1. EF5603
Managing Funding
Liquidity Risk Under The
Basel III Framework
Dr. LAM Yat-fai (林日辉博士)
Doctor of Business Administration (Finance)
CFA, CAIA, FRM, PRM, MCSE, MCNE
PRMIA Award of Merit 2005
E-mail: quanrisk@gmail.com
2:00 pm to 3:15 pm
Saturday
15 January 2011
2
Outline
Banking on funding liquidity
Basel III framework on funding liquidity
management
Liquidity risk modelling
3
Banking activities
Customer
deposits
0.5%
Shareholders’
equity
Dividend +
stock
appreciation
Loans,
debts,
equities,
FX
1% - 20%
Bank
4

2. Bank’s borrowing
and lending businesses
Deposits and
borrowing
1 day to
5 years
Bank
1 year to
30 years
Lending
5 6
7
HKD interbank rate 31 Dec 2010
8
A typical yield curve
Maturity (year)

3. 9
Long-short interest rate strategy
Investment strategy
Borrow short term with low interest rate
Lend long term with high interest rate
Continue to renew short term borrowing
Risky assumption on interest rates
Short term interest rates remain at low level
Risky assumption on funding liquidity
Short term borrowing CAN be renewed
10
Loan securitization – CDOs
A “waterfall” defines
the precise rules for
allocating cash flows
to tranches
Loan 1
Loan 2
Loan 3
Loan N
Principal =
$100 mn
SPV
Senior tranche
Principal = $70 mn
Return = 6%
Mezzanine tranche
Principal = $20 mn
Return = 10%
Equity tranche
Principal = $10 mn
Return = 30%
11
Securitization strategy
Investment strategy
Borrow short term with low interest rate
Lend long term with high interest rate
Securitize loan pool
Sell CDO tranches to investors at premium
Pay back short term borrowing
Risky assumption on interest rates
Entire yield curve remains stable
Risky assumption on funding liquidity
CDO tranches CAN be sold
12
Global financial tsunami in 2008
Funding sources stopped to lend
Short term borrowing CANNOT be renewed
Securitization market totally disappeared
CDO tranches CANNOT be sold
Banks’ loss as a result of lacking funding liquidity
Fire sale on assets at discounted price
Realized loss
Downward pressure on capital market
Unrealized mark-to-market loss
Bankruptcy
Total loss

4. 13
Outline
Banking on funding liquidity
Basel III framework on funding liquidity
management
Liquidity risk modelling
14
Funding liquidity and
funding liquidity risk
Funding liquidity is the ability of a bank to fund
increases in assets and meet obligations as they come
due, without incurring financial and/or non-financial
losses
Funding liquidity risk is the risk that the bank will
not be able to meet efficiently both expected and
unexpected current and future cash flows and
collateral needs without affecting either daily
operations or the financial condition of the bank
15
Basel Committee’s
classification of financial risks
Credit risk
Market risk
Interest rate risk
Operational risk
Liquidity risk
Reputation risk
Legal risk
Strategic risk
Basel II
Basel III
16
Basel Committee’s initiative
on liquidity risk

5. 17
Basel III adequacy requirements
on regulatory liquidity
Standards
Liquidity coverage ratio
Net stable funding ratio
Monitoring tools
Contractual maturity mismatch
Concentration of funding
Available unencumbered assets
Market-related monitoring tools
18
Liquidity coverage ratio
Stock of high quality liquid assets
30
100%
30
LCR
Total net cash outflows over the next calendar days
=
≥
Stock of high quality liquid assets
Total cash inflows over the next calendar days
Total cash out
+
≥ flows over the next 30 calendar days
19
Liquidity coverage ratio
To ensure that a bank maintains an adequate level of
unencumbered, high-quality liquid assets that can be
converted into cash to meet its liquidity needs for a
30 calendar day time horizon under a significantly
severe liquidity stress scenario specified by
supervisors
The stock of liquid assets should enable the bank to
survive until day 30 of the stress scenario, by which
time it is assumed that appropriate corrective actions
can be taken by management and/or supervisors,
and/or the bank can be resolved in an orderly way
20
Net stable funding ratio
A minimum acceptable amount of stable funding based on the liquidity
characteristics of an institution’s assets and activities over a one year
horizon
To act as a minimum enforcement mechanism to complement the LCR
and reinforce other supervisory efforts by promoting structural changes in
the liquidity risk profiles of institutions away from short-term funding
mismatches and toward more stable, longer-term funding of assets and
business activities
To ensure that long term assets are funded with at least a minimum
amount of stable liabilities in relation to their liquidity risk profiles
To limit over-reliance on short-term wholesale funding during times of
buoyant market liquidity and encourage better assessment of liquidity risk
across all on- and off-balance sheet items
To offsets incentives for institutions to fund their stock of liquid assets
with short-term funds that mature just outside the 30-day horizon for that
standard

6. Available amount of stable funding
21
Net stable funding ratio
100%
NSFR
Required amount of stable funding
=
≥
Available amount of stable funding
Required amount of stable funding
≥
22
Contractual maturity mismatch
To identify the gaps between the contractual inflows
and outflows of liquidity for defined time bands
To indicate how much liquidity a bank would
potentially need to raise in each of these time bands
if all outflows occurred at the earliest possible date
To provide insight into the extent to which the bank
relies on maturity transformation under its current
contracts
23
Contractual maturity mismatch
24
Concentration of funding
To identify those sources of wholesale funding that
are of such significance that withdrawal of this
funding could trigger liquidity problems
To encourage the diversification of funding sources
Thresholds
Significant counterparties 1%
Significant instruments / products 1%
Significant currencies 5%

