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LO 56.3: Explain challenges in modeling a banks revenues, losses, and its balance sheet over a stress test horizon period.
Current stress tests are based on macro-scenarios (e.g., unemployment, GDP growth, the HPI). One concern is how to translate the macro-risk factors employed in stress testing into micro (i.e., bank-specific) outcomes related to revenues and losses. Supervisors need to map from macro-factors into intermediate risk factors that drive losses in specific products and geographic areas. Although not limited to these products, geographic differences are especially important in modeling losses in both commercial and residential real estate lending.
Credit card losses are particularly sensitive to unemployment figures. For example, unemployment was 12.9% in Nevada in July 2011, 3.3% in North Dakota, and the national unemployment rate was 9.1%. Credit card loss rates varied dramatically from region to region during this period. The geographic diversity with respect to macro-factors makes a one-size-fits-all stress testing regime less meaningful.
Geography is not the only difference supervisors must contend with. Risks affect different asset classes in different ways. For example, during recessions people buy fewer automobiles overall. Flowever, if a person needs a car during a recession, he is more likely to buy a used car. Thus, if default rates increase, loss given default (LGD) (i.e., loss severity) may not increase as much.
The business cycle also affects different industries at different times. Consider the airline industry versus the healthcare industry during a recession. Airplanes are collateral for loans to airlines. If the airline industry is depressed, the bank gets stuck with collateral that is very difficult to sell except at extremely depressed prices. Healthcare is somewhat recession-proof but that doesnt mean the bank can transform an airplane it is stuck with into a hospital. These factors increase the difficulty of mapping broader macro-factors to bank-specific stress results.
Modeling revenues over a stress test horizon period is much less developed than modeling losses. The 2009 SCAP did not offer much clarity on how to calculate revenue during times of market stress. The main approach to modeling revenue is to divide a banks total income into interest and non-interest income. The yield curve can be used to estimate interest income, and it can reflect credit spreads during stress testing scenarios; however, it remains unclear how bank profitability is directly influenced by the net impact of changing interest rates. Estimating noninterest income, which includes fees and service charges, is even more difficult to model. This is alarming given the steady increase in noninterest income among U.S. banks.
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The typical stress test horizon is two years. Over this period, both the income statement and balance sheet must be modeled to determine if capital is adequate post-stress. Generally speaking, capital is measured as a ratio of capital to assets. There are different types of capital (e.g., Tier 1 and Tier 2) but in general (and for the sake of simplicity), capital can be
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defined as common equity. Risk-weighted assets (RWA) are computed based on the Basel II risk weight definitions. For example, agency securities have a lower risk weight than credit card loans.
In a stress model, the beginning balance sheet generates the first quarters income and loss from the stressed scenario, which in turn determines the quarter-end balance sheet. At that point, the person modeling the risk must consider if any assets will be sold or originated, if capital is depleted due to other actions such as acquisitions or conserved as the result of a spin-off, if there are changes made to dividend payments, if shares will be repurchased or issued (e.g., employee stock or stock option programs), and so on. These decisions make modeling the balance sheet over the stress horizon quite difficult. The stress model doesnt determine if it would be a good time to sell a subsidiary or lower dividend payments.
The challenges of balance sheet modeling exist under both static and dynamic modeling assumptions. The bank must maintain its capital (and liquidity) ratios during all quarters of the stress test horizon. At the end of the stress horizon the bank must estimate the reserves needed to cover losses on loans and leases for the next year. This means that a two-year horizon stress test is actually a three year stress test (i.e., aT-year stress test requires the bank to estimate required reserves to cover losses forT+1 years).
S t r e s s T e s t C o m p a r i s o n s
Disclosure was a significant feature of the 2009 SCAP. It disclosed projected losses for each of the 19 participating banks for eight asset classes. It also disclosed resources the bank had to absorb losses other than capital (e.g., pre-provision net revenue and reserve releases if available). This high level of disclosure created transparency. It allowed investors and the market to check the severity of stress tests and to comprehend stress test outcomes at the individual bank level. Before the 2009 SCAP, banks only reported realized losses, not forecasted losses (i.e., possible losses given the stress scenario).
The 2011 CCAR required only that macro-scenario results be published, not bank level results. This differed dramatically from the 2009 SCAP requirements. The market had to figure out whether a bank had passed the test or not (i.e., market participants had to do the math themselves). For example, if a bank increased its dividend, it was assumed by the market to have passed the stress test. However, the 2012 CCAR disclosed virtually the same amount and detail of bank level stress data as the 2009 SCAP (i.e., bank level loss rates and losses by major asset classes). The regulatory asset classes are: 1. First and second lien mortgages.
2. Commercial and industrial (C&I) loans.
3. Commercial real estate loans.
4. Credit card lending.
5. Other consumer loans.
6. Other loans.
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One of the key contributions of the CGAR was that in both 2011 and 2012 the CCAR required banks to submit the results of their own scenarios, both baseline and stress, not just supervisory stress test results. The Fed also reported dollar pre-provision net revenue (PPNR), gains and losses on available-for-sale and held-to-maturity securities, and trading and counterparty losses for the six institutions with the largest trading portfolios. These firms were required to conduct the trading book stress test. The numbers that were reported were supervisory estimates, not bank estimates, of losses under the stress scenario.
In contrast, the 2011 European Banking Authority (EBA) Irish and 2011 EBA European wide stress tests, both disclosed after the CCAR, contained considerable detail. In the Irish case, the report contained a comparison of bank and third party estimates of losses. The EBA data was available in electronic, downloadable form. Ireland needed credibility, having passed the Committee of European Bank Supervisors (CEBS) stress test in July 2010 only to need considerable aid four months later. In general, the faith in European supervisors was harmed and only by disclosing detailed information on bank-by-bank, asset-class, country, and maturity bucket basis could the market interpret the data and draw its own conclusions about individual bank risks. Figure 2 summarizes the differences among the various stress test regimes.
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Figure 2: Comparison of Macro-prudential Stress Tests
Stress Test SCAP (2009). All banks with $ 100 billion or more in assets as of 2008 year end were included.
bank level projected required to raise losses and asset/ product level loss rates. six months. The
Disclosure Methodologies Tested simple scenarios with First to provide three dimensions, GDP growth, unemployment, and the house price index (HPI). Historical experience was used for the market risk scenario (i.e., the financial crisisa period of flight to safety, the failure of Lehman, and higher risk premia). A one-size-fits-all approach.
Findings 19 SCAP banks were six months. The $75 billion within undercapitalized banks actually raised $77 billion of Tier 1 common equity and none of the banks were forced to use the Treasurys Capital Assistance Program funds.
CCAR (2011)
CCAR (2012)
In recognition of one-size- fits-all stress testing, CCAR asked banks to submit results from their own baseline and stress scenarios. Banks were again asked to submit their own baseline and stress test results.
EBA Irish (2011)
Similar in design to EBA Europe 2011.
Only macro scenario results were published.
Similar in detail to SCAP 2009 bank level and asset/ product level loss rates disclosed. Comparison of bank and third party proj ected losses; comparison of exposures by asset class and geography. Data is electronic and downloadable.
EBA Europe (2011). [formerly the Committee of European Bank Supervisors (CEBS)] 90 European banks were stress tested.
Specified eight macro-factors Bank level (GDP growth, inflation, projected losses. unemployment, commercial Comparisons of exposures by asset and residential real estate price indices, short and class and geography. long-term government rates, Data is electronic and downloadable. and stock prices) for each of 21 countries. Specified over 70 risk factors for the trading book. It also imposed sovereign haircuts across seven maturity buckets.
After passing the 2010 stress tests, 2011 stress tests revealed Irish banks needed 24 billion. Greater disclosure in 2011 resulted in tightening credit spreads on Irish sovereign and individual bank debt. Eight banks were required to raise 2.5 billion.
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The key benefit of greater disclosure is transparency. Transparency is especially important in times of financial distress. However, during normal times, the costs of disclosure may outweigh the benefits. For example, banks may window dress portfolios, making poor long-term investment decisions to increase the likelihood of passing the test. Traders may place too much weight on the public information included in stress test disclosure and be disincentivized to produce private information about financial institutions. This harms the information content of market prices and makes prices less useful to regulators making policy decisions.
One thing to note is that prior to the CCAil 2011 requirements, all supervisory stress tests imposed the same scenarios on all banks (i.e., a one-size-fits-all approach to stress testing). In recognition of the problem, the 2011 and 2012 CCAR asked banks to submit results from their own scenarios in addition to the supervisory stress scenario in an attempt to reveal bank-specific vulnerabilities.
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Ke y C o n c e pt s
LO 56.1 After the 20072009 financial crisis, it was clear that traditional risk measures such as regulatory capital ratios were insufficient. Supervisory stress-testing became an important risk-assessment tool at that point.
The goal of stress testing is to assess how much capital and liquidity a financial institution needs to support its business (i.e., risk taking) activities.
