest rate contracts, (c) credit linked contracts, (d) equity linked contracts, and (e) commodity linked contracts. The equity linked contracts and commodity contracts have been relatively insignificant and are absent in the domestic Indian OTC markets.
The structure of the OTC derivatives market (excluding equity and commodity linked derivatives) is broadly depicted in the chart below. (Instruments in bold face indicate that these are traded in the Indian market at present).
The Indian OTC derivatives market is dominated by Forex derivatives, followed by interest rates. In the OTC Forex derivatives, FX Swaps have been the most widely used instrument, followed by currency options and cross currency swaps. In the Indian markets, four OTC interest rate products are traded, viz., Overnight Index Swap based on overnight MIBOR (Mumbai Inter Bank Offered Rate - a polled rate derived from the overnight unsecured inter-bank market), contracts based on MIFOR (Mumbai Inter-Bank Forward Offered Rate—a polled rate derived from London Interbank Offer Rate (LIBOR) and USD-INR forward premium), contracts based on INBMK (Indian Benchmark Rate—a benchmark rate published by Reuters that represents yield for government securities for a designated maturity), and contracts based on MIOIS (Mumbai Interbank Overnight Index Swap—a polled rate derived from the MIBOR rates of designated maturity)
A typical characteristic of the Indian interest rate market is that unlike in the overseas inter-bank funds markets, there is very little activity in tenors beyond overnight and as such there is no credible interest rate in segments other than overnight. Absence of a liquid 3-month or 6-month funds market has been a hindrance for trading in Forward Rate Agreements (FRA), as also in swaps based on these benchmarks. This is reflected in trading volumes of the products as shown in Table 12.6. It is seen that the market for OTC interest rate derivatives is predominated by Interest Rate Swaps (IRS) with no activity in FRAs. It is also evident that MIBOR swaps dominate the market.
TABLE 12.6 TREND IN INTEREST RATE PRODUCTS TRADE
Another aspect of the market, which is not unique only to India, has been the concentration of market participants. Share of foreign banks is about 80 per cent of the total market volume with virtual absence of nationalized banks. Activity in the IRS market is fairly spread across the swap curve between 1-10 years. There are no swap trades beyond 10 years.
All scheduled commercial banks (SCBs) excluding Regional Rural Banks, primary dealers (PDs) and all-India financial institutions (please refer to Chapter 1 for a list of financial institutions) have been allowed to use IRS and FRA for their own balance sheet management as also for the purpose of market making. The non-financial corporations have been allowed to use IRS and FRA to hedge their balance sheet exposures, with a caveat that at least one of the parties in any IRS/FRA transaction should be a RBI regulated entity. In addition to the RBI circular of 1999 (dated July 7,1999) which lays down principles for accounting and risk management for positions in IRS/FRA, RBI has, in 2007 (RBI circular dated April 20, 2007), released comprehensive guidelines on derivatives comprising general principles for derivatives trading, management of risk and sound corporate governance requirements along with a code of conduct for market makers.
Interest rate options were introduced in December 2016.
The guidelines for interest rate options and periodical updates in the guidelines can be accessed at www.rbi.org.in
(Sources: RBI, May 2011, Report of the Working group on reporting of OTC interest rate and forex derivatives, and RBI, 2012, Report of the Working Group on enhancing liquidity in the Government securities and Interest rate derivatives markets)
The OTC derivatives market is characterized by large exposures between a limited number of market players. When the market is characterized by the existence of a few market makers, most of the activity takes place between these players and disruptions at any major dealer would soon transmit to other financial institutions and spread contagion to the entire market. The risk in the OTC derivative market also emanates from the opacity in the market that constrains the market participants from assessing the quantum of risk held with the counterparty. Further, with increase in volumes and complexities of the OTC derivatives, the non-standardized infrastructure for clearing and settlement also becomes a major impediment in containing risk, especially in the wake of the financial crisis of 2007-08. At the G 20 Toronto summit declaration of June 2010, Central banks and Market regulators agreed to initiate measures to enhance the post trading infrastructure in the OTC derivative markets.
Establishing Central counterparties (CCP) and Trade Repositories (TR) were two of the important commitments made at the above Summit.
A CCP is a financial institution that interposes as an intermediary between security (including derivatives) market participants. This reduces the amount of counterparty risk that market participants are exposed to. A sale is contracted between the seller of a security and the central counter party on one hand and the central counterparty and the buyer on the other. This means that no market participant has a direct exposure to another and if one party defaults, the central counterparty absorbs the loss. Settlement through a central counterparty has been progressively used on most major stock and security exchanges. However, a CCP based system can lead to concentration of risk with the CCP, which issue needed to be addressed.
