Bank Liquidity Risk Management and Supervision: Which Lessons from Recent Market Turmoil?

Journal of Money, Investment and Banking
ISSN 1450-288X Issue 10 (2009)
© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/JMIB.htm

Bank Liquidity Risk Management and Supervision: Which
Lessons from Recent Market Turmoil?


Gianfranco A. Vento
Regent’s College, London and Università Telematica “Guglielmo Marconi”, Rome
E-mail: gianfranco.vento@uniroma1.it

Pasquale La Ganga*
Banca d’Italia, Banking Supervision Department


Abstract

The aim of the paper is to analyse the current liquidity risk management techniques
and supervisory approaches, in order to identify how both could be improved in the light of
the recent market turmoil caused by the sub-prime crisis and potential sources of instability
directly connected with the ‘originate-to-distribute’ business model.
Current liquidity risk models demonstrated to undervalue extreme events affecting
funding and market risk in global scenarios. At the same time, regulatory and supervisory
regimes continue to be nationally based and substantially differentiated, pointing out
significant differences which, in some circumstances, could generate regulatory arbitrages,
as well as the effectiveness of supervisory actions could be reduced. The research,
therefore, intends to highlight the most significant features to consider in order to
implement an effective liquidity risk management and to achieve a more integrated
supervisory framework for global financial markets. In this perspective, the effort of a
regulatory authority to validate the adoption of internal models for liquidity risk is also
investigated. Last, the paper analyses the most important lessons concerning liquidity
management from recent episodes of stress.


Keywords: Bank Regulation, Deposit, Liquidity, Rating Agencies.
JEL Classification Codes: G1; G21; G24; G28.

1. Introduction1
The 2007 market turmoil caused by the sub-prime crisis highlighted how several key factors can
strongly affect the banks’ capability to keep their financial equilibrium under stress. As a consequence
of the increase in interest rates in US and of the decrease of house prices, the default rate in sub-prime
mortgages augmented significantly and, therefore, also structured securities based on such sector
started to be downgraded. Rapidly, structured securities issued by bank-related special purpose
vehicles experimented significant difficulties in raising funds in the money market and, consequently,

* The views expressed in this paper are those of the author and do not involve the responsibility of Banca d’Italia.
1 Despite this paper is the result of a research jointly carried on by the authors, sections 1, 2, 7 and 8 can be attributed to
Gianfranco A. Vento, while sections 3, 4, 5 and 6 have been written by Pasquale La Ganga. The authors are grateful to
Andrea Pilati, Franco Tutino e Umberto Viviani for their useful comments. Any errors are responsibility of the authors
alone.

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Journal of Money, Investment and Banking - Issue 10 (2009)
sponsoring banks had to intervene in order to provide liquidity. However, liquidity on US interbank
market rapidly dried up.
The crisis came as a surprise for financial markets, institutions and supervisory authorities
because in the last years, in parallel with financial innovation and other key factors which are largely
investigated in this research, financial industry was not able to develop sophisticated models in order to
highlight the implications of some business lines (i.e., structured finance, securitisation, re-
securitisation, etc.) on liquidity risk management. As a result, after August 2007 central banks had to
carry on a significant effort in order to support both the functioning of money market and, in a few
cases, individual institutions.
Financial markets are progressively reshaped by potential sources of instability directly
connected with the originate-to-distribute business model. In order to allocate risk efficiently, this
mechanism entails a number of threats, some of them intrinsic to its mechanism - products may be
opaque, market liquidity may dry up, and some operators may not have strong incentives to screen and
monitor their customers - others linked to the greater interdependence of the financial system. Even as
systemic events may have become less probable due to diversification and risk dispersion, tail risk
might be larger than how it is normally thought. At the same time, current liquidity risk models
demonstrated to undervalue extreme events affecting funding and market risk in global scenarios.
Furthermore, regulatory and supervisory regimes continue to be nationally based and substantially
differentiated, pointing out significant differences which, in some circumstances, could generate
regulatory arbitrages, as well as reducing the effectiveness of supervisory actions. In this framework,
there is no confidence among regulators that capital requirements can be useful to prevent liquidity
crises, despite in the last year it has been demonstrated that well capitalised banks are facilitated,
ceteris paribus, in raising funds on interbank markets.
This paper, therefore, highlights the most significant features to take into consideration in order
to implement an effective liquidity risk management and to achieve a more integrated supervisory
framework for global financial markets. Last, the paper analyses the most important lessons concerning
liquidity management from recent financial crisis.
The paper is structured as follows. Section 2 considers some definitions of liquidity and
liquidity risk developed over time in the most significant multinational financial fora. In section 3 we
analyse the most updated techniques used in order to measure the liquidity risk, while section 4 is
devoted to the investigation of cash flow uncertainty and how it can be modelled. Section 5 extends the
analysis to liquidity risk into VaR models and section 6 is dedicated to the implication of originate-to-
distribute business models on liquidity risk management. Section 7 focuses on supervisory approaches
on liquidity risk. Finally, section 8 offers some concluding remarks proposing some ideas for an
effective liquidity risk management.


