Asset Concentration Limits: Limits set to control the amount of any particular asset held by the company usually applied to more complex exposures that are illiquid or more difficult to value.
Asset Liability Management Process: Management of the business and financial objectives of an institution by assessing and evaluating assets and liabilities on its portfolio in an integrated manner. It is a continuous process involving the formulation, implementation, review and subsequent revision (if needed) of asset and liability management strategies to ensure that they are within the acceptable risk tolerance levels.
Available amount of Stable Funding (ASF): The ASF comprises of the bank’s capital, preferred stock and liabilities with maturities greater than or equal to one year, portions of demand and term deposits by retail customers and wholesale funding having residual maturities < 1 year which are not expected to be withdrawn during a stress event. It does not include borrowings from the central bank other than those available through regular open market operations.
Each of these components are slotted into 5 separate ASF categories which are assigned ASF factors representing the amount of that components’ carrying value that will be included in the calculation of the numerator of the ratio.
Available unencumbered assets liquidity metric: A report of the amount, currency, type and location of, and estimated haircuts applicable to, available unencumbered assets which can be used as collateral in the secondary markets and/ or are central bank eligible.
Basel II: Recommendations on banking regulations and standards by the Basel Committee on banking supervision that set minimum capital requirements for banks and financial institutions. The objective was that these entities should have adequate capital given their exposures to risks to reduce or provide for risks such as credit, market and operational risks as well as other risks associated with the banks investing and lending practices.
Basel III reforms: These reforms are to the capital and liquidity framework under the Basel II Accord. They cover the supervisory framework for liquidity risk measurement via two minimum funding liquidity standards. They aim to resolve the weaknesses and fill in the loopholes of the current Basel II framework that became apparent in the recent financial crisis. They will come into full effect in January 2019 but there is a long period of transition into the revised framework that will begin from January 2013.
Basis Risk: One source of interest rate risk. It is the risk arising from the imperfect correlation between earned and paid rates on instruments having similar maturities and re-pricing characteristics. This imperfect correlation results in unexpected changes in cash flows and earning spread.
Cash flow limits: Limits on discrete (or individual) and cumulative cash flow mismatches or gaps over specified short- and long- term horizons under both expected and adverse business conditions. These could be in the form of cash flow or liquidity coverage ratios or specified aggregate amounts based on historical averages or desired targets.
Cash flow matching: Also known as portfolio dedication. This is an asset liability management tool where each and every liability cash flow is matched with an equal asset cash flow.
Concentration Limits: These limits are used to ensure that the traders risk is not concentrated in one instrument or market.
Concentration of funding liquidity metric: There are three metrics measured within this tool, one each for assessing wholesale funding concentrations by counterparty, product/ instrument and currency. It is used to identify significant sources of funding that if withdrawn could lead to a liquidity crisis for the bank.
Contingent Liability Limits: These are limits applied to the amounts of unfunded loan commitments and lines of credit so that they remain reasonable relative to available funding.
Contractual maturity mismatch liquidity metric: This presents the contractual cash and security inflows and outflows from all on- and off- balance sheet items for each defined maturity time band. It is used to identify the maturity gaps and mismatches for each maturity time band defined.
Convexity: A measure that explains the change in price that is not explained by Duration (see below).
Cost to close liquidity gaps: A methodology used to assess a bank’s exposure to liquidity risk. It involves identifying the gaps that exist between its assets and liabilities for pre-defined time buckets, and then calculating the cost that would be incurred to close out those gaps.
Current Ratio: This is the proportion of current assets that cover current liabilities. It is calculated to ascertain whether the company’s short term assets are readily available to pay off its short term liabilities.
Duration: A measure of how rapidly the prices of interest sensitive securities change as the rate of interest changes.
Duration Gap Analysis: A methodology used to assess the vulnerability of an institution towards the adverse movements of the interest rate term structure. The procedures identify interest rate sensitive assets and liabilities, calculates their market values or MTMs, calculates the duration for each asset and liability, determined the weighted average duration across assets and liabilities respectively and then derived a Duration Gap measure. The duration Gap measure is then used to calculate the change in the market value of equity for a % increase in the interest rates.
Duration Matching: An Asset Liability Management tool. See Immunization below.
Earnings at Risk (EAR): Earnings-at-Risk (EAR) is used to evaluate the impact of interest rate change on earnings. It utilizes a dynamic a VaR based approach assuming non-parallel shifts in the term structure of interest rates and its impact on the earnings portfolio of the bank.
Exception Limits: See Operational Limits below.
Exposure Limits: Limits that restrict the dollar amount that can be booked in a given day in any dealer, product, desk, tenor, risk combination.
Funding Concentration limits: These are limits that address diversification issues relating to the nature of the deposits or the sources of borrowed funds.