On the other hand, the objective of TRs is simply to maintain an authoritative electronic database of all open OTC derivative transactions. It collects data derived from centrally or bilaterally clearable transactions as inputted/verified by both parties to a trade. An important attribute of a TR is its ability to interconnect with multiple market participants in support of risk reduction, operational efficiency and cost saving benefits to individual participants and to the market as a whole. The typical drawback of the OTC market is that the information concerning any contract is usually available only to the contracting parties. While expanding the scope of availability of information, it became pertinent to distinguish between information available to regulators, to market participants and to public at large. Post trade processing services is another important function of TR.
The reporting arrangement in interest rate derivatives in India follows a two tier system. Since at least one party to an OTC interest rate derivatives transaction is a RBI regulated entity, there has been an elaborate prudential reporting requirement in so far as the risk implication of the derivative positions for the entity is concerned.
In 2003, an internal Working Group of the RBI on Rupee derivatives had recommended a centralized clearing system for OTC derivatives through Clearing Corporation of India Ltd (CCIL). Preparatory to introduction of centralized clearing as also to get a better understanding of interest rate derivative market in India, RBI, in 2007, made it mandatory for the RBI regulated entities to report inter-bank/PD transactions in interest rate derivatives (FRAs and IRS) on a platform developed by the CCIL. Subsequently, all inter-bank/PD deals were required to be reported by the banks and PDs on the CCIL platform within 30 minutes of initiating the transaction. The information captured through this reporting system is comprehensive. Further, CCIL’s evolution as a repository owed to a regulatory mandate, unlike repositories like DTCC which evolved out of a need to facilitate post trade processing.
As noted above, In India, RBI initiated measures for transaction-wise reporting of IRS Trades and mandated reporting of all inter-bank trades to Clearing Corporation of India Limited (CCIL) in August 2007. It is noteworthy that the Indian financial market has had a well-functioning CCP, viz., CCIL that has been offering CCP-guaranteed settlement for transactions in government securities, a few money market instruments, and forex i.e., dollar-rupee transactions. However, CCIL does not provide post trade services except aggregate data dissemination.
From April 2014, all entities regulated by the Reserve Bank should report their secondary market OTC trades in Corporate Bonds and Securitized Debt Instruments within 15 minutes of the trade on any of the stock exchanges (NSE, BSE and MCX-SX). These trades may be cleared and settled through any of the clearing corporations (NSCCL, ICCL and MCX-SX CCL). (RBI circular dated February 24, 2014)
TRs help in obtaining a clear understanding of:
They also help in the development of tools that allow regulators and other stake holders to have access to more information and thereby identify emerging systemic risks.
Currently the major TRs globally are: (in order of their establishment)
While DTCC contributes its Deriv/SERV matching and confirmation engine, Markit’s data and valuation provides the much needed post trade valuation services. This alliance provides a fully integrated system for processing OTC derivatives across borders and asset classes to provide a service that helps a wide range of market participants achieve greater certainty in their transaction processing. It also addresses the challenges of rapid growth, increased cost and operational risks associated with the OTC derivative markets.
TriOptima, a Stockholm-based technology company was selected by ISDA to operate as an interest rate derivatives TR. A number of broker-dealers, buy-side firms and industry associations, committed to record all interest rate derivatives trades in this TR. The OTC Derivatives Interest Rate Trade Reporting Repository (IR TRR) launched by TriOptima in early 2010 was an important step towards improving transparency in the global OTC derivatives markets.
An important innovation in OTC derivative markets introduced during the last few years relates to portfolio compression services offered by TriOptima. Since the only way to exit a position in an OTC derivative is to enter into another with opposite pay off, the gross notional outstanding multiplies manifold as a result. Apart from the fact that this does not capture the economic essence of the portfolios, it increases the demand on capital for the regulated entities. TriOptima’s TriReduce and TriResolve services reportedly offer multilateral netting with bilateral settlement whereby an entity can extinguish its OTC derivative positions without affecting its MTM value or the PV01(change in price of a bond for a change in yield in absolute monetary value rather than percentage as in modified duration. PV01 is measured as the product of the modified duration and price/value. For more on modified duration please refer to the Annexure to this chapter).
In India too, the service has been used by the IRS portfolio holders with significant reduction in the gross notional positions. The first such exercise was undertaken in July, 2011 wherein a compression of 94.30 per cent of the submitted trades was achieved. The second cycle of compression was carried out in March 2012 with a compression of 90.31 per cent. As already stated, ‘Portfolio compression’ reduces the overall notional size and number of outstanding derivatives contracts in the portfolio without changing the overall risk profile of the portfolio. During this period, RBI has also taken initiatives to strengthen the legal framework in respect of OTC derivatives in interest rates and forex.
