Managing Liquidity in Banks - Rudolf Duttweiler - ebook

Managing Liquidity in Banks ebook

Rudolf Duttweiler

179,99 zł


"Liquidity risk is a topic growing immensely in importance in riskmanagement. It has been much neglected by financial institutionsand regulators in recent years and receives, in the course of thesub-prime crisis, sudden and great attention. This book iswell-structured and provides a comprehensive and systematicapproach to the topic. It will help risk controllers tosystematically set up a liquidity risk framework in theirbank." --Peter NEU, European Risk Team Leader, The BostonConsulting Group, and co author of Liquidity Risk Measurementand Management "Mr Duttweiler's book is a welcome addition to the literature onliquidity risk measurement and management. In addition to hiscontributions to liquidity risk theory and liquidity pricing, theauthor provides a good overview of all of the criticalelements." --Leonard Matz, International Solution Manager, LiquidityRisk and co-author of Liquidity Risk Measurement andManagement Liquidity Risk Management has gained importance overrecent years and particularly in the last year, as major bankfailures have led to a re-evaluation of the significance ofliquidity in stressed market conditions. Liquidity risk is closelyrelated to market risk and solvency, suggesting its significance intimes of volatile and 'bear' markets, where a single bank'sfailure can have dramatic effects on market liquidity. The term liquidity is not well-define, and a comprehensiveunderstanding of its common elements is often missing within abanking organisation. In too many cases, liquidity risk managementhas not been developed with a coherent framework and generallyaccepted terms and methods, creating weaknesses in its structureand vulnerability to market risk. In this title, Duttweileradvances the study of quantitative liquidity risk management withthe concept of the 'Liquidity Balance Sheet', which allocatesportfolios into a specific structure, and consequently is able toaccount for potentially negative surprises so that the necessarybuffers can be quantified. The book begins with an overview of liquidity as part offinancial policy and highlights the importance of liquidity as partof a general business concept and as protector and supporter of abusiness as a going concern. The author examines the role oliquidity in helping managers to achieve high-level liquidity aimsto support operating units to achieve business goals. He looks atquantitative methods of assessing a banks liquidity levels,including LaR and VaR, to establish an integrated concept in whichliquidity is incorporated into the framework of financial policies.He also presents methods, tools, scenarios and concepts to create apolicy framework for liquidity and to support contingencyplanning.

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Half Title page

Title page

Copyright page





About the Author

Chapter 1: Liquidity and Risk: Some Basics

1.1 Some Understanding of Liquidity

1.2 The Meaning of Liquidity Risk

Chapter 2: Liquidity in the Context of Business and Financial Policy

2.1 Introduction

2.2 Equilibrium As A Tool Within Financial Policy

2.3 The Concept Enlarged to Fit Banks

Chapter 3: Liquidity as an Element of Banking Risk

3.1 Some Clarifications

3.2 The Concept of Downside Risk (Var) and its Circle of Relationships

3.3 Lar: Liquidity Risk and The Missing Theoretical Concept

3.4 An Attempt At an Integrated Concept For Lar

3.5 Summary

Chapter 4: A Policy Framework for Liquidity

4.1 Some Thoughts and Considerations

4.2 An Overview of Elements Regarding Liquidity Policy

4.3 The Elements of A Liquidity Policy in Detail

4.4 Contingency Planning

4.5 A Technical Framework Supporting Liquidity Policy

4.6 The Link to Liquidity Management

Chapter 5: Conceptual Considerations on Liquidity Management

5.1 Introduction

5.2 From Accounting Presentation to Defining The Liquidity Balance Sheet

5.3 The Liquidity Balance Sheet and Liquidity Flows

Chapter 6: Quantitative Aspects of Liquidity Management

6.1 General Consideration

6.2 Liquidity At Risk As One Determinant of The Buffers

6.3 Defining and Quantifying The Buffers

6.4 Limit-Related input For Liquidity Policy

6.5 Transfer Pricing and An Alternative Concept

Chapter 7: The Concept in Practice

7.1 introduction

7.2 Establishing The Base

7.3 Case 1: A Shock Event (9/11)

7.4 Case 2: A Name-Related Stress (Commerzbank in Autumn 2002)

7.5 ‘Subprime’ Crisis: A Stress in Progress

7.6 Final Remarks and Considerations

Chapter 8: Acting Within the Supervisory Frame

8.1 High-Level Risks

8.2 The Regulatory Focus Set By Supervisors

8.3 Considerations and Conclusions For Bank Management



Managing Liquidity in Banks

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ISBN 978-0-470-74046-0

To My ChildrenJan and Alexandra


Exact timing is essential for a good treasurer – and this book arrives right on time! In his book, Rudolf Duttweiler presents the sum of 24 years of professional experience, gathered in positions of responsibility at several banks, 14 years of which include working for Commerzbank. He is definitely no theoretical analyst, but a practitioner with high standards for logical and structured thinking.

This book appears at a time of probably the most severe financial crisis since the Great Depression of 1929. One of the many lessons learnt from the ‘subprime’ crisis is without doubt that liquidity risks were underestimated across the board. Possibly the intensive debate over the last few years on default risks, solvency and Basel II has distracted too much attention from these kinds of risks. With hindsight they should have been considered as a grave threat to the financial sector, and it is clear that liquidity is crucial: for individual market participants, for the markets and for the whole financial system.

Another thing to note is that products, markets and financial institutions are more closely connected by the new financial innovations that have been created. At the same time, the worldwide ramifications of such developments are not sufficiently transparent to both market participants and supervisory authorities. The reasons are, amongst other things, international differences or ‘loopholes’ in regulatory frameworks, as well as differing transparency standards – consider, for example, conduits and similar arrangements.

In a nutshell, liquidity management has become more important than ever for banks.

There are two conclusions in this book which I think are especially important. One conclusion is that securing and managing bank liquidity is not merely a supporting, back office task which can be easily delegated. Since there is a strategic dimension, it needs to be done at top management level. It is only at such a level that decisions can be made on exactly what measures need to be taken, to what extent and at what costs, in order to deal with any kind of situation threatening the liquidity of a bank.

