Liquid Asset Buffer Management Stephen Temple January 2019 Key - - PowerPoint PPT Presentation

Stephen Temple

January 2019

Liquid Asset Buffer Management

2

Key Themes

1. Where have we come from 2. Evolution of Liquid Asset Buffers post crisis 3. Constructing a Liquid Asset Buffer (LAB) 4. Conclusion

The destruction of the inducement to invest by an excessive liquidity-preference was the

• utstanding evil, the prime impediment to the growth of wealth, in the ancient and medieval

worlds. John Maynard Keynes

3

The Evolution of Liquidity Risk Regulation

2021: NSFR is expected to be implemented in Europe Oct 2015: LCR becomes the PRA’s regulatory liquidity stress test Sep 2007: Northern Rock emergency liquidity assistance made public leading to a run on deposits Dec 2009: Basel consultation LCR and NSFR begins (Basel 3) July 2008: Deterioration in wholesale funding markets for UK banks Apr 2007: First signs of stress in the US sub- prime market Sep 2008: Lehman Brothers collapse

2009 2010 2015 2016 2017 2008 2007 2021

Sep - Dec 2008: HBOS experiences significant

• utflows

Oct 2014: Final European LCR rules published Dec 2009: FSA liquidity stress tests introduced (ILG)

4

0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30% Year 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017

Sterling liquid assets relative to total asset holdings of UK banking sector

% of Total Assets

What Has New Regulation Meant for Bank Balance Sheets?

– Liquidity management existed before the crisis but in a very different form – Liquid Asset Buffer requirements are driven by internal and regulatory liquidity stress tests – Now a meaningful part of a bank balance sheet – Funding costs associated with liquidity buffer needs are high – Emergence of a dedicated investment function to manage liquid assets and associated market liquidity – Activities governed by specific legislation but also firm specific risk appetite leading to unique, proprietary approaches

0.0 50.0 100.0 150.0 200.0 250.0 300.0 350.0 400.0 450.0

UK Bank 5 Year CDS Spreads (funding cost proxy)

RBS BARCLAYS LLOYDS SANUK

Source: Bloomberg Source: Bank of England

5

Evolution of Eligible Assets

Asset type PRA ILG (BIPRU 12) BCBS LCR EBA’ LCR empirical findings EBA’s LCR recommendat ion LCR delegated act 2010 Jan-13 Dec-13 Dec-13 Oct-14 Central bank reserves

• 1

1 1 1 Notes and coins

• 1

1 1 1 Government debt

• 1

1 1 1 Central bank debt

• 1
• 1

1 Supranational/Sub-Sovereign/Agency

• 1

2A 1 1 Regional govt. / local authority debt backed by central govt.

• 1

2A 2A 1 Covered bonds > €500m, AA-, OC 2%

• 2A

1 2A 1 Covered bonds > €250m, A-, OC 7%

• 2A

2A 2A RMBS

• 2B

2B 2B 2B Auto-loan ABS

• 2B

Consumer lending / credit card ABS

• 2B

Corporate bonds

• 2B

Equities

• 2B

Restricted-use central bank facilities

• 2B

– Range of assets has broadened over time – some super equivalence in the UK initially – Risk appetite means that the majority of liquidity pools are concentrated in Level 1 assets. More limited investment in level 2A and 2B assets – Risk appetite, return and liquidity haircuts drive portfolio mix decisions

6

Liquid Asset Buffer Construction – Confluence of Risk Appetites

Minimum Rating Criteria Minimum Rating Criteria Market Depth and Liquidity Market Depth and Liquidity Credit Risk Appetite Liquidity Risk Appetite Market Risk Appetite Haircuts Haircuts Asset Class Restrictio ns Asset Class Restrictio ns Risk Weighted Assets Risk Weighted Assets Capital Committe d (VaR) Capital Committe d (VaR) Portfolio Diversifica tion Portfolio Diversifica tion Capital Ratio Volatility (AFS reserves) Capital Ratio Volatility (AFS reserves) Other considerations:

• Environmental,

Social and Governance (ESG)

• Geopolitical

Risks Other considerations:

• Environmental,

Social and Governance (ESG)

• Geopolitical

Risks Price Stability Price Stability

7

Liquidity Risk: Liquid Asset Buffer Construction is not only about return

Asset LCR Category Return over SONIA (bps) A Liquidity Haircuts (%) B Indicative Capital Reqt. (%) C RoC (%) (A-B(D))/C Rank on Return

• n

Capital Rank on Return

• n

Leverag e Rank on Liquidity*

UK Gilt 9y 1 10 1.34 7 5 5 2 US Treasury 7y 1 32 1.36 23 3 3 1 European SSA 7y 1 20 1.19 33 1 4 3 European Covered Bond 7y 1/2A 69 7-15 1.75 32 2 2 4 UK Prime RMBS 3y 2B 100 25 3.38 23 3 1 5

