Liquidity Gaps 2w6i39

LIQUIDITY GAP Liquidity gaps are the differences at all future dates between assets and liabilities of the banking portfolio. Gaps generate liquidity risk, the risk of not being able to raise funds without excess costs. Liquidity risk exists when there are deficits of funds (whenever assets are greater than resources). Excess of funds results in interest rate risk. Future deficits also create interest rate risk Controlling liquidity risk implies spreading over time amounts of funding, avoiding unexpected important market funding and maintaining a cushion of liquid short term assets so that selling them provides liquidity without incurring capital gains and losses. Asset Liability Management (ALM) structures the time schedule of debt issues or investments in order to close the deficits or excess liquidity gaps.

Liquidity Gaps are calculated as algebraic difference between assets and liabilities. A positive gap is equal to deficit and vice versa. L A

Gap

Time

Time Profile of Gaps

• Marginal or incremental gaps are the differences between the changes in assets and liabilities during a given period. A positive marginal gap means that the algebraic variation of asset exceeds the algebraic variation of liabilities. The marginal gaps represent the new funds required or the new excess funds available for investing. When assets and liabilities amortize over time, such variations are negative and a positive gap is equivalent to an outflow. Fixed assets and equity also affect liquidity gaps.

Static and Dynamic Gaps Gaps based on existing assets and liabilities are static gaps. These are time profiles of future gaps under cessation of all new business, implying a progressive meltdown of the balance sheet. Gaps for both existing and new assets and liabilities are required to project the total excesses or deficits of funds. These are called dynamic gaps. It is a common practice to focus first on existing assets and liabilities to calculate the gap profile. One reason is that there is no need to obtain funds in advance for new transactions or to invest resources that are not yet collected. Another reason is that dynamic gaps depend on commercial uncertainties.

Liquidity Gaps and Risks Liquidity gaps (deficits) create liquidity risk and interest rate risk. Surpluses generate interest rate risk. In a floating rate universe, interest rate risk will arise if there is mismatch between the reference rates applicable to assets and liabilities or the timing of resets of floating rate. If the asset return is indexed to 3 months LIBOR and the debt rate to 1 month LIBOR, the margin is sensitive to changes in interest rate. In some cases, interest rate risk may be present without the liquidity gap. For example, a long fixed rate loan funded through a series of 3 month loans carrying the 3 month LIBOR. Future excesses or deficits in liquidity may be locked with respect to interest rates now based on interest rate expectations and bank policy with respect to interest rate risk.

Cash Matching Cash matching is a basic concept for the management of liquidity and interest rate risks. It implies that the time profiles of amortization of assets and liabilities are identical. The nature of interest applicable (fixed or floating) may also be the same. With cash matching, liquidity gaps are zero. When the balance sheet amortizes over time, it does not generate any deficit or excess of funds. If in addition, interest rate resets are similar or if they are fixed interest rates on both sides, the interest margin cannot change over time. Cash matching is only a reference. In general, deposits do not match loans. But it is possible to structure financial debt in order to replicate the asset's time profile. Cash matching can be done for individual transactions.. But cash matching is implemented generally after netting assets and liabilities.

Liquidity Posture of the Balance Sheet The liquidity posture of the bank is characterized by the gap profile. The benchmark is zero liquidity gap. Various typical situations are given below:

L A L Gap profiles close to zero

L A

Deficits

A Excess Funds

In all the above cases, the current gap is zero and nonzero gaps appear only in the future. Once the debts amortize completely, the level of capital is reached. The figures ignore the gap between fixed assets and equity.

New Business Flows With new business transactions, the gap profile becomes dynamic. The difference between the total assets and existing assets at any date represent the new business Total Assets Total Liabilities New Assets New Liabilities Existing Liabilities Existing Assets

Cash Matching in a Fixed Rate Universe It involves matching the profile of assets and target resources. The process needs to define a horizon. The treasurer then piles up 'layers' of debts starting from the longest horizon. There can be two types of situations: (i) The gap decreases continuously until the horizon. (ii) The gap increases with time, peaks and then narrows.

Assets 1000 750 500 Resources 800 650 450 Gap 200 100 50 New Funding Debt 1 50 50 50 2 50 50 3 100 Total Funding 200 100 50 Gap after funding 0 0 0 In the above case, the existing gap is 200 and the cash matching funding necessitates debts of various maturities. Layer 1 is a bullet debt extending from now to the end of period 3. Its amount is equal to the gap at end of period 3 (50). A second bullet debt from now to period 2 of amount 50 bridges the gap at period 2. There is still a gap of 100 left for period 1. A bullet debt of 100 is contracted for one period.