The other conclusion, masterfully illustrated here, is not just to fulfil all liabilities completely. This would also be possible to do at the price of breaking up a bank, albeit not punctually. No, it is primarily about preserving a bank, its reputation and thus its ongoing client and investor connections. Otherwise, its business network would be lost, a network built on hard-won trust, sometimes over centuries.

Another great achievement of the author is the provision of clear definitions and practical explanations, including the big picture.

Over the years, I have come to know and hold Ruedi Duttweiler in high esteem both personally and as a professional. I am deeply grateful to him – not only personally, but also on behalf of the shareholders, clients and colleagues of Commerzbank.

Ruedi Duttweiler has in particular been responsible for skilfully securing the liquidity, and thus helping to preserve the continued existence, of Commerzbank. For the first time, the related stress situations are revealed in detail for a professional audience in Chapter 7. Special attention is devoted to the intentional, yet completely unfounded rumours of liquidity shortages in 2002 which put the bank in a precarious position. The author was able to calm markets then, thanks to a conservative, high-liquidity strategy that he and his colleagues in the treasury department pursued. With his long professional experience and the steady hand of a ‘veteran’ (he is, by the way, a reserve officer in the Swiss Army), he exuded the necessary credibility amongst his peers worldwide. Consequently, he was able to convey the message that there was no reason to believe these rumours. The public support of the German banking supervisory authorities at that time can without doubt be attributed to a significant extent to his calm strategy and the good liquidity management he employed at Commerzbank.

To summarise: this book and its conclusions merit a large number of readers, thoughtful reading, and consideration as a textbook for daily treasury practice. Once this happens, the author will have provided an invaluable service to the whole financial community.

Klaus-Peter Müller

Chairman of the Supervisory Board, Commerzbank AG

President of the Association of German Banks


Liquidity risk and its management have become public focal points in the course of the US subprime mortgage crisis, when state intervention was necessary on a large and unprecedented scale to avoid the collapse of the financial system. The response is understandable given the severe implications when lacking control over it. And control over it seemingly has been lacking in many cases, as illustrated by well-known names in many countries: Bear-Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Fortis, Kaupthing, Northern Rock, Royal Bank of Scotland, UBS, Hypo Real Estate or IKB, to mention but a few. Yet it is surprising how little seems to have been known or applied in the banking industry when it comes to dealing with liquidity risk. We do not necessarily refer to the handling of the crisis, but mainly to the apparent shortcomings in the preparation to keep this type of risk within manageable levels. After all, next to downside risk, it is the most important risk elements immediately endangering solvency.

Why then has the banking industry been affected so strongly – in fact, more severely than in any liquidity crisis in the last 50 years or so when considered on a global basis? It is obviously neither the lack of general knowledge about the subject nor any disregard on a large scale which caused it. Based on rules and regulations agreed by the members of the Bank for International Settlements (BIS), national supervisors have put such principles into national legislation, not in a uniform manner but with their essence preserved and adjusted for local conditions. At the turn of the millennium in 2000 the Basel Committee on Banking Supervision set out principles in respect of ‘Sound Practices for Managing Liquidity in Banking Operations’. More detailed recommendations have been delivered since. The banking industry thus had time to familiarise itself with the subject and to put legislation into concrete action.

My personal assessment relates much of the impact to having failed to read the equivalent of the ‘small print’ in a contract. Liquidity is an extremely complex subject and liquidity risk has many dimensions. Board decisions on business policies such as dynamic internal growth or a substantial acquisition can drastically alter the liquidity structure of a bank. Substantial losses will impinge on capital ratios and hence on the financial health of a bank, which in turn may affect the attitude of lenders and thus funding capacity. Or the funding markets may have turned less liquid, thus reducing or eliminating the level of borrowing at normal spreads and volumes, and the effects may have occurred despite an unaltered structure in liquidity or financial health of an institute. Any cautious bank management will have provided for such events by establishing liquidity buffers in the form of tradable assets. However, how liquid are liquid assets when they actually have to perform their duty? The answers to each question have found their way into modern liquidity management and the quantitative part into the respective measurements.

For bank management entrusted with securing and furthering the commitment to shareholders and stakeholders, staying liquid cannot be regarded as an isolated goal. It has to be brought into a balanced equation of further business and financial aims, as there are additional elements endangering solvency. Considering the latter point, the expectations of bank management exceed the primary goal of liquidity management, which is: to ensure that all payment obligations are fulfilled as and when they fall due. Taking the latter goal in extremis, it includes fulfilling all obligations till the last transaction is off the books leaving a skeleton of a bank with no customers left. Surviving a crisis thus means keeping the core of the business and customers, i.e. the franchise, intact. Defining it and determining the degree and duration of protection are the prerogatives of bank management.

Considering the high-level implications of liquidity as well as the management’s respective responsibilities, it is advisable not to begin with technicalities, however. What is required is the application of a top-down approach. Derived from set business and financial goals, we are going to formulate a policy framework for liquidity based on which specific aspects of liquidity management and measurement are evaluated. Taking this route will permit us to embed the subject within the overall frame of decision making applicable to bank management. The approach is based on practical experience put into concepts, with the understanding that, without working in conceptual frames, the ‘small-print’ syndrome cannot be avoided.

We start in Chapter 1 by defining liquidity, its risk and its relation to solvency. This serves as an introduction to the basics and lists at the end elementary but vital principles to be applied to any liquidity scheme with a chance of success. Since policy aspects of liquidity related to banking have been rather neglected until recently, Chapter 2 evaluates traditional concepts including schemes applied in corporate finance. In view of the difference in complexity between ‘corporates’ (i.e. non-financial firms) and banks, the key financial determinants for banks are evaluated by using a technique developed to deal with complex structures.

