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Recent credit crises have demonstrated that liquidity is a fundamental cause of economic shocks, say Anthony Asher, Simon Webb and Andrew Doughman, who suggest that actuaries can play a vital role in finding solutions for liquidity risk.
This is an edited extract of a paper that was prepared for the Institute of Actuaries of Australia’s (Institute) 4th Financial Services Forum 2008.
Recent events have once again demonstrated that liquidity is a fundamental cause of economic shocks. We suggest that actuaries can play a vital role in the development and maintenance of solutions that deal with liquidity risk. Actuaries are well placed to contribute to:
1. Modelling the underlying risks
2. Designing appropriate instruments that properly charge for liquidity
3. Modelling customer behaviour.
We use the 2007 liquidity crunch in the market for various innovative loan instruments to examine the causes and effects of a liquidity crisis. Our paper then considers current liquidity issues and the role of central banks, regulators and markets. It goes on to identify groups of long-term investors and borrowers, who do not necessarily require immediate liquidity. While it may not always be the case, the current environment shows that there can be cost savings and yield gains if investors are prepared to surrender immediate liquidity. Matching these groups and obtaining these gains requires innovative approaches that actuaries are well equipped to consider. We describe a few possibilities.
Credit crises as experienced in 2007 have been a regular feature of financial markets, but do not have to recur with the same force. Proper liquidity management firstly requires that investors have a deep understanding of the instruments in which they invest in order to prevent uncertainty about credit risks spilling over into a liquidity crisis.
Secondly, institutions should limit their exposure to short-term withdrawals through the use of appropriately designed instruments that offer a reasonable price for liquidity and duration.
Finally, there is a need for financial institutions to understand their assets and liabilities and their likely behaviour in times of stress.
The Senior Supervisors Group (2008) looked at how 11 large institutions fared during the liquidity crisis in 2007. They found that the firms that lost less in the crisis did have more effective risk identification, assessment and management systems.
They used a wider range of risk measures, were more able to adapt them as conditions changed – and had “charged business lines appropriately for building contingent liquidity exposures to reflect the cost of obtaining liquidity in a more difficult market environment.”
In reading their report, the thought emerges that firms that are more successful are those that panic first and the system as a whole remains vulnerable to discontinuities. There are, however, a variety of ways of improving the robustness of all companies within the financial system:
Create sources of liquidity: The Financial Services Authority (FSA) 2008 report describes how banks can create new sources of liquidity by having agreements in place with each other – and the central bank – that allow them to access liquidity in times of stress.
Preparations to implement such agreements may include the securitisation of some illiquid assets so that they are transferable at no notice. Such agreements should be tested in practice from time to time to ensure that they are ready.
These agreements do not guarantee that the counterparty will necessarily provide the liquidity. They, however, should include the necessary due diligence so that the counterparty can readily compute the value of the underlying assets at the time. Given that superannuation and life insurers may well have spare liquidity in times of crisis, they might consider entering into such agreements in advance. The advantage might arise from banks that are prepared to pay something for the privilege, or from gains that would arise from an ability to buy assets at a discount at the time of the crisis.
Match investors and borrowers by term: There is currently limited demand for the actuarial skills of matching assets and liabilities by term. There are, however, a number of natural matches between the long-term savers and borrowers.
The most significant of the natural matches is that which sits between the need for inflation-protected retirement income and the instalments that young home owners can most naturally afford. This could be done using a salary-linked mortgage with instalments set at a predefined percentage of income. The borrower is protected against both interest rate increases and salary increases that are lower than expected. Investors gain an asset that returns the average salary increase of the borrower. This will include promotional increase, which will be larger than average if borrowers are younger. If the expected return is inadequate, instalments can be loaded to match demand and supply of funds.
Retirement income could also provide finance for infrastructure projects, particularly those where the charges are regulated and can be designed to increase in line with inflation.
Avoid making liquidity promises: In this respect, hedge funds have provided the lead in ensuring that their solvency is not threatened by unwise liquidity promises. The Corporations Act also has specific provisions (in Part 5C.6) that require Australian Managed Investment Schemes to maintain sufficient liquid assets and gives rules of how to ration liquidity should this prove necessary.
It would appear appropriate for all financial institutions to make it clear to their investors that they are unable to guarantee unlimited liquidity. Contracts and product disclosure statements should provide for some limits to tradability and for the suspension of withdrawals or payments in specie under conditions where the solvency of the institution is threatened.
Charging for liquidity: While we have observed that the cost of liquidity appears to be artificially reduced in the current market, it is not entirely free – even for banks as is being demonstrated in the current market. The Senior Supervisors Group (2008) commended firms that had measures in place to charge internal business lines for the costs of maintaining adequate liquidity. Failure of some firms to do so (and this survey covered only the largest firms), suggests that liquidity may still be under-priced in some parts of the market.
Illiquid liabilities have lower value: In particular, we may have underestimated the value of the illiquidity of defined benefit liabilities and insurance policies that do not allow for surrender or trading. By not giving this ‘real’ option to trade, the insurer must be gaining some value, which might allow it to reduce the size of its liability. It would seem acceptable if there are illiquid, but otherwise riskless, stocks in the insurer’s portfolio that match the liability and are valued at a higher discount rate than the risk-free rate.
Building better models: One way to begin to understand financial structures and their inherent risk is to develop models that show how cash flows emerge, and the main drivers of their volatility. This is where actuaries can have an important role.
A model enables the investor to gain an in-depth understanding of the structure or instrument and to develop a best-estimate outcome, as well as to perform scenario and sensitivity testing. Deutsche Bank, for instance, reports in the FMG Review (April 2008) that it was able to “securitise part of their mid-cap portfolio during a time when the markets were allegedly closed for securitisations” because of the clear information available.
In the case of securitisation structures, models must incorporate two key dynamics: the expected cash flows of the underlying assets themselves, and the resulting cash flows through the structured finance vehicle.
We have found that readily available actuarial software is capable of monthly projections over many years and has easily been adapted to model these cash flows.
Bank rules to manage liquidityBanks are normally required to have liquidity sufficient to meet various stress scenarios. Typical scenarios would be: Retail call deposits• 5% of balances run-off over 5 days • 7.5% of balances run-off over 5 days • Greater of 5% run-off or 3 standard deviations of historic withdrawal rates over 5 days • 5% run-off of remaining balances per day over 5 days Other deposits• 15% of “quasi-retail” balances run-off over 5 days • 50% of “quasi-wholesale” balances run-off over 5 days • 100% of maturing “wholesale deposits” run-off over 5 days • 20% of “corporate deposit” balances run-off over 5 days Undrawn commitments• 5% of unutilised facilities are drawn down over 5 days • 15% of unutilised facilities are drawn down over 5 days • $xxmillion are drawn down over 5 days |
To view this paper in full, see www.mbr.monash.edu.au
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URL: http://www.austlii.edu.au/au/journals/MonashBusRw/2008/49.html