1fiedler R Liquidity Modelling

Liquidity risk is hard to understand.
It needs Robert Fiedler is one of a handful of
Liquidity Modelling
to be broken down into its components and thought leaders in the field of liquidity risk
drivers in order to manage and model it management at financial institutions. He is
Liquidity
successfully. also one of the most experienced observers
and contributors. No one is better qualified
The market turmoil that began in mid-2007 than Robert to address the topics in this book.
re-emphasised the importance of liquidity to Leonard Matz, Liquidity Risk Advisers
the functioning of financial markets and the
banking sector. In advance of the turmoil,
Modelling
asset markets were buoyant and funding was
By Robert Fiedler
readily available at low cost. The reversal in
market conditions illustrated how quickly
liquidity can evaporate and that illiquidity
can last for an extended period of time.
Financial regulators across the globe are
urging institutions to address this dimension
of financial risk more comprehensively.
In this comprehensive guide to modelling by Robert Fiedler

liquidity risk, Robert Fiedlers practical
approach equips the reader with the tools to
understand the components of illiquidity risk,
how they interact and, as a result, to build a
quantitative model to display, measure and
limit risk.
Liquidity Modelling is required reading

for financial market practitioners
who are dealing with liquidity risk
and who want to understand it.
PEFC Certified
This book has been

produced entirely from
sustainable papers that
are accredited as PEFC
compliant.
www.pefc.org
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Liquidity Modelling
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Liquidity Modelling
by Robert Fiedler
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Published by Risk Books, a Division of Incisive Media Investments Ltd
Incisive Media
3234 Broadwick Street
London W1A 2HG
Tel: +44(0) 20 7316 9000
E-mail: books@incisivemedia.com
Sites: www.riskbooks.com
www.incisivemedia.com
2011 Incisive Media

ISBN 978-1-906348-46-5
Reprinted with corrections 2012
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Publisher: Nick Carver

Commissioning Editor: Sarah Hastings
Managing Editor: Lewis OSullivan
Designer: Lisa Ling
Copy-edited and typeset by T&T Productions Ltd, London
Printed and bound in the UK by Berforts Group
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While best efforts have been intended for the preparation of this book, neither the publisher,
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from or in reliance upon its information, meanings and interpretations by any parties.
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I dedicate this book to my father, Edvard Fiedler

19242005
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Contents
About the Author ix
Preface xi
1 Introduction 1
2 Setting the Scene: Why Liquidity Is Important in a Bank 11
3 What Is Liquidity Risk? 19
4 Illiquidity Risk: The Foundations of Modelling 35
5 Capturing Uncertainties 53
6 A Template for an Illiquidity Risk Solution 79
7 The Counterbalancing Capacity 117
8 Intra-Day Liquidity Risk 167
9 Liquidity Transfer Pricing and Limits 219
10 The Basel III Banking Regulation 249
Index 281
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About the Author
Robert Fiedler owns and runs Liquidity Risk Corp, which consults
on methodology and processes and also builds prototypes and IT
solutions for liquidity risk.
In the first half of his career, Robert spent over a decade in the
treasury/dealing rooms of numerous international major banks as
a money market liquidity manager, trading interest rate products
and derivatives. Later he switched to risk management and devel-
oped Deutsche Bank Groups liquidity risk methodology, on which
he successfully built a global system (LiMA) which measures and
limits the banks funding liquidity. Moving into software develop-
ment, Robert became country coordinator for Germany and exec-
utive director of Asset Liability Management (ALM) and Liquidity
Risk Solutions at Algorithmics Inc, Toronto. Subsequently, he joined
the board of Fernbach Software, Luxembourg, where he oversaw the
development of ALM, performance measurement, IFRS and liquid-
ity risk software. During this time he constantly developed liquidity
methodologies and taught his research results. Jointly with the Uni-
versity of St Gallen, Switzerland, he developed a stochastic model
that optimises the risk and return of investing non-maturing assets
and liabilities.
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Preface
This is a second impression of the first edition, which has been

revised to amend errors in mathematical notation and data tables.
PREFACE TO THE FIRST EDITION