The key determinants are then integrated into a conceptual framework in Chapter 3. The two dominant financial risk factors in banking – loss and liquidity – are analysed and the possibility of applying to liquidity the widely accepted methods for calculating downside risk is evaluated. The chapter concludes with a conceptual framework integrating all relevant points concerning liquidity policy in banking. We then formulate the elements of the latter in Chapter 4, including contingency planning and securing the franchise of a bank. Given the significant diversity in size, structure, complexity and environment within the banking industry, we abstain from uniform recommendations. Instead, whenever possible, alternatives are presented, their pros and cons discussed and personal preferences stated if applicable.

The following two chapters address the aspects of liquidity management derived from the conclusions drawn when discussing policy elements. The subject is divided into a more qualitative and a rather quantitative part. Chapter 5 covers the former. For the purpose of presenting the key elements within the liquidity status in an aggregated high-level form, the instrument of the liquidity balance sheet is introduced. Franchise, security buffers, assets at risk, stable and non-stable funding are all defined and their interaction and relevance to liquidity management discussed, followed by specific recommendations with regard to policy as a form of feedback. Chapter 6 brings in the quantitative aspects. New mathematical methods proposed for managing liquidity risk are presented and their value assessed. For determining the size and structure of buffers, our own approach is introduced and put forward. The chapter ends with limit-related aspects and two concepts referring to transfer pricing.

In Chapter 7, dealing with stresses is analysed from the point of view of an insider. Although having inevitably encountered quite a few stressed conditions as treasurer, the author has selected both a shock (9/11) and a chronic type (name-related stress in late 2002). Preparations to withstand such occurrences as well as actually dealing with them are outlined in a real-life manner in the case of Commerzbank. Furthermore, a preliminary assessment of the subprime crisis is added. The chapter concludes with generally valid recommendations derived from the experiences.

The final chapter takes a broader view and extends this to supervisors and their role with regard to controlling liquidity risk. The issues covered address their perception vis-à-vis banks and the stability of the financial system as well as the concepts applied. This is followed by an assessment of whether and to what extent supervision is or is supposed to secure goals defined by bank management.

Rudolf Duttweiler


Any practical experience is enhanced by in-house and external communication in discussions and presentations. Many of these have formed my present view and understanding of dealing with liquidity risk and thus contributed indirectly to the book. I wish to thank my former team at Commerzbank as well as the members of the European Bank Treasurer Group of which I had the pleasure to belong for more the 10 years. Namely, ABN Amro: Rolf Smit and Karl Guha; Allied Irish: Nick Treble; BPH: Miroslaw Boniecki and Ryszard Petru; Intesa Sanpaolo: Giovanni Gorno Tempini and Stefano del Punta; Bank Austria Creditanstalt: Heinz Meidlinger; Barclays Bank: Chris Grigg and Jonathan Stone; BNP Paribas: Michel Eydoux; Danske Bank: Jens Peter Neergaard; EIB: Anneli Peshkoff; KBC Bank: Patrick Roppe; and UBS: Andreas Amschwand and Stephan Keller.

Special thanks go to Dr Kai Franzmeyer, my former head of liquidity and subsequent successor with whom many of the basic principles have been developed; to Peter Bürger and Dr Peter Bartetzky for their suggestions and critical review of specific subjects; as well as to Sandra Appelt and Sandra Hartmann who patiently and diligently transformed these ideas into graphical presentations.

Presenting the view from inside a bank requires information and consent to use it for publication purposes. My thanks for this go to the CEO, Martin Blessing and to the Executive Board of Commerzbank, represented by its member Michael Reuther.

Rudolf Duttweiler

About the Author

Rudolf Duttweiler is an economist by training with a PhD from the University of St Gallen, Switzerland. Liquidity has played an important part in all his professional life. His first practical experience of banking was gained in Zurich and London as Treasurer of the Swiss Bank Corporation (now UBS) and Credit Suisse. From 1993 until 2006 he headed the Group Treasury of Commerzbank at its headquarters in Frankfurt. This was the formative period during which a comprehensive understanding of liquidity policy and respective concepts for managing liquidity were developed. Throughout his professional life he has continued to publish and lecture on market- and liquidity-related subjects. His last publication in 2008 referred to liquidity as part of banking-related financial policy, in which the basis was laid to integrate liquidity into the framework of business policy for banking. Dr Duttweiler is a lecturer on Bank Treasury Management at the University of St Gallen.

Chapter 1

Liquidity and Risk: Some Basics

The term ‘liquidity’ is anything but well defined. In any meaningful discussion with treasury colleagues in other banks or with controllers on liquidity, one can be confident that everybody will have a solid knowledge of liquidity and risk as terms. Often, however, it is well into the discussion before one encounters a common understanding of the specific elements on liquidity being addressed. This is somewhat surprising given the fact that the issue has been around for a very long time. Back in the nineteenth century, Knies (1876, page 249) stressed the necessity for a cash buffer to bridge negative gaps between payment inflows and outflows in cases where their timing cannot be completely regulated. In the last century the issue was also taken up and intensely discussed, as for example initiated by Stützel (1959, pages 622–629). The further discussions primarily centred on basic considerations such as the relationship between liquidity and level of solvency (Stützel, 1983, page 33f.) or the distinction between the level of liquidity reserves and its structure (Witte, 1964, page 770f.), for example.

Around the mid-1990s a new wave started, became intensified after the turn of the millennium and is still continuing. It is clearly distinct from former discussions. Its focus is on specific issues of liquidity management, but only touches policy issues related to liquidity. A selection of publications covering wider aspects, in addition to the numerous papers on very specific issues, may illustrate the point made: namely, Matz (2002), Zeranski (2005), Matz and Neu (2007) and Bartetzky, Gruber and Wehn (2008).


Why then can we not relate to clearly defined terms after the subject has been dealt with for well over 100 years? The long intervals certainly have not helped. More importantly, however, banks, as one of their basic functions, are collecting points of money for the various groups within society. Thus, for most of the time, getting funds has been of little concern in itself, and this especially so if compared with employing these funds as assets in a secure and profitable manner. Furthermore, liquidity has many dimensions. The term is used to express a specific condition for a product, an institution, a market segment or even an economy, just to mention some important applications, as can be seen in Figure 1.1.