The 2009 U.S. bank stress test, known as the Supervisory Capital Assessment Program (SCAP), was the first macro-prudential stress test after the 20072009 financial crisis.
Disclosure was a significant feature of the 2009 SCAP. This high level of disclosure lead to transparency and allowed investors and the market the ability to check the severity of the stress tests and the outcomes of the stress at the individual bank level.
In 2011, CCAR required only macro-scenario results be published, not bank level results, differing significantly from the 2009 SCAP requirements. The 2012 CCAR disclosed virtually the same amount and detail of bank level stress data as the 2009 SCAP. The EBA Irish and the EBA Europe required significant disclosures as well. The disclosures were needed to increase trust in the European banking system.
LO 56.2 One of the challenges regulators face is designing coherent stress tests. The sensitivities and scenarios must be extreme but must also be reasonable and possible (i.e., coherent). Problems are inherently multi-factor, making it more difficult to design a coherent stress test.
LO 56.3 Current stress tests are based on macro-scenarios (i.e., unemployment, GDP growth, the HPI). One concern is how to translate the macro-risk factors employed in stress tests into micro (i.e., bank specific) outcomes related to revenues and losses. Supervisors must be able to map from macro-factors into intermediate risk factors that drive losses in specific products and geographic areas.
In a stress model, the starting balance sheet generates the first quarters income and loss from the stressed scenario, which in turn determines the quarter-end balance sheet. The bank must maintain its capital (and liquidity) ratios during all quarters of the stress test horizon, typically two years.
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C o n c e pt C h e c k e r s
1.
2.
3.
4.
5.
Which of the following changes in stress testing was not the result of the 2009 Supervisory Capital Assessment Program (SCAP)? A. Banks are now required to provide the results of their own scenario stress tests. B. Stress scenarios are now broader in nature. C. Stress testing now focuses on the whole firm. D. Stress testing now focuses on revenues, costs, and losses.
Piper Hook, a bank examiner, is trying to make sense of stress tests done by one of the banks she examines. The stress tests are multi-factored and complex. The bank is using multiple extreme scenarios to test capital adequacy, making it difficult for Hook to interpret the results. One of the key stress test design challenges that Hook must deal with in her examination of stress tests is: A. multiplicity. B. efficiency. C. coherence. D. efficacy.
Greg Nugent, a regulator with the Office of the Comptroller of the Currency, is presenting research on stress tests to a group of regulators. He is explaining that macro-variable stress testing can be misleading for some banks because of geographical differences in macro risk factors. He gives the example of the wide range of unemployment rates across the U.S. following the 20072009 financial crisis. Which type of loan did Nugent most likely identify as having losses tied to unemployment rates? A. Residential real estate loans. B. Credit card loans. C. Commercial real estate loans. D. Industrial term loans.
A risk modeler has to make assumptions about acquisitions and spinoffs, if dividend payments will change, and if the bank will buy back stock or issue stock options to employees. These factors make it especially challenging to: A. get a CAMELS rating of 2 or better. B. determine if the bank has enough liquidity to meet its obligations. C. meet the Tier 1 equity capital to risk-weighted assets ratio. D. model a banks balance sheet over a stress test horizon.
One of the key differences between the 2011 CCAR stress test and the 2011 EBA Irish stress test is that: A. the CCAR did not require banks to provide results from their own stress the CCAR did not require banks to provide results from their own stress scenarios. the EBA Irish did not find any banks in violation of capital adequacy requirements.
B.
C. the CCAR required disclosure of macro-level, not bank level, scenario results. D. the EBA Irish allowed for 1-year stress horizons.
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C o n c e pt Ch e c k e r A n s w e r s
1. A The 2009 U.S. bank stress test, known as the Supervisory Capital Assessment Program (SCAP), was the first macro-prudential stress test after the 2007-2009 financial crisis.
The 2011 CCAR, not the 2009 SCAP, required that banks provide results of their own stress scenarios along with supervisory stress scenarios.
2. C One of the challenges of designing useful stress tests is coherence. The sensitivities and
scenarios must be extreme but must also be reasonable or possible (i.e., coherent). Problems are inherently multi-factored, making it more difficult to design a coherent stress test. Hook is dealing with the possibly incoherent results of the banks stress tests.
3. B Credit card losses are particularly sensitive to unemployment figures. For example,
unemployment was 12.9% in Nevada in July 2011, 3.3% in North Dakota, and the national unemployment rate was 9.1%. Credit card loss rates varied dramatically from region to region during this period. Residential mortgages are affected by unemployment as well but people are generally more likely to quit paying credit card bills before mortgages.
4. D
In a stress model, the starting balance sheet generates the first quarters income and loss from the stressed scenario, which in turn determines the quarter-end balance sheet. At that point the person modeling the risk must consider if any assets will be sold or originated, if capital is depleted due to other actions such as acquisitions or conserved as the result of a spin off, if there are changes made to dividend payments, if shares will be repurchased or issued (e.g., employee stock or stock option programs), and so on. This makes it challenging to model the balance sheet over the stress horizon.
5. C The 2011 CCAR required banks to provide results from their own stress scenarios but the EBA Irish did not. After the 2011 EBA Irish tests, 24 billion was required to increase the capital of several banks. The 2011 CCAR, unlike the SCAP and the 2012 CCAR, only required the disclosure of macro-level scenario results. The EBA Irish did not change the stress horizon from two years to one year.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
G u i d a n c e o n Ma n a g i n g O u t s o u r c i n g Ri s k
Topic 57
E x a m F o c u s
This short and nontechnical topic begins by examining the general risks arising from a financial institutions use of service providers. It then provides details on the key elements of an effective service provider risk management program. For the exam, focus on the three broad areas of due diligence. Also, be familiar with the details from the numerous contract provisions that should be addressed with third-party service providers.

LO 56.2: Explain challenges in designing stress test scenarios, including the problem of coherence in modeling risk factors.
One of the challenges of designing useful stress tests is coherence. The sensitivities and scenarios must be extreme but must also be reasonable or possible (i.e., coherent). Problems are inherently multi-factored, making it more difficult to design a coherent stress test. For example, an increase in volatility can lead to credit markets freezing. High unemployment and falling equity prices often go hand-in-hand. It is not sufficient to specify one potential problem (i.e., risk factor) because the others do not remain fixed. The supervisors key challenge is to specify the joint outcomes of all relevant risk factors.
Additionally, not everything goes bad at once. For example, if some currencies are depreciating, others must be appreciating. If there is a flight to quality, there must also be safe haven assets in the stress model. So while it is important to look at, for example, what happens if U.S. Treasury debt becomes riskier and is no longer a safe haven, the model would at the same time have to identify the risk-free asset(s) in which capital would flee under those circumstances.
The problem is even greater when designing stress scenarios for marked-to-market portfolios of traded securities and derivatives. Risk is generally managed with a value at risk (VaR) system. Hundreds of thousands of positions in the trading book must be mapped to thousands of risk factors, tracked on a daily basis. The data that results is used to estimate volatility and correlation parameters. It is very difficult to find coherent outcomes in such a complex, multi-dimensional universe.
The 2009 SCAP tested rather simple scenarios with three variables: growth in GDP, unemployment, and the house price index (HPI). Historical experience was used for the market risk scenario (i.e., the financial crisisa period of flight to safety, the failure of Lehman, and higher risk premia). While the market risk scenario did not test for something new, the overall framework achieved coherence of financial and other stresses of the time period.
One thing to note is that prior to 2011 all supervisory stress tests imposed the same scenarios on all banks (i.e., a one-size-fits-all approach to stress testing). In recognition of the problem, the 2011 and 2012 Comprehensive Capital Analysis and Review (CCAR) asked banks to submit results from their own stress scenarios in addition to the supervisory stress scenario in an attempt to reveal bank-specific vulnerabilities. This was an important step forward from the 2009 SCAP as it gave supervisors a sense of what banks think are the high risk scenarios. This provides regulators with not only bank-specific (i.e., micro prudential) insight but also improves macro-prudential supervision as it highlights common risks across banks that may have been underemphasized or unnoticed before.
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LO 56.1: Describe the historical evolution of the stress testing process and compare methodologies of historical EBA, CCAR and SCAP stress tests.
In the wake of the financial crisis, there was much uncertainty about the soundness of the U.S. banking system. Regulators needed to assess the capital strength of financial institutions. If there was a gap between what a bank needed in terms of capital and what it had, regulators had to find a credible way to fill the hole. The 2009 U.S. bank stress test, known as the Supervisory Capital Assessment Program (SCAP), was meant to serve that purpose. It was the first macro-prudential stress test after the 20072009 financial crisis. Macro-prudential regulation focuses on the soundness of the banking system as a whole (i.e., focuses on systematic risks) while micro-prudential regulation focuses on the safety and soundness of the individual institution.
