Risk Management Framework II

Question 1

What is Liquidity Risk and what can it result in?

Answer 1

The risk that a firm is unable to meet its obligations as they fall due, resulting in:

1. Inability to support normal business activity
2. Limited ability to support lending, trading and investments
3. Inability to fulfil lending obligations
4. Failing to meet liquidity regulatory requirements - Regulatory breaches e.g. FCA or PRA standards
5. Rating agency concerns
6. Forced reduction of balance sheet and sale of assets

Question 2

How does Basel define Liquidity Risk?

Answer 2

The ability of a bank to fund increases in assets and meet obligations as they come due, without occurring acceptable losses. Basel has 17 liquidity principles grouped into subheadings:

• Fundamental principle for the management and supervision of liquidity risk
• Governance of liquidity risk management
• The role of supervisors
• public disclosures

Question 3

What are features of Liquid Assets?

Answer 3

• Can be sold rapidly, with minimal loss of value within market hours
• Ready and willing buyers and sellers at all times in large quantities
• The probability is that the next trade is executed at a price equal to the last one

Question 4

How does Liquidity Risk develop?

Answer 4

• Liabilities cannot be met when they fall due
• Liabilities can only be met at an uneconomic price
• Can be name-specific or systemic

Question 5

What are features of Declining Liquidity?

Answer 5

• Widening of bid-offer spread
• Setting aside explicit liquidity reserves
• Lengthening the holding period for VaR calculations

Question 6

What techniques can be used to manage Liquidity Risk?

Answer 6

1. Liquidity Gap Analysis – bucketing cash flows to highlight periods when a portfolio will have large cash outflows – called liquidity gaps. Basically a maturity ladder w/buckets
2. Maturity Ladders – compares a firm’s future cash inflows to its cash outflows over a series of time periods
3. Stress Testing – analysis that considers the effects of different market conditions, business strategies and client behaviour
4. Liquidity Limits – covering credit spread changes, wholesale funding, regulatory limits and changes in ratings
5. Counterparty Credit Limits – should be established for all counterparties and aggregated globally and across all products
6. Scenario Analysis – process of analysing possible future events by considering alternative possible outcomes

Question 7

What questions are used to determine ‘Stickiness’ – the tendency of funding not to run off quickly (wrt liquidity) in stressed conditions?

Answer 7

1. Is the liability an insured deposit?
2. Is the liability secured?
3. Are the funds controlled by the owner?
4. Does the counterparty have other relationships with the bank?
5. Is the counterparty a net borrower?
6. Does the funds provider lack internet access to the funds?
7. Is the counterparty financially unsophisticated
8. Does the bank obtain deposits directly or through a broker?

Question 8

Give examples of Netting.

Answer 8

• Payment Netting – reduces settlement risk. Multiple cash flows can be netted with one payment per currency
• Closeout Netting – reduces pre-settlement risk when counterparties have multiple obligations to one another
• Bilateral Netting – allows two counterparties to net with one another and is common in OTC markets
• Multilateral Netting – occurs between multiple counterparties and is facilitated by a central counterparty such as an exchange, thereby mitigating credit risk

Question 9

What is Cash Flow at Risk (CaR)?

Answer 9

Actual net funding amounts over a defined time interval are counted and put into on of a series of buckets that represent intervals of amounts e.g. (EUR -10m to EUR -6m).

Can therefore use the resulting graph to calculate the probability of being in a certain net funding position.

Question 10

What is Liquidity at Risk (LaR)?

Answer 10

LaR = p(liquidity) – CaR

Where p(liquidity) = probability to access a certain amount of liquidity; i.e. can the required amount of money be accessed at a reasonable cost.

Question 11

What is Diversification?

Answer 11

Spread activity across multiple markets to vary the level of risk in individual markets and geographical areas

Question 12

What is Market Risk?

Answer 12

The risk that the value of a market position will decrease due to the change in value of market factors such as:

1. Price Level Risk – the prices of tradable assets are moving throughout the trading day
2. Commodity Risk – shortages of supply squeeze the market
3. Basis Risk – the difference between the spot price (current value) and the cash price (future value). Changes in basis prevents perfect hedging
4. Interest Rate Risk – affects the value of investments and volatility
5. Volatility Risk – the speed at which prices change. Rapid price swings represent high volatility
6. Liquidity Risk – not being able to execute trade due to inadequate market depth
7. Currency Risk – some investments will be denominated in currencies that are different to our domestic currency

Question 13

How is Total Market Risk calculated?

Answer 13

(Unsystematic Risk) + (Systematic Risk) = (Total Risk)

Unsystematic Risk – risk specific to sectors, companies or projects – can be reduced by diversification (investing in different countries, sectors and industries)

Systematic Risk – variability of returns caused by factors affecting the whole market – cannot be reduced (risk remains even if portfolio is diversified)

Total Risk – total variability of returns – the residual risk remaining after considering hedging and diversification

i.e. the more you diversify a portfolio, the lower the unsystematic risk gets

Question 14

What is the Top-down Market Risk Limit Structure Pyramid?

Answer 14

• General Management
  
  • Group Risk
    
    • Management Committees
      
      • Dealers, trader and dealing rooms

Question 15

What is the Top-down Market Risk Limit Mechanisms Pyramid i.e. what are risk limits assigned to each group in last pyramid?

Answer 15

• Basic VaR Limits
  
  • Scenarios (process of estimating value of portfolio after a given period of time) and Greeks (sensitivity of derivative to underlying)
    
    • Detailed Limits
      
      • Individual Limits

Question 16

What is Stress Testing and what are the basic principles?

Answer 16

Stress Testing is performed to test the reliability of a system or component to carry out a designated task

• Understand your business
• Identify variable elements
• Calculate data distribution
• Vary the data by unitary amounts
• Evaluate the differentials

Question 17

What are the advantages & disadvantages of Stress Testing?

Answer 17

+

• Assesses the impact of significant but likely changes to the business
• Helps to form risk mitigation strategies
• Enables informed decision making (e.g. closing out high risk positions)

-

• Modelling makes assumptions
• Is considering a single variable realistic?
• Is varying more than one variable too hard?
• How good is the modelling?

Question 18

What considerations should be made when planning Stress Testing?

Answer 18

What considerations should be made when planning Stress Testing?

• What stress tests are suitable?
• What level of stress testing shall we do?
• How often will we stress test?
• How will results be reported?