Figure 1.1 Different meanings of liquidity

(Source: Adapted from Bartetzky, 2008, page 9)

As a starting point we take the basic and most narrow definition (Box 1.1).

Liquidity thus is neither an amount nor a ratio. It rather expresses the degree to which a bank is capable of fulfilling its respective obligations. The opposite would be ‘illiquidity’, i.e. the lack of the respective capability to fulfil them. In this sense, liquidity represents a qualitative element of the financial strength of a bank (Duttweiler, 2008, page 30).

1.1.1 What do we know about liquidity?

The understanding of how liquidity is affected under different circumstances has improved significantly within the last decade. This is not so much because many of the aspects have been

Box 1.1 Definition of liquidity

Liquidity represents the capacity to fulfil all payment obligations as and when they fall due – to their full extent and in the currency required.Since it is done in cash, liquidity relates to flows of cash only. Not being able to perform leads to a condition of illiquidity.

known for much longer, but it is only relatively recently that methods have been developed that allow a more precise quantification. By following a selected and illustrative list of known facts, a commonly used segregation into risk types can be made:

Volume and tenor of assets depend largely on business policy.The more the long-term assets are financed with short-term liabilities, the bigger the liquidity gap will be.The more stable deposits do come from the retail sector, but they are structurally short term in nature. Usually, their volume is not sufficient to finance all assets on the balance sheet.Banks do write options to their customer base. They can differ in name, like committed lines of credit; backup lines for issuers in the commercial paper (CP) market; drawdown facilities in the mortgage finance sector; or early repayment facilities. But they are similar in character: the option may or may not be executed, or partly only; and the timing of the event is very much open to an agreed timeframe.If one allows for liquidity gaps to stay, the initial funding matures before the respective asset falls due. Thus, the bank will have to go into the market at a later date to finance the old asset for the remaining time till maturity.How easy the later financing can be executed in the market and the price one has to pay at that date in the future are not known in advance.Some assets are generally marketable, i.e. they can be turned into cash through selling or entering into a repo transaction for example. As conditions of instruments and markets can change, their value as liquidity is subject to alterations.The willingness of the market to provide funding will depend on the financial solidity of the borrowing institution, as assessed by the market at that future date.The financial status of a bank itself, as well as its perception by the market, are made up of various interrelated business data such as quantity and quality of risk taken on the book, capital and capital ratio, earning power and expected future trend, to mention just a few.There is no guarantee that one can forecast today what one’s own financial status will be a few years down the road. Furthermore, one does not know how this status will be perceived by the market at that time.

When it comes to the characteristic of liquidity sources, the following distinctions are generally made: availability, maturity structure, cost structure and liquidity risk. Structurally they are usually grouped into the following four blocks:

1. Call liquidity risk: This relates to both assets and liabilities. Drawings under an option facility may be executed. Deposits can be withdrawn heavily at the earliest date possible instead of being prolonged.

2. Term liquidity risk: Payments deviate from the contractual conditions. Repayments may be delayed for example.

3. Funding liquidity risk: If an asset has not been financed congruently, the follow-up financing may have to be done under adverse conditions, i.e. at a higher spread. In extreme cases, funds may even be withdrawn heavily as explained under call risk.

4. Market liquidity risk: Market liquidity relates again to assets and liabilities. Adverse market conditions may reduce the capacity to turn marketable assets into cash or to fund the required quantity. A combination of both effects is possible as well.

Furthermore, we know that liquidity is just one element to be watched and managed within a bank. Applying a categorisation as is common in the business literature, one can start with business risk, go to customer risk, add the trinity of market, credit and operational risk, and close the circle with auxiliary risks (Figure 1.2).

Figure 1.2 Liquidity risk as one element of banking risk

(Source: Adapted from Bartetzky, 2008, page 11)

As all the other items have a formative influence on liquidity status, it follows that liquidity is not a driving element but is of a subsequent nature. The question then arises about the importance of its role within the large frame of issues and risks.

1.1.2 What is the issue about liquidity?

Experience shows that most of the time it is plentiful. There are periods when it is somewhat scarce and thus at a premium pricewise. As soon as we start to consider longer periods, these differences in price will average out. Movements in spreads are not dissimilar from what a bank may experience in its other market segments. This cost is sustainable by a bank and rather a question of optimising return than securing survival.

However, it is a characteristic of liquidity that it has to be available all the time and not on average or most of the time. Payments have to be executed on the day when they are due, or the bank is declared illiquid if it fails to perform. Statistically, the chances of this happening are very low. But if it happens, the effects will be severe and could be fatal to the bank. No manager can sensibly take such a risk and play with the investments of shareholders.

When talking about potential illiquidity, one should not concentrate on just the extreme case. Clearly, the ultimate stress model one can think of has to be analysed. However, this case should not be the main concern of a liquidity manager for the following reasons:

Firstly, it is hard to imagine a single liquidity controller who would miss this. The ultimate stress case is definitely on the risk report.Secondly, the chances are that this stress will closely resemble something like the biblical Flood. Should one therefore build the financial equivalent of Noah’s ark for this?Thirdly, if one did, business would be greatly restrained and earnings curtailed. This again cannot be in the interest of management.And lastly, liquidity strains occur more frequently on a level less severe than the Flood but still sufficiently dangerous to interrupt business for a while, making it necessary to alter the business strategy of the company, or at least elements of it.

Those people and committees responsible for securing an appropriate liquidity status in a bank will aim to keep the various types of risk at acceptable levels as well as in the form of a weighted equilibrium. Taking these goals into account, any liquidity policy has to consider the aspect of securing payment obligations on the one hand as well as allowing a subsequent earning-related business strategy on the other hand. In other words, the extremes of total neglect and the equivalent of the Flood cannot be part of the policy applied.