At this point the Federal government planned to infuse equity capital into banks that were undercapitalized based on stress testing. The Treasury intended to borrow money and downstream it as equity in banks via the Treasurys Capital Assistance Program (CAP). If banks could not convince investors to fill the hole (i.e., infuse banks with needed equity capital), current investors would be diluted by the governments equity investment. In the end, 19 SCAP banks were required to raise $75 billion within six months. The undercapitalized banks raised $77 billion of Tier 1 common equity and did not need to draw on the CAP funds.
Prior to 2009, stress testing was relatively simple. Figure 1 summarizes the differences in stress testing pre-SCAP and post-SCAP.
Figure 1: Comparison of Stress Testing Pre-SCAP and Post-SCAP
Pre-SCAP Primarily assessed exposure to single-shocks (e.g., volatility increases OR interest rate increases OR increasing unemployment). Focused on specific bank products or business units (e.g., lending or trust).
Typically focused on earnings shocks (i.e., losses) but not on capital adequacy.
Focused exclusively on losses. Stress testing was static in nature.
Post-SCAP Considers broad macro-scenarios and market-wide stresses with multiple factors occurring/changing at once, as evidenced in the 2007-2009 financial crisis. Focuses on the whole firm, a more comprehensive look at the effect of the stress scenarios on the institution. Explicitly focuses on capital adequacy. Considers the post-stress common equity threshold to ensure that a bank remains viable. Focuses on revenues, costs, and projected losses. Stress testing is now dynamic and path dependent.
Professors Note: We w ill compare and contrast SCAP, CCAR, and EBA stress tests later in this topic.
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C h a l
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LO 55.3: Describe policy measures that can alleviate firm-specific and systemic risks related to large dealer banks.
The 2009 Public Private Investment Partnership (PPIP) was instituted by the U.S. Treasury Departments 2008 Troubled Asset Relief Program (TARP) to help dealer banks and the financial industry recover from the crisis at hand. One of the policy objectives was to mitigate the effect of adverse selection in the market for toxic assets, such as the CD Os backed by subprime mortgages. Adverse selection is the principle that buyers are only willing to buy the assets at a deep discount due to the information asymmetries that exist regarding the assets true value. A dealer bank may be forced to sell illiquid assets in order to meet liquidity needs. This results in additional losses due to the lack of demand for those assets. The PPIP subsidizes bidders of toxic assets by offering below-market financing rates and absorbing losses beyond a predetermined level.
The United States Federal Reserve System and the Bank of England provided new secured lending facilities to large dealer banks when they were no longer able to obtain credit from traditional counterparties or the repo market. When the dealer banks solvency is questioned, tri-party clearing banks are likely to limit their exposure to the dealer bank. A tri-party repo utility is proposed as an alternative and would be designed to have fewer conflicting incentives and less discretion in rolling over a dealers repo positions. New standards could be adapted for transaction documentation, margin requirements, and daily substitution of collateral with respect to repos. These standards could be incorporated through either the new repo utility or traditional tri-party clearing approaches.
Another potential approach is the creation of an emergency bank that could manage the orderly unwinds of repo positions of dealer banks with liquidity difficulties. The central bank would grant access to the discount window for the emergency bank to insulate critical clearing banks from losses during this unwinding process.
Capital requirements will most likely be increased and include off-balance sheet positions in an effort to reduce the leverage positions of dealer banks. The separation of tri-party repo clearing from other clearing account functions would also reduce a dealer banks leverage by tightening the dealers cash-management flexibility.
Central clearing will reduce the threat of OTC derivatives counterparties fleeing a questionable dealer bank. Although this would not eliminate the liquidity effect resulting from a derivative counterparty reducing their exposure to a particular dealer bank, it would reduce the total exposure to the dealer that would need to be managed through clearing.
Some large dealer banks and financial institutions are viewed as being too-big-to- fail based on the systemic risk their insolvency would place on the financial markets. Therefore, another proposed resolution for large dealer banks with questionable solvency that are deemed too-big-to-fail is to provide bridge banks similar to the approach used for traditional banks.
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Ke y C o n c e pt s
LO 55.1 Large dealer banks are active participants in over-the-counter (OTC) derivatives, repo, and securities markets. Their functions in these markets, as well as asset managers and prime brokers, result in a variety of liquidity risks when their solvency is questioned and counterparties reduce their exposure with them.
LO 55.2 A liquidity crisis is accelerated when prime broker clients or counterparties in the OTC derivatives or repo markets question the solvency of a dealer bank and desire to exit their positions or reduce their exposures with the dealer bank.
LO 55.3 The creation of emergency banks in the form of tri-party repo utilities and clearing banks are policy proposals to mitigate firm specific and systemic liquidity risk in the OTC derivatives and repo markets. The U.S. Treasury Departments 2008 Troubled Asset Relief Program (TARP) was designed to mitigate adverse selection in toxic asset markets by providing below market financing and absorbing losses above a pre-specified amount.
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C o n c e pt Ch e c k e r s
1.
2.
3.
4.
5.
A dealer banks liquidity crisis is least likely to be accelerated by: A. the refusal of repurchase agreement creditors to renew their positions. B. C. a counterpartys request for a novation through another dealer bank. D. depositors removing their savings from the dealer bank.
the flight of prime brokerage clients.
Banks are most likely to diversify their exposure to a specific asset class such as mortgages by grouping these assets together and selling them to: A. hedge funds. B. government agencies. C. the U.S. Federal Reserve. D. special purpose entities.
The formation of large bank holding companies results in diseconomies of scope with respect to: A. risk management. technology. B. C. marketing. D. financial innovation.
One potential solution for mitigating the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures is most likely the: A. use of central clearing. B. use of a novation through another dealer bank. C. requirement of dealer banks to pay out cash to reduce counterparty exposure. D. creation of new contracts by counterparties.
Which of the following items is not a policy objective of the U.S. Treasury Departments 2008 Troubled Asset Relief Program to help dealer banks recover from the subprime market crisis? A. Provide below-market financing rates for bidders of toxic assets. B. Absorb losses beyond a pre-specified level. C. Force the sale of illiquid assets in order to better determine the true value. D. Mitigate the effect of adverse selection.
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C o n c e pt C h e c k e r An s w e r s
1. D A liquidity crisis for a dealer bank is accelerated if counterparties try to reduce their exposure by restructuring existing OTC derivatives with the dealer or by requesting a novation. The flight of repo creditors and prime brokerage clients can also accelerate a liquidity crisis. Lastly, the loss of cash settlement privileges is the final collapse of a dealer banks liquidity.
2. D Banks can diversify their exposure to a specific asset class, such as mortgages, by grouping
these assets together and selling them to special purpose entities.
3. A Some argue that information technology, marketing, and financial innovation result in
economies of scope for large bank holding companies. Conversely, the recent financial crisis raised the concern that the size of bank holding companies creates diseconomies of scope with respect to risk management.
4. A One potential solution for mitigating the liquidity risk caused by derivatives counterparties
exiting their large dealer bank exposures is the use of central clearing through a counterparty. However, central clearing is only effective when the underlying securities have standardized terms. The reduction of a counterpartys exposure through novation, entering new offsetting contracts, or requiring a dealer bank to cash out of a position will all reduce the liquidity of the dealer bank.
5. C The U.S. Treasury Departments 2008 Troubled Asset Relief Program was designed to create policies to help dealer banks recover from the subprime market crisis by mitigating the effect of adverse selection, by providing below-market financing rates for bidders of toxic assets, and by absorbing losses beyond a pre-specified level. Forcing the sale of illiquid assets would worsen the liquidity position of the troubled dealer bank.
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St r e ss Te st i n g Ba n k s
Topic 56
E x a m F o c u s
This topic focuses on the use of bank stress testing to determine if liquidity and capital are adequate. The discussion focuses primarily on capital adequacy but notes that the issues are similar with respect to liquidity. For the exam, understand the details of the 2009 Supervisory Capital Assessment Program (SCAP), the first stress testing required after the 20072009 financial crisis. Also, be able to explain the issue of coherence in stress testing and describe the challenges with modeling the balance sheet using stress tests in the context of the stress test horizon. Finally, understand the differences in disclosure between U.S. and European stress tests and the way that stress test methodologies and disclosure have changed since the 2009 SCAP.
S t r e s s T e s t i n g
In the wake of the 20072009 financial crisis, regulators and other policymakers realized that standard approaches to risk assessment, such as regulatory capital ratio requirements, were not sufficient. At that point, supervisory stress testing became a popular tool for measuring bank risk. There was a pop-quiz quality to the post-financial crisis stress tests. They were difficult to manipulate because they were sprung on banks at short notice. As a result, the information provided by the stress tests to regulators and the market was truly new. This allowed financial markets to better understand bank risks and, as a result, regain a level of trust in the banking sector.
The goal of stress testing, as well as capital/liquidity and economic capital/liquidity (i.e., internal, bank-specific) models, is to assess how much capital and liquidity a financial institution needs to support its business (i.e., risk taking) activities. It is relatively easy for banks to swap out of lower risk assets and into higher risk assets. Stress testing provides clarity about the true risk and soundness of banks.
