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Capital-Markets Activities Manual
Activities: Liquidity Risk
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
Institutions face two types of liquidity
risk in their capital-markets and trading activities: ''Funding-liquidity
risk'' refers to the ability to meet investment and funding requirements
arising from cash-flow mismatches, and ''marketliquidity risk'' is the
risk that an institution cannot easily eliminate or offset a particular
position without significantly affecting the previous market price because
of inadequate market depth or market disruption. Measuring, monitoring,
and addressing both types of liquidity-risk exposures are vital activities
of a financial institution. Ultimate responsibility for setting liquidity
policies and reviewing liquidity decisions lies in the financial institution's
highest level of management, and its decisions should be reviewed periodically
by the board of directors.
In developing guidelines for controlling liquidity risks, institutions
should consider the possibility that they could lose access to one or
more markets because of concerns about the institution's own creditworthiness,
the creditworthiness of a major counterparty, or generally stressful market
conditions. At such times, the institution may have less flexibility in
managing its market-, credit-, and liquidity-risk exposures. Institutions
that make markets in over-the-counter derivatives or that dynamically
hedge their positions require constant access to financial markets, and
that need may increase in times of market stress. The institution's liquidity
plan should reflect the institution's ability to turn to alternative markets,
such as futures or cash markets, or to provide sufficient collateral or
other credit enhancements to continue trading under a broad range of scenarios.
Examiners should ensure that financial institutions that participate in
over-the-counter derivative markets adequately consider the potential
liquidity risk associated with the early termination of derivative contracts.
Many forms of standardized contracts for derivatives transactions allow
counterparties to terminate their contracts early if the institution experiences
an adverse credit event or a deterioration in its financial condition.
Under conditions of market stress, customers may also ask for the early
termination of some contracts within the context of the dealer's market-making
activities. In these situations, an institution that owes money on derivative
transactions may be required to settle a contract early and possibly at
a time when the institution may face other funding and liquidity pressures.
Furthermore, early terminations may expose additional market positions.
Management and directors should be aware of these potential liquidity
risks and address them in the liquidity plan and management process. Examiners
should consider the extent to which such potential obligations could present
liquidity risks to the institution.
Funding-liquidity risk refers to the ability
to meet investment and funding requirements arising from cash-flow mismatches.
Virtually every financial transaction or commitment has implications for
an institution's liquidity. Traditionally, funding-liquidity-risk management
focused on the balance-sheet activities of financial institutions; however,
the major growth in off-balance-sheet activities in recent years has made
liquidity management of these exposures increasingly important. Activities
such as foreign exchange, securities, and derivatives trading can have
an important impact on a financial institution's liquidity.
The ability of a financial institution to raise funds in the wholesale
marketplace can be influenced by systemic factors, which affect the spectrum
of market participants, as well as weaknesses confined to the individual
institution, such as a real or perceived decline in its credit quality.
The perception that a financial institution's credit quality is declining
can have a dramatic impact on its wholesale funding capabilities. Additionally,
customers may wish to reduce or eliminate their exposures to the institution
by unwinding their in-the-money positions. (In this instance, the customers'
in-the money position refers to contracts with a positive value to the
customer; the position would be out-of-the-money to the financial institution.)
While not necessarily obligated to unwind positions, the institution may
feel compelled to accommodate its counterparties if it perceives that
a continued presence as an active market maker is required to avoid damaging
its marketmaking reputation. Similarly, to the extent that the institution
has entered into transactions documented with agreements containing margin
or collateralization provisions in favour of the counterparty, or has
granted the counterparty the right to terminate the contract under certain
conditions, the institution may be legally obligated to provide cash or
cash-equivalent collateral to in-the-money counterparties. Correspondingly,
the institution's ability to collect margin or collateral from its customers
on its in-the-money positions may be affected by the ability of its counterparties
Management Information Systems
Virtually all financial institutions have a staff dedicated to measuring
and managing the institution's liquidity. Generally, the management information
systems designed for liquidity measurement should relate to the level
of the activities of the financial institution. An institution's investment
in information systems designed to gather liquidity information on balance-sheet
and off-balance-sheet exposures may be substantial for firms actively
involved in the marketplace, especially if these activities are conducted
globally. Correspondingly, financial institutions who are primarily end-users
of off-balance-sheet products may have less sophisticated systems. Cash-flow
projections should always incorporate all significant cash-flow sources
and uses resulting from on- and off-balance-sheet activities. For institutions
operating in a global environment, these projections should also reflect
various foreign-currency funding requirements.
