Liquidity Position and Sensitivity to Market Risk

Liquidity Position

Having adequate liquidity is critical for a bank. The Basel III framework introduced two minimum liquidity standards:

1. Liquidity coverage ratio (LCR) is calculated as the value of a bank’s highly liquid assets divided by its expected cash outflows.

Highly liquid assets are those that are easily convertible into cash, while expected cash flows are the estimated one month liquidity needs in a stress scenario. The standards recommend a minimum LCR of 100%.

1. Net stable funding ratio (NSFR) is the percentage of required stable funding that is sourced from available stable funding.

Available stable funding is a function of the composition and maturity distribution of a bank’s funding sources (i.e., capital, deposits, and other liabilities). Required stable funding is a function of the composition and maturity distribution of the bank’s asset base.

Available stable funding (ASF) is determined based on an ASF factor that is assigned to each funding source, as shown in Figure 10.1.

Figure 10.1: Available Stable Funding Components

NSFR relates the liquidity needs of a bank’s assets to the liquidity provided by the bank’s liabilities (i.e., funding sources). Longer dated liabilities are considered more stable and hence would be suitable to fund assets with longer maturities (e.g., long term loans). Deposits from retail and small business clients are considered more stable than deposits from corporate clients.

The standards recommend a minimum NSFR of 100%.

Other liquidity monitoring metrics recommended by Basel III include concentration of funding and maturity mismatch. Relatively concentrated funding indicates a bank’s reliance on relatively few funding sources. This lack of diversification may pose a problem when the sources withdraw funding, resulting in heightened liquidity risk for the bank.

Maturity mismatch occurs when the asset maturities differ meaningfully from maturity of the liabilities (funding sources). The higher the mismatch, the higher the liquidity risk for the bank. For example, sometimes banks try to maximize the spread between lending and borrowing rates by borrowing at low, short term rates and lending at higher, longer term rates.

This mismatch in assets and liabilities may expose the bank to a liquidity crunch if it is unable to roll over its borrowings at reasonable rates.

Sensitivity to Market Risk

Bank earnings are affected by various market risks (e.g., volatility of security prices, currency values, interest rates). The most critical of these is interest rate risk. A bank’s interest rate risk is the result of differences in maturity, rates, and repricing frequency between the bank’s assets and its liabilities.

For example, in a rising interest rate scenario, if the assets are repriced more frequently than liabilities, the bank’s net interest income would increase.

Banks respond to opportunities presented in the market and alter their balance sheets. For example, following the financial crisis of 2008, central banks around the world reduced short term interest rates, allowing banks to borrow at lower rates. To benefit from this interest rate scenario, many banks increased their duration risk (i.e., borrowed more short term funds while lending long term).

Similarly, the impact of a change in the shape of the yield curve differs among banks, based on differences in the composition of their assets and liabilities. In the MD&A section of their annual reports, banks often disclose exposure to a wide variety of market and nonmarket risks. For example, a bank may disclose the impact of a change in yield on its earnings.

The impact of market risk can be captured by value at risk (VaR). We will discuss this important risk metric in the portfolio management topic area of the curriculum.