Interest rate futures (IRF) were introduced in June 2003 when National Stock Exchange (NSE) launched three IRF contracts - futures on 10-year notional G-Sec with a coupon of 6 per cent, 10-year notional zero-coupon G-Sec and 91-Day T-Bills. However, these contracts did not attract enough market interest since its introduction and soon became defunct. The use of ZCYC to determine the daily settlement price and for MTM of the contract resulted in large basis risk for participants trying to hedge their cash market positions through the futures market thereby making the futures contract unattractive, if not risky (All the terms – ZCYC, MTM and basis risk – have been described in earlier chapters). Further, the prohibition of banks from taking trading positions in the futures market had resulted in very low/negligible liquidity in this market.
A second joint committee of the RBI and Securities and Exchange Board of India (SEBI) based its recommendations on the above findings in June 2009. Its primary suggestion was to introduce physically settled Interest rate futures contract on 10 year Government of India (GoI) coupon bearing security.
Subsequently, RBI issued Interest Rate Futures (Reserve Bank) Directions, 2009, on August 28, 2009, and followed it up with amendments upto December 2011. The latest Directions have come into effect in December 2013. The RBI has included cash settlement for 10 year Government of India (GoI) securities, which can also be settled by physical delivery. The other underlying securities included are 91 day Treasury bills, 2 year, 5 year and coupon bearing GoI securities, which are eligible for cash settlement.
Banks are permitted to participate in IRF both for the purpose of hedging the risk in the underlying investment portfolio and also to take trading position. However, banks are not allowed to undertake transactions in IRFs on behalf of clients. Similarly, stand-alone Primary Dealers are allowed to deal in IRF for both hedging and trading on own account and not on client’s account.
However, experts attribute lack of activity in IRF to structural factors such as lack of liquidity in the underlying cash market, SLR prescriptions and HTM facility. Other factors normally cited for the lack of market activity are (a) banks and MFs have portfolio duration of less than 5 years; (b) IRF contract cannot be used as a perfect hedge; (c) the market hesitancy to take a view on long-term interest rates; and (d) lack of significant buy side interest in a rising interest rate cycle and over supply of G-secs.
The latest guidelines on exchange traded derivatives can be accessed at www.rbi.org.in
From 1 April 1999, banks in India were expected to implement an effective ALM system, the guidelines for which were contained in RBI circular dated 10 February 1999. The salient features of this system are as follows:
Liquidity Risk Management Guidelines Primarily, liquidity was to be tracked through maturity or cash flow mismatches. For this purpose, a standard tool was to be adopted, involving the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates. Within each specified time bucket, there could be mismatches between expected cash inflows and outflows. The main area of concern here would be the short-term mismatches—those up to 28 days. Hence, RBI had asked banks to keep the mismatches (negative gap) during this time period within 20 per cent of cash outflows in each time bucket. Bank assets and liabilities are grouped into different maturity profiles and presented in the statement of structural liquidity for decision making.
The statement of structural liquidity would essentially show all expected cash inflows and outflows during the specified period. A maturing liability will be a cash outflow while a maturing asset would represent a cash inflow. In determining the likely timing and magnitude of these cash flows, banks will have to make several assumptions based on whether they resort to asset management or liability management.
The guidelines also suggest a format that would enable banks to estimate short-term dynamic liquidity, i.e., monitor their short-term (1 to 90 days) liquidity, as in the cash flow method described in Section V.
Interest Rate Risk Management Guidelines44 RBI has proposed in April 2006 that the Modified Duration Gap approach be adopted for interest rate risk management. The steps to be followed for computing the Modified DGAP would be as follows:
DA = Weighted average Modified Duration of assets and
DL = Weighted average Modified Duration of liabilities.
Illustration, 12.12 excerpted from the RBI guidelines, will serve to clarify the mechanics, which can be applied to assets, liabilities and equity:
EVE | (₹ in Crores Amount |
---|---|
Net worth | 1,350.00 |
RSA | 18,251.00 |
RSL | 18,590.00 |
Modified duration of gap | |
DA (Weighted modified duration of assets) | 1.96 |
DL (Weighted modified duration of liabilities) | 1.25 |
Weight = RSL/RSA | 1.02 |
DGAP = DA – W × DL | 0.69 |
Leverage ratio = RSA / (Tier 1 + Tier 2) | 13.52 |
Modified duration of equity = DGAP × Leverage Ratio | 9.34 |
For a 200 bp | 18.68% (9.34 × 2) |
Rate shock the drop in equity value is |
The basic slotting of various assets and liabilities based on their maturity profile and interest rate sensitivity is shown in Annexure V. It is to be noted that these profiles are fine-tuned in subsequent RBI guidelines to refine the process of interest rate risk and liquidity risk management.
The global financial crisis of 2007 has highlighted, like never before, the role of prudent liquidity management as the cornerstone of financial stability. On November 7, 2012, RBI released guidelines for liquidity risk management, based on the documents Principles for Sound Liquidity Risk Management and Supervision as well as Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring published by the Basel Committee on Banking Supervision (BCBS) in September 2008 and December 2010 respectively. Banks had to implement the guidelines immediately. However, these guidelines have been further refined based on the January 2013 document of the Basel committee titled ‘Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools’, the salient features of which were discussed in Section V.