2. Liquidity and Liquidity Risk: Some Definitions from Multinational Financial
Institutions
Liquidity in financial markets and intermediaries has several different meanings. First, liquidity
represents the capability of a financial firm to maintain constantly an equilibrium between the financial
inflow and outflow over time. As it is illustrated in the paper, banks can adopt different strategies and
techniques in order to achieve such goal. Second, liquidity is a measure of the capability of a financial
firm to turn an asset into cash quickly, without capital loss or interest penalty. In this meaning, the
emphasis is focussed on the assed side of the balance sheet, since a potential source of liquidity can be
achieved by selling, permanently or temporarily through repo operations, financial assets which are
negotiated in markets having certain characteristics in terms of depth, breadth and size. Third, liquidity
is somehow interpreted as the capability of a bank to raise funds on the wholesale financial markets -
first of all on the unsecured interbank market - by increasing its liabilities. In a broader sense, liquidity
can be considered as the aptitude of a financial firm to acquire funds when these funds are needed.

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Journal of Money, Investment and Banking - Issue 10 (2009) 81
The nature of banking business implies that banks structurally invest in assets having a different
degree of liquidity. Therefore, the liquidity of a financial firm involves several different managerial
aspects. While a significant percentage of assets are illiquid and cannot be easily converted in cash,
without incurring in losses, typical liabilities of banks and financial firms are more liquid and imply a
considerable degree of discretion as far as the timing of depositors’ withdrawal.
Thus, there are different elements to consider in order to analyse the liquidity of a financial
firm. On one hand, traditional financial intermediation is based on different degree of discretionary
power as far as the timing of use of funds. Consequently, the bank must maintain the confidence of
depositors to have the faculty to withdraw their deposit on demand or at the scheduled moment. On the
other hand, contemporary banking is based on more innovative financial services, which can also affect
the capability of a bank to be liquid, as it has been demonstrated in 2007 financial crisis. The increase
in the complexity of financial instruments, the securitisation, the growth of collateral usage and the
trend to raise funds on wholesale capital markets are, among others, some of the reasons underlying the
increase in the complexity of liquidity management in the financial firms.
In the light of above, liquidity risk can be considered as the risk that a financial firm, though
solvent, either does not have enough financial resources to allow it to meet its obligations as they fall
due, or can obtain such funds only at excessive cost. However, different institutions and authors, in
diverse moments, highlighted several different features in defining liquidity risk. First of all, according
to a supervisory approach, the Basel Committee on Banking Supervision since 1992 made the effort to
define ‘A Framework for Measuring and Managing Liquidity’, stressing the fact that supervisory
authorities have to differentiate the approaches for large international banks and domestic ones, as well
as proposing different methodologies based alternatively on maturity ladder or scenario analysis in
order to implement an effective liquidity management. Eight years later, the Basel Committee on
Banking Supervision (2000) simply defined the liquidity as ‘the ability to fund increases in assets and
meet obligations as they come due’; in this framework, the Committee illustrated the evolutions in
liquidity management and supervision, stressing, in fourteen key principles, the importance to design
different managerial solutions for the day-to-day management of liquidity compared to the approaches
to be adopted in emergency situations and the relevance to measure and monitor the net funding
requirements. However, also this second paper did not identify dominant methodologies in order to
assess and to manage liquidity risk. Nevertheless, the paper has the merit to clearly link, for the first
time, liquidity risk to other typical risks of banking business, like credit risk, market risk and
operational risk, as well as it dedicated a significant space to the importance of contingency plans
against liquidity shocks.2
In 2006 The Joint Forum of the Basel Committee integrated the principles divulgated in 2000,
proposing an ‘integrate liquidity risk management across sectors’ in financial groups, also considering
the impact on liquidity of the off-balance sheet instruments and of on-balance sheet contracts with
embedded optionality 3. In this framework, following a classification previously adopted by the
European Central Bank (2002), the Joint Forum differentiated the liquidity risk in funding liquidity risk
(as ‘the risk that the firm will not be able to efficiently meet both expected and unexpected current and
future cash flow and collateral needs without affecting either daily operations or the financial condition
of the firm’) and market liquidity risk (which is ‘the risk that a firm cannot easily offset or eliminate a
position without significantly affecting the market price because of inadequate market depth or market
disruption’). From this paper onwards, such distinction between funding liquidity risk and market
liquidity risk became a common element in all the literature on liquidity risk management. However,
still in 2006 the managerial practices adopted by banks for facing liquidity risk continued to be
significantly differentiated and also supervisory authorities persisted to adopt dissimilar and
heterogeneous models in order to assess the liquidity profiles of financial institutions.

