Banking regulators move to tackle liquidity risk

The Banking regulators are getting excited about liquidity risk, but I am afraid I still have issues with this. And that's because nobody thinks of the implementation aspects of these regulations. Here's an idea, nobody actually has thought about why the previous liquidity risk proposals did not work. And nobody is thinking about how these current proposals will actually operate, much less think about how they will be rolled out.

And we will, most probably be here, in 10 years time, thinking about more regulation. We keep on being told about back testing of our risk models, but has anybody ever tried to do back testing of the regulatory models? I have written a fuller essay on this and hopefully will come up next week.

Technorati Tags: Liquidity Risk,Financial Institutions,Financial Markets

Managing VaR at a time of liquidity and volatility problems

Value at Risk – the dangers within

The Bank of England warned earlier this year about the propensity of banks to rely on Value at Risk (VaR) models to manage and guide them on risks. We have been here before, for example during the 1990’s Russian Crisis. Almost exactly the same thing happened, at least on the market side. The was a liquidity crunch as everybody rushed to the exit at the same time.

When everybody rushes to the exit at the same time, one side of the bargain (the buy bit) disappears, and therefore the price formation process is seriously out of whack. When that happens, even small movements in price can and do influence volatility and correlations disproportionately.

Now usually, you are ok to measure your VaR at daily intervals and you don’t update your correlation matrices more than weekly (if you are extremely particular, generally, you can go for 3 months without needing to change, market micro-structures do not change that fast). But as we know, markets have fat tails. Extreme events happen at a far greater frequency than what your normal distribution will suggest.

Consequently, what your VaR numbers will be telling you will not be an accurate reflection of the actual situation. In other words, these numbers tell you the risk that you are carrying. But if you decide to act on that risk number, you will find that the market does not support the consequent decision because there is simply nobody out there to offload your risk to. If nobody wants to purchase your debt or paper, then what are you going to do? You simply suck it up. Or you pray to the great gods of the central banks to provide you with some liquidity.

There is another problem and I quote from the FT article:

In the current environment, no bank chief executive who hopes to hang on to that job can afford to give regulators or shareholders the impression that they are being cavalier about risk. And since VAR is often used to define what level of margins – or financial buffers – are set against trades, some banks are doubly keen to cut VAR, to reduce pressure on their own balance sheets.

But as the banks embark on this task, some are finding themselves caught in an unpleasant trap. The easiest way to reduce a risk exposure is to sell risky assets, such as risky loans. In recent weeks, many banks have been trying to do precisely that.

But these sales have been occurring on such a large scale that they have pushed up market volatility. Thus, measured VAR has risen, exactly as the Bank warned all those months ago.

One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuring market price swings.

By scurrying to reduce risk, in other words, the banks may end up simply running to stand still.

The only way to resolve this is by having stringent stress testing or scenario analysis running. But very few banks that I know of have management trip wires or even have management who take action based upon these stress scenario’s. But all I can predict at this moment is that we will again have this issue. See my previous post on Carnegie as an example.

All this to be taken with a grain of piquant salt!!!

Ignore Risk Management at your peril, your entire bank might be at risk

Here we go again, now Carnegie, the Swedish investment bank, is being pummelled by the markets and country, for having completely mucked up its risk management, allowed traders to run amok and ended up with huge losses. 200 years of pristine reputation, clean and transparent firm, all firmly driven into the toilet.

How many times have we seen this? Risk management underinvestment and then traders take wrong posititions or mis vale or mark to model or something like that and then it blows up, usually bringing down the very management who did not pay money or attention to their risk management systems.

After thinking about it for 2 seconds, I came up with some questions arise which I would ask to the CEO

1. Who does the chief risk officer report to? If the CEO with NO dotted lines, then fine. If there are any dotted lines or matrix management, then there is a disaster waiting to happen. This is applicable to market, credit, ops, liquidity risk

2. Are each division's capital allocated based upon risk?

3. Do you match the divisional RoE with their P &L? On a monthly basis?

4. How do you base your bonus pool allocations? On revenue or adjusted risk levels?

5. Who develops your risk scenario's? How often do you do war gaming? Do your head of trading attend? What is your definition of comfort values?

6. Why are you not making your divisional risk and RoE transparent?

7. What is your investment in IT? What is the ratio of risk investments to trading investments? If less than 20 percent, why?

8. When was the last time you had an independent risk and trading systems audit? And seen the results? And acted upon them? And reviewed them? And fired somebody for not following them?

9. Where does product control fit it? Do they report to trading or risk heads?

10. Who is looking after your model risk? Do you know the stress scenario results? Under what circumstances do they fail? Negative interest rates? Liquidity risk? Spreads very wide? Exchange stops trading? A dr death scenario?

But I am afraid this will happen again and again and again, people just do not listen and short term profits will again overwhelm the risk manager's warnings. And then the bank will again drop into the muck!

All this to be taken with a grain of piquant salt!!!

Northern Rock - shutting the door after the horse has bolted

In the old days, you and I will get together, plonk some money into the cooperative building society as our deposits. Then Mr. X will come to ask for a mortgage and the building society will give him our deposit money. X will repay the money back to the building society at the mortgage rate and the society will give us a savings interest rate which is lower than the mortgage rate obviously. Now, sometimes it would happen that there wouldn't be sufficient deposits coming in from individuals so the society can approach other banks to give some money to the society. The society does not want to turn away borrowers, after all. And in the fullness of time, the lending from the other banks will be covered by other deposits and repayments, and life was good, simple, easy, low risk and fun.

Ok, so the basic problem with Northern Rock was that it was funding its mortgage lending through the wholesale markets rather than mainly through its deposit base. And when the market understood that there was far too much exposure to the wholesale markets compared to the deposit base, the market said, your business is too risky and we cannot lend our depositors money to you as we are not sure you can repay it back. In other words, there was a liquidity problem!

Now this is something that the Financial Services Authority is supposed to track and warn financial institutions if they are going to go off. Well, we know what happened, it all went potty and nobody knows who was responsible for this gruesome mess.

Guess what the FT is reporting now? I quote:

The Financial Services Authority has sent a comprehensive one-off liquidity questionnaire to all banks and building societies asking for details of how they plan to fund future mortgage commitments.
The spreadsheet is designed to pinpoint future problems among mortgage lenders – particularly if the capital markets in effect remain closed for the foreseeable future.
The FSA has asked lenders to give details of their current pipeline of home loans commitments to the end of the year, as well as how much funding they have from the capital markets.It also asks how often the lenders have monitored their liquidity position.
It also wants to know what management actions have been considered as well as what contingency planning is in place. In addition, it also asks lenders what other sources of funding they have.

All very good and nice to know. But very curiously, why NOW? what was it doing before when the credit crisis was in full flow? Or even before when the signals were flashing high and spreads were widening even further than normal?

Technorati Tags: Financial Markets , Credit Risk , Market Risk , Liquidity Risk , Financial Institutions , UK