After starting in a banks money market and payment department in
the 1990s, I had drifted to asset/liability management, then to trad-
ing and finally to market risk. In the summer of 1997 I was asked to
develop a short methodology for a system that should limit the
consumption of the banks cash liquidity by the different business
lines. Searching for more information within the bank and in the lit-
erature of the time, my first finding was that there was no consensus
in the usage of the expression liquidity: sometimes it described the
saleability of instruments, while elsewhere it described the banks
daily cash position, the supply of central bank funds in a market, the
banks ability to acquire cash and, indeed, had various other mean-
ings. My first action was to invent and market clumsy naming con-
ventions like Expected Future Liquidity (we would now call this
the forward liquidity exposure (FLE)), which enabled the different
liquidity (risk) types to be distinguished and thus for practitioners
to agree on what type of liquidity was relevant for the purpose.
The next step was for me to separate the liquidity forecast at the
start of the day from the forecast at the end of the day (which includes
all liquidity management effects the bank carries out during its daily
business). As the results were disappointing (the bank would most
likely simply square possible deficits or surpluses of the morning
forecast), I described a thought experiment in which the bank tries
to generate as much liquidity as it can (whether it needs the liquid-
ity in the given situation or not), known as the counterbalancing
capacity (CBC). Obviously, the FLE reflects what can happen to the
bank, whereas the CBC describes what the bank could do against a
potential shortfall. This work took place around 1998, and although
the idea is now widely accepted (eg, in the high-quality-liquid-assets
concept of Basel III), it took many years to convince the risk manage-
ment world that it is not capital (as is the case for market, credit and
operational risk) that should be the liquidity risk buffer, but CBC.
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At that time, value-at-risk (VaR) techniques had been commonly

accepted for market risk, and comparable credit VaR concepts were
emerging. It was widely expected that similar deviations from the
original VaR concept, liquidity-at-risk (LaR), had to be the next
logical step. After taking up the basic LaR ideas (we would now
call it cashflow-at-risk) and transforming them into the expected
LaR concept, I had to realise that they do not give any of the desired
answers like how big are the expected losses?, like market-VaR
does, but instead reflect merely the model risk of the cash-forecasting
procedure. The logical consequence seemed to be to reflect the value
risk aspect and develop a value-liquidity-at-risk concept, but,
doing this, I felt that the approach was going into the wrong direc-
tion (not least because the acronyms were getting too complicated)
and tried to exploit other aspects of the VaR concept.
Obviously the liquidity forecast is predominantly driven by future
cashflows which bear uncertainty. In market risk approaches like
Monte Carlo techniques, the cashflows are categorised (eg, into
fixed, floating and optional) and then accordingly simulated.
A similar, more rigorous classification seemed to be the right way
forward for liquidity risk simulations. In hindsight it was the wrong
way: more complex simulations (eg, for credit risk events) cannot be
worked out at the level of cashflows, but instead need to be done at
the level of transactions.
Another problem became apparent at that time: in market and
credit risk, portfolios that comprise existing transactions of the
bank are investigated, but new, as-yet non-existent transactions are
ignored. In liquidity risk, however, not only we are interested in
what happens to the part of the balance that already existed when
the forecast was made, but we need to model hypothetical transac-
tions as well. When hypothetical transactions were introduced (with
the CBC, which is created by hypothetical cashflows), they were not
to the liking of the risk community, which at that time was heav-
ily focused on market and credit risk. They were largely rejected as
unforecastable, or even speculative; the situation only changed
when asset/liability managers became interested in the underlying
balance-sheet simulation.
Another legacy from the risk management practices at this time
was the idea that the basis of all calculations should be one most
likely scenario. On the other hand, it was evident that, at least in
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PREFACE
theory, doom could strike at any time and make all forecasts that
have been made on a going-concern basis obsolete. The solution
was to introduce more pessimistic VaR measures like conditional
VaR, as well as to consider extreme scenarios (sometimes called
stress tests). Although this proceeding is not wrong in principle,
it obscured for some time the realisation that all scenarios, including
the most likely ones, are only theoretical, fragile constructions.
For a long time it was impossible to convince risk managers and
senior executives to make risk forecasts scenario dependent. If mul-
tiple scenarios were considered, the outcomes of the most likely sce-
narios were weighted with a high probability, whereas the extreme
scenarios were weighted with extremely low probabilities. Unsur-
prisingly, the overall weighting of the scenario results was within
boundaries the bank could digest, but only if the weighting of the
extreme scenarios was low enough. Failure was not an option.
Another obstruction of the development was the predominant
view in which liquidity risk is always initiated by market, credit
and operational risk realisations and thus is simply a consequence
of other risks. At that time, however, it was the prevailing view that
led to a focus on questions like How can the results of credit risk
modelling be transformed into liquidity results?. After 2008 it was
clear that liquidity risk could strike without an actual loss occurring,
triggered only by the fear that such a loss could potentially occur:
why did Socit Gnrale survive and Fortis go under?
After the Y2K hysterics1 had calmed down, almost nothing hap-
pened in liquidity risk development. Most banks were still con-
cerned with operational risk concepts, because they are part of the
Basel II framework and these banks were, on the practical side,
too busy to implement Basel II itself. When on September 11, 2001,
the (financial) world was reminded of its vulnerability, there was a
light hiccup, but after the central banks had successfully calmed the
payment markets it was business as usual again.
In the following years liquidity risk was not a hot issue. Insiders
expected that capital and unresolved credit issues (but not liquidity
risk) would be on the agenda of the expected Basel III regulation.
Then, in 2007 the financial crisis hit the banks.
For most banks it was too late to do something about their liquidity
measurement systems before the peak of the crisis in late 2008. After
that, almost all banks started liquidity risk initiatives, but, as always,
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those that would need these initiatives most were too busy with fire
fighting, and the others were waiting for the new Basel III rules to
be finalised. The summer of 2011 saw the banking market in panic
mode again and fighting just to survive.
OUTLOOK
The liquidity framework of Basel III has changed a lot since its ini-
tial proposal. Specialists at the regulatory bodies have started to
get to grips with liquidity risk concepts. Many banks have started
on actual projects to comply with the regulations. Risk managers
within the banks are realigning to liquidity risk, dragging academics
with them. Software vendors and consulting companies have not
yet taken many concrete steps, but they have identified the Basel III
regulation and economic liquidity risk as a target market.
The issue is hot. Let us all hope that the financial markets will
not collapse and thus give us the time to further develop these
fascinating conceptions.
ACKNOWLEDGEMENTS
I would like to thank the fellow enthusiasts with whom I had inspir-
ing conversations, namely Werner dHaese and Jean-Marcel Phefun-
chal. I acknowledge the contribution of Darren Brooke and thank
him for his persuasion and guidance in penetrating my somewhat
nebulous ideas until we were able to transform these concepts into
a piece of working software. I also thank Matthias Kstner for his
relentless but still constructive feedback on every concept uttered
in the manuscript. He contributed many thoughts, especially on the
last four chapters, and without him this book would have probably
not been finished.
I acknowledge with gratitude the editorial assistance of Sarah
Hastings and Lewis OSullivan of Risk Books.
Lastly, I must acknowledge my wife, Claudia, for her endless
patience during the writing of the book.
1 See http://www.britannica.com/EBchecked/topic/382740/Y2K-bug.
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Introduction
WHAT IS THIS BOOK ABOUT?