Stress testing is an old tool that banks and other firms have used to examine risk. It asks the question what is the institutions resilience to deteriorating conditions? and simulates financial results given various adverse scenarios. Stresses are generally of two basic types: scenarios or sensitivities. An example of a scenario is a severe recession. An example of sensitivity is a significant increase in interest rates. Risk managers can stress test the sensitivity of a single position or loan or an entire portfolio.
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S u p e r v i s o r y C a p i t a l A s s e s s m e n t P r o g r a m (SCAP)

LO 55.2: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks.
A liquidity crisis for a dealer bank is accelerated if counterparties try to reduce their exposure by restructuring existing OTC derivatives with the dealer or by requesting a novation (as discussed in the following). The flight of repo creditors and prime brokerage clients can also accelerate a liquidity crisis. Lastly, the loss of cash settlement privileges is the final collapse of a dealer banks liquidity.
As mentioned previously, when OTC derivatives counterparties question the solvency of a dealer bank, they will begin to reduce their exposures to the dealer. A counterparty could reduce their exposure by borrowing from the dealer or by entering into new offsetting derivatives contracts with the dealer. A counterparty may also request to have in-the-money options revised to at-the-money strike prices and, thus, reduce their exposure to the dealer by receiving cash from the option position.
Another means that a counterparty has of reducing their exposure to a dealer is through a novation to another dealer. For example, a hedge fund may use a credit default swap from a dealer to protect themselves from a loss on a borrower. If the hedge fund was concerned about the solvency of the dealer bank, they could request a novation from another dealer bank to protect themselves from default arising from the original dealer bank. Although these novations are often granted by dealer banks, in the case of Bear Stearns, the request was denied, which raised additional concerns regarding the solvency of Bear Stearns. In addition to decreasing the reputation capital and franchise value of this dealer bank, the liquidity position was also under increased stress. A novation could result in the removal of the cash collateral of the original dealer bank and transfer of this collateral to the second dealer bank.
Central clearing mitigates the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures. OTC derivatives are novated or cleared to a central clearing counterparty that stands between the original counterparties. The use of a central clearing counterparty also mitigates the systemic risk of financial markets and institutions when the solvency of a large dealer bank is questioned. However, the use of central clearing counterparties is only effective with derivatives that contain relatively standard terms. Thus, this was not an effective means of dealing with the infamous customized MG credit derivatives.
Further liquidity pressure can arise if derivative counterparties desire to reduce their exposure by entering new contracts that require the dealer bank to pay out cash. For example, a dealer bank may try to signal their strength to the market by quoting competitive bid-ask spreads on an OTC option. If the bid price is then accepted, the dealer
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must settle with a cash payment to the counterparty which reduces their liquidity. If the dealer refuses to quote competitive bid prices, it may further signal their liquidity concerns to the market.
Money market funds, securities lenders, and other dealer banks finance significant fractions of a dealer banks assets through short-term repurchase agreements. As mentioned previously, if the repo counterparty questions the solvency of a dealer bank, they are unlikely to renew repos. In this event, the repo creditors may have an incentive, or be legally required, to sell the collateral immediately. If the sale of the collateral is less than the cash position, then the dealer counterparty may face litigation for the improper disposal of assets. Without a government or central bank stepping in as a lender of last resort, dealer banks have no place to turn when repos are not renewed. They could reinvest their cash in new repos, but other counterparties are unlikely to take these positions if the dealer banks solvency is questioned.
The dealer bank can mitigate the liquidity risk caused by a run of short-term creditors by establishing lines of bank credit, holding cash and liquid securities, and by laddering the maturities of its liabilities. When a dealer bank ladders its liabilities, the maturities are spread out over time so that only a small fraction of its debt needs to be refinanced overnight. In 2008, the New York Federal Reserve Bank created the Primary Dealer Credit Facility to finance securities of investment banks. Immediately following the failure of Lehman, the remaining two dealer banks, Morgan Stanley and Goldman Sachs, became regulated bank holding companies. As a bank holding company, the firms gained access to the discount window and could turn to the government for financial support, including FDIC deposit insurance and loan guarantees.
Prime brokerage accounts are a source of cash inflows for large dealer banks. In normal circumstances, the cash and securities of prime brokerage clients are a source of liquidity for the bank. In the United Kingdom, assets from client prime brokerage accounts are commingled with the banks own assets. Flowever, in the United States, dealer banks are allowed to pool the money together into a separate account from the banks own funds. Thus, the prime broker is able to use the cash from one client to help meet the liquidity needs of another client.
As mentioned previously, when the solvency of a prime broker is questionable, a hedge fund could demand cash margin loans from the dealer that are backed by the securities held in their account with the prime broker. The prime broker may not be able to use those same securities as collateral with other lenders who may question their solvency. Lenders may not find any incentive to lend to the questionable dealer bank. Thus, even without a run by prime brokerage accounts, considerable strain could be placed on the dealer banks liquidity position.
In addition, if prime broker clients do leave on short notice, then their cash and securities are no longer in the pool of funds to meet the needs of other clients. In this case, the dealer bank must use its own cash to meet liquidity needs. The reduction of collateral securities caused by the flight of prime brokerage clients can lead to a systemic shortage of collateral and a liquidity crisis. In the future, hedge funds are likely to mitigate their exposure to a few dealer banks by diversifying their sources of prime brokerage with custodian banks.
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Under normal conditions, a clearing bank may extend daylight overdraft privileges to clearing customers who are creditworthy. However, when the solvency of a dealer bank is questioned, the clearing bank may refuse to process transactions that are insufficiently funded by the dealer banks cash fund account. For example, in the case of Lehmans default, J.P. Morgan Chase was the clearing bank that invoked its full right of offset. Under this legal right, J.P. Morgan Chase was able to offset their exposures using Lehmans cash, and at the same time, discontinued to make cash payments during the day on Lehman transactions that would bring Lehmans account below zero. The failure to meet its transactions obligations on that day forced Lehman into bankruptcy. To mitigate this risk in the future, emergency banks are proposed to act as either a clearing bank or a tri-party repo utility.
The basic economic principles causing a liquidity crisis, and potentially the insolvency of a large dealer bank, are not that different from the traditional retail bank run. Banks may finance illiquid assets with short-term deposits. However, an unexpected liquidity demand from depositors or the inability of borrowers to repay their loans may lead to concerns about the solvency of the bank. If the concern persists, a bank run could lead to liquidity problems, and the concern about the banks failure could end up as a self-fulfilling prophecy.
While the basic economic principles of a bank run are similar for large dealer banks and retail banks, the institutional mechanisms and the systemic destructiveness are very different. For example, dealer banks play an essential role in providing liquidity in the OTC derivatives and securities markets. When the solvency of a dealer bank is questioned, counterparties of these markets and prime brokerage clients begin to reduce their exposure to the dealer. The OTC derivatives counterparty may reduce their exposure by borrowing from the dealer, entering new offsetting derivatives contracts with the dealer, or requesting a novation. A counterparty may also request to receive cash from options positions that are in-the-money by having them revised to at-the-money. Prime broker clients may remove collateral and cash, which results in further accelerating the liquidity crisis. The fact that dealer banks are often counterparties to other dealer banks increases the systemic risk in the financial markets where dealer banks play essential roles.
Another area that dealer banks are very active involving liquidity is the repo markets. Especially in cases where the dealer banks are highly leveraged, the liquidity position is severely threatened when the dealer banks solvency is questioned and counterparties are unwilling to renew repo positions overnight. Thus, a dealer bank is involved in many functions that result in increased liquidity pressures that traditional banks are not exposed to.
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P o l
i c e s t o A l
l e v i a t e D e a l e r B a n k R i s k s

LO 55.1: Describe the major lines of business in which dealer banks operate and the risk factors they face in each line of business.
Large dealer banks provide a variety of intermediary functions in the markets for over-the- counter (OTC) derivatives, repurchase agreements, and securities. In addition, large dealer banks act as a prime broker for hedge funds and provide asset management for wealthy individuals and institutions.
Large dealer banks play an important function in the OTC derivatives market. Dealer banks transfer the risk of the derivatives positions requested by counterparties by creating new derivatives contracts with other counterparties. Examples of types of OTC derivatives are interest rate swaps, collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and credit default swaps (CDSs).
Counterparty risk in the OTC market refers to the risk that one or more of the counterparties will default on their contractual obligations. The total amount of wealth does not change as derivatives transfer wealth from one counterparty to another as contingencies are realized over time. However, if a counterparty incurs large losses, their derivatives contracts incur frictional bankruptcy costs that result in distress costs for their counterparties. Dealer banks are often counterparties to other dealer banks and large market players. Therefore, the solvency and liquidity problems of one large dealer bank can quickly result in increased systemic risk and a potential liquidity crisis.