The RBI circular on LCR was issued in June 2014 and can be accessed at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CA09062014F.pdf. The measurement process shown in Section V has been customized to suit local practices. The LCR requirement would be binding on banks from January 2015. In order to provide a transition time for banks, the requirement would be minimum 60% for the calendar year 2015 i.e. with effect from January 1, 2015, and rise in equal steps to reach the minimum required level of 100% on January 1, 2019.
RBI issued draft guidelines for implementing NSFR standards in March 2015. This document can be accessed at www.rbi.org.in.
As we have seen earlier, a ‘negative gap’ within a time bucket indicates that maturing assets during that time period are lower than the liabilities maturing during the same period. This implies that the cash flows from assets (say interest payments, principal repayments, etc., from loans, advances or investments) would not be sufficient to cover the demands made by depositors and other creditors during the period under consideration.
The simple Illustration 12.13 shows the impact of ‘negative gap’ on liquidity management through simple matching of ‘maturities’. The illustration is an example of “contractual maturity mismatch” as a liquidity monitoring tool, as mentioned in both the Basel document of 2013 and RBI guidelines of June 2014
Bank D has the following assets and liabilities classified by maturity.45 Note that these are maturing liabilities and assets in each time bucket.
Maturity Mths | Liabilities | Assets |
---|---|---|
Less than 1 | 7 | 10 |
1–3 | 13 | 8 |
4–6 | 11 | 10 |
7–12 | 9 | 20 |
13–24 | 24 | 27 |
25–36 | 29 | 19 |
Above 36 | 10 | 9 |
We will now find the GAP in each time bucket, affix a sign to this GAP, and then find the cumulative gap.
Matching assets and liability by maturity
What can we conclude about the bank’s liquidity risk from the above table?
We see that in the near term, i.e., up to 6 months, the bank has two time buckets of negative gaps, which are not offset by the positive gap in the first time band, up to 1 month.
This implies that the bank is subject to liquidity risk even if all the assets yield cash flows as expected during this period. Further, if there is a shortfall in expected cash flows from maturing assets or if there is unexpected increase in demand from liability holders, the bank’s liquidity position will deteriorate. Hence, the bank has to plan ahead for alternative sources of liquidity over the next 6 months.
This approach not only limits liquidity risk exposure in specific time buckets, but also recognizes the cumulative impact on liquidity over time periods in the near future, which is the most relevant for banks’ liquidity.
According to these guidelines, banks have to undertake dynamic liquidity management. The guidance for slotting future cash flows is shown in Annexure V.
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What conclusions can you draw from the above results?
Deposits | 6.75% |
Borrowings | 8.00% |
Advances | 11.00% |
Investments | 6.80% |
Change in Interest Rates | Probability |
---|---|
–0.5% | 0.10 |
+0.5% | 0.20 |
–1.0% | 0.30 |
+1.0% | 0.40 |
If the earning assets of the bank are at ₹50,000 crore, NII is ₹1,500 crore, and the bank expects a variation of 10 per cent in NII,
Interest rate risk management can be effective only if interest rate forecasts are realistic and accurate. The forecasts are primarily based on the shape of the future yield curve.
The yield curve, simply stated, is a measure of the market expectations of movements in future interest rates, given the current market conditions. It is shown as a graph comparing yields on securities of different maturities, assuming other factors such as, default risk or marketability as identical for all the securities being compared. This is also known as the ‘term structure’ of interest rates.
Government securities are considered risk free and their yields are often used as the benchmark for other instruments with similar maturities. The yield curve is constructed as a graph in which the ‘yield to maturity’ is plotted on the vertical axis and the number of years to maturity on the horizontal axis. The two essential assumptions made while graphing are that the securities are noncallable and are akin to zero coupon bonds that mature on the common payment date. Typically, yield curves for risky bonds will be at a higher level on the graph than the yield curves for comparatively safe bonds.
The exact shape of the yield curve is closely scrutinized since it can be different at any point in time. An upward sloping yield curve is typical of economic recovery, where the long-term interest rates are expected to exceed the short-term interest rates and the spot rates are increasing. Similarly, when the yield curve tends to slope downward, indicating that long-term interest rates are less than short-term rates and the spot rates are declining, the economy could be heading for a recession. Hence, a change in the shape of the yield curve serves as a signal to the investors to change their outlook on the economy.
The slope of the yield curve is also seen as an important indicator—the greater the slope, the greater is the gap between short- and long-term interest rates.
In order to further elaborate, there are essentially three patterns created by the yield curves, which are as follows:
The shape of the yield curve is explained through a few popular theories. Before we describe the theories, we will have to understand the two terms – ‘spot’ rate and ‘forward’ rate.