Liquidity risk is hard to understand. It needs to be broken down
into its components and drivers in order to manage and model it
successfully.
It is important to discern the specific risk of a bank to not be
able to execute contractually agreed payments from the general con-
cept of liquidity risk, which also comprises the liquidity of financial
products, markets, exchanges, etc.
This book is about the risk of banks losing their ability to stay
liquid, or to become illiquid, which we will call illiquidity risk. The
term liquidity risk describes a status which can be understood
straightforwardly (liquid) and is then endangered (risk); the
latter does not require an explicit definition of the perils (subsiding
funding base, declining saleability of assets, default of loans, etc,
which would be necessary if we were to talk about liquidity risk
instead of illiquidity risk).
ILLIQUIDITY RISK: A RISK TYPE OF ITS OWN?

Many financial professionals regard illiquidity risk not as a risk in
itself but only as a consequential risk which comes into play after
traditional risks have materialised in a loss: if this loss is too big (and
becomes public), potential depositors start to doubt the banks finan-
cial soundness and ask for higher funding spreads or even refrain
from making a deposit, while existing depositors might withdraw
their funds. Subsequently, the banks profitability suffers from the
increased refinancing cost and in the worst case the bank ends up
insolvent or illiquid.
First you lose the money, and then you go bust: this view is not
wrong but incomplete. Illiquidity risk is more than a consequence of
losses. Banks can run into liquidity problems simply by having an
unfavourable relationship between assets and liabilities over time.
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LIQUIDITY MODELLING
Let us look at banking history: in the summer of 2007 the prices of