In the process of formulating any policy it is helpful if one can refer to the experience of similar institutions, or, better, to adapt generally agreed rules. For some aspects of banking significant progress has been made in this respect. On the question of capital adequacy, the systematic to rate customers that the bank is exposed to or the principles applied to assess market risk for example, rules exist which are comparable beyond national borders. As these rules are similar, it helps banks to refer to an accepted standard while allowing them to compare institutions against each other. Unfortunately, that stage has not yet been reached regarding liquidity. National rules applied by the respective supervisors can still differ greatly from country to country. Endeavours towards reaching an effective and comparable systematic for liquidity as well are on their way, but for the time being it means adhering to national rules and, in case they do not keep up with the complexity of one’s own institution, developing liquidity concepts which appropriately cover in-house needs.

1.1.3 How to look at liquidity

As stated earlier, liquidity represents a qualitative element of the financial strength of a bank or institution. Although true, management looks at liquidity in a more practical way and generally differentiates the following aspects (Figure 1.3).

Figure 1.3 Aspects of liquidity Level of aggregation

In our case, aggregation incorporates several dimensions (Box 1.2) such as amount, currency and time factor. Which level to choose is not easy to advise. Supervisors or controllers seem to have a preference for rules on an aggregated level. No doubt the latter has the advantage of concentrated information with few figures to deal with. It is almost inevitable that the highest possible level will be aggregated if one wishes to use ratios. They have become very popular. Ratios are relatively easy to benchmark and to compare. Moreover, there is no need to look at many details. What weight do we then put on the question of currency mix?

For a bank hardly extending its activities outside its own currency area the answer is easy. There will be the odd payment in foreign currency. It has to be taken care of within the frame of correspondent banking. Moreover, we do not seriously distort reality if small amounts are shown in local currency equivalents.It is a different matter in the case of large multi-currency banks. They may have sufficient liquidity overall, but concentrated in one or a few currencies. As long as markets work in

Box 1.2 Principle to be applied for aggregation

Keeping all the possibilities and the respective implications in mind, one can only advise maintaining information on liquidity as detailed as possible, even if it is not required by supervisors and controllers.

a satisfactory way, balances can be closed in time through short-dated foreign exchange transactions. At the moment disturbances occur, the system may no longer work smoothly, however.

In cases where geographical locations are far apart, we may be acting in two different time zones. Clearing deadline in Tokyo tends to be at midnight in New York, i.e. outside working hours. Furthermore, amounts may be out of the general pattern from time to time. In both cases a proper infrastructure as well as working relationships with banks in foreign centres are required to cover larger liquidity needs in a short period of time.The potential danger of illiquidity is not limited to main currencies. Failing to perform can also stretch to modestly used currencies and still be followed by severe repercussions. Natural and artificial liquidity

Natural in this sense relates to flows from maturing assets or liabilities. Artificial liquidity is created through the capacity to transform an asset into cash before the maturity date is reached. The process can be achieved, for example, through a sale or a repo transaction with the market or by using the instrument as collateral with the central bank. Technically, it is known as shiftability and marketability. Assets with these characteristics are thus generally called ‘marketable’.

There are two points which we should introduce now. They will be important when we address the question of forecasting implications under various scenarios:

For most of the time a specific security may easily be transformed into cash. The market for this product is mostly deep and wide. As long as a single firm wishes to turn a security into cash the market is capable of absorbing the transaction. Even the price of the security will not be negatively affected. As soon as large groups of investors are faced with the same needs, the market may become out of balance. It may take longer to execute the desired volume. At the same time, sellers may be faced with a shift in pricing against them.Natural liquidity refers to the legal maturities. Especially in banking, a transaction with a customer at maturity is often rolled over, either for the same amount or a smaller/larger one. The customer base in total behaves mostly in a rather predictable way. For specific portfolios one will experience a pattern in prolongation. This is true not only for assets but also for liabilities.

The main point is that customers expect certain behaviour from their chosen institution. They want to be sure they can reinvest or borrow again after the prior transaction has matured. Commercial customers need working capital. The nature of each drawing may be short term but the line will be used frequently. The relationship they keep with the specific bank includes a basic understanding of reliability: namely, that business will be continued. The legal view

Box 1.3 The term ‘optionalities’

The term ‘optionalities’ expresses the commitment of a bank equal to that of an option seller.

Optionalities can relate to assets or liabilities; on- or off-balance-sheet transactions.

on maturities to assess future gaps in liquidity neglects all these expectations. Leaving your customers out in the rain undermines your franchise and thus your own future as a bank. If any liquidity policy aims at surviving not only as a legal entity but also as a bank with its customer base intact, a different approach is required. We call it the ‘business view’, in contrast to the legal or accounting perspective, an approach which takes into account that the franchise is too valuable to be neglected. Optionalities (Box 1.3)

The option market, whether exchange traded or over the counter (OTC), has increased impressively in the last few decades. The number of option buyers has spread through all markets. They are willing to pay a premium for the right to choose whether or not to execute the contract at the agreed respective date. Simultaneously, their counterparts have grown in numbers as well. Ready to wait for the decision of the buyer, they receive compensation from the buyer in the form of a premium. The magnitude of some markets has reached levels which have made it advisable for supervisors to introduce controls and some restrictions.

The risk is asymmetric between counterparts in options. The buyer of a contract for paying a premium can choose whether to execute the deal or not. The buyer’s maximum cost is defined by the premium paid. The earning potential, if the market goes the buyer’s way, is only limited by the extent of the market move. For the seller of an option it is the reverse. First the seller gets a premium but then price movements of the respective product determine the seller’s earnings or losses. Such earnings are limited to the premium received. Losses are a result of market moves against the seller. That is the principle, although any position will be managed and not left to the mercy of the market.

Liquidity in this segment can be affected in three ways:

1. The pure cash element: Whatever is ‘paid’ for premiums or losses, it will be an outflow of cash. And whatever is ‘received’ as premium or profit is an inflow of cash. To compute the effects on liquidity after options have been revalued may be cumbersome but is not difficult. To assess the future flows to be generated by options is, however, a challenge. Flows will depend on market price behaviour, which in itself is not predictable. The best one can go for is approximation. Today there are techniques available to do this. They are not perfect but give an acceptable degree of information on what might happen.