Gap limits: see Cash Flow limits above.
High quality assets: Assets that remain liquid during times of extreme stress and which ideally are central bank eligible for intraday and overnight liquidity needs.
Immunization: Also know as Duration matching. It is an investment strategy under which the investment portfolio remains insensitive or immune to a general change in the rate of interest.
Interest Rate Risk: Interest rate risk is the risk to earnings and/ or capital arising from changes in the interest rates. There are four primary sources of interest rate risk. They are re-pricing or maturity risk, yield curve risk, basis risk and option risk.
Interest Rate Shocks sensitivity analysis: An interest rate risk stress test that evaluates the vulnerability of an institution towards the adverse movements of the interest rate. See Duration Gap Analysis above.
Internal Capital Adequacy Assessment Process (ICAAP): Introduced under Pillar 2 of the Basel II Accord with the objective of fulfilling the need for an internal and invasive assessment of the capital profile of a bank. It would be a process that would allocate and attribute risk capital to all significant sources of risk, stress test the results and keep the board informed of any expected or projected capital shortfall. Under ICAAP requirements a bank needs to have in place internal procedures and processes to ensure that it possesses adequate capital resources in the long term to cover all of its material risks.
Inventory Age Limits: These are limits to the time period that any security may be held without being sold. The motive behind them is to prevent traders from sitting on illiquid positions or positions with an unrecognized loss. The time allowed will depend on the overall purpose of the desk. If the desk is expected to trade in and out of the position quickly, the limits will be on the order of days. If the desk is expected to use long-term strategies then the limit can be on the order of weeks or months.
LCR by significant currency liquidity metric: This metric allows banks and supervisors to track potential currency mismatches under a stress scenario
Limits: Limits are controls set on various target accounts (such as metrics and/ or characteristics) by an entity in order to manage and reduce its risks. There are many different kinds of limits: operational limits, stop loss limits, inventory age limits, concentration limits, transaction limits, exposure limits, etc.
Limits Breach: When a metric that is being evaluation exceeds or falls short of the limits set by an entity.
Limits exception: When a breached limit is allowed to be processed further without any restriction in terms is it marked as an exception. Usually, exceptions may only be allowed by designated authority such as the Board of Directors. Such exceptions need to be monitored and tracked separately.
Liquidity: Assets that are liquid can be converted to cash quickly without loss of value. Also, they tend to be highly traded so they can be purchased and sold without impacting the market price.
Liquidity Contingency Funding Plan: A plan that addresses alternative sources of funds if initial projections of funding sources and uses are incorrect. It acts as a bridge between the actual liquidity that is being held by the entity and the maximum that would be needed in the event of a run on liquidity.
Liquidity Coverage Ratio (LCR): A short term resilience liquidity standard to be introduced with the Basel III reforms. a measure of the strength of the short term liquidity position of the banks. It implies that banks should hold, on a continuous basis, sufficient unencumbered, high quality assets that can easily be converted into cash to meet liquidity needs that could arise during a 30-calendar day period of significantly severe liquidity stress. The stress scenario is specified by the supervising authority and in general, incorporates most of the shocks to liquidity that was experienced during the recent financial and liquidity crisis. It is the proportion of the value of the stock of high quality liquid assets in the given stress scenario to the total net cash outflows over the next 30 calendar days. The value of this ratio should be greater than or equal to 100%. It will come into effect in 2015.
Liquidity Gap: A methodology for evaluating liquidity risk which assesses the overall concentration of assets and liabilities and the difference (gap) between them across the maturity buckets.
Liquidity Risk: Liquidity risk is the risk of potential loss to an entity due to the non-availability or insufficiency of liquidity. This could mean that the entity fails to meet its financial commitments and obligations because of its inability to convert assets into cash, or because it cannot obtain enough funds at a reasonable cost. Liquidity risk could also arise because of a market disruption or liquidity squeeze which could hamper the entity’s ability to sell off its exposures or to do so at a loss or significant discount.
Liquidity Shocks sensitivity analysis: A stress test for liquidity risk that evaluates the resilience of the banks towards the fall in liquid liabilities.
Macaulay Duration: Weighted average term to maturity of a security’s cash flows. The weights are the present value of each cash flow as a percentage of the present value of all cash flows.
Management Action limits: see Operational Limits below.
Market Value of Equity (MVE) at Risk: An ALM risk measurement tool.
Also known as Fall in Market Value of Equity. The value depicts a change in the market value of equity due to changes in market values of assets and liabilities. The respective changes in assets and liabilities are computed by the application of interest rate shocks derived using a dynamic value at risk (VaR) approach.
Market-related monitoring tools liquidity metric: This involves the use of high frequency market data, having little or no time lag, to identify signs of potential liquidity stress. The data is monitored at a market wide as well as an entity specific level.