Management information systems should also be able to project cash flows
under a variety of scenarios, including (1) a ''business-as-usual'' approach,
which establishes the benchmark for the ''normal'' behaviour of cash flows
of the institution; (2) a liquidity crisis confined to the institution;
and (3) a systemic liquidity crisis, in which liquidity is affected at
all financial institutions. While the magnitude and direction of net cash
positions can be forecast, it will fluctuate with changes in the market
and activity in the portfolios.
As in other areas of risk management, liquidity-information systems and
the liquidity-management process should be subject to audit. The examiner
should ensure that the overall liquidity-risk-management process takes
into account the risks in trading activities, especially when those activities
are substantial, and the firm is a market maker. Evidence of analysis
should be available for examiner review. A more detailed discussion of
funding-liquidity risk can be found in the Commercial Bank Examination
Contingency Funding Plans
The complexity of large trading portfolios can make liquidity and cash-flow
management difficult. For example, as market prices change, required adjustments
to hedge ratios, variation margin calls, and customers' exercise of options
may cause a portfolio that is hedged and solvent in a present-value sense
to experience, at a point in time, a shortfall of cash inflows over outflows-thus
creating a liquidity squeeze. Even if its portfolio is solvent, a financial
institution may be unable to borrow to cover the cash-flow asymmetry because
the complexity of the portfolio can obscure its true financial condition
from potential lenders, making it appear too risky for lenders to quickly
approve an urgent request for funds. For a financial institution with
insufficient liquid assets, this cash-flow management problem adds to
the dimensions over which a portfolio must be managed.
In addition to liquidity-management information systems, management should
operate under comprehensive contingency funding plans. These plans should
address both confined as well as systemic liquidity problems, which may
be temporary or enduring. Courses of action under both scenarios should
be outlined and management responsibilities well defined.
Market-liquidity risk refers to the risk
of being unable to close out open positions quickly enough and in sufficient
quantities at a reasonable price. In dealer markets, the size of the bid/ask
spread of a particular instrument provides a general indication as to
the depth of the market under normal circumstances. However, disruptions
in the marketplace, contraction in the number of market makers, and the
execution of large block transactions are some factors which may result
in the widening of bid/ask spreads.
Disruptions in various financial markets may have serious consequences
for a financial institution that makes markets in particular instruments.
These disruptions may be specific to a particular instrument, such as
those created by a sudden and extreme imbalance in the supply and demand
for a particular product. Alternatively, a market disruption may be all-encompassing,
such as the stock market crash of October 1987 and the associated liquidity
The decision of major market makers to enter or exit specific markets
may also significantly affect market liquidity, resulting in the widening
of bid/ask spreads. The liquidity of certain markets may depend significantly
on the active presence of large institutional investors; if these investors
pull out of the market or cease to trade actively, liquidity for other
market participants can decline substantially.
Market-liquidity risk is also associated with the probability that large
transactions in particular instruments, by nature, may have a significant
effect on the transaction price. Large transactions can strain liquidity
in markets that are not deep. Also relevant is the risk of an unexpected
and sudden erosion of liquidity, possibly as a result of a sharp price
movement or jump in volatility. This could lead to illiquid markets, in
which bid/ask spreads are likely to widen, reflecting declining liquidity
and further increasing transaction costs.
