The Liquidity Risk Book


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The Economic and Regulatory Views on Liquidity Risk are Different

In the Liquidity Coverage Ratio (LCR) of Basel III, a bank’s potential liquidity exposure (Total Net Cash Outflows, TNCO) needs to be related to the size and quality of its liquidity buffer (High Quality Liquid Assets, HLA):
HLA/TNCO ≥ 100%.
From a regulatory point of view
it is sufficient for the TNCO of, e.g. a loan portfolio, to calculate once a month the reimbursement flows that are expected within the next 30 days. From an economic perspective, however,  the bank’s future liquidity exposure, FLE, requires the daily generation of all cash flows for every day of the considered time horizon.

When cash outflows and cash inflows are economically mitigated, they are usually simply added; a possible risk-adjusted view is seperately modeled. In the LCR cash inflows and outflows are netted with the maximum-75%-rule which automatically provides a (very raw) risk adjustment - but makes it impossible to distill a most likely view of the future. Although the Basel III method on average accounts for a higher risk, in specific situations it might be understating the bank’s risk because it does not capture possible minimum values of the FLE within the first 30 days.

For the denominator of the LCR, it is sufficient to multiply the nominal of the unencumbered HLA with their prevailing price and eventually deduct a haircut. In order to estimate the banks CounterBalancing Capacity appropriately in an economically realistic way, however, the bank e.g. might need to simulate the likeliness that certain classes of liquid assets can be liquified in time by repo, central bank repo or sales – possibly depending on distinctive scenario assumptions.

In this example the regulatory view (LCR) can be regarded as a special case of a more widespread economic view:
just three liquifiability classes (HLA1, HLA2 and none), a basic liquification process, simplified cash flow generation but with a tricky netting technique for in- and outflows.