2 See par. 4.
3 These are contracts imply an implicit options for the counterparty, which can determine a liquidity outflow.

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Journal of Money, Investment and Banking - Issue 10 (2009)
Thus, in order to review liquidity supervision practices in member countries, the Basel
Committee on Banking Supervision at the end of 2006 established the Working Group on Liquidity
(WGL). Such Working Group, which operated during the summer 2007 financial turmoil, functioned
in a context of evidence that the models adopted by banks in order to predict liquidity crises
demonstrated to be ineffective, the contingent liquidity plans were not always successful in avoiding
liquidity crises, as well as did not consider extreme market events, which actually incurred; moreover,
also the models used by supervisory authorities demonstrated to be excessively optimistic. The WGL
terminated its study at the end of 2007 with a paper that the Basel Committee on Banking Supervision
published in February 2008 as ‘Liquidity Risk: Management and Supervisory Challenges’. The
definition of liquidity risk suggested in this paper is in line with the previous ones identified by the
Committee, but there is a clear emphasis on the equivalent relevance to manage liquidity by raising
funds acting on the assets side and liability side, as liquidity risk is ‘the risk that demands for
repayment outstrip the capacity to raise new liabilities or liquefy assets’. Last, in June 2008 the Basel
Committee published an updated draft for consultation of the ‘Principles for Sound Liquidity Risk
Management and Supervision’ in which, stressing how the banking system did not adopted adequate
models which efficiently considered liquidity risk posed by some businesses, the Committee updated
the key principles for the management and supervision of liquidity risk. Among others, the paper
emphasizes the importance of ‘allocating liquidity costs, benefits and risks to all significant business
activities’, the necessity to identify and measure ‘the full range of liquidity risk, including contingent
liquidity risk’ and the need for designing and using ‘severe stress test scenarios’. These features are
largely examined in this paper.
Beside the Basel Committee, other institutions in the last years investigated the liquidity risk.
The European Central Bank (2002), despite did not provide an original definition of liquidity and
liquidity risk, stressed the stochastic dimension of liquidity. In the ECB glossary, furthermore, there is
a distinction between liquidity risk and insolvency, pointing out that the counterparty ‘may be able to
settle the required debt obligations at some unspecified time thereafter’. The Financial Stability Forum
(2008), among the recommendations for enhancing the resilience of markets and financial institutions,
dedicated a specific attention to liquidity risk, emphasizing the fact that supervisors and central banks
have ‘to promote more robust and internationally consistent liquidity approaches for cross-border
banks’. As a response to such request, the EU Commission is consulting the public on possible
improvements of the Capital Requirements Directive (Directive 2006/49/EC), in order to include
specific requirements for liquidity risk in Europe.
At the same time, in last two years the European Union stated to closely investigate liquidity
risk. On March 2007, the European Commission issued a Call for Advice asking the Committee of
European Banking Supervisors (CEBS) to provide technical advice on liquidity risk management at
credit institutions and investment firms. Thus, the CEBS recently issued and updated survey of the
regulatory regimes across the EEA and published an in-depth analysis of the variables that may
significantly affect liquidity risk management. According to the Committee of European Banking
Supervisors (2008) liquidity risk ‘can be seen as the potential threat to this cash generating capacity at
fair costs, which is needed as a counterbalancing capacity at liquidity demands’. Such definition imply
a dynamic view of liquidity risk, since the key element in order to face such risk is the perception of
the cash generating capacity, which has to be sufficient for counterbalancing the unforeseen demand of
liquidity.