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If the dealer bank does not have the liquidity to function, they will become insolvent. The failure of a large dealer bank would result in increased systemic risk for the OTC market. When counterparties question the solvency of a dealer bank, they will take actions to reduce their exposure and exit their positions. For example, the default of Lehman Brothers in September of 2008 not only disrupted the OTC derivatives markets, but the repercussions were also felt by other financial markets and institutions.
.Another important function of large dealer banks is in the short-term repurchase or repo market. Large dealer banks finance significant fractions of another dealer banks assets through repos. Prior to the recent crisis, dealer banks used overnight repos to finance holdings of agency securities, corporate bonds, Treasuries, mortgages, and collateralized debt obligations (CDOs) with little incremental capital. Some large dealer banks had very high leverage due to the lack of capital requirements for these repos. The high leverage caused significant solvency risk when the use of subprime mortgages as collateral was questioned.
The systemic and firm specific risk is significantly increased if a repo counterparty questions the solvency of a dealer bank. Counterparties are unlikely to renew repos, and the repo creditors may be legally required to sell collateral immediately. Without a government or central bank stepping in as a lender of last resort, dealer banks have no place to turn when repos are not renewed. As many dealer banks act as counterparties for other positions, the solvency of one dealer bank is likely to have a ripple effect and greatly increase the systemic risk of these markets.
Dealer banks provide investment banking functions through the management and underwriting of securities issuances. These investment banking functions also include advising corporations regarding mergers and acquisitions and merchant banking functions, such as the buying and selling of oil, metals, and other commodities. These functions provide an important source of revenue for dealer banks. An additional strain on liquidity is caused by the lack of cash inflows when issuers question the solvency of the dealer bank and take their business elsewhere. This can lead to systemic risk as new issues and the liquidity of existing issues are halted, as few institutions are able or willing to fill the void when a large dealer banks solvency or liquidity are questioned.
Large dealer banks act as a prime broker to large investors such as hedge funds. In this context, the services provided by the dealer banks include custody of securities, clearing, securities lending, cash management, and reporting. When the solvency of a prime broker is questionable, a hedge fund could demand cash margin loans from the dealer that are backed by securities. The prime broker may not be able to use those same securities as collateral with other lenders who may also question their solvency. Thus, the dealer banks liquidity position is weakened if large clients reduce their exposure by exiting their positions or entering new positions to offset their risk.
In addition, if prime broker clients leave, then their cash and securities are no longer in the pool of funds to meet the dealer banks liquidity needs for other clients. A systemic shortage of collateral and a liquidity crisis can result from the reduction of collateral securities caused by the flight of prime brokerage clients. Systemic risk is even greater when hedge funds do not mitigate their exposure through diversification. Prior to the recent financial crisis, hedge funds had significant positions with only a few dealer banks.
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Dealer banks also provide an important function as a counterparty for derivatives for brokerage clients. Dealer banks sometimes operate internal hedge funds and private equity partnerships. Off-balance sheet entity functions such as internal hedge funds, structured investment vehicles, and money market funds can have substantial losses. The dealer banks have an incentive to voluntarily support these entities to protect their reputation and franchise value. When a dealer bank shows signs of distress, counterparties and others may begin to exit their relationships, which severely increases the dealer banks liquidity risk.
In addition, large dealer banks provide traditional commercial banking functions, such as gathering deposits for corporate and consumer lending. The risks for a dealer bank are similar to a traditional bank with respect to these functions. However, prior to the recent financial crisis, dealer banks did not have access to the discount window (borrowing money from the central bank), and their accounts were not federally insured. For these reasons, a run on the banks deposits was more likely to lead to a liquidity crisis. With increased concerns of the solvency of large dealer banks, the availability of credit across the industry was threatened. This had the potential to lead to severe market slowdowns if borrowers were unable to obtain credit.
D e a l e r B a n k M a r k e t s
Large dealer banks operate in markets that are outside the scope of traditional bank-failure resolution mechanisms, such as conservatorship or receivership. The dealer banks are organized under the umbrella of holding companies in order to provide the wide variety of commercial banking, merchant banking, investment banking, brokerage, and off-balance sheet partnership activities. In addition, dealer banks often have large asset-management divisions that provide custody of securities, cash management, brokerage, and alternative investments vehicles. Dealer banks are also typically the general partner with limited partner clients.
In the primary securities market, dealer banks are the security underwriter. They buy equity and bond securities from issuers and sell them to institutions and investors over a period of time. Dealer banks also play a major role in the secondary securities market in providing liquidity to the market. They are the primary intermediary in the OTC securities markets by assisting in the private negotiation between investors and corporations, municipalities, certain national governments, and securitized credit products. Dealer banks are also actively involved in publicly traded equity markets by acting as brokers, custodians, securities lenders, and facilitating large block trades.
A major market in which dealer banks operate is the repurchase agreements, or repos, market. Repos are short-term cash loans collateralized by securities. In the repo market, one counterparty borrows cash from another counterparty. The majority of repos are for a very short period of time, such as overnight. The loans are collateralized by government bonds, corporate bonds, mortgages, agency securities, or other securities such as CDOs. In order to reduce counterparty risk, a clearing bank often acts as a third party and holds the collateral. The clearing bank facilitates the trade and somewhat reduces the risk of default for the lender. It is common for counterparties to renew these positions on a continuous basis as long as the solvency of the dealer bank is not questioned. It is not uncommon for these counterparties to be another dealer bank.
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Dealer banks are usually counterparties in the OTC derivatives market. The most prominent OTC derivatives are interest rate swaps where variable rate commitments often linked to the London Interbank Offering Rate (LIBOR) are exchanged for a fixed rate for a specific time period. Dealer banks typically perform what is known as a matched book dealer operation. They transfer the risk of the derivatives positions requested by counterparties by creating new derivatives contracts with other counterparties, who are oftentimes other dealer banks. Thus, dealer banks have large OTC derivatives exposures with other dealer banks. In addition to dealing with interest rate swaps, dealers are often counterparties in CDSs. In these contracts, the dealer bank transfers the default risk rather than the interest rate risk for the counterparties involved in the contracts.
Some large dealer banks are very active in off-balance sheet financing. In these markets, a bank can sell residential mortgages or other loans to a special purpose entity (SPE). The SPE compensates the sponsoring bank for the assets with the proceeds of debt that it issues to third-party investors or hedge funds. The SPE pays for the principal and interest of the debt issued with the cash flows from the mortgages or other assets that were purchased from the sponsoring bank. Thus, the SPE holds the collateralized pool of assets and provides an innovative product for hedge funds and other investors to purchase. These SPEs also provide a means for financial institutions to diversify their exposure by transferring risk to other investors who are either in or outside the financial industry.
For example, prior to the recent financial crisis, dealer banks were actively participating as sponsor banks for structured investment vehicles (SIVs), which are a form of a special purpose entity. The SIV finances residential mortgages or other debt obligations with short term debt sold to other investors in the form of CDOs and CMOs.
Before the recent crisis, banks were not required to include the off-balance sheet assets and debt obligations in minimum capital requirement and accounting reports. Thus, some dealer banks became highly leveraged as they were allowed to operate much larger loan purchases and origination businesses with a limited amount of capital. The fall in residential housing values in the summer of 2007 led to the rise of mortgage defaults, which threatened the ability of the SIV to make payments. As short-term creditors became concerned with the solvency of the SIVs, they refused to renew loans, and this created a liquidity and solvency issue for SIVs. Dealer banks had to provide support to SIVs to protect its reputation and franchise value.
D i s e c o n o m i e s o f S c o p e
As mentioned, dealer banks act as holding companies in order to provide a wide variety of commercial banking, prime brokerage, investment banking, asset management, and off-balance sheet activities. The recent financial crisis caused many to question the ability of dealer banks to manage risks properly. It is sometimes argued that forming large bank holding companies results in economies of scope with respect to information technology, marketing, and financial innovation. However, the recent financial crisis clearly identified diseconomies of scope in risk management and corporate governance. The executive management and board of directors did not fully understand or control the risk taking activities within their organizations.
For example, prior to their insolvency, Bear Stearns and Lehman relied heavily on overnight repos with leverage ratios above 30. These dealer banks held these assets on their balance
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sheets with little incremental capital. Management did not properly manage the amount of off-balance sheet risk the bank was exposed to. Thus, the over-leveraged positions made it impossible to overcome the liquidity and solvency issues that quickly arose when the values of the banks assets were questioned. Increased awareness or more appropriate risk models may have prevented the insolvency of these dealer banks.
L i q u i d i t y C o n c e r n s f o r D e a l e r B a n k s

LO 54.8: Calculate the expected transactions cost and the spread risk factor for a transaction, and calculate the liquidity adjustment to VaR for a position to be liquidated over a number of trading days.
