Stress Testing Framework For Liquidity Risk-Books Pdf

Stress Testing Framework for Liquidity Risk
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A well designed Stress Testing Framwork provides,the ability to design forward looking extreme. yet plausible scenarios and strategies to counter the. effects of an extreme event This paper proposes a,Stress Testing Framework designed to handle. liquidity risk,About the Authors,Zeeshan Rashid, Zeeshan Rashid is a senior consultant in the Risk Management. Practice of Tata Consultancy Services TCS He has more than. 11 years of experience in banking and consulting He has worked. with banks across the globe in the area of risk consulting and as a. derivatives trader with a global bank before joining TCS He holds. a master s degree in business administration,A N Jayaraman. A N Jayaraman is the head of the Center of Excellence CoE for. the Banking and Financial Services Risk and Compliance Practice. at Tata Consultancy Services He has over 17 years of experience. in the banking industry and over 9 years of experience in the. IT industry covering banking risk management assurance and. compliance His current responsibilities include management of. the CoE development of solutions and offerings pre sales. and consulting in the risk management space He is a certified. associate of the Indian Institute of Bankers and a graduate in. Table of Contents,Introduction 5,The Lifecycle of a Liquidity Crisis 5.
Liquidity Risk Stress Testing Framework 6,Conclusion 11. Reference Acknowledgements 12,Introduction, Stress tests have traditionally been associated with market risk and credit risk Liquidity risk had been. considered a secondary risk and clubbed with Asset Liability Management ALM However liquidity risk. took center stage during the recent financial crisis It was observed how quickly a contagion can dry up. liquidity from the market making even strong institutions run for cover Banking behemoths such as Bear. Sterns and Lehman Brothers collapsed as a result of liquidity mismanagement and too much reliance on. short term funding In the case of Lehman Brothers it was also observed that if liquidity is managed at. the parent company level it puts subsidiaries at risk prompting regulators to consider liquidity. ringfencing a widely debated topic today, As a result regulators are emphasizing the importance of liquidity risk management and liquidity risk. stress testing more than ever before Previously liquidity risk stress testing was never a part of any bank s. stress testing framework some banks ran some tactical scenarios under ALM Hence the magnitude of. an idiosyncratic or market wide liquidity stress event was always underestimated Besides historically. there has been no incidence of liquidity events to make the case for liquidity risk stress testing stronger. This paper proposes a Liquidity Risk Stress Testing Framework The framework begins with identifying the. composition of the balance sheet understanding factors which affect the balance sheet the most and. then moves on to design scenarios based on the identified factors The analysis of the stress tests feeds. the contingency plan ensuring that all the extreme but plausible material scenarios are identified and a. plan of action defined,The Lifecycle of a Liquidity Crisis. Bank Financial Markets Government,I D Funding Cost.
Contagion Fundamentals,E Short Term,B Long Term,Hedge Funds Stress AMCs. C G Fire Sale,Credit rating,H Run on the, Pension Funds Other Corporates Insurance Companies. Figure 1 Life Cycle of a Liquidity Crisis, The Liquidity Risk Life Cycle depicted in Figure 1 traces the evolution of a liquidity crisis from one that is. limited to a bank idiosyncratic to a systemic one that affects the entire market Such a crisis can be. triggered by an event which is internal to a bank huge trading loss big counterparty default fraud and. so on or external market collapse sub prime crisis and so on The event is big enough to affect the. fundamentals of the bank and negatively impact the sequential quaterly numbers top line and bottom. line Over a period of time this brings down the credit rating of the institution This chain of events. affects funding cost which starts going up resulting in short term stress If the bank does not have. measures in place to contain short term stress it transforms into long term stress resulting in drastic. shrinking of funding sources to the point where there are none left This creates stress in the markets. and the liquidity and marketability of assets is greatly reduced The bank may try to counterbalance the. effect through fire sale of assets However distress selling can never make up for the gap created by long. term stress and the bank may eventually face liquidation Liquidation occurs in a worst case scenario. normally there is an elongated period of stress with depressed asset prices and marketability and. reduced funding sources which severely affect the institution s health When a bank enters into long term. stress the tremors are felt in larger markets where they affect other players as well Whether it transforms. into a contagion or not is dependent on factors such as the size of the institution affected the severity of. the event central bank intervention and coupling of institutions. Liquidity Risk Stress Testing Framework, Given the balance sheet composition behavioral profile concentration of the assets and liabilities and. organizational strategy the objective of a liquidity risk stress test is to. n Identify key risk factors and drivers affecting assets and liabilities. n Design scenarios extreme yet plausible which align with assets and liabilities. n Test the resilience of funding sources and alternatives under idiosyncratic and systemic disruptive. It is important to understand that stress testing is not just about identifying the breaking point It is also. about understanding an institution s internal composition how it would react to the vagaries of the. internal and external environment and what measures can be proactively built in to act as shock. absorbers to keep it afloat in a worst case scenario. The stress testing framework should evolve from an understanding of the fundamentals of the bank. This will help the bank react proactively as soon as an event which might develop into a crisis is identified. Figure 2 charts out a Liquidity Risk Stress Testing Framework This framework comprises four stages. n Identify,n Build and execute,n Quantify and control.
Build Execute Quantify Control,Historical,Identify Outflows. and Inflows under,Balance Sheet Idiosyncratic each scenario. Composition Asset Liquidity Risk Drivers,Simulated Define. Concentration a Plan of Action,Behavioral Liability Incorporate it in. Systemic the Contingency,Hybrid Plan,Figure 2 Liquidity Risk Stress Testing Framework.