3. Quantitative Framework for Measuring Funding Liquidity Risk
The analysis of liquidity requires bank management to identify, measure and monitor its positions on
an ongoing basis as well as to examine how funding requirements are likely to evolve under various
scenarios, including adverse conditions.

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Journal of Money, Investment and Banking - Issue 10 (2009) 83
However, ‘liquidity is difficult to define and even more difficult to measure’ (Persaud, 2007).
Measuring liquidity risk can be a challenge, mainly because the underlying variables driving the
exposures can be dynamic and unpredictable.
Until recently, managing and measuring liquidity risk was rarely seen as a high priority by most
banks and financial institutions. Furthermore, no agreement existed in the international financial
community and in the available literature on the proper measurement of liquidity 4. There was not an
integrated measurement tool able to cover all the dimensions of liquidity risk and commonly adopted
by the majority of institutions.
As to liquidity risk metrics in use, it is necessary to distinguish between analytical approaches,
such as VAR, that are focused on assessing potential effects on profitability (i.e. ‘P&L effects’) and
liquidity risk models and measures, which aim at assessing cash flow projections of assets and
liabilities, or the inability to conduct business as a result of a lack or a reduction of secured and
unsecured funding capacity and/or liquid assets.
In the ‘liquidity risk universe’, banks generally apply a variety of measurement techniques -
depending on which type of risk they want to assess (e.g. insolvency risk, funding liquidity risk,
contingency liquidity risk, market liquidity risk, etc.) - with a different degree of sophistication and
accuracy. In line with the stance taken by the Joint Forum’s Working Group on Risk Assessment and
Capital (2006), the main approaches to measure funding liquidity risk include a stock approach, a cash
flow analysis and an unadjusted (or hybrid) maturity mismatch framework.

3.1. The Stock Approaches
The stock-based approaches look at liquidity as a stock. By comparing the balance-sheet items, these
financial metrics aim at determine a bank's ability to reimburse its short-terms debts obligations as a
measurement of the liquid assets’ amount that can be promptly liquidated by the bank or used to obtain
secured loans. The long-term funding ratio and the cash capital position are the most commonly used
approaches based on liquidity stock.

a). The Long Term Funding Ratio
The best-known liquidity ratio - the long-term funding ratio (LTFR) - is based only on the cash flow
profile arising from on- and off-balance sheet items of an institution. It indicates the share of assets
with a maturity of n years or more, funded through liabilities of the same maturity5.

In a short-term horizon, the LTFR is frequently lower than 100 percent, because of maturity
mismatches between assets and liabilities. Its evolution over time and the comparison with peer groups
may draw attention to a potential maturity discrepancy between assets and liabilities (table 1).

Table 1:
An example of Long Term Funding Ratio

Balance Sheet Items
n = 5 Years
n = 10 Years
Assets (A)
1000 850
Funds Available (B)
850 700
Net Funding
1850 1550
Long Term Funding Ratio (B/A)
85,00%
82,35%


4 The available researches on the subject mainly tried to explain the limitations of the different techniques.
5 Alongside this ratio, credit institutions often set limits also on roll-over risk, concentration risk, term transformation and
so on, as these are important drivers for the liquidity risk that an institution is subject to.