The spot rate is the prevailing interest rate that can be obtained from the following equation:
The forward rate is the interest rate that is expected to prevail at some future specified dates. According to a popular theory (Pure Expectations Theory), the current forward rate is an unbiased predictor of future spot rates. In other words, a bank would earn identical yields on a two-year loan, irrespective of whether the loan tenure is of two years or one year, rolled over at the end of the first year. Such a rate, at which the rolled over loan would earn an identical yield is called the ‘implicit forward interest rate’. Thus, the implicit forward interest rate would, in effect, represent the future rate of a short-term loan when rolled over and would be equal to the present long-term rate. In mathematical terms, the equation can be generalized as follows:
where rt = yield on a loan with maturity ‘t’
rt−1 = yield on loan with maturity ‘t − 1’
Ft−1 = implicit forward interest rate
We will now provide a brief overview of some of the popular theories.
Pure Expectations Theory This theory is also called the ‘unbiased expectations theory’ and the assumption here is that forward rates are unbiased estimates of expected spot rates. In other words, the theory attempts to explain the difference in yields on securities with different maturities arising due to varying investor expectations regarding interest rate movements in future. This implies that the investors will prefer securities with the highest return, regardless of the maturities. For example, an investor with a three-year planning horizon may choose one of the following alternatives to achieve his investment objective: (a) he can invest in a security with a maturity period of three years or (b) invest for one year and roll over twice or (c) invest for two years and roll over for one year or (d) invest for one year and roll over for two years thereafter. According to this theory, the interest rate that equates the return on a series of short-term securities with the return on a long-term security carrying the same final maturity would represent the market’s expectation of the future interest rate. An inherent assumption is of course that the alternatives enumerated above can be carried through without cost. Therefore, after summarizing, the theory hypothesises that (a) the long-term interest rates are an average of the current and expected future short-term interest rates, (b) the expected short-term interest rate is the market forecast of future interest rates and (c) the investors would substitute maturities for better yields. Going by this theory, an upward sloping yield curve augurs an increase in interest rates, while a downward sloping yield curve is a signal that interest rates would dip in future. However, the interpretation could be too simplistic since an upward sloping curve can shift downwards in its entirety when rates decline, yet preserving the upward slope.
Liquidity Theory This theory is also called the ‘liquidity premium theory’ and is an extension of the pure expectations theory. The liquidity theory incorporates the additional factor of the investor’s expectations of ‘price risk’ in forecasting the market rates. Even if expected returns are identical for long-term securities and a series of same maturity shortterm securities, the investors would have to be induced into buying long-term securities due to the price fluctuations that could arise over a fairly longer term. That is, if an investor receives a return of 10 percent for securities with maturities of both one and two years’ maturities, he may prefer to have the option of investing for a year and roll over for another, if interest rates are still favourable after a year. In other words, investors would expect additional return for investing in long-term securities in the form of a risk premium. Essentially, therefore, long-term rates would be set as the average of current and expected short-term rates plus a ‘liquidity premium’. In effect, the forward rate, too, would then equal the expected rate plus a liquidity premium. The yield curve is theoretically expected to be upward sloping since the long-term rates are always expected to stay above the short-term rates and the imposition of a liquidity premium exerts an upward bias. However, in the very long term, the yield curve implicit forward interest rate would tend to flatten out, since there is a little differential price risk at longer maturities. Further, if the yield curve becomes inverted, there would be expectation of a very sharp drop in the short-term rates to compensate for the heightened liquidity premiums.
Preferred Habitat Theory While not contesting the validity of the liquidity premium, this theory argues that it cannot be extended to cover all maturities. The maturity preference of borrowers and lenders depends on their unique needs, preferences and constraints. Hence, the presence of a premium might induce them to change maturity patterns only to a certain level, beyond which even enhanced premiums may not induce investors to change their maturity patterns.
Market Segmentation Theory This theory closely resembles the preferred habitat theory and states that the investors operate in different markets essentially due to their asset liability maturity patterns. The interest rates in each of these market segments are governed by the supply and demand forces within the segment. The investors in any segment are not induced by the presence of premiums to shift maturities. For example, most banks prefer to operate in the mediumterm segment since the maturity profile of the bulk of their liabilities is medium term. On the other hand, insurance and pension funds are typically long-term investors and infrastructure funding has to be long term. Maturity restrictions can also arise from regulatory prescriptions as in the case of government securities or money market instruments. Under this theory, an upward sloping yield curve would result when, at each interest rate, the supply of funds exceeds the demand, more for short-term securities than for long-term securities. The smaller demand pressure on short-term funds would then push short-term rates below long-term rates and the curve would slope upward. Similarly, in the case of a downward sloping yield curve, the short-term rates outstrip the longterm rates, since at each interest rate, the demand for funds outstrips the supply, more for short-term securities than for long-term securities.