Understanding the composition of the balance sheet is crucial to designing relevant stress scenarios Each. institution will have a unique balance sheet hence the composition of assets and liabilities will differ from. institution to institution An understanding of the behavioral characteristics of assets and liabilities is one. of the most crucial elements in designing relevant stress scenarios This can be analyzed in terms of. n Pre payment characteristics The pre payment characteristics of and drivers for a mortgage loan. are different from that of a commercial loan although there are common drivers such as age of the. facility charges and interest rate cycle Liquidity risk typically occurs when there is a mismatch in. terms of the funding and the tenor of the loan or mortgage and the issue becomes complicated as. pre payment needs to be included in the model, n Deterministic and non deterministic cash flows It is important to gauge the composition of such. cash flows and their proportion in funded and non funded products and maturity based and. perpetual products Models based on identifying core and volatile parts of such cashflows are key in. obtaining a view of the behavior of non deterministic cashflows. The concentration of assets and liabilities and the corresponding sources and alternatives of funding play. a crucial role in designing relevant stress scenarios It is crucial to understand the concentration of. funding sources retail wholesale structured and funding alternatives call money commercial. paper interbank certificate of deposit structured alternatives and so on Each source behaves. differently under different business scenarios as its sensitivity varies For example in terms of increasing. sensitivity and complexity the order will be retail wholesale structured hence the haircuts required for. structured sources are higher than the other two, The next step after assessing and understanding the DNA of the balance sheet is to figure out which. liquidity risk factors or drivers affect the balance sheet the most In most cases the genesis of liquidity risk. lies within a market risk credit risk and or an operational risk event or a combination of these risk classes. The canvas of liquidity risk is therefore larger than any other form of risk and hence the risk factors to be. considered for designing scenarios is also larger The analysis of the concentration of assets and liabilities. and their behavioral profile will aid in identifying the main risk factors from the larger population. Techniques such as Principal Component Analysis PCA can help in reducing the number of factors to be. considered for designing stress scenarios by choosing those which explain 95 or 99 of historically. observed variations,Build and Execute, The previous two steps Assess and Identify ensure that the scenarios which are built to perform stress. tests are in sync with the nature of the balance sheet and the factors affecting it We also have to consider. a concentrated set of factors from the larger population by using techniques such as PCA. The Build and Execute phase of the framework is more computationally intensive Regulators need banks. to design scenarios taking into consideration both idiosyncratic stress and system wide stress. The scenarios can be built by adopting Historical Simulated and Hybrid methods A comparision of the. three methods is depicted in Table 1 below,Historical Simulated Hybrid. Historical Data,Reliance on judgment,Ease to design build and execute.
Probability of over under estimation,High Medium Low. Table 1 Methods to Design Scenarios,General Market. n Interest Rates,n Credit Spreads,1D 1W 1M 3M 6M 1Y 3Y 5Y 7Y. n Inflation,100 200 500 500 500 1000 1000 1000 1000. Shock points in bps,200 500 1000 1000 1000 1500 1500 1500 1500.
Bank Specific Factors, n Increase in the roll 500 1000 1500 1500 1500 2000 2000 2000 2000. over of loans, n Impairment in the 1000 1500 2000 2000 2000 5000 5000 5000 5000. rollover of liabilities,n Reduced funding,1500 2000 5000 5000 5000 7500 7500 7500 7500. n Change in the,2000 5000 7500 7500 7500 9000 9000 9000 9000. behavioral profile of, assets and liabilities 5000 7500 9000 9000 9000 10000 10000 10000 10000.
n Rating downgrade,Shock Grid,Systemic Disruptive,n Full blown recession. n Fall of Government Severe,n Major devaluation of. currency Catastrophic,n Failure of large,Institutions. n War act of terror,n Historic Market,disruptive events. n Rating downgrade,Figure 3 Building Blocks of Stress Scenarios.
Figure 3 shows the Building Blocks of Stress Scenarios and consolidates the factors sample which affect. liquidity risk under three headings, n General market factors such as changes in interest rates spreads and currency rates. n Bank specific factors such as adverse changes in assets and liabilities funding sources contingent. claims rating downgrade and large counterparty default. n Systemic disruptions such as country risk war and collapse of a large institution Historic systemic. disruptive events such as the Russian crisis the Long Term Capital Management LTCM crisis and the. 2008 financial crisis can be good sources to build scenarios It has to be noted that systemic disruptive. events cause changes in the market factors and bank specific factors from which scenarios can be. The Shock Grid in Figure 3 defines the severity of movements in risk factors over different time periods. This is a simplistic representation of a grid the actual grid that a bank designs will be much larger and. granular in terms of tenor coverage and shock points The severity in terms of Bad Severe and. Catastrophic on the Shock Grid helps in sorting out the scenarios for each run It is important to consider. that the timing of the cashflows as well as the settlement cycles of currencies and markets can differ. resulting in a severe strain on the liquidity position Since the grid charts out the shock points across. tenors short term and long term it would aid in the final calculation of Liquidity Coverage Ratio LCR. and Net Stable Funding Ratio NSFR, The biggest challenge a bank is likely to face while building and executing scenarios is availability of. quality data Well established frameworks for market and credit risk still face hurdles due to unavailability. of correct data As such the challenge for liquidity risk will be more pronounced. Quantify and Control, After developing the scenarios based on the building blocks shown in Figure 3 each scenario is. executed The scenarios which produce negative net cash flows are studied carefully and probabilities of. banks across the globe use such as gap ratios based on structural and tactical liquidity concentration metrics and others Since liquidity risk measures are unique it would be logical to create a stress testing framework designed to suit the needs of liquidity risk The current economic environment is one wherein

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