Market liquidity in over-the-counter (OTC) dealer markets depends on the
willingness of market participants to accept the credit risk of major
market makers. Changes in the credit risk of major market participants
can have an important impact on the liquidity of the market. Market liquidity
for an instrument may erode if, for example, a decline in the credit quality
of certain market makers eliminates them as acceptable counterparties.
The impact on market liquidity could be severe in those OTC markets in
which a particularly high proportion of activity is concentrated with
a few market makers. In addition, if market makers have increased concerns
about the credit risk of some of their counterparties, they may reduce
their activities by reducing credit limits, shortening maturities, or
seeking collateral for security-thus diminishing market liquidity.
In the case of OTC off-balance-sheet instruments, liquid secondary markets
often do not exist. While cash instruments can be liquidated and exchange-traded
instruments can be closed out, the ability to effectively unwind OTC derivative
contracts is limited. Many of these contracts tend to be illiquid, since
they can generally only be cancelled by an agreement with the counterparty.
Should the counterparty refuse to cancel the open contract, the financial
institution could also try to arrange an assignment whereby another party
is ''assigned'' the contract. Contract assignments, however, can be difficult
and cumbersome to arrange. A financial institution's ability to cancel
these financial contracts is a critical determinant of the degree of liquidity
associated with the instruments. Financial institutions which are market
makers, therefore, typically attempt to mitigate or eliminate market-risk
exposures by arranging OTC contracts with other counterparties executing
hedge transactions on the appropriate exchanges, or, most typically, a
combination of the two.
In using these alternative routes, the financial institution must deal
with two or more times the number of contracts to cancel its risk exposures.
While market-risk exposures can be mitigated or completely cancelled in
this manner, the financial institution's credit-risk exposure increases
in the process.
For exchange-traded instruments, counterparty credit exposures are assumed
by the clearinghouse and managed through netting and margin arrangements.
The combination of margin requirements and netting arrangements of clearinghouses
is designed to limit the spread of credit and liquidity problems if individual
firms or customers have difficulty meeting their obligations. However,
if there are sharp price changes in the market, the margin payments that
clearinghouses require to mitigate credit risk can have adverse effects
on liquidity, especially in a falling market. In this instance, market
participants may sell assets to meet margin calls, further exacerbating
liquidity problems in the marketplace.
Many exchange-traded instruments are liquid only for small lots, and attempts
to execute a large block can cause a significant price change. Additionally,
not all financial contracts listed on the exchanges are heavily traded.
While some contracts have greater trading volume than the underlying cash
markets, others trade infrequently. Even with actively traded futures
or options contracts, the bulk of trading generally occurs in short-dated
contracts. Open interest, or the total transaction volume, in an exchange-traded
contract, however, provides an indication of the liquidity of the contract
in normal market conditions.
''Unbundling'' of Product Risk
Both on- and off-balance-sheet products typically contain more than one
element of market-risk exposure; therefore, various hedging instruments
may need to be used to hedge the inherent risk in one product. For example,
a fixed coupon foreign currency-denominated security has interest-rate
and foreign-exchange risks which the financial institution may choose
to hedge. The hedging of the risks of this security would likely result
in the use of both foreign-exchange and interest-rate contracts. Likewise,
the hedging of a currency interest-rate swap, for example, would require
By breaking the market risk of a particular product down into its fundamental
elements, or ''unbundling'' the risks, market makers are able to move
beyond product liquidity to risk liquidity. Unbundling not only eases
the control of risk, it facilitates the assumption of more risk than was
previously possible without causing immediate market concern or building
up unacceptable levels of risk. For example, the interest-rate risk of
a U.S. dollar interest-rate swap can be hedged with other swaps, forward
rate agreements (FRAs), Eurodollar futures contracts, Treasury notes,
or even bank loans and deposits. The customized swap may appear to be
illiquid but, if its component risks are not, then other market makers
would, under normal market conditions, be willing and able to provide
the necessary liquidity. Positions, however, can become illiquid, particularly
in a crisis.