Assuming that daily changes in the bid-ask spread are normally distributed, the 99% confidence interval on the transactions cost in dollars is:
+/- P x i/2(s + 2.33a )
where: P = an estimate of the next day asset midprice, usually set to P, the most recent price
observation
s = expected or typical bid-ask spread calculated as: (ask price bid price) / midprice a s = sample standard deviation of the spread
This confidence interval estimates the expected transactions costs in dollar terms. The V^(s + 2.33as) component is referred to as the 99% spread risk factor.
Example: Computing transactions cost
Brieton, Inc., recently traded at an ask price of $100 and a bid price of $99. The sample standard deviation of the spread is 0.0002. Calculate the expected transactions cost and the 99% spread risk factor for a transaction.
Answer:
midprice = (100 + 99) / 2 = 99.50
s = (100-99)/ 99.5 = 0.01005
transactions cost = 99.50 x 1/2[0.01005 + 2.33(0.0002)] = $0,523
spread risk factor = V4[0.01005 + 2.33(0.0002)] = 0.005258
Note that in this example, we use the current midprice as the estimate for the next day asset midprice.
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A d j u s t
i n g Va R f o r P o s i t
i o n L i q u i d i t y
Liquidity-adj usted value at risk (LVaR) is a tool used to measure the risk of adverse price impact. The trader will often liquidate the position over a period of days in order to ensure an orderly liquidation of the position.
P rofessors N ote: The a ctu a l calcu lation o f liq u id ity-a d ju sted VaR (u sin g con stan t a n d exogenous spread approaches) was show n in Topic 52. H ere w e discuss h ow VaR m ay he oversta ted w hen a d ju stin g f o r d ifferen t tim e horizons (via th e square root o f tim e rule) sin ce this a d ju stm en t does n ot a cco u n t f o r th e liq u idation o f p osition s over th e tim e p er io d o f analysis.
Adjusting VaR for liquidity requires an estimate of the number of days it will take to liquidate a position. The number of trading days is typically denoted T. Assuming the position can be divided into equal parts across the number of trading days and liquidated at the end of each trading day, a trader would face a 1-day holding period on the entire position, a 2-day holding period on a fraction (T 1) / T of the position, a 3-day holding period on a fraction (T 2) / T of the position, and so on. The 1-day position VaR adjusted by the square root of time is estimated for a given position as:
VaRt x J T
However, this formula overstates VaR for positions that are liquidated over time because it assumes that the whole position is held for T days. To adjust for the fact that the position could be liquidated over a period of days, the following formula can be used:
VaRt x
(1 + T)(1 + 2T)
6T
For example, if the position can be liquidated in four trading days (T = 4), the adjustment to the overnight VaR of the position is 1.3693, which means we should increase VaR by 37%. This is greater than the initial 1-day VaR, but less than the 1-day VaR adjusted by the square root of T.
M e a s u r i n g M a r k e t L i q u i d i t y
Factors such as tightness, depth, and resiliency are characteristics used to measure market liquidity. Tightness (or width) refers to the cost of a round-trip transaction, measured by the
bid-ask spread and brokers commissions. The narrower the spread, the tighter it is. The tighter it is, the greater the liquidity.
Depth describes how large an order must be to move the price adversely. In other words,
can the market absorb the sale? The market can likely absorb a sale by an individual investor without an adverse price impact. However, if a large institution sells, it will likely adversely impact the price.
Resiliency refers to the length of time it takes lumpy orders to move the market away from the equilibrium price. In other words, what is the ability of the market to bounce back from temporary incorrect prices?
Both depth and resiliency affect how quickly a market participant can execute a transaction.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
Redemption requests, especially in times of market stress, may require hedge fund managers to unwind positions rapidly, exposing the fund to transactions liquidity risk. If this happens to many funds at once, fire sales may result. Hedge funds manage liquidity via: Cash. Cash can be held in money market accounts or Treasury bills and unencumbered liquidity. Cash is not wholly without risk, however, because money market funds may suspend redemptions in times of stress or crisis, and broker balances are at risk if the broker fails.
Unpledged assets. Unpledged assets, also called assets in the box, are assets not currently
being used as collateral. They are often held with a broker. Price volatility of the assets affects their liquidity. Only Treasury securities, and more specifically Treasury bills, may be used as collateral during a financial crisis. Even government agency securities were not sufficient collateral during the 20072009 financial crisis. Unpledged assets can be sold, rather than pledged, to generate liquidity. However, in times of market stress, asset prices are often significantly depressed.
Unused borrowing capacity. This is not an unfettered source of liquidity as unused
borrowing capacity can be revoked by counterparties by raising haircuts or declining to accept pledged assets as collateral when it is time to rollover the loan. These loans are typically very short term and credit can, as it did during the 2007-2009 financial crisis, disappear quickly.
During the crisis, a systemic risk event, hedge funds that had not experienced large losses still faced a liquidity crisis as investors, seeking liquidity themselves, issued redemption requests.
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K e y C o n c e p t s
LO 54.1 Liquidity has two essential properties, which relate to two essential forms of risk. Transactions liquidity deals with financial assets and financial markets and is related to the ability to sell an asset quickly, cheaply, and without moving the price too much. Funding liquidity is related to individuals or firms creditworthiness.
LO 54.2 Banks only expect a fraction of deposits and other liabilities to be redeemed at any point in time. As a result, they do not hold all deposits in liquid assets, but make loans with deposits instead. This is known as a fractional-reserve bank and the process of using deposits to finance loans is known as asset-liability management (ALM).
LO 54.3 Systematic funding risks were apparent in many market sectors during the subprime mortgage crisis. Liquidity issues arose during the recent financial crisis for a variety of investment strategies.
Money market mutual funds (MMMFs) have net assets (NAVs) equal to $1.00. However, credit write-downs can result in net asset values falling below $1.00. This is known as breaking the buck. Liquidity risk can also cause NAVs to fall below $1.00.
LO 54.4 Collateral markets enhance the ability of firms to borrow money. They also make it possible to establish short positions in securities. Cash and securities may be borrowed in the market for collateral.
Firms with excess cash are more willing to lend at a low rate of interest if the loan is secured by collateral. The full value of the securities is not lent. The difference is called a haircut.
Collateralized loans are used to finance securities or other assets or trades. The securities pledged to one firm are often loaned or pledged again, hence the collateral circulates. This process is known as rehypothecation or repledging.
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LO 54.5 A firms leverage ratio is equal to its assets divided by equity. That is:
A _ ( E + D) E E
D E
Return on equity (ROE) is higher as leverage increases, as long as the firms return on assets (ROA) exceeds the cost of borrowing funds. This is called the leverage effect. The leverage effect can be expressed as:
rE = LrA – ( L –
1 )rD
LO 54.6 There is embedded leverage in short positions and derivatives such as options and swaps. Economic balance sheets can be constructed to help investors and/or firms measure the implicit leverage of these transactions.
LO 54.7 Transactions liquidity implies that an asset can be bought or sold without moving its price. Transactions liquidity risk is fundamentally related to the costs of searching for a counterparty, the institutions required to assist in that search, and the costs of inducing a counterparty to hold a position.
To understand transactions liquidity risk, one must understand market microstructure fundamentals. Trade processing costs, inventory management, adverse selection (i.e., dealing with informed versus uninformed traders), and differences of opinions regarding asset prices affect transactions liquidity.
Factors such as tightness, depth, and resiliency are characteristics used to measure market liquidity. Tightness (or width) refers to the cost of a round-trip transaction, measured by the bid-ask spread and brokers commissions. Depth describes how large an order must be to move the price adversely. Resiliency refers to the length of time it takes lumpy orders to move the market away from the equilibrium price.
Hedge funds manage liquidity via cash, unpledged assets, and unused borrowing capacity. In times of market stress, redemption requests may require hedge fund managers to unwind positions rapidly, exposing the fund to transactions liquidity risk. If this happens to many funds at once, fire sales may result.
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LO 54.8 Assuming that daily changes in the bid-ask spread are normally distributed, the 99% confidence interval on the transactions cost in dollars is:
+/- P x i/2(s + 2.33cr)u
The spread risk factor is equal to V^(s + 2.33crs).
Liquidity-adj usted VaR is a tool used to measure the risk of adverse price impact. Traders will often liquidate positions over a period of days in order to ensure an orderly liquidation of the position.
LO 54.9 Risks associated with liquidity are interrelated and can exacerbate problems. For example, an increase in funding liquidity risk can lead to an increase in transactions liquidity risk. Also, severe stress to the financial system from a liquidity risk event would impact market participants simultaneously, suggesting that the illiquidity or insolvency of one counterparty may impact other market participants.
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C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
Jackson Grimes, a trader for Glenn Funds, works on the repurchase agreement (repo) desk at his firm. Markets have been highly volatile but Glenn Funds has a large capital base and is sound. Grimes reports to the CEO that in the last month, the firm Glenn Funds borrows from has been consistently increasing collateral requirements to roll over repos. From the perspective of Glenn Funds, this represents: A. systematic risk. B. C. balance sheet risk. D. maturity transformation risk.
transactions liquidity risk.