The term signifies a ‘buy and sell’ strategy, where a portfolio manager purchases a medium- or long-term bond when the yield curve is upward sloping and sells it before maturity to make a capital gain.
The drawback with this strategy is the risk in riding the yield curve when it is changing. Further, frequent buying and selling (versus holding till maturity) entails higher transaction costs.
It is evident from the above discussion that the basic types of yield curves do not account for securities that have varying coupon rates. This is because the YTM is calculated with the assumption that coupons are reinvested at an interest rate equal to the coupon rate. For example, comparing a 10-year bond paying 12 per cent coupon with a 10-year government security with a coupon of 5 per cent may not be meaningful. That is, the bond paying 5 per cent may not be the most suitable benchmark for the bond yielding 12 per cent.
The spot-rate curve differentiates the yields from government securities from yields arising out of similar noncallable fixed income securities. It is formed by graphing the yields of zero coupon government securities like treasury bills and their corresponding maturities. The interest rate emerging from this graph is called the ‘spot rate’. The spot rate given by each zero-coupon security and the spot-rate curve are considered in tandem to determine the value of each zerocoupon component of a noncallable fixed-income security. The implication is that the yield curve is graphed as though each coupon payment of a noncallable fixed-income security resembled a zero-coupon bond.
Also called the ‘quality spread’, this represents the additional yield from a corporate bond over a similar government security. The ‘spread’ reflects the yield curve of the corporate bond. Since the yield curve is used to forecast the direction that interest rates would take when inflation rates are increasing, the credit spread between corporate and government securities widens, indicating that all is not well with the economy. The widening of the credit spread also indicates that the investor would seek compensation in the form of higher coupon for taking on the higher risk of corporate bonds. When interest rates are declining, the credit spread between government and corporate fixed-income securities generally narrows, indicating that the economy is growing. Falling interest rates encourage firms to borrow at lower rates, thus increasing expectations of healthier cash flows and lowering default risk.
Thus, the yield curve, used in tandem with the credit spread, can also be used to price corporate fixed income securities.
When interest rates rise, bond prices fall. But to what degree do bond prices change when interest rates change? It depends on the bond’s ‘duration’, its ‘term to maturity’ and ‘yield to maturity’.
What is ‘duration’ in the context of bonds? Simply stating, ‘duration’ measures the number of years it takes for the price of the bond to be repaid by the cash flows. It is different from ‘maturity’ of the bonds. It is an important measure for investors, since bonds with higher durations are perceived as more risky and as having higher price volatility than bonds with lower durations. For example, between a zero coupon bond and a plain vanilla (or ‘straight’ bond that pays coupon at fixed periodicities) bond, a typical investor would prefer the latter, since its duration will always be less than its maturity. For a zero coupon bond, the duration is equal to its time to maturity. The reason is clear. In the case of a plain vanilla bond, cash flows (coupon payments) occur at fixed periods before maturity, enabling the investor to recoup his investment (price of the bond) earlier (using the time value of money, where earlier cash flows have greater weight). The zero coupon bond pays both coupon and original investment only at maturity and hence no interim cash flows occur.
In the case of a plain vanilla bond, as coupons are paid out, they no longer represent future cash flows to be paid to the investor and hence would not be included in computing the duration. Therefore, as more and more coupons get paid out, the duration changes and decreases as time moves closer to the bond’s maturity. Eventually, duration converges with the bond’s maturity. That is why a zero coupon bond’s duration is the same as its maturity.
Besides the time to maturity, bonds with high yields (high coupon rates) tend to have lower durations than bonds with lower yields. This makes sense, since a higher yield translates into faster repayment of the investment made.
Though ‘duration’ is used as a common terminology in the market, there are at least three prevalent types of duration measures. These differ in the way they consider assumptions related to interest rate changes or the other features of securities such as options or maturity.
Macaulay’s Duration Created by Frederick Macaulay in 1938, this concept gained popularity only in the 1970s. Macaulay’s duration is calculated as the weighted average maturity of the cash flow stream of a security. The present value of each cash-flow interest and principal is used as the weight and it is multiplied by the time it is received. The aggregate is divided by the current value of the security. For calculating the present value of the cash streams, the yield to maturity is used as the appropriate discount rate. In effect, the ‘duration’ of a bond, calculated in this manner, represents the ‘average’ time taken to receive various parts of the cash flow of the security. In short, it represents the ‘weighted average term to maturity’ of security. In its simplest form, Macaulay’s duration can be represented as follows:
where, ‘c’ represents the payments received at time periods 1, 2, etc.,
‘P’ represents the current value of the security,
‘r’ represents yield to maturity, and
‘T’ represents the number of periods for which cash flows are received.
The illustration given below will help clarify the point. Assume that you hold a three-year security with a face value of ₹1000 and coupon rate of 10 per cent. Assume that the interest rates are also at 10 per cent and the coupons are paid out annually. The duration is computed as follows:
That is, the weighted average term to maturity of the above mentioned security is 2.73 years approximately.
