# LIQUIDITY AND INTEREST-RATE RISK - Global Money Markets

Liquidity risk arises because a bank’s portfolio will consist of assets and liabilities with different sizes and maturities. When assets are greater than resources from operations, a funding gap will exist which needs to be sourced in the wholesale market. When the opposite occurs, the excess resources must be invested in the market. The differences between the assets and liabilities is called the liquidity gap. For example if a bank has long-term commitments that have arisen from its dealings and its resources are exceeded by these commitments, and have a shorter maturity, there is both an immediate and a future deficit. The liquidity risk for the bank is that, at any time, there are not enough resources (or funds) available in the market to balance the assets.

Liquidity management has several objectives; possibly the most important is to ensure that deficits can be funded under all foreseen circumstances without incurring prohibitive costs. In addition, there are regulatory requirements that force a bank to operate within certain limits, and state that short-term assets be in excess of short-run liabilities, in order to provide a safety net of highly liquid assets. Liquidity management is also concerned with funding deficits and investing surpluses, with managing and growing the balance sheet, and with ensuring that the bank operates within regulatory and in-house limits. In this section we review the main issues concerned with liquidity and interest-rate risk.

The liquidity gap is the difference, at all future dates, between assets and liabilities of the banking portfolio. Gaps generate liquidity risk. When liabilities exceed assets, there is an excess of funds. An excess does not of course generate liquidity risk, but it does generate interest-rate risk because the present value of the book is sensitive to changes in market rates. When assets exceed liabilities, there is a funding deficit and the bank has long-term commitments that are not currently funded by existing operations. The liquidity risk is that the bank requires funds at a future date to match the assets. The bank is able to remove any liquidity risk by locking in maturities, but of course there is a cost involved as it will be dealing at longer maturities.4

Gap Risk and Limits

Liquidity gaps are measured by taking the difference between outstanding balances of assets and liabilities over time. At any point a positive gap between assets and liabilities is equivalent to a deficit, and this is measured as a cash amount. The marginal gap is the difference between the changes of assets and liabilities over a given period. A positive marginal gap means that the variation of the value of assets exceeds the variation of value of the liabilities. As new assets and liabilities are added over time, as part of the ordinary course of business, the gap profile changes.

The gap profile is tabulated or charted (or both) during and at the end of each day as a primary measure of risk. For illustration, a tabulated gap report is shown in Exhibit and is an actual example from a UK banking institution. It shows the assets and liabilities grouped into maturity buckets and the net position for each bucket. It is a snapshot today of the exposure, and hence funding requirement, of the bank for future maturity periods.

Exhibit is very much a summary presentation, because the maturity gaps are very wide. For risk management purposes, the buckets would be much narrower; for instance, the period between zero and 12 months might be split into 12 different maturity buckets. An example of a more detailed gap report is shown in Exhibit , which is from another UK banking institution. Note that the overall net position is zero, because this is a balance sheet and therefore, not surprisingly, it balances. However along the maturity buckets or grid points there are net positions which are the gaps that need to be managed.

Example Gap profile

Detailed Gap report

(Continued)

Gap maturity profile in graphical from

Gap maturity profile,bank with no short funding allowed

The maturity gap can be charted to provide an illustration of net exposure, and an example is shown in Exhibit , from yet another UK banking institution. Some reports present both the assets and the liabilities are shown for each maturity point, but in our example only the net position is shown. This net position is the gap exposure for that maturity point. A second example, used by the overseas subsidiary of a middle eastern commercial bank, which has no funding lines in the interbank market and so does not run short positions, is shown in Exhibit , while the gap report for a UK high-street bank is shown in Exhibit .

Note the large short gap under the maturity labelled “non-int”; this stands for non-interest bearing liabilities and represents the balance of current accounts (cheque or “checking” accounts) which are funds that attract no interest and are in theory very short-dated (because they are demand deposits, so may be called at instant notice).

Gap Maturity Profile, UK High-Street Bank

Gaps represent cumulative funding required at all dates. The cumulative funding is not necessarily identical to the new funding required at each period, because the debt issued in previous periods is not necessarily amortized at subsequent periods. For example, the new funding between months 3 and 4 is not the accumulated deficit between months 2 and 4 because the debt contracted at month 3 is not necessarily amortized at month 4. Marginal gaps may be identified as the new funding required or the new excess funds of the period that should be invested in the market. Note that all the reports are snapshots at a fixed point in time and the picture is of course a continuously moving one. In practice the liquidity position of a bank cannot be characterized by one gap at any given date, and the entire gap profile must be used to gauge the extent of the book’s profile.