7. 25
Concentration of funding
.
'
/
.
'
.
Funding liabilities sourced from each significant counterparty
a
The bank s balance sheet total
Funding liabilities sourced from each significant product instrument
b
The bank s balance sheet total
Fund
c
ing liabilities sourced by each significant currency
'
The bank s balance sheet total
26
Available unencumbered assets
The assets that have the potential to be used as
collateral to raise additional secured funding in
secondary markets and/or are eligible at central
banks and as such may potentially be additional
sources of liquidity for the bank
A list of quantity of available unencumbered assets
that are marketable as collateral in secondary
markets and/or eligible for central banks’ standing
facilities by denominating currency, location and
other major characteristics
27
LCR by significant currency
To evaluate banks’ ability to raise funds in foreign currency
markets and the ability to transfer a liquidity surplus from one
currency to another and across jurisdictions and legal entities
Higher currency LCR expected for currencies in which a
bank has limited ability to raise funds in foreign currency
markets and/or the ability to transfer a liquidity surplus from
one currency to another and across jurisdictions and legal
entities
Amount of total net foreign exchange cash outflows to be net
of foreign exchange hedges
30
Foreign currency LCR
Stock of high quality liquid assets in each significant currency
Total net cash outflows over the next calendar days in each significant currency
=
28
Market-related monitoring tools
Market-wide information
Equity market indices, interest rates, currency rates,
commodity prices, volatility indices and CDS indices
Information (news) on the financial sector
To track whether the financial sector as a whole is
mirroring broader market movements or is experiencing
difficulties
Bank-specific information
The confidence of market in a particular institution or has
identified risks at an institution, e.g. stock prices,
volatilities, credit spreads and credit ratings

8. 29
Advancements
A big step from the Basel Committee’s guideline “Principles
for Sound Liquidity Risk Management and Supervision” (Sep
2008)
Formally define regulatory liquidity in a consistent and a
measurable framework
Accounting approach
Snapshot, simple rating factor, deterministic
Scenario based on stressed conditions
Easy to calculate
An inventory of common practices for monitoring funding
liquidity
Recognition of government related entities as the top funding
sources
30
Limitations
Competition on high quality assets = high cost of liquidity
Encouraging banks to reduce lending
Insufficient details on derivatives
Regulatory liquidity economic liquidity
Deterministic approach, no risk elements
Having addressed NONE of the critical concerns of a
liquidity risk manager
Only a regulatory standard on liquidity sufficiency projection
Not a liquidity risk measurement and management framework
Lacking support from members of Basel Committee
LCR in 2015, NSFR in 2018
31
Risk management concerns
1. What is the funding liquidity risk of my bank?
2. Is the funding liquidity risk increasing or decreasing during
the last 12 months?
3. Which branch/product contributes the most funding liquidity
risk?
4. How to set funding liquidity risk limits?
5. How to diversify the funding sources?
6. How to perform funding liquidity stress testing?
7. What will be the potential loss in the next funding liquidity
crisis?
8. How to plan for contingency funding?
9. How to incorporate funding liquidity risk into cost?
32
Regulatory effort (1)
HKMA Viewpoint article 11 June 2009
http://www.info.gov.hk/hkma/eng/viewpt/
20090611e.htm
*Source : Reorganisation of Banking
Departments in April 2010, HKMA

9. 33
Regulatory effort (2)
34
Outline
Banking on funding liquidity
Basel III framework on funding liquidity
management
Liquidity risk modelling
35
Modelling total cash inflow
Probability
Amount
Estimated total
cash inflow
Total cash inflow
Greater than or equal to 0
Asymmetric
Modelling total cash inflow
Lognormal total cash inflow model
 
σ
2
= +
μ σ
dI Idt IdW
I
= 0 exp  ( μ − I
) + σ
⋅ 0,1

I I T T Normal
T I I I I
2
 
I0 : Total estimated cash inflow at time 0
IT : Total realized cash inflow at time T
μ I
: Drift of total cash inflow
σI
: Volatility of total cash inflow
( )
Long right tail 36

10. 37
Modelling total cash outflow
Probability
Amount
Estimated total
cash outflow
Total cash outflow
Greater than or equal to 0
Asymmetric
Modelling total cash outflow
Lognormal total cash inflow model
 
σ
2
= +
μ σ
dO Odt OdW
O
= O
0 exp  ( μ − ) + σ
⋅ 0,1

O O T T Normal
T O O O
2
 
O0 : Total estimated cash outflow at time 0
OT : Total realized cash outflow at time T
μO : Drift of total cash outflow
σO : Volatility of total cash outflow
( )
Long right tail 38
39
Liquidity surplus
Liquidity surplus
Stock of high quality liquid assets
Total cash inflow next month
Total cash outflow next month
=
+
−
A random variable subject to
Estimated total cash inflow and estimated total cash
outflow
Volatilities of total cash inflow and total cash outflow
Correlation between total cash inflow and total cash
outflow
40
Monte Carlo simulation in Excel

11. 41
Liquidity shortage
42
Liquidity risk measure
At 99.9% confidence level
What is the liquidity surplus?
Will there be any liquidity shortage?
If yes, when? how much? why?
Will the liquidity shortage be temporary or
persistent?
Applications of liquidity risk measures
43
Trend analysis
What is the change of liquidity risk during last year?
Peer analysis
Which branch is the outlier?
Liquidity risk limit
Positive liquidity surplus at 99.9% confidence level, 1 year horizon
Diversification analysis
What is the benefit of adding more funding sources?
Scenario analysis
How much more liquidity is required if a new branch is opened in
Shanghai?
Stress testing
Manipulation of expected cash inflow level, cash outflow level,
volatilities and correlation
Your opinions
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