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.5 0.75 1.5 3 5 8 15 30 50 80

Liquidity Cost Size of holding (m)

*Cost of immediate liquidation

Gilt SSA Covered

Cost of liquidation highly correlated to size of holding for SSAs and secured assets

D = Cost of funding Worst outcome Best outcome

8

Liquidity Risk: Asset Buffer Construction – Immediacy of Liquidation

Liquidity Risk Aggressive Conservative

Level 2B assets High Grade Sovereign Bonds Level 2A assets

• Liquidation of LAB is driven by liquidity stress test outflows
• Portfolio construction should ensure rate of asset liquidation at least matches expected outflows

Surplus Liquidity Resource Notional Cumulative Stressed Liquidity Outflows Highly Liquid (cash) Level 1 Highly Liquid (sovereign bonds and Supras) Level 2 A Covered Bonds Level 2B assets Stressed outflow period Outflow Notional

9

• Returns dictate Pillar 1 and 2A capital allocations. These define risk appetite and portfolio

composition

• Volatility of asset valuations in the AFS also impacts CET1 resources – requires risk

management (or different accounting treatment)

• Risk and capital to be modelled, measured and managed

Market Risk: Capital Allocation and Risk Management

Risk Appetite Setting Risk Management Return

• n

Capital/ Leverag e Return

• n

Capital/ Leverag e Capital Allocatio n Capital Allocatio n Risk Appetit e Risk Appetit e Value at Risk Modellin g Value at Risk Modellin g PV01/ Nominal Allocatio n PV01/ Nominal Allocatio n AFS Reserve s Volatility AFS Reserve s Volatility Risk Management Risk Management Early Warning QVaR Early Warning QVaR Optimal Portfolio Composition

10

• 12
• 10
• 8
• 6
• 4
• 2

2 £m

£10m swapped 10 year gilt MTM Gilt MTM Swapped gilt MTM

Market Risk: Risk Appetite and Available for Sale Reserves Volatility

Market Risk Aggressive Conservative

High volatility assets Open IR01 Position Asset Swap Spread Risk

Source: Bloomberg

11

• 3
• 2
• 1

1 2 £m

£10m equiv 10 year Portfolio MTM Swapped gilt MTM Swapped bund MTM Swapped treasury MTM Scaled portfolio MTM

Market Risk: Liquid Asset Buffer – Portfolio Diversification Benefits

Market Risk Aggressive Conservative

High volatility assets Open IR01 Position Asset Swap Spread Risk

Source: Bloomberg

12

Canada, 17% Denmark, 2% Finland, 1% France, 13% Germany, 16% Norway, 7% Sweden, 5% UK, 5% Australia, 7% Austria, 2% Belgium, 2% Ireland, 1% Italy, 5% Nether, 4% New Zealand, 1% Spain, 8% Switzerland, 5%

Covered Bond Market Share by Jurisdiction

UK, 16% France, 18% Germany, 9% Nether, 4% Finland, 1% Austria, 2% Belgium, 4% Canada, 4% Argentina, 2% Italy, 19% Spain, 9% Portugal, 1% Greece, 1% Australia, 4% Korea, 5%

Top 15 Govt. Bond Markets (excl. US & Japan)

Credit Risk: Liquid Asset Buffer Construct Considerations

• Credit Risk should be considered in the context of the firm's overall risk governance framework -

under supervision of Credit Committee

• Primary risk considerations include:
• Jurisdiction
• Emerging risks and market developments
• Issuer credit ratings
• Rating agency assessments

13

Accounting For a Liquidity Portfolio: Classification of Bonds

The accounting for financial instruments is governed by IFRS9 (introduced 2018), which allows three possible classifications: 1.Amortised Cost: Bonds are not fair valued after initial purchase, hence there is no MTM volatility in the financial statements. MTM gains and losses are only recognised in P&L at the point of sale. Interest is accrued in P&L as normal.

• 2. Fair Value through Other Comprehensive Income (FVOCI):

Bonds are fair valued, but the MTM volatility is held in a reserve within equity until

• sale. Used to be called ‘AFS’. Accruals continue to be recognised in P&L.
• 3. Fair Value through Profit and Loss (FVTPL):

MTM gains/losses affect P&L daily, which can make earnings volatile and treasurers unpopular! The classification above is determined by a combination of two tests:

• 1. An assessment of the contractual terms of the bond
• 2. An assessment of the business model the bond is held in

14

Conclusion

• Constructing a liquid asset buffer requires a multi dimensional

approach, giving consideration to: –Turning assets into cash in a timely manner (Liquidity Risk) –Buying assets that fit the organisations overall credit risk appetite –Optimising capital consumption and minimising ratio volatility (Market Risk)

• Return is not always the abiding consideration but portfolio
• ptimisation is required to maximise it
• The regulatory framework means there is a commonality to portfolio

constituents but individual firm risk appetites will drive end state portfolio asset allocations