The above simple example holds two important conclusions as well.
Hence, other things being equal, the higher the coupon rate and the yield to maturity, the shorter is the duration. It also follows that in the case of a zero coupon bond, the duration and the maturity of the bond would be identical.
Modified Duration It thus appears that the volatility or interest rate sensitivity of a security is approximately related to its duration.
That is,
In the foregoing example, the volatility of the security would be (2.73/(1+.10)) or approximately 2.49. This implies that a change of 1 per cent in the required yield would result in a change of about 2.49 per cent in the price of the security. This is also called ‘modified duration’. Thus,
and is used to estimate the relative price volatilities of different securities. Rewriting the above equation, price volatility is represented as follows:
where, ∆r is the estimated change in yield.
To sum up, modified duration is a different version of the Macaulay model and demonstrates the extent of change in duration for each percentage change in yield. It also follows that for fixed income securities without embedded options, prices and interest rates move in opposite directions and hence, there is inverse relationship between modified duration and an approximate one per cent change in yield.
Effective Duration The modified duration model assumes that expected cash flows from a security will not change even when interest rates change. However, when the security contains embedded options, expected cash flows would change when interest rates change. ‘Effective duration’ is used to estimate the price sensitivity of the security for the securities with embedded options. Effective duration typically requires the use of ‘binomial trees’ to arrive at the Option-Adjusted-Spread (OAS). One simple model for estimating effective duration is as follows:
where, P0 = initial price
Pi+ = price when interest rates rise
Pi− = price when interest rates fall
i− = initial market rate less decrease in rate
i+ = initial market rate plus increase in rate
Therefore, effective duration compares the estimated price of a security in a rising and falling interest rate scenario.
The following are the key points to remember about duration:
If the relationship between bond price and yield is graphed, typically the price of a 30 year bond changes more rapidly than that of a one-year bond. This implies that the graph is more a curve than a straight line. The degree of curvature represents the extent to which bond prices change in response to the yield. Technically, this curvature is termed as ‘convexity’.
If we graph a tangent at a particular price of a bond (where the tangent meets the price-yield curve), the linear tangent is the bond’s (Macaulay) duration. The slopes of these lines are negative due to the inverse relationship between bond duration and yields, but the bonds have positive duration. In mathematical terms, convexity is the second derivative of price with respect to yield. This also means that while the duration equation works well for small changes in yield, it may not work as well for large changes, since the duration also changes as yield changes.
Thus, convexity reveals an important limitation of duration analysis. Since different bonds exhibit different amounts of convexity, correcting convexity could be quite difficult.46
Therefore, rather than correcting bond convexity, we can estimate the extent of convexity using the following equation:
where, CFJ is the value of the cashflow received in the year, j
We can also use a Taylor’s series to estimate convexity. The series lays out the risk factors that affect the price of a security. The more such factors are estimated, the more accurate will be the estimate of price changes.
The convexity can then be incorporated into the modified duration equation as given below.
In other words, for very small changes in yield, say, 10 basis points, the changes in convexity will be very small (the square of change in yield would be around .000001) and hence can be ignored. However, large changes in yield would yield large components of convexity.
Convexity has the following properties:
Simply stating, when an investor with an identified future financial liability invests a specified amount today, such that its future value will equal the value of the liability when the liability falls due, the investor has immunized himself against future default in payment. For example, a person who wants to repaint his newly built house at a cost of ₹1 lakh in 10 years’ time could invest in a 10 year ₹1 lakh zero coupon bond today at a discounted cost. In short, the investor is certain to have ₹1 lakh in 10 years to repaint his house.
Immunization utilizes the sensitivity of bond prices to changes in interest rates to create portfolios that will realize the yield at the time of purchase over the length of a planning period, regardless of the movements of interest rates during that period. In times of volatile interest rates, therefore, immunization theoretically restores a bond to its traditional role as a ‘safe’ financial asset.
Duration measures the percentage price change of a bond for a 1 per cent change in yield. Convexity measures the degree to which duration changes as the yield to maturity changes. Duration is additive, so the duration of a portfolio of bonds is the weighted sum of the duration of the individual bonds. Because duration and convexity measure price risk, they can be helpful in immunizing interest rate risk.
To immunize the portfolio to interest rate risk, assets or liabilities can be added to make the duration of the portfolio equal to zero. Other terms commonly used to denote immunization are ‘hedging’ and ‘duration matching’.
When the weighted duration of assets does not equal that of the liabilities, derivatives (such as futures or swaps) can be employed to match the asset with liability duration.
Duration changes as time passes and as yields change. Therefore, in order to maintain an immunized position, the portfolio must be periodically rebalanced. A more precise form of immunization is dedication or cash flow matching. If a portfolio is perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.