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Journal of Money, Investment and Banking - Issue 10 (2009)
b). The Cash Capital Position
A variant of the stock approach is represented by the Cash Capital Position (CCP) analysis. In general,
in order to guarantee an appropriate balance sheet structure with respect to liquidity risk, illiquid assets
should be funded by stable liabilities, or otherwise total marketable assets (TLA) 6 should be funded by
total volatile liabilities (TVL)7.
Consider the following balance-sheet’s structure (table 2):

Table 2:
Stock based approaches: the cash capital position


Assets
Liabilities

Collateral value of unencumbered
Short-term funding (CP, Euro
assets (=liquid asset excluding
CP, short-term bank facilities,
Liquid
Volatile
haircuts)
etc.)
assets
liabilities
Cash Non-core
deposit

Reverse Repos
Repos



Total Liquid Assets (TLA)
Total Volatile Liabilities (TVL)

Illiquid assets (e.g. fixed assets,
Medium/long term funding Core
Core and
intangibl., etc.)
deposits
Core funding
illiquid assets
+ Equity

Haircuts Equity


Total on balance-sheet


Commitment to lend (CTL)
Steadily available lines of credit


The difference between TLA and the sum of TVL and commitments to lend (CTL) is known as
cash capital position. For example, in the previous balance-sheet CCP is calculated as8:
CCP = TLA – TVL - CLT
that is, highly liquid securities (i.e. cash, eligible assets, repoable bonds, etc.) should be able to replace
for unsecured ‘rating sensitive’ funding 9. CCP measures a bank’s ability to fund its assets on a fully
collateralized basis and ensures the bank to conduct business for the survival period 10.
If the result is negative, it means that illiquid assets are greater than long-term funding11.
This approach is far more preferable framework to simply relying on other liquidity ratios, such
as ‘loan to deposits’, because the latter ignores the quantity of loans that can quickly generate cash by
either being pledged or sold 12. Nevertheless, CCP has some drawbacks:

6 Total marketable assets (TLA) are primarily composed by cash, promptly reimbursable loans (i.e. mortgages that can be
reimbursed without causing the borrower to meet financial distress) and unencumbered assets, that is widely marketable
securities that are available to be used as collateral. Generally, they are calculated as the market value of net security
positions after accounting for bond and equity financing transactions (i.e. reverse repo securities, borrowing securities,
etc.). The collateral value is determined by subtracting haircuts, depending on security marketability from the current
market value.
7 Total volatile liabilities (TVL) include overnight and very short term wholesale funds, shares of customer demand
deposits that could be claimed in the short term, such as save and sight deposits.
8 As remarked by Resti and Sironi (2008), steadily available lines of credit are not included as third parties may be willing
to face the legal costs of refusing to issue the loans to avoid creating new exposure to the bank.
9 Rating sensitive funding is related to the fact that a part of banks’ funding depends on the perceived riskiness, and
therefore on the rating, of the bank itself.
10 Moody’s initially created the cash capital position to analyze the liquidity structure of a bank’s balance-sheet as part of its
external rating process. Its intention was to measure the bank’s ability to fund its assets on a fully collateralized basis,
assuming that the access to unsecured funding has been lost. For example, such scenario can occur after the downgrading
of a bank’s (short term) rating.
11 All things being equal, this is a more challenging situation than a positive outcome, which points out that illiquid assets
are more than fully funded by long-term funding.
12 The loan to deposit ratio, or total loans divided by total deposits, indicates the degree to which a bank can support its core
lending business through deposits; a sophistication of this ratio excludes from total deposits the more stable retained
component, to demonstrate the degree to which credit business is actually supported by hot money. The above-
mentioned ratio assumes that all sources of funding other than deposit are stable and all assets other than loans are
completely liquid.

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Journal of Money, Investment and Banking - Issue 10 (2009) 85
• it excludes the unfunded commitments, which the bank could be obliged to fund at anytime;
• it does not take into account of long-term liabilities that are maturing within a short-term
horizon;
• it does not incorporate cash earnings generated by the bank’s business;
• the discount applied to marketable securities could be too low and may increase at a time of
greater illiquidity;
• furthermore, dividing balance-sheet items in ‘liquid’ and ‘illiquid’, there are no statements
on when exactly positions can be liquidated or become due. Therefore, a binary approach is
intrinsically unsatisfactory as it cannot appropriately consider the unlimited variety of
liquidity degree.
In general, stock-based approaches are not forward looking and therefore not capable to cover
all material aspects of the liquidity risk that an institution faces.