2. The seller of options may feel uncomfortable with the position held and thus will try to reduce or even square it. The principle one is working with is based on the assumption of moving quickly and with negligible loss, i.e. assuming a perfect or at least an absorbing market. A tightening in the derivative market could pass through to the cash market if too many position takers were to undo their exposure at the same time. The reason could also lie in the cash market itself due to systemic liquidity problems. Either way, risk parameters are no longer the same. It will take longer to get out of a position and almost certainly prices will move against the seller. As a consequence we will have to cater not only for normal but also for stressed market conditions as well.

One may argue that the respective implications on profit and loss just mentioned should not be related to liquidity but to earnings. This is a valid point, but only in principle. Where margin calls are standard there is a specific injection of liquidity required, be it at the end of the day or during the day. It does not help to create earnings somewhere in the bank and compensate them with margin requirements. Earnings may not be followed by a corresponding flow of cash. Depending on bookkeeping and market rules, accounting for earnings may deviate from the actual flow of cash in timing. Furthermore, even if cash does actually flow, it may not be available at the place and time needed. Thus margin accounts have to be managed properly and separately to avoid failing to fulfil payment obligations. This point was addressed earlier when we discussed the proper level of aggregation (

3. For many institutions it is the third aspect related to liquidity which can alter cash flows significantly as well as abruptly. Banks and in particular commercial banks support and service their client base with standby facilities. Clients need them for possible and unforeseeable events when cash need rises beyond the normal credit lines granted. Lines of credit for working capital are one channel. Depending on seasonal fluctuations in sales of goods and services as well as payment patterns, utilisation of the line may oscillate within a wide band. The movements may be smooth or jumpy and volatile. Standby letters of credit and CP backup lines belong to the same group of standby facilities. It is common to both that they are not used for primary financing. Utilisation of these lines will be triggered only when the channel of primary financing is closed for whatever reason. Over the years banks have rarely been called to back up. To provide and develop this kind of service became attractive. Without actually lending and using much capital, income was still received in the form of fees. However, the magnitude of the risk involved for many a bank materialised during preparations for Y2K (switching computers to the year 2000). On looking into the matter it soon became apparent how a simple technical failure in IT could trigger an injection of liquidity by the guaranteeing bank. And the potential sums involved often were not at all small.

Security settlement and clearing as well as correspondent banking services are further areas. Within limits customers can draw on the bank at their discretion and debit or credit their account respectively. In various countries borrowers in the mortgage market are given the right to early amortisation and repayment. In other words, the cash can flow earlier than originally agreed.

From a purist’s point of view, this definition may have stretched the term ‘option’ somewhat. There are, however, good reasons for putting all these banking products under a single heading. They have one thing in common: once the bank has agreed to provide the service, it has largely put itself into the position of an option seller. Whether or not, when and to what extent the option will be utilised are solely at the discretion of the option buyer – the bank’s customer. The amounts of required cash can be very substantial, but hardly predictable. Business and financial plan

Within the planning process of a firm, strategic decisions concerning short-, medium- and long-term goals are made. Elements can be enlarging or reducing investments, entering new markets or market segments, or changing finance-related business activities on assets as well

Box 1.4 Liquidity and business policy

Business policy impacts strongly on the liquidity structure of a bank. The former has thus to be looked at as a ‘driving’ force.

as liabilities. They are an important source and should not be neglected when anticipating future needs for liquidity (Box 1.4).

For our later analysis we must stress two vital principles that we get from this process:

Firstly, liquidity is too often looked at from a static point of view. To a certain extent it has to do with both the need to collect data and to report them to banking supervisors. What one gets is the outlook based on the accounting data from yesterday or the last month end. It is similar to planning a trip and basing the weather forecast on the conditions prevailing during the previous week. However, what is needed is a dynamic approach where actions affecting the future status of liquidity are incorporated to the largest extent possible. The process of business and financial planning supports this need – at least for effects derived from management decisions.Secondly, when net earnings are calculated a firm will follow accounting rules. Accruals, revaluation earnings/losses on assets and liabilities, amortisation, just to mention some of the items, are taken to arrive at the result. Not all of them trigger a corresponding flow in cash. In fact it works in two ways: some of the income and cost of the accounting period presented will induce a flow in cash at a later date. In the case of long-term credit lending, for example, earnings are calculated on an accrual basis. In accounting terms, for each day and thus each month, the precise income is computed and shown. According to the contract, interest will be paid in intervals of 3 or 6 months. Cash thus flows only in longer intervals and not daily or monthly. When bought securities are revalued, the result is reflected in the profit and loss statement of the period under consideration. The cash will flow later, either at maturity or when the security is sold. Conversely, we will recognise cash from payments made and received from transactions already considered by accounting in earlier periods. As a consequence, as much as integrating planned activities help to assess future flows, a high-level view is not sufficient. One has to work with a precise time schedule.


In the previous section we looked at liquidity and some of its major determinants. We recognised how important it is to be clear about the strategic goals: the franchise one wishes to protect puts limits on flexibly adjusting exposures in order to lower the cash needed. Acting as an option seller opens up a whole range of channels through which cash may be drawn. Whether or not, to what extent and when cash is called for are largely open. Planning in the sector of option-related products requires the use of methods of approximation and probability. We also fully appreciated that liquidity is flow of cash. The term does not include any monetary value if it is not turned into cash in the period under consideration. The change in one’s status of cash and flow of cash does not, however, necessarily imply any risk at all. As an institution you may still be in a position to fulfil your obligations to pay as, when, where and in the currency and amount needed.

Box 1.5 Definition of liquidity risk

Liquidity risk represents the danger of not being able to fulfil payment obligations, whereby the failure to perform is followed by undesirable consequences.

So the danger is that you cannot fulfil your obligations and the failure to perform may have undesirable consequences. The term ‘danger’ has been used on purpose, although the condition is usually expressed by the term ‘risk’. The expression ‘risk’ in many understandings simply means a deviation from the expected outcome. The concern in our case is limited to an undesirable deviation, because, if it were not undesirable, why should we concern ourselves? Thus, our general understanding will be: liquidity risk is the possibility that the capacity may not be sufficient to fulfil payment obligations when and where they fall due (Box 1.5); that not performing the duties in full will have undesirable consequences up to and including company failure.