Assets Resources Gap

1000 800 200

750 400 350

500 400 100

New Funding Debt 1 2 3 Total Funding Gap after funding

100 100 200 0

100 100 150 350 0

100 100 0

In this case, the above process does not apply because the gap increases and after a while, decreases until the horizon. It is not possible to reach cash matching with resources raised today. One bullet debt of 100 bridges partially the gaps from now up to the final horizon. A second bullet debt of 100 starts today and runs until the end of period 2. Then the treasurer needs a third forward starting debt of 150. In a fixed rate universe, a forward contract should lock in its rate as of today. However, effective raising of liquidity occurs only at the beginning of period 2 and remains up to the end of period 2.

ALM and Excess of Funds When there are excess of funds, ALM should structure the timing of investments and their maturities according to guidelines. This problem also arises for equity funds because banks do not want to expose capital to credit risk by lending these funds. It becomes necessary to structure a dedicated portfolio of investments matching equity. Investments are spread over successive periods of maturities to avoid locking in the rate of a single maturity and the drawback of renewing entirely the investment at selected maturity at uncertain rates. This policy smoothes the changes of the yield curve shape over time up to the selected longest maturity. There are variations around this policy such as concentrating the investment at both short and long ends of the maturity structure of interest rates. Policies that are more speculative imply views on interest rates and betting on expectations. •

Problems in determining the liquidity gap time profile The basic inputs to build the gap profile are the outstanding balances of all assets and liabilities and their maturity schedules. However, many assets have no explicit maturity e.g. overdrafts, credit card consumer loans, renewed lines of credit, committed lines of credit and other loans without specific dates. Demand deposits are liabilities without maturity. Therefore assumptions, conventions or projections are required to be used for these items. These are: (i) Demand Deposits: A large fraction of current deposits is stable over time and represents the ‘core deposit base’ (ii) Contingencies such as Committed lines of credit : The usage of these lines depends on the customer initiative subject to the limit set by the lender.

(iii) Prepayment options embedded in loans: Even when the maturity schedule is contractual, it is subject to uncertainty due to prepayment options. The effective maturity is uncertain In case of demand deposits, there can be many solutions: (i) Group all outstanding balances into one maturity bucket at a future date , which can be the horizon of the bank. This excludes the influence of demand deposit fluctuations from the gap profile, which is neither realistic nor acceptable. (ii) Make a convention with respect to amortization e.g. using a yearly amortization of 5 % to 10%. This convention generates an additional liquidity gap equal to this amortization forfeit every year which, in general is not in line with reality.

(iii) Divide deposits into stable and unstable balances. The volatile fraction istreated as a short term debt. Separating core deposits from others is close to reality though the rule for splitting the deposits into core/ others could be crude. (iv) Make projections modeled with some observable variables correlated with outstanding balances of deposits. Such variables include the trend of economic conditions and some proxy for their short term variations. Such analyses use multiple regression techniques or time series analyses. However, this approach also has limitations because all parameters affecting deposits( like new fiscal regulations relating to tax free earning of deposits which can alter the allocation of customer resources between types of deposits) cannot be considered. However, this approach is closer to reality than any other.

• Contingencies given (Off –balance sheet): In such cases like committed lines of credit, only the authorization and its expiry date are certain and fixed. Statistics, experience, knowledge of customers’ s and of their needs help to make projections on the usage of such lines. Otherwise, assumptions are required. However, most of these facilities are variable rate and drawings are necessarily funded at unknown rates. Matching both variable rates eliminates the interest rate risk.

• Amortizing Loans : Prepayment of loans makes heir effective maturity different from their contractual maturity. Help of historical data and prepayment models can be taken. Some models are simple that use a constant prepayment ratio applicable to overall outstanding balances. The more sophisticated ones make prepayment dependant on several variables such as interest rate differential between the loan and the market or the time elapsed since origination.

Multiple Scenarios : Making use of assumptions and conventions tends to hide the risks. Making these risks explicit with several scenarios is a better solution. For example, if deposit balances are quite uncertain, the uncertainty can be captured by a set of scenarios such as base case plus other cases where the deposit balances are higher or lower. If prepayments are uncertain, multiple scenarios could cover high, average and low prepayment rate assumptions. The use of multiple scenarios makes the risk more explicit but also introduce additional complexity. Besides, the scenarios are judgemental making them less objective. The need is therefore to have multiple sources of uncertainty such as volume, prepayment and new business in a scenario.