3.2. The Cash-Flows Based Approaches
A second group of liquidity models are those based on cash-flow. Often banking institutions control
their liquidity principally by managing the structure of the respective maturities of their assets and
liabilities, so as to generate adequate net cash flows.
In the cash-flow based approach, the ‘essence’ of liquidity risk is cash flow. Such metric
principally aims at safeguarding the bank’s ability to meet its payment obligations (that is funding
liquidity risk) and calculating and limiting the liquidity maturity transformation risk, based on the
measurement of liquidity-at-risk figures. Although this method is somehow recommended by the Basel
Committee on Banking Supervision’s (BCBS) Sound Practices of Liquidity Risk Management and
seems to be accepted among the vast majority of supervisors as well, the details of the approaches used
seem to be quite differentiated across the banking industry.
This risk measurement tool is based on a maturity ladder used to compare bank's future cash
inflows - arising from eligible and marketable assets, illiquid products and established credit lines and
outflows - including liabilities falling due and contingent liabilities, especially committed lines of
credit that can be drawn down - both on a day-to-day basis as well as over a series of specified time
periods (calendar date is considered as the starting point and it usually coincides with the following
day), checking for their consistency (table 3).

Table 3:
An example of the cash-flow based approaches: the (unadjusted) maturity ladder

Bands (upper limits)
ON
1 W
2 W
1 M
3 M
6 M
1 Y
>1 Y
TOT
Loans
40 80 110 170 250 400 650 900 2600
Main expected
Securities

10 100 130 110 200 350 900
Inflows
Cash & Other
35 35
Deposits
-10 -30 -50 -90 -200 -350 -590 -650
-1970
Main Ex
Oth
pected er Funding
-30 -30 -50 -50 -60 -50 -110 -80 -460
outflows
Bond


-130 -160 -200 -300 -770 -1560
CTL
-5 -25 -30 -20 -30 -110 -100 -100 -420
Net Funding Req. (NFR)
30 -5 -10 -20 -70 -200 -250 -350 -875
Cumulative Fund. Req. (CFR)
30 25 15 -5 -75
-275
-525
-875

This grid allows to measure a ‘cash flow mismatch’ or ‘liquidity gap’ analysis; in its simplest
structure such analysis is not supported by explicit assumptions on the future behaviour of assets,
liabilities and off-balance-sheet items 13 and, consequently, a calculation of the cumulative net excess
or shortfall over the time frame (T) for the liquidity assessment is performed.
CFR =
NFR
T
?
t
i?T

13 If a pure maturity mismatch approach is applied, only projected incoming cash flows are taken into consideration.

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Journal of Money, Investment and Banking - Issue 10 (2009)
where CFR is the cumulative funding requirement and NFR represents the net funding requirement.
Typically, a bank may find substantial negative funding gaps over long-term horizons and will
endeavour to fill these gaps by influencing the maturity of transactions, so as to offset the gap (graph
1). The excess or deficit of funds in each time bucket becomes a starting-point for a measure of a
bank's future liquidity excess or shortfall 14.

Graph 1: An example of the path of the net cumulative outflows (NCO)

Net Cumulative Outflows (NCO)
100
Net Outflows (NO)
Net Cumulative Outflows (NCO)
0
-100
-200
-300
-400
-500
-600
-700
-800
-900
ON
1 W
2 W
1 M
3 M
6 M
1 Y
Time buckets
>1 Y


A maturity ladder can assume a multiplicity of structures and cash flows composition according
to the different objectives, time horizons and business units involved (i.e. Treasury Unit, Risk
Management Department, Economic and Financial Planning, etc.). For instance, the ‘operational
maturity ladder’ supports the definition of the short-term funding strategy and the monitoring of a bank
risk limit’s system (table 4).

14 The granularity of time horizons must be carefully considered. While an extremely detailed cash flow breakdown can
provide valuable information, it can also generate a certain amount of confusion in interpretation. This is particularly true
if a bank is operating in a very dynamic environment, where cash flows arising in two or three weeks might change. The
optimal level of granularity should be chosen in accordance with the previous experience.