Before entering more deeply into liquidity risk let us review some strongly related items, namely solvency, interest rate risk and market risk. Each one has its own characteristics. At the same time they correspond partly to each other but definitely with liquidity risk. In later chapters we will refer to them time and again. Therefore, we will start with a common understanding of how to use these terms.

1.2.1 Liquidity versus solvency

To be solvent signifies being able to cover losses. They may occur for various reasons like too high a cost base compared with earnings (business risk); loans may not be repaid as some of the customers have failed (credit risk); trading positions may have gone wrong (market risk). On the operational side (operational risk) significant costs may have occurred through legal compensation or fallout from technical systems, to mention a couple of possibilities.

The risks may materialise singly or in combination. In any case, if for any of these reasons the profit and loss account turns negative, payments have to come out of a buffer, which is the capital of the company. The Basel Committee emphasises the importance of capital in particular as it declares the ratios of credit and market risk to capital as key elements of supervisors’ control. Does that mean the lower the risk ratios and thus the bigger the capital buffer, the better the quality of solvency and hence the smaller the liquidity risk? Is it a possible chain reaction?

In a certain way, yes it is, but with some reservations. Reserves in the form of capital are available to bear for the losses. As long as capital can cover losses the company is solvent. Can it also pay the bills? Not necessarily. Capital may be invested in assets which cannot be turned easily into cash. Payments are to be made in cash, however. If payments cannot be fulfilled the bank will be illiquid, with all the consequences following that situation. Obviously, a company can be solvent and illiquid at the same time.

What then is the relationship between solvency and liquidity (Box 1.6)? Solvency is a condition of having sufficient capital to cover losses. In a narrower sense solvency is an expression of capital adequacy. In a wider sense solvency requires additionally having ready money available when payments have to be fulfilled. In other words, a sound capital base is a necessary condition but is not sufficient in itself. A link also exists the other way around. To be liquid requires being solvent in the first place. If a firm is left without capital it will not have ready money to pay the bills.

Box 1.6 The relationship between solvency and liquidity

A positive status of solvency is a precondition for being liquid. As liquidity, in contrast to solvency, is solely cash related, it is possible to be solvent and illiquid at the same time.

There is a third link as well. Liquidity as flows of cash is very much determined by the behaviour of the customer base and business counterparts in general. For them, the status of solvency indeed influences their relationship with the bank. This is not limited to their considerations of whether to invest with your bank in whatever form, e.g. deposit with you, buying bonds issued in your name or holding shares in your company. Your status also affects your asset side. The customer base, for the sake of its own financial stability, inevitably watches and assesses a bank in respect of willingness and ability to secure their own financial needs – at least within a certain framework.

In one way or another, we touched upon these elements when dealing with the customer franchise. The angle then was a different one. There we put forward the question of how flexibly management can act on restricting cash outflow, when it wants to protect its customer franchise. This time, we will have a look at the customer base and ask how it will react in the light of status regarding solvency.

How then do counterparts form a view about the condition of solvency and liquidity? It is too early to go into details at this time. At the moment there is only one fact we should keep in mind. No outsider, whether customer or market, knows the liquidity status of an institution. A view will be formed based on various information but not on detailed knowledge. Thus one could say that it is not so much the actual status, but the perceived status, which directs their actions. Whether or not the perception reflects the truth has no immediate impact on their behaviour. As we stated earlier, liquidity is neither an amount nor a ratio. It is a qualitative element of a firm’s financial position.

1.2.2 Liquidity versus interest rate risk

We covered this subject briefly when referring to the business and financial plan (, stressing why focusing on cash is crucial.

At first sight, both liquidity and interest rate risk can be viewed in a similar way when it comes to gapping. If, from lending to customers, one has got an interest exposure 6 months long in an amount of 20 million euros, the risk manager has various choices on how to handle the risk. But let us assume that the decision enters into a compensating transaction, e.g. borrowing the same amount for 6 months. Now the interest rate (IR) risk position is fully closed. That is the example on interest rate risk. On liquidity it works the same way. As long as borrowing and lending are equal in amount, currency and tenor, the positions are closed and any gap is eliminated. In a way, a systemic relationship exists between gaps in interest rate and in liquidity, given certain conditions. We will now evaluate the conditions by adding further instruments related to on- and off-balance-sheet transactions.

In the following example (see Figure 1.4 and Table 1.1) we enter into a few money market transactions in cash and compare the gaps in the interest rate and liquidity positions respectively.

Figure 1.4 The transactions used

Table 1.1 Example 1: transactions 1, 2, 5 and 7

In order to distinguish clearly the effects on the liquidity and interest rate sensitivity reports respectively, we will address the issue in three steps. We start with some short-term transactions and later add long-term commitments with interest rates adjusted during the lifetime of the contract. Finally, we hedge part of the interest rate position with a derivative contract (FRA = Future Rate Agreement).

We recognise the gaps on both sides as being equal. The lack of deviation derives from the fact that interest rates are fixed for the same period as applies for liquidity. If we take transaction 5, for example, the interest rate is fixed for the period of 3 months. In this case it coincides with the contractual period, which is the determinant for liquidity.

In Example 2 (Table 1.2) we continue using cash transactions only, with one alteration added. Some of the transactions are of longer maturities with interest rates fixed in shorter intervals (so-called floaters).

Table 1.2 Example 2: adding transactions 3, 4, 6 and 8

Although we still stick exclusively to cash transactions, the systemic relationship recognised in the prior example is broken. Gaps are not equal. While liquidity is using as its parameter the tenor when cash actually flows, interest rate gaps are determined by the structure of interest payments. When taking transaction 4, for example, the underlying commitment relevant to liquidity is for 2 years; the interest rate is, however, fixed for 3 months only.

When interest rate risk is managed in a commercial or financial institution it is not done with cash instruments alone. Very often cash may not even be used primarily. Interest derivatives such as futures, swaps, options, swaptions, etc., play an accepted role in risk management. Irrespective of their risk behaviour, when utilising them, no payments of principal are involved. The differences between interest rate and liquidity gaps may thus be even more accentuated.