Dynamic Hedging Risks
Certain unbundled market-risk exposures may tend to be managed as individual
transactions, while other risks may be managed on a portfolio basis. The
more ''perfectly hedged'' the transactions in the portfolio are, the less
the need to actively manage residual risk exposures. Conversely, the use
of dynamic hedging strategies to cover open price-risk exposures exposes
the financial institution to increased risk when hedges cannot be easily
adjusted. (Dynamic hedging is not applied to an entire portfolio, but
only to the uncovered risk.) The use of dynamic hedging strategies and
technical trading by a sufficient number of market participants can introduce
feedback mechanisms that cause price movements to be amplified and lead
to one-way markets. Some managers may estimate exposure on the basis of
the assumption that dynamic hedging or other rapid portfolio adjustments
will keep risk within a given range even in the face of large changes
in market prices. However, such portfolio adjustments depend on the existence
of sufficient market liquidity to execute the desired transactions, at
reasonable costs, as underlying prices change. If a liquidity disruption
were to occur, difficulty in executing the transactions needed to change
the portfolio's exposure will cause the actual risk to be higher than
anticipated. Those institutions who have open positions in written options
and, thus, are short volatility and gamma will be the most exposed.
The complexity of the derivatives strategies of many market-making institutions
can further exacerbate the problems of managing rapidly changing positions.
Some financial institutions construct complex arbitrage positions, sometimes
spanning several foreign markets and involving legs in markets of very
different liquidity properties. For example, a dollar-based institution
might hedge a deutschemark convertible bond for both equities and foreign-exchange
risk and finance the bond with a dollar deutschemark bond swap. Such a
transaction may lock in many basis points in profit for the institution,
but exposes it to considerable liquidity risk, especially if the arbitrage
transaction involves a combination of long-term and short-term instruments
(for example, if the foreign exchange hedging were done through three-month
forwards, and the bond had a maturity over one year). If key elements
of the arbitrage transaction fall away, it may be extremely difficult
for the institution to find suitable instruments to close the gap without
sustaining a loss.
Multifaceted transactions can also be particularly difficult to unwind.
The difficulty of unwinding all legs of the transaction simultaneously
can temporarily create large, unhedged exposures for the financial institution.
The ability to control the risk profile of many of these transactions
lies in the ability to execute trades more or less simultaneously and
continuously in multiple markets, some of which may be subject to significant
liquidity risks. Thus, the examiner should determine whether senior management
is aware of multifaceted transactions and can monitor exposures to such
linked activity, and whether adequate approaches exist to control the
associated risks in a dynamic environment.
Risk measures under stress scenarios should be estimated over a number
of different time horizons. While the use of a short time horizon, such
as a day, may be useful for day-to-day risk management, prudent managers
will also estimate risk over longer horizons because the use of such a
short horizon assumes that market liquidity will always be sufficient
to allow positions to be closed out at minimal losses. However, in a crisis,
market liquidity, or the institution's access to markets, may be so impaired
that closing out or hedging positions may be impossible, except at extremely
unfavourable prices, in which case positions may be held for longer than
envisioned. This unforeseen lengthening of the holding period will cause
a portfolio's risk profile to be much greater than envisioned in the original
risk measure, as the likelihood of a large price change (volatility) increases
with the horizon length. Additionally, the risk profiles of some instruments,
such as options, change radically as their remaining time to maturity
Market makers should consider the bid/ask spreads in normal markets and
potential bid/ask spreads in distressed markets and establish risk limits
which consider the potential illiquidity of the instruments and products.
Stress tests evidencing the ''capital-at-risk'' exposures under both scenarios
should be available for examiner review.
Market makers may establish closeout valuation reserves covering open
positions to take into consideration a potential lack of liquidity in
the marketplace upon liquidation, or closing out of, market-risk exposures.
These ''holdback'' reserves are typically booked as a contra account for
the unrealized gain account. Since transactions are marked to market,
holdback reserves establish some comfort that profits taken into current
earnings will not dissipate over time as a result of ongoing hedging costs.