Chris Clayton, an analyst for a private equity fund, noticed that merger arbitrage strategies at several hedge funds experienced large losses in late 2007 to early 2008. These losses were likely due to: A. abandoned merger plans due to a lack of available financing. B. C. acquirers filing for bankruptcy as the subprime mortgage crisis unfolded. D. idiosyncratic risks surrounding the merger arbitrage strategy.
target prices falling precipitously due to stock market corrections.
With respect to the valuation of money market mutual fund (MMMF) assets, funds: A. are not required to mark-to-market the underlying assets daily. B. must reflect changes in the values of underlying assets that are the result of changes in credit risks but may ignore value changes that are the result of changes in interest rates.
C. will set the notional values of each of the underlying assets equal to $1.00. D. are not allowed to invest in any asset with a rating below AAA because asset
values must not fluctuate outside of a 10% range around the historical value in order to keep the notional value equal to $1.00.
Charleston Funds intends to use leverage to increase the returns on a convertible arbitrage strategy. The return on assets (ROA) of the strategy is 8%. The fund has $1,000 invested in the strategy and will finance the investment with 75% borrowed funds. The cost of borrowing is 4%. The return on equity (ROE) is closest to: A. 4%. B. 32%. C. 20%. D. 12%.
Brett Doninger recently placed an order to sell a stock when the market price was $42.12. The market was volatile and, by the time Doninger s broker sold the stock, the price had fallen to $41.88. In the market, this phenomenon is known as: A. adverse selection. B. C. slippage. D. the spread risk factor.
transactional imbalance.
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C o n c e p t C h e c k e r A n s w e r s
1. C Funding liquidity risk or balance sheet risk results when a borrowers credit position is either deteriorating or is perceived by market participants to be deteriorating. It also occurs when the market as a whole deteriorates. Under these conditions, creditors may withdraw credit or change the terms of credit. In this case, the lender is increasing the haircut and is thus changing the terms of credit. Glenn Funds creditworthiness does not actually have to decline for a lender to withdraw credit or change the terms of credit.
2. A
Systematic funding risks were apparent in many market sectors during the subprime mortgage crisis. Hedge funds engaged in merger arbitrage experienced losses in the early stages of the subprime mortgage crisis. After a merger is announced, the targets stock price typically increases and the acquirers price sometimes declines due to increased debt. The merger arbitrage strategy exploits the difference between the current and announced acquisition prices. Hedge funds experienced large losses as mergers were abandoned when financing dried up.
3. A MMMFs use a form of accounting called the amortized cost method, under the Securities
and Exchange Commissions (SEC) Rule 2a – 7. This means that MMMF assets do not have to be marked-to-market each day, as required for other types of mutual funds. However, the values of the underlying assets in the fund, despite their relative safety, are subject to change. As such, redemptions may be limited if asset values fall.
4. C debt = $1,000 x 0.75 = $750
leverage ratio = total assets / equity leverage ratio = $1,000 / $250 = 4
rE = LrA- ( L – 1)rD
where: rA = return on assets r = return on equity rD = cost of debt L = leverage ratio
return on equity = 4(8%) – [(4 – 1)(4%)] = 32% – 12% = 20%
5. C Liquidity risks are introduced when bid-ask spreads fluctuate, when the traders own actions
impact the equilibrium price of the asset (called adverse price impact), and when the price of an asset deteriorates in the time it takes a trade to get done. When the price deteriorates in the time it takes to get a trade done, it is called slippage.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Th e Fa i l u r e M e c h a n i c s o f D e a l e r Ba n k s
Topic 55
E x a m F o c u s
Understanding the key failure mechanics for dealer banks is crucial for mitigating liquidity and solvency risks. Liquidity risks are accelerated when counterparties or prime broker clients question the solvency of a large dealer bank and, in turn, limit their exposure. This results in increased liquidity risk and insolvency risk for the bank and increased systemic liquidity risk for the financial markets in which dealer banks play commingled roles. Dealer banks play key roles as prime brokers, securities underwriters, special purpose entities (SPE), and as counterparties in the over-the-counter (OTC) derivatives and repo markets. Diseconomies of scope in risk management and corporate governance were revealed by the recent market crisis. Thus, new policies to alleviate dealer bank risks were implemented to address off- balance sheet risks, capital requirements, leverage, liquidity risks, clearing banks, and adverse selection effects in toxic asset markets.
F u n c t
i o n s o f D e a l e r B a n k s

LO 54.7: Explain methods to measure and manage funding liquidity risk and transactions liquidity risk.
An asset is liquid if it resembles money. That is, it can be exchanged for goods or services quickly and at a certain value. However, assets have to be liquidated in order to buy goods and services because we do not have a barter economy.
Transactions liquidity implies that an asset can be bought or sold without moving its price. However, large transactions may move an assets price because they create a short-term imbalance between supply and demand. Transactions liquidity risk is fundamentally related to the costs of searching for a counterparty, the institutions required to assist in that search, and the costs of inducing a counterparty to hold a position.
In order to understand transactions liquidity risk, it is important to understand market microstructure fundamentals. These fundamentals are: Trade processing costs. The first cost is associated with finding a counterparty in a timely fashion. In addition, processing costs, clearing costs, and the costs of settling trades must also be considered. These costs do not typically increase liquidity risk except in circumstances, either natural or man-made, where the trading infrastructure is affected. Inventory management. Dealers provide trade immediacy to market participants. The dealer must hold long or short inventories of assets and must be compensated by price concessions. This risk is a volatility exposure.

Adverse selection. There are informed and uninformed traders. Dealers must
differentiate between liquidity or noise traders and information traders. Information traders know if the price is wrong. Dealers do not know which of the two are attempting to trade and thus must be compensated for this lemons risk through the bid-ask spread. The spread is wider if the dealer believes he is trading with someone who knows more than he does. However, the dealer does have more information about the flow of trading activity (i.e., is there a surge in either buy or sell orders).
Differences of opinion. It is more difficult to find a counterparty when market
participants agree (e.g., the recent financial crisis where counterparties were afraid to trade with banks because everyone agreed there were serious problems) than when they disagree. Investors generally disagree about the correct or true price on an asset and about how to interpret new information about specific assets.
These fundamentals differ across different types of market organizations. For example, in a quote-driven system, common in over-the-counter (OTC) markets, market makers are expected to publicly post 2-way prices or quotes and to buy or sell at those prices within identified transaction size limits. In contrast, order-driven systems, typically found on organized exchanges, are more similar to competitive auction models. Typically the best bids and offers are matched throughout the trading session.
Liquidity risks are introduced when bid-ask spreads fluctuate, when the traders own actions impact the equilibrium price of the asset (called adverse price impact) and when the price of an asset deteriorates in the time it takes a trade to get done (called slippage).
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
In general, regulators have focused more on credit and market risks and less on liquidity risk. Liquidity risk is difficult to measure. However, since the financial crisis, more attention is being paid to measuring liquidity risks in a firm.
T r a n s a c t
i o n s C o s t

LO 54.6: Explain the impact on a firms leverage and its balance sheet of the following transactions: purchasing long equity positions on margin, entering into short sales, and trading in derivatives.
Purchasing stock on margin or issuing bonds are examples of using leverage explicitly to increase returns. However, there are other transactions that have implicit leverage. It is important to understand the embedded leverage in short positions and derivatives, such as options and swaps. By constructing economic balance sheets for investors and/or firms, it is possible to measure the implicit leverage of these transactions.
Margin Loans and Leverage
First, consider margin loans. The stock purchased with the margin loan is collateral for the loan. The haircut (h) is the borrowers equity and 1 h is loaned against the market value of the collateral. The leverage is calculated as 1 / h. The Federal Reserve requires that an investor put up a minimum of 50% equity (i.e., h = 50%) in a stock purchase using borrowed funds.
First, assume that a firm has $100 cash invested by the owners (i.e., no borrowed funds). The balance sheet in this case is:
Assets
Cash Total assets
$100 $100
Liabilities and Equity Debt $0 $100 Equity $100
TL and OE
If the firm uses the cash to purchase stock, the balance sheet is:
Assets
Stock Total assets
$100 $100
Liabilities and Equity Debt $0 $100 Equitv $100
TL and OE
Thus, the leverage ratio is equal to 1 (i.e., $100 / $100 or 1.0 / 1.0).
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
Next, assume that the firm uses 50% borrowed funds and invests 50% (i.e., h = 50%) equity to buy shares of stock. Immediately following the trade, the margin account balance sheet has 50% equity and a $50 margin loan from the broker. That is:
Assets
Stock Total assets
$100 $100
Liabilities and Equity $50 $50 $100
Equity
Margin loan
TL and OE
The full economic balance sheet as a result of the borrowed funds (remember, owners put in $100 of equity initially so the firm now has $100 of stock and $50 of cash) is:
Assets
Cash Stock Total assets
$50 $100 $150
Margin loan
Liabilities and Equity $50 $100 $150 Equity Equity TL and OE
Thus, the leverage ratio has increased to 1.5 (i.e., $150 / $100 or 1 / 0.667). Note that the broker retains custody of the stock to use as collateral for the loan.