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Journal of Money, Investment and Banking - Issue 10 (2009) 87
Table 4:
Cash flows projections: same metrics, different time horizons.

Net Funding Requirement (NFR)
Maturity Ladder: estimate of
Net Cumulative Outflows (NCO)
Short-term horizon
Medium/Long-term horizon
Operational maturity ladder
Strategic maturity ladder
(Treasury &
(Planning, Structural Funding &
RM Units)
Risk Management Unit, ALCO)
ON 1 M 3 M 6 M … 12 M Time


The main purpose of maturity ladder is to simulate the path of short-term treasury liquidity
gaps, based on neutral assumptions on balance sheet items’ future growth. Because of the shortest time
horizon of the operational maturity ladder (e.g. up to 3 months), the balance sheet items included in
such maturity ladder belong to the treasury book: short-term cash and derivative wholesale instruments
interbank and institutional clients deposits, repurchase agreements, cross currency swaps, MTN,
CD/CPs, etc. Other items, like high volatile trading assets, cash accounts and credit cards are not
integrated in the analysis because they are considered stable or too tricky to predict 15. Money and
capital market positions are managed dynamically on contractual maturity basis.

3.3. The Hybrid Approaches
The hybrid approaches combine elements of the cash flow matching and of the liquid assets
approaches. The idea underlying these models is that every credit institution is exposed to unexpected
cash in- and outflows, which may occur in the future because of unusual deviations in the timing (term
liquidity risk) or magnitude (call liquidity risk) 16, so requiring a considerably larger quantity of cash
than the amount needed for bank projects. For this reason, the bank tries to match cash expected and
unexpected outflows in each time bucket against a combination of contractual cash inflows, plus
inflows that can be generated through the sale of assets, repurchase agreement or other secured
borrowing. Unencumbered assets, that are used as collateral in financing transactions securing access
to adequate funding sources (e.g. interbank lines of credit, discount facilities with central banks, etc.)
and most liquid assets are typically counted in the shortest time buckets, while less liquid assets are
counted in later time buckets (table 5).

15 The positions do not considered in the operational maturity ladder scheme are assumed to be passively managed or ex-
post funded on an overnight basis.
16 Cash flows with non deterministic timing are for example early redemption clauses or triggers. Examples for cash flows
not deterministic in their magnitude but in their timing would be European options, dividends or, more generally, non
hedged cash flows in a foreign currency. Cash flows that are stochastic in their timing and in the magnitude stem from
American options or deposit withdrawals.

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Journal of Money, Investment and Banking - Issue 10 (2009)
Table 5:
An example of hybrid approach and the liquidation horizon

Band (upper limit)
Based on Maturity
Based on liquidation horizons
ON
0 550
1 W
0 100
2 W
10 100
1 M
100 50
3 M
130 0
6 M
110 0
1 Y
200 50
> 1Y
350 50
Total
900 900

Even though a strong (regulatory or economic) capital position is a prerequisite for high-
investment grade rating and, consequently, improves funding costs and accessibility and contributes to
the reduction of the likelihood of liquidity pressure, capital is not considered an appropriate risk
cushions in stressful conditions or liquidity shortage. In such context, bank capital is usually replaced
by a mix of risk management techniques in order to reduce the net cumulative outflows (NCO) and by a
surplus of unencumbered assets to counterbalance NCO. The implied suggestion is that liquidity risk is
adequately covered if the cash inflows, which could be generated from unencumbered eligible assets
(UEA) within a time interval T, go beyond the net cumulative outflows within the same time horizon.
In this framework, it is necessary to do some hypothesis on the capability to raise funds from eligible
assets (graph 2).

Graph 2: An hypothesis of treatment of eligible assets

The treatment of eligible assets
600
Based on Maturity
Based on liquidation horizons
500
Eligible assets
400
Haircuts and
Cash
illiquid securities
flows
300
200
100
0
ON
1 W
2 W
1 M
3 M
6 M
1 Y
> 1Y
Time buckets


As shown in the table 6, the adjusted liquidity gap is now positive on all time buckets shorter
than a year.

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