Holdback reserves may represent a significant portion of the current mark-to-market
exposure of a transaction or portfolio, especially for those transactions
involving a large degree of dynamic hedging. The examiner should ensure,
however, that the analysis provided can demonstrate a quantitative methodology
for the establishment of these reserves and that these reserves, if necessary,
Examination objectives relating to funding-liquidity risk are found in
the Commercial Bank Examination Manual. The following examination objectives
relate to the examination of market-risk liquidity.
1. To evaluate the organizational structure of the risk-management function.
2. To evaluate the adequacy of internal policies and procedures relating
to the institution's capital-markets and trading activities in illiquid
markets and to determine that actual operating practices reflect such
3. To identify the institution's exposure and potential exposure resulting
from trading in illiquid markets.
4. To determine the institution's potential exposure if liquid markets
suddenly become illiquid.
5. To determine if senior management and
the board of directors of the financial institution understand the potential
market-liquidity-risk exposures of the trading activities of the institution.
6. To ensure that business-level management has formulated contingency
plans in the event of sudden illiquid markets.
7. To ensure the comprehensiveness, accuracy, and integrity of management
information systems providing analysis of market-liquidity-risk exposures.
8. To determine if the institution's liquidity-risk-management system
has been correctly implemented and adequately measures the institution's
9. To determine if the open interest in exchange-traded contracts is sufficient
to ensure that management would be capable of hedging or closing out open
positions in one-way directional markets.
10. To determine if management is aware of limit excesses and takes appropriate
action when necessary.
11. To recommend corrective action when policies, procedures, practices,
or internal controls are found to be deficient.
These procedures represent a list of processes and activities that can
be reviewed during a full-scope examination. The examiner-in-charge will
establish the general scope of examination and work with the examination
staff to tailor specific areas for review as circumstances warrant. As
part of this process, the examiner reviewing a function or product will
analyze and evaluate internal-audit comments and previous examination
workpapers to assist in designing the scope of examination. In addition,
after a general review of a particular area to be examined, the examiner
should use these procedures, to the extent they are applicable, for further
guidance. Ultimately, it is the seasoned judgment of the examiner and
the examiner-in-charge as to which procedures are warranted in examining
any particular activity.
Examination procedures relating to funding-liquidity risk are found in
the Commercial Bank Examination Manual. The following examination procedures
relate to the examination of market-liquidity risk.
1. Review the liquidity-risk-management organization.
a. Check that the institution has a liquidity-risk-management function
with a separate reporting line from traders and marketers.
b. Determine if liquidity-risk-control personnel have sufficient credibility
in the financial institution to question traders' and marketers' decisions.
c. Determine if liquidity-risk management is involved in new-product discussions
in the financial institution.
2. Identify the institution's capital-markets and trading activities and
the related balance-sheet and off-balance-sheet instruments and obtain
copies of all risk-management reports prepared by the institution to evaluate
liquidity-risk-control personnel's demonstrated knowledge of the products
traded by the financial institution and their understanding of current
and potential exposures.
3. Obtain and evaluate the adequacy of risk-management policies and procedures
for capital-markets and trading activities.
a. Review market-risk policies, procedures, and limits.
b. Review contingency market-liquidity-risk plans, if any.
c. Review accounting and revaluation policies and procedures. Determine
that revaluation procedures are appropriate.
4. Determine the credit rating and market acceptance of the financial
institution as a counterparty in the markets.
5. Obtain all management information analyzing market-liquidity risk.
a. Determine the comprehensiveness, accuracy, and integrity of analysis.
b. Review bid/ask assumptions in a normal market scenario.
c. Review stress tests that analyze the widening of bid/ask spreads and
determine the reasonableness of assumptions.
d. Determine whether the management information reports accurately reflect
risks and that reports are provided to the appropriate level of management.
6. Determine if any recent market disruptions
have affected the institution's trading activities. If so, determine the
institution's market response.