For illustrative purposes we leave physical deals as in Example 2. However, to reduce the interest rate risk, the interest rate gaps beyond 3 months’ maturity are to be closed with a derivative transaction (Table 1.3).

Table 1.3 Example 3: hedging part of IR position of Example 2

The interest hedge of transaction 9 has eliminated all gaps in interest exposure beyond the 3 months’ period. As no principal and thus no cash are flowing, the liquidity status has not been affected at all.

The three examples tell us that the systemic relationship between risk in interest rates and liquidity exists under very restrictive conditions only. Transactions need to be in cash and with the interest rate fixed for the whole contractual period. Adjustments of rates during the lifetime of the contract and using derivatives cause gaps to differ.

In the extreme case where interest rate risks were created solely through derivatives, no position of payments of principal would occur on the liquidity balance sheet. Would that also mean that no cash would flow at all? Not necessarily, as there may be subsequent flows of cash. Transactions after conclusion undergo changes in value whenever the actual market price moves up or down. The trading instruments are usually valued mark to market on a daily basis. Contractual agreements between the parties involved may demand compensation to each other daily for the balances accrued. To do so, cash payments are involved. Official exchanges have worked on this principle since the inception of derivative contracts. In the OTC market, compensating positive and negative values during the lifetime of a deal is not obligatory. Many participants nevertheless see the benefit in joining netting systems with margin calls attached. In this way credit risk exposures may be significantly reduced.

However, under any circumstance and if no intermediate compensation had been agreed, the required payments have to be fulfilled at the end of the contractual period, and this has to be done in cash. True, the amounts are small compared with volumes generated by cash instrument, where the principal is exchanged as well. With many of the big players the sum of cash changing hands every day due to margin calls alone can still be substantial and thus relevant for liquidity management.

There are further asymmetric conditions one can find when optionalities come into play.

We do not refer to the standby facilities, the group of options which, when utilised, trigger an outflow of cash. Assume that a customer suddenly and quite unexpectedly can no longer draw funding from the CP market. For this case the customer would have gained an assurance from the bank of a backup line. The customer will now utilise his or her right and the bank will pay on the basis of the agreement. In this case the bank’s interest position will immediately be affected according to the specifications of the transaction. So also will the liquidity position, as the loan is a cash outflow with the specifications of the same transaction. Both the interest and the liquidity balance sheets carry risk as shown in Example 1 where the condition is a symmetric one.

What we are referring to is an asymmetric pattern as, for instance, with early amortisation. The mortgage loan may have been granted many years previously. Final maturity is still some years ahead. The bank at the beginning of the contract had secured funding and eliminated any interest rate risk. If the mortgage is paid back earlier, the bank has a new risk position in interest rates. The financial implications will depend on how far the present rates for the remaining period differ from the contractual ones. It could result in unexpected income or cost. Early amortisation also means having the cash back already, although the related funding has still not matured. In our definition of liquidity risk, there is none in this case. We certainly have the capacity to fulfil the payment obligation when it falls due, as cash has already been returned. In the short term, or till the maturity date of the funds borrowed, we are indeed over-liquid.

To sum up: based on typical bank transactions we compared implied risk on liquidity and interest rate in some detail. We found singular types of transactions where a symmetric condition is inherent. Indeed, there are also many types where it is not. What does this imply? Let us visualise a typical balance sheet of a bank, consisting of short- and long-term assets as well as liabilities. Then we look at the lines below the balance sheet with all the derivatives to hedge the interest rate risks and at the optionalities granted and properly listed. What are the chances of arriving at a predictable relationship between the two risks? One would say close to zero. Thus again it is advisable to have separate and detailed calculations. One should not be tempted to derive liquidity from interest rate gaps, for the sake of simplicity only.

1.2.3 Liquidity risk versus market liquidity risk

When we asked about how to look at liquidity, among other issues we differentiated between natural and artificial liquidity ( The latter, we concluded, is created through the capacity to transform an asset into cash before the maturity date is reached. The term used to state the level of how easy or difficult the transformation may be is ‘level of marketability’. Depth, breadth and resilience of a market seem to be helpful indicators to judge a market’s capability of turning assets into cash at negligible cost (Schwartz and Francioni, 2004, page 60f.).

The market size is a good first indicator. Marketable securities for example, be it stocks or bonds, generally are held by a large number of investors. The more there are, the greater is the interest declared to buy and sell close to above and below the prevailing price. The markets for German Bunds and US Treasury Bills fit well into this category. If larger orders are put into the market there are sufficient bids and offers in the pipeline to restore a reasonable market value.

Even if markets are liquid, prices are affected by specific determinants. A large portfolio manager for example or a group of market participants may decide to buy or sell an influential portion of a financial commodity over a very short period. The disparity in supply and demand will cause prices to move up or down. As long as a new level of market price equilibrium is found within a short space of time, the market has proven to be liquid.

More likely, markets are affected by news. Economic data may indicate future pressure on interest rates. Committee members of a central bank’s policy body talk in a hawkish manner. A company’s chief executive is delighted to announce increased earnings beyond market expectations. Whatever is said, the information will be analysed, digested and the new market price will incorporate the news. Indeed, most likely not at the level it was before.

To call an asset liquid does not imply a stable value irrespective of the period under consideration. Even the most liquid markets over time will see prices rise and fall. Nevertheless, the market has depth and width all the time. Larger sums could be placed short term.

Negligible in our understanding refers to execution cost. These costs are expressed in small or wide spreads and the accepted size of a single transaction. In other words, they reflect the level of liquidity of the market. When spreads are low, the market is liquid and capable of absorbing larger orders. Whether the market price stays at historic highs or lows is not the point. In a large market with no dominant or oligopolistic groups, the process of making decisions is widely decentralised. Whenever prices deviate from equilibrium a new sustainable level will be found. In a large, decentralised and transparent market the process of reaching the new equilibrium will take a short period of time. In other words, the market is resilient as new orders are soon available.