Typically, sound liquidity and funds management policies will do all or most of the following factors:
A necessary prerequisite to sound liquidity management decisions is a sound management information system (MIS). Report formats and content would vary from bank to bank depending on the bank’s strategy, its balance sheet structure and its funds management practices.
However, some basic details that should find a place in the MIS are as follows:
Some internal and market indicators could be useful to assess whether a potential liquidity problem is developing.
Internal indicators are as follows:
Market indicators are as follows:
(Research conducted in May 2006 by the Bank for International Settlements.47)
The review, carried out by the Joint Forum’s48 Working Group on Risk Assessment and Capital, studied the funding liquidity risk management practices of 40 large conglomerates involved in banking, securities and insurance activities.
The review was designed to address five key questions, which are as follows:
The review found that most of the conglomerates surveyed, monitored and managed liquidity risk primarily through the use of (a) risk limits, (b) monitoring systems and (c) scenario analyzes that are incorporated into contingency funding plans (CFPs).
The group inferred that the following factors appeared to exert significant influence on the approach of the conglomerates towards liquidity risk management: (a) scope of international operations, (b) level of complexity of activities undertaken in different jurisdictions in which the conglomerate is present, (c) types of foreign currency exposure, (d) supervisory requirements, (e) legal environment and restrictions, (f) commercial market environment and (g) national markets.
What is of more relevance to the present banking environment is that the group found a greater range of liquidity risk management practice within the banking sector, than within the securities and insurance sectors, especially in areas such as, liquidity risk measures and limits, types of scenarios, time considerations and underlying assumptions.
The study also found that though the metrics to measure liquidity risk varied, the basic approaches could be classified as follows:
The study found that the banking sector used more of approaches (b) and (c).
Other interesting findings include the following:
However, all these ‘best practices’ were put to severe test during the financial crisis of 2007.
Principles 5 to 12 of the quoted BIS document have been framed in the aftermath of the global financial crisis of 2007. These principles are encapsulated in the following statements (pages 3,4):
Principle 5: A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.
Principle 6: A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.
Principle 7: A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.
Principle 8: A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
Principle 9: A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilized in a timely manner.
Principle 10: A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institutionspecific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies and positions and to develop effective contingency plans.
Principle 11: A bank should have a formal CFP that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
Principle 12: A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding.
(Excerpted from RBI’s ‘Asset Liability Management (ALM) System’, 1999, Appendix I and II.)
(Note that though the basic rate sensitivities and maturity profiles largely remain unchanged in respect of bank assets and liabilities, subsequent RBI circulars attempt to fine tune the classification for better analysis and control. Accordingly, rate sensitivity framework/classification into time buckets have been revised to suit the ‘Modified Duration Approach’ in April 2006. The revised framework can be accessed at Appendix I of the ‘Draft Guidelines on Improvements to Banks’ Asset Liability Management Framework’ issued by the RBI on 17 April 2006.)
The table given below shows the interest rate sensitivity.
The table below shows the various facets of liquidity risk management.
GUIDANCE FOR SLOTTING THE FUTURE CASH FLOWS OF BANKS IN THE REVISED TIME BUCKETS
Northern Rock in July 2007 was Britain’s fifth largest mortgage lender. It had a robust credit book and analysts were positive on its medium-term outlook.
Less than 2 months later, Northern Rock collapsed. The run on Northern Rock was the first in over 100 years in the UK. Liquidity had dried up in the bank. How did it happen, so suddenly and so dramatically?
Northern Rock was not an international bank and did not have significant cross border operations. It was not a major bank either. It had been set up in 1965 as a building society, but subsequently enjoyed spectacular growth and expansion. Before the crisis, 80 per cent of the bank’s liabilities were sourced from securitizations, covered bonds and wholesale sources of funding. Retail deposits comprised only about one-fifth of the liabilities.
When the sub-prime crisis spilled over from the US into securities and money markets of other countries, Northern Rock, with its low deposit to loan ratio, was unable to renew its other sources of short-term financing. It turned to the Bank of England for ‘financial assistance’ on 14 September 2007, in view of ‘extreme conditions’ in financial markets. When the news broke, most retail customers rushed to withdraw their savings from the bank. It was reported that the UK had not witnessed such panic-driven withdrawals since 1866.
In its report, ‘The Run on the Rock’, the House of Commons Treasury Committee stated that Northern Rock was a victim of its own funding structure. Its reliance on short term, wholesale funding was responsible for its inability to cope with the liquidity pressure placed on it when the international markets dried up after the credit crisis in the US.
In February 2008, the bank was nationalized after two unsuccessful bids for take over.
During the course of all this trouble, it is noteworthy that Northern Rock did not face a problem of inadequate capital! But its vulnerability to liquidity shocks in wholesale markets proved its undoing.
A key lesson flowing from the Northern Rock debacle is that bank capital and liquidity are equally important for regulation and solvency of banks.