11.1 CREATING A RISK FRAMEWORK
11.1.4 Liquidity risk
The framework can also be used to limitlong-term credit exposuresby counterparty rating (e.g. any transaction exceeding 12 months). Thus, AA/AAA counterparties might receive 10- or 15-year unsecured credit lines through the framework, while BBB/A counterparties might be limited to five or seven years and borderline investment grade/sub-investment clients to only 12 months. Limiting the term of credit transactions helps keep exposures to counterparties that might be vulnerable to rapid financial deterioration in check. It is worth pointing out that well-rated companies can fall from grace quickly. We have recently been acutely exposed to this through the Enron debacle.
Secured credit exposurescan also be limited so that concentrations, and especially correlated concentrations, do not grow out of control. This can be done by setting the maximum amount of a particular security that can be used to collateralize exposures across all counterparties (e.g.
$500 million total of esoteric mortgage-backed securities being used to collateralize credit exposures to all clients) and/or the total amount of the free float of a security against which lending can occur; the emphasis here is, of course, on less liquid or lesser quality collateral rather than on highly liquid, risk-free collateral (e.g. US Treasuries, Japanese government bonds).
The framework can also be used to limit correlated exposures across all counterparties to prevent a build-up of positions that can sour at the same time (e.g. a maximum of $100 million of Turkish bonds being used to collateralize financings for Turkish banks). An example of collateralized limits (per collateral asset and counterparty) is depicted in Figure 11.6.
In Figure 11.7 we illustrate a simple example of secured collateral/counterparty framework limits for exposures that are highly correlated. For ease, we assume in the illustration that Collateral asset 1 (e.g. Turkish bond) is perfectly correlated with Counterparty 1 (e.g. Turkish bank) but not Counterparty 2 (a US bank) or Counterparty 3 (a European investment fund), and that each desk deals only with a single counterparty. Thus, any collateral exposure from Asset 1 carried on Desk 2 in its dealings with Counterparty 2 is counted against the total secured limits granted to Desk 1 (collateral and credit exposure with Turkey/Turkish banks). All other applicable limits described above relating to other counterparties and collateral concentrations remain in force.
Desk 1Desk 2Desk 3 Collateral asset 1Collateral asset 1Risk class limits: Collateral asset 2Risk class limits: Collateral asset 2 Collateral asset 3Risk class limits: Collateral asset 3 Collateral asset 4Risk class limits: Collateral asset 4 Collateral asset 5Risk class limits: Collateral asset 5 Desk limits:Desk limits:Desk limits:Division limits: All securedAll securedAll securedAll secured business, perbusiness, perbusiness, perbusiness, per counterparty andcounterparty andcounterparty andcounterparty and collateralcollateralcollateralcollateral Figure11.6Deskandriskclasslimitallocation:collateralizedcredit
Desk1Desk 2Desk 3 Collateral asset 1Collateral asset 1 Collateral asset 2
Risk class limits: Collateral asset 1 Risk class limits: Collateral asset 2 Collateral asset 3Risk class limits:Collateral asset 3 Collateral asset 4Risk class limits: Collateral asset 4 Collateral asset 5Risk class limits: Collateral asset 5 Desk limits:Desk limits:Desk limits:Division limits: All securedAll securedAll securedAll secured business withbusiness withbusiness withbusiness, per Counterparty 1Counterparty 2Counterparty 3counterparty and collateral Figure11.7Deskandriskclassallocation:correlatedexposures
changing market dynamics, lack of investor/client demand, or mismarking can all contribute to this accumulation; failure to properly adjust valuations simply compounds the problem.
Over time, a bank might realize that its overall asset portfolio is much less liquid than de- sired and that asset values may not reflect market clearing levels; it is therefore incumbent on management to ensure thresholds intended to cap holdings of “illiquid” assets are defined, communicated, monitored and managed. Management then needs to review the portfolio, its valuations and these thresholds on a regular basis. The framework can also be used to constrain aspects of theforward balance sheetas well. Though these limits might be based on somewhat imprecise assumptions about future events, they can serve to keep the firm’s future balance sheet construction in check. Such limits might control the maximum allow- able growth in total footings, maximum incremental financing requirements at various future points, and so forth. They will also prevent people from “by-passing” balance sheet limits by creating off-balance sheet exposures that will ultimately come back as assets necessitating funding!
11.1.4.2 Concentration limits
As noted in Chapter 3, undue concentrations can create liquidity problems. Using framework concentration limitsto control the build-up of concentrations can help limit potential problems.
For instance, a bank may prohibit positioning of more than $50 million in any high-yield issuer and $500 million across all high-yield issuers, and $200 million in any high-grade corporate issuer and $2 billion across all high-grade issuers. Positions in excess of these limits would require the review and approval of those in the governance structure – making them aware that by doing so they are potentially increasing the firm’s liquidity risk profile. In order to set concentration limits a firm must have appropriate monitoring tools and infrastructure. This generally requires some type of aggregation platform that draws in, and consolidates, identical positions carried in different businesses or locations.
11.1.4.3 Diversified funding
In order to manage funding liquidity risk and reduce the need for sudden asset disposal, the framework should be used to limitfunding concentrations. This is done by forcing the firm to use standardization around:
r
Diversified funding markets (e.g. domestic market, offshore market, loan market, capital market, short-term financing market, secured market);r
Diversified lenders (e.g. domestic and international banks, investment banks, funds, other credit providers);r
A range of instruments (e.g. payables, commercial paper, short- and medium-term notes, bonds, bank loans, equity-linked financings, secured financings, and so forth);r
A range of maturities (e.g. short-term funding, medium-term funding, long-term funding);r
A high percentage of truly committed facilities.As part of the process a firm should prove to itself that it has enough funds to meet a variety of crisis situations; it should stress its program by considering scenarios that reflect disasters (e.g. withdrawal of a large portion of its funding, availability to access new funds, a spike in interest rates, large, unexpected payments, changes in the forward balance sheet, and so on).
Where necessary it may want to place limits on funding of different legal entities, especially for heavily regulated institutions where “upstreaming” of capital or dividends is sometimes not possible; this can help ensure there is no trouble tapping funds in the right entity, when needed.
Moving capital around may also entail other consequences that require careful consideration.