Maturity Limits: Limits that control the volume or amount of securities that mature in a given period. They are useful for controlling liquidity risk. By staggering the maturities of the securities, the company can reduce the volatility as well as control the liquidity position of the company at any given time period.
Model Risks: Risks of modeling that the modeler and subsequent users of the model should be aware of, that arise because of the technical construction and use of the models. These may include the model selected not being applicable to the process; the model chosen may be incorrect; the model may be correct by the solution from the model may be incorrect due to carelessness or misunderstandings; the model may be put to use in situations where it was never intended in the first place; the degree of accuracy may be limited; implementation errors due to programming, code optimization processes, revisions by new developers who are not the original writers of the model, etc.; dated and unrepresentative model parameters.
Name Crisis: A liquidity risk event triggered by a change in market conditions that impact a fundamental business driver for the bank. The change in market conditions triggers either a large operational loss or a series of operation losses, at times related to a correction in asset prices, at other times resulting in a permanent reduction in margins and spreads. Depending on when this is declared and becomes public knowledge and what the bank does to restore confidence drives what happens next. One approach used by management teams is to defer the news as much as possible by creative accounting or accounting hand waving which simply changes the nature of the crisis from an asset price or margin related crisis to a much more serious regulatory or accounting scandal with similar end results.
Net Interest Income at Risk (NIIR): A methodology that evaluates the impact of interest rate shocks on cumulative gaps for on-balance sheet and off-balance sheet items for and across different maturity buckets.
Net Stable Funding Ratio (NSFR): The long term supervisory measure for assessing liquidity risk to be introduced with the Basel III reforms. It covers a horizon of 1 year, under conditions of extended firm-specific stress, and aims to dissuade banks from relying on short term funding of their longer term assets rather that they should rely on more stable sources of funding on an ongoing basis. In essence, the ratio hopes to ensure that any short term structural funding liquidity mismatches are effectively captured, which can then ensure that they are addressed and removed and that the bank can then move to more stable longer term funding. It is given by the proportion of the available amount of stable funding to the required amount of stable funding. The value of this ratio should be greater than or equal to 100%. It will come into effect in 2018.
Operational Limits: Also known as Exception limits or Management Action limits. These are limits that require immediate management action or intervention when breached and generally lead to a partial reduction or a closeout of the offending transaction.
Options Risk: One source of interest rate risk. It is the risk arising from the seller or holder of an asset, liability or off-balance sheet item having the right to alter the level and timing of its cash flows when interest rates change.
Portfolio Dedication: An Asset Liability Management (ALM) tool. See cash flow matching above.
Price of an instrument: This is the discounted value of the cash flows, i.e. the sum of the present values of all cash flows of the given instrument to a given date.
Price Sensitive Gap: A methodology for evaluating the impact of shifts in a given term structure on the economic value of balances sheet items.
Quick Ratio: This is the proportion of highly liquid assets with current liabilities. It is more conservative than the current ratio (see above) because it excludes current assets which are difficult to convert quickly to cash. A higher ratio means a more liquid current position.
Rate sensitive securities: Securities whose values are impacted by changes in market interest rates.
Rate sensitive gap: Difference between the book values of rate sensitive assets and liabilities. Usually, the rate sensitive gap is calculated for various maturity buckets as well as cumulatively across buckets.
Rate sensitivity: The responsiveness of the asset and liability portfolio to changes in interest rates.
Re-pricing or Maturity Mismatch Risk: One source of interest rate risk. It is the risk arising from timing difference in the maturity and re-pricing of assets, liabilities and off balance sheet items.
Required Amount of Stable Funding (RSF): The weighted sum of the value of assets held and funded by the entity including off-balance sheet exposures. The weights represent the portion of the asset that would not be able to be monetized either by its sales or its use as collateral in an extended firm-specific liquidity stress scenario- assets in effect that would need to be covered by more stable sources of funds.
Stop Loss limits: These limits state that a specified action must take place if the loss exceeds a threshold amount.
They are a safety valve in case something starts to go wrong.
Stress test: A methodology where the risk factors are changed so as to derive results under stressed or worst case scenarios. Generally used by banks to plan and prepare for unexpected situations that may arise in the future.
Target Liquid Reserves: These are targets for unpledged liquid asset reserves and are usually expressed as aggregate amounts or as ratios.
Value at Risk (VaR): A risk measure that measures the worst case loss with limits on time period and probability. In other words, VaR measures the largest loss likely to be suffered on a portfolio or a position over a holding period (usually 1 to 10 days) with a given probability (confidence level).
Yield Curve Risk: One source of interest rate risk. It is the risk arising from unanticipated shifts in the yield curve indicating a change in the relationship between interest rate of different maturities relating to the same market.