7. Establish that the financial institution is following its internal
policies and procedures. Determine whether the established limits adequately
control the range of liquidity risks. Determine that the limits are appropriate
for the institution's level of activity. Determine whether management
is aware of limit excesses and takes appropriate action when necessary.
8. Determine whether the institution has established an effective audit
trail that summarizes exposures and management approvals with the appropriate
9. Determine whether management considered potential illiquidity of the
markets when establishing capital-at-risk exposures.
a. Determine if the financial institution established capital-at-risk
limits which address both normal and distressed market conditions.
b. Determine if senior management and the board of directors are advised
of market-liquidity-risk exposures in illiquid markets as well as of potential
risk arising as a result of distressed market conditions.
10. Determine whether business managers have developed contingency plans
which reflect actions to be taken in suddenly illiquid markets to minimize
losses as well as the potential damage to the institution's market-making
11. Based on information provided, determine the institution's exposure
to suddenly illiquid markets resulting from dynamic hedging strategies.
12. Recommend corrective action when policies, procedures, practices,
internal controls, or management information systems are found to be deficient.
Internal Control Questionnaire
The internal control questionnaire relating to funding-liquidity risk
is found in the Commercial Bank Examination Manual. The following internal
control questions relate to the examination of market-risk liquidity.
1. Review the liquidity-risk-management organization.
a. Does the institution have a liquidity-risk-management function that
has a separate reporting line from traders and marketers?
b. Do liquidity-risk-control personnel have sufficient credibility in
the financial institution to question traders' and marketers' decisions?
c. Is liquidity-risk management involved in new-product discussions in
the financial institution?
2. Identify the institution's capital-markets and trading activities and
the related balance-sheet and off-balance-sheet instruments and obtain
copies of all risk-management reports prepared.
a. Do summaries identify all the institution's capital-markets products?
b. Define the role that the institution takes for the range of capital-markets
products. Determine the hedging instruments used to hedge these products.
Is the institution an end-user, dealer, or market maker? If so, in what
c. Do liquidity-risk-control personnel demonstrate knowledge of the products
traded by the financial institution? Do they understand the current and
potential exposures to the institution?
3. Does the institution have comprehensive, written risk-management policies
and procedures for capital-markets and trading activities?
a. Do the policies provide an explanation of the board of directors' and
senior management's philosophy regarding illiquid markets?
b. Have limits been approved by the board of directors?
c. Have policies, procedures, and limits been reviewed and re-approved
within the last year? d. Are market-liquidity-risk policies, procedures,
and limits clearly defined?
e. Are the limits appropriate for the institution and its level of capital?
f. Are there contingency market-liquidity-risk plans?
g. Do the policies address the use of dynamic hedging strategies?
4. Has there been a credit-rating downgrade? What has been the market
response to the financial institution as a counterparty in the markets?
Are instances in which the institution provides collateral to its counterparties
5. Obtain all management information analyzing market-liquidity risk.
a. Is management information comprehensive and accurate and is the analysis
b. Are the bid/ask assumptions in a normal market scenario reasonable?
c. Do management information reports accurately reflect risks? Are reports
provided to the appropriate level of management?
6. If any recent market disruptions affected the institution's trading
activities, what has been the institution's market response?
7. Is the financial institution following its internal policies and procedures?
Do the established limits adequately control the range of liquidity risks?
Are the limits appropriate for the institution's level of activity?
8. Has the institution established an effective audit trail that summarizes
exposures and management approvals with the appropriate frequency?
9. Has management considered potential illiquidity of the markets when
establishing capital-at-risk exposures?
a. Has the financial institution established capital-at-risk limits which
address both normal and distressed market conditions? Are these limits
aggregated on a global basis?
b. Are senior management and the board of directors advised of market-liquidity-risk
exposures in illiquid markets as well as of potential risk arising as
a result of distressed market conditions?
10. Has management determined the institution's exposure to suddenly illiquid
markets resulting from dynamic hedging strategies?
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