The liquidity book manager may decide to match its assets with its liabilities. This is known as cash matching and occurs when the time profiles of both assets and liabilities are identical. By following such a course the bank can lock in the spread between its funding rate and the rate at which it lends cash, and generate a guaranteed profit. Under cash matching, the liquidity gaps will be zero. Matching the profile of both legs ofthe book is done at the overall level; that is, cash matching does not mean that deposits should always match loans. This would be difficult as both result from customer demand, although an individual purchase of say, a CD, can be matched with an identical loan. Nevertheless, the bank can elect to match assets and liabilities once the net position is known, and keep the book matched at all times. However, it is highly unusual for a bank to adopt a cash matching strategy.

Liquidity Management

The continuous process of raising new funds or investing surplus funds is known as liquidity management. If we consider that a gap today is funded, by balancing assets and liabilities and thus squaring-off the book, the next day a new deficit or surplus is generated which also has to be funded. The liquidity management decision must cover the amount required to bridge the gap that exists the following day, as well as position the book across future dates in line with the bank’s view on interest rates.

Usually in order to define the maturity structure of debt a target profile of resources is defined. This may be done in several ways. If the objective of ALM is to replicate the asset profile with resources, the new funding should contribute to bringing the resources profile closer to that of the assets, that is, more of a matched book looking forward. This is the lowest-risk option. Another target profile may be imposed on the bank by liquidity constraints. This circumstance may arise if for example the bank has a limit on borrowing lines in the market so that it could not raise a certain amount each week or month. For instance, if the maximum that could be raised in one week by a bank is $10 million, the maximum period liquidity gap is constrained by that limit. The ALM desk will manage the book in line with the target profile that has been adopted, which requires it to try to reach the required profile over a given time horizon. Managing the banking book’s liquidity is a dynamic process, as loans and deposits are known at any given point, but new business will be taking place continuously and the profile of the book looking forward must be continuously rebalanced to keep it within the target profile. There are several factors that influence this dynamic process, the most important of which are reviewed below. Demand Deposits Deposits placed on demand at the bank, such as current accounts (cheque or checking), have no stated maturity and are available on demand at the bank. Technically they are referred to as “non-interest bearing liabilities” becausethe bank pays no or very low rates of interest on them, so they are effectively free funds. The balance of these funds can increase or decrease throughout the day without any warning, although in practice the balance is quite stable. There are a number of ways that a bank can choose to deal with these balances, which are: ■ to group all outstanding balances into one maturity bucket at a future date that is the preferred time horizon of the bank, or a date beyond this. This would then exclude them from the gap profile. Although this is considered unrealistic because it excludes the current account balances from the gap profile, it is nevertheless a fairly common approach; ■ to rely on an assumed rate of amortization for the balances, say 5% or 10% each year; ■to divide deposits into stable and unstable balances, of which the core deposits are set as a permanent balance. The amount of the core balance is set by the bank based on a study of the total balance volatility pattern over time. The excess over the core balance is then viewed as very short-term debt. This method is reasonably close to reality as it is based on historical observations; ■ to make projections based on observable variables that are correlated with the outstanding balances of deposits. For instance, such variables could be based on the level of economic growth plus an error factor based on the short-term fluctuations in the growth pattern. Pre-Set Contingencies A bank will have committed lines of credit, the utilization of which depends on customer demand. Contingencies generate outflows of funds that are by definition uncertain, as they are contingent upon some event, for example the willingness of the borrower to use a committed line of credit. The usual way for a bank to deal with these unforeseen fluctuations is to use statistical data based on past observation to project a future level of activity. Prepayment Options of Existing Assets Where the maturity schedule is stated in the terms of a loan, it may still be subject to uncertainty because of prepayment options. This is similar to the prepayment risk associated with a mortgage-backed security. An element of prepayment risk renders the actual maturity profile of a loan book to be uncertain; banks often calculate an “effective maturity schedule” based on prepayment statistics instead of the theoretical schedule. There are also a range of prepayment models that may be used, the simplest of which use constant prepayment ratios to assess the average life of the portfolio. The more sophisticated models incorporate more parameters, such as one that bases the prepayment rate on the interest rate differential between the loan rate and the current market rate, or the time elapsed since the loan was taken out. Interest Cash Flows Assets and liabilities generate interest cash inflows and outflows, as well as the amortization of principal. The interest payments must be included in the gap profile as well. Interest-Rate Gap The interest-rate gap is the standard measure of the exposure of the banking book to interest-rate risk. The interest-rate gap for a given period is defined as the difference between fixed-rate assets and fixed-rate liabilities. It can also be calculated as the difference between interest-rate sensitive assets and interest-rate sensitive liabilities. Both differences are identical in value when total assets are equal to total liabilities, but will differ when the balance sheet is not balanced. This only occurs intra-day, when, for example, a short position has not been funded yet. The general market practice is to calculate the interest-rate gap as the difference between assets and liabilities. The gap is defined in terms of the maturity period that has been specified for it. The convention for calculating gaps is important for interpretation. The “fixed-rate” gap is the opposite of the “variable-rate” gap when assets and liabilities are equal. They differ when assets and liabilities do not match and there are many reference rates. When there is a deficit, the “fixed-rate gap” is consistent with the assumption that the gap will be funded through liabilities for which the rate is unknown. This funding is then a variable-rate liability and is the bank’s risk, unless the rate has been locked-in beforehand. The same assumption applies when the banks run a cash surplus position, and the interest rate for any period in the future is unknown. The gap position at a given time bucket is sensitive to the interest rate that applies to that period. The gap is calculated for each discrete time bucket, so there is a net exposure for say, 0–1 month, 1–3 months, and so on. Loans and deposits do not, except at the time of being undertaken, have precise maturities like that, so they are “mapped” to a time bucket in terms of their relative weighting. For example, a$100 million deposit that matures in 20 days’ time will have most of its balance mapped to the 3-week time bucket, but a smaller amount will also be allocated to the 2-week bucket. Interest-rate risk is measured as the change in present value ofthe deposit, at each grid point, given a 1 basis point change in the interest rate. So a \$10 million 1-month CD that was bought at 6.50% will have its present value move upwards if on the next day the 1-month rate moves down by a basis point.