Short Positions and Leverage
In a short trade, the investor borrows the shares of stock and sells them. The transaction lengthens the balance sheet because the cash generated from the short sale along with the value of the borrowed securities appear on the balance sheet.
Assume the firm borrows $100 of stock and sells it short. The firm has an asset equal to the proceeds from selling the stock and a liability equal to the value of the borrowed shares. However, the firm cannot use the cash for other investments as it is collateral. It ensures that the stock can be repurchased and returned to the lender. It is in a segregated short account. In the event that the stock price increases rather than decreases, the firm must also put $50 in a margin account.
Immediately following the trade, the margin account and short account has $50 equity and a $50 margin loan from the broker.
Assets
$150 due from broker: Margin Short sale proceeds Total assets
Liabilities and Equity
$50 $100 $150
Borrowed stock
$100
Equity
TL and OE
$150
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
The firms full economic balance sheet given the short sale is:
Assets
Cash Due from broker Total assets
$50 $150 $200
Borrowed stock
Liabilities and Equity $100 $100 $200
Equitv
TL and OE
Thus, the leverage ratio has increased to 2.0 (i.e., $200 / $100 or 1 / 0.50). The leverage is higher in this case than in the previous margin example because the full value of the stock is borrowed in a short transaction. Leverage is inherent in the short position but is a choice in the long position. The firm only borrows 50% of the balance of the stock in the long position.
If the short position plays a hedging role in the portfolio, the position will reduce market risk. This means that leverage will overstate the overall risk because it ignores the potential risk reducing benefits of the short positions. As such, a distinction must be made between gross and net leverage. Gross leverage is the value of all the assets, including cash generated by short sales, divided by capital. Net leverage is the ratio of the difference between the long and short positions divided by capital.
Derivatives and Leverage
Derivatives allow an investor to gain exposure to an asset or risk factor without actually buying or selling the asset. Derivatives also allow investors to increase leverage. Although derivatives are generally off-balance sheet, they should be included on the economic balance sheet as they affect an investors returns. Derivatives are synthetic long and short positions. To estimate the economic balance sheet, find the cash-equivalent market value for each type of derivative. Derivatives include: Futures, forward contracts, and swap contracts. These contracts are linear and
symmetric to the underlying asset price. The amount of the underlying instrument represented by the derivative is set at the initiation of the contract so values can be represented on the economic balance sheet by the market value of the underlying asset. These contracts have zero net present values (NPVs) at initiation.
Option contracts. These contracts have a non-linear relationship to the underlying
asset price. The amount of the underlying represented by the option changes over time. The value can be fixed at any single point in time by the option delta. Thus, on the economic balance sheet, the cash equivalent market values can be represented by the delta equivalents rather than the market values of the underlying assets. These contracts do not have zero NPVs at initiation because the value is decomposed into an intrinsic value (which may be zero) and a time value (which is likely not zero).
In this next example, the counterparty is assumed to be the prime broker or broker-dealer executing the positions. This means that margin will be assessed by a single broker on a portfolio basis.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
First, assume the firm enters a 1-month currency forward contract and is short $100 against the euro and the 1-month forward exchange rate is $1.25 per euro. The balance sheet is:
Assets
Liabilities and Equity
$100 equivalent of 80 bank deposit
Broker loan
$100
Now, assume the firm buys a 3-month at-the-money call option on a stock index with an underlying index value of $100. The calls delta is currently 50%. The transaction is equivalent to using a $50 broker loan to buy $50 of the stock index. That is:
Assets
$50 long index position
$50
Liabilities and Equity Broker loan
$50
Next, assume the firm enters a short equity position via a total return swap (TRS). The firm pays the total return on $100 of ABC stock and the cost of borrowing the ABC stock (i.e., the short rebate). This is equivalent to taking a short position in ABC. Assuming the market price of ABC is $100, we have:
Assets
$100 due from broker (proceeds from short sale)
Liabilities and Equity
$100
Borrowed ABC stock
$ 100
Finally, assume the firm adds short protection on company XYZ via a 5-year credit default swap (CDS) with a notional value of $100. This position is equivalent to a long position in a par-value 5-year floating rate note (FRN) financed with a term loan.
The firms combined economic balance sheet that includes all of the derivatives positions is:
Assets
Cash Due from broker
$50 margin $ 100 short sale proceeds
Equivalent of 80 bank deposit Long equity index XYZ FRN Total assets
$50 $150
$100 $50 $100 $450
Liabilities and Equity
Short-term broker loan
$150
Term loan Borrowed ABC stock
Equitv TL and OE
$100 $100
$100 $450
The firm has increased its leverage to 3.5 in its long positions. The long positions combined with the short position (the ABC TRS) means the firm has gained economic exposure to securities valued at $450 using $50 of cash.
Notice that computing leverage is complex when derivatives are used. Also, correctly interpreting leverage is important since risk may be mitigated if short positions are used to hedge. For example, currency and interest rate risks can be hedged accurately. However, the positions are of the same magnitude as the underlying assets. If the positions are carried on the economic balance sheet, leverage will be overstated and other material risks in the portfolio may be ignored.
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S o u r c e s o f T r a n s a c t
i o n s L i q u i d i t y R i s k

LO 54.5: Describe the relationship between leverage and a firms return profile, calculate the leverage ratio, and explain the leverage effect.
A firms leverage ratio is equal to its assets divided by equity (total assets / equity). That is:
L = A = (E + D)
E E
D E
For an all-equity financed firm, the ratio is equal to 1.0, its lowest possible value. As debt increases, the leverage ratio (i.e., multiplier) increases. For example, a firm with $100 of assets financed with $50 debt and $50 equity has a leverage ratio equal to 2.0 ($100/$50 = 2).
Return on equity (ROE) is higher as leverage increases, as long as the firms return on assets (ROA) exceeds the cost of borrowing funds. This is called the leverage effect. The leverage effect can be expressed as:
rE = LrA – ( L ~ 1 )rD
where: rA = return on assets r = return on equity rD = cost of debt L = leverage ratio
It may help to think of this formula in words as follows:
ROE = (leverage ratio x ROA) [(leverage ratio 1) x cost of debt] For a firm with a zero cost of debt, return on equity is magnified by the leverage factor; however, debt is not free. Thus, return on equity (ROE) increases with leverage, but the cost of borrowing, because there is more debt, also increases. The L 1 factor multiplies the cost of debt by the proportion of the balance sheet financed with debt. For example, with a leverage ratio of 2, 50% of the balance sheet is financed with debt and 50% with equity. So for every $2 of assets, $1 comes from shareholders and $1 comes from borrowed funds. We multiply the cost of debt by 1 in this case. If the leverage ratio is 4, 25% is financed with equity and 75% is financed with debt. Thus, for every $4 of assets, $1 is equity and $3 is borrowed funds. In the formula, we multiply the cost of debt by 3. The higher the leverage factor, the bigger the multiplier but also the higher the debt costs. Leverage amplifies gains but also magnifies losses. That is why leverage is often referred to as a double-edged sword.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
The effect of increasing leverage is expressed as:
9 < r / <9L = rA – rD
where: < 9 r = change in retained earnings &L = change in the leverage ratio
This formula implies that, given a change in the leverage ratio, ROE changes by the difference between ROA and the cost of debt.
The equity in the denominator of the leverage ratio depends on the entity. If it is a bank, it may be the book value of the firm. It might also be calculated using the market value of the firm. The net asset value (NAV) of a fund is the appropriate denominator for a hedge fund. The NAV reflects the current value of the investors capital in the fund.
Example: Computing firm ROE (total assets = $2)
Martin, Inc., a U.S. manufacturing company, has an ROA equal to 5%, total assets equal to $2, and equity financing equal to $1. The firms cost of debt is 2%. Calculate the firms ROE.
Answer:
rE = L r A – ( L – 1)rD
rP = [(2 / 1) x 5%] – [(2 – 1) x 2%] = 8%
Example: Computing firm ROE (total asset = $4)
Martin, Inc., a U.S. manufacturing company, has an ROA equal to 5%, total assets equal to $4, and equity financing equal to $1. The firms cost of debt is 2%. Calculate the firms ROE.
Answer:
rE = LrA ~ ( L – 1)rD
rE = [(4 /1) X 5%] – [(4 –
1) X 2%\ = 14%
Given a cost of debt of 2%, increasing the leverage factor from 2 to 4 increased the firms ROE from 8% to 14%.
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Leverage is also influenced by the firms hurdle rate (i.e., required ROE). For example, assume a firms hurdle rate (i.e., ROE) is 10%, ROA equals 6%, and its cost of debt equals 2%. The firm will choose a leverage ratio of 2.0. That is:
ROE = (2 x 6%) – (1 x 2%) = 10%
E x p l
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a n d I m p l
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L e v e r a g e