The net change in present value for a 1 basis point move is the key measure of interest-rate risk for a banking book and this is what is usually referred to as a “gap report,” although strictly speaking it is not. The correct term for such a report is a “PVBP” or “DV01” report, which stand for “present value of a basis point” and “dollar value of an 01 [1 basis point]”, respectively. The calculation of interest-rate sensitivity assumes a parallel shift in the yield curve; that is, it assumes that every maturity point along the term structure moves by the same amount (here one basis point) and in the same direction. An example of a PVBP report is given in Exhibit , split by different currency books, but with all values converted to British pounds sterling.

Banking book pvbp grid report

The basic concept in the gap report is the net present value (NPV) of the banking book. The PVBP report measures the difference between the market values of assets and liabilities in the banking book. To calculate NPV we require a discount rate, and it represents a mark-to-market of the book. The rates used are always the zero-coupon rates derived from the benchmark government bond yield curve, although some adjustment should be made to this to allow for individual instruments.

Gaps may be calculated as differences between outstanding balances at one given date, or as differences of variations of those balances over a time period. A gap number calculated from variations is known as a margin gap. The cumulative margin gaps over a period of time plus the initial difference in assets and liabilities at the beginning of the period are identical to the gaps between assets and liabilities at the end of the period.

The interest-rate gap differs from the liquidity gap in a number of detail ways, which include:

■whereas for liquidity gap all assets and liabilities must be accounted for, only those that have a fixed rate are used for the interest-rate gap;

■ the interest-rate gap cannot be calculated unless a period has been defined because of the fixed-rate/variable-rate distinction. The interest rate gap is dependent on a maturity period and an original date.

The primary purpose in compiling the gap report is to determine the sensitivity of the interest margin to changes in interest rates. As we noted earlier, the measurement of the gap is always “behind the curve” as it is an historical snapshot; the actual gap is a dynamic value as the banking book continually changes.