so-called sub-prime securities fell dramatically. As a consequence,
funding spreads peaked for banks with large exposure in sub-prime
assets, and banks like IKB and Sachsen LB in Germany became
unable to acquire sufficient funds and finally had to be taken over
by larger banks. When funding spreads for banks with weak credit
ratings rallied, more and more banks tightened their policies on lend-
ing to other banks. In in the spring of 2008, however, bankers talked
wishfully at liquidity conferences about markets returning to nor-
mality with low funding spreads and fathomless liquidity. When,
contrary to expectation, funding spreads rose during the summer
break, most European governments felt forced to placate clients by
guaranteeing their retail deposits with banks. In autumn 2008 some
European banks could only survive with state guarantees or were
taken over by other banks.
At the beginning of the sub-prime crisis, the liquidity risks devel-
oped as described in the textbooks for consequential risk. The
realised or potential losses from the sub-prime securities triggered
hindered funding and higher costs. In in the summer of 2008 the
crisis peaked and almost every bank was put under general suspi-
cion and the unsecured lending between banks almost dried up. But
why did some banks go under, and why and how did others sur-
vive? The answer is not straightforward, as there are factors which
are extrinsic from the banks point of view, like the grading they get
from rating agencies or the willingness and ability of their govern-
ment to rescue them. The intrinsic factors, however, are less opaque.
First, banks that had funded their assets with liabilities of equiv-
alent duration were far less obliged to acquire refinancing in the
markets, independently of the quality of their assets. Second, banks
with sufficiently large portfolios of unencumbered liquid assets were
able to generate sufficient secured funding independently of their
credit standing. Thirdly, only banks with short-term liabilities not
matching their long-term assets (which themselves cannot be used
for secured funding) had to submit to the potential debtors decision
whether or not to give them money.
Illiquidity risk is a risk type of its own. It can result from other risks
or be intertwined with them. Market risk, for example, can materi-
alise as a loss stemming from the illiquidity of assets (insufficient
saleability at the right price), but a banks inability to sufficiently
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INTRODUCTION
fund itself can lead to fire sales and thus to the materialisation of
market risk.
MEASURING ILLIQUIDITY RISK: WHAT IS THE PROBLEM?

Banks risk management practices have undergone fundamental
changes in the two decades since the 1990s. The continuous devel-
opment of advanced statistical techniques has improved the quan-
tification of risks. Market and credit risks are defined as potentially
detrimental effects resulting from the uncertainty in determining
the value of portfolios. Inappropriate handling of a banks busi-
ness might worsen the situation (operational risk). Consequently,
these risks are expressed as distributions of losses (the potential
value minus the current value) which are derived by historical stat-
istical inference. Finally, the complexity is reduced by using specific
moments of these distributions, known as value-at-risk (VaR).
Risk professionals attempted to apply these techniques to illiq-
uidity risk and model it in a way that the result is one number,
liquidity-at-risk (LaR). Unfortunately, these concepts turned out to
be unusable in the 2008 crisis and have since almost disappeared
from public discussion among risk professionals. There are two main
reasons for the inadequacy of this approach:
1. illiquidity risk can only inadequately be expressed as value
risk;
2. historical statistical inference is problematic because illiquidity
risk emerges only in situations when behaviours and markets
which have been stable for long periods suddenly leap.
The historical risk models failed during the global financial crisis.
Why? Because these models were designed to answer the question
what could go wrong in the future?
These models therefore focus on the market variables that have
fluctuated in the past and tend to filter out variables which have so
far been inconspicuous. In particular, if financial markets have been
working properly for a long time, we cannot know which variables
will remain steady, even in situations of stress, and which might,
possibly together with others, change dramatically. Unfortunately,
we do not have the cognitive faculty to discriminate which histor-
ically stable variables will become unstable and which will remain
stable.
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LIQUIDITY MODELLING
To ensure the inclusion of risks which come to the fore as a result

of debatable assumptions, it would be better to ask which market
conditions must prevail to allow a transaction to mature as sched-
uled? Or, more broadly in the context of this book, what assump-
tions must be made to allow a bank to develop its balance sheet as
planned?
In the past too many banks made the fatal assumption that if
everything stayed as it was liquid, with assets and liabilities being
traded at their fair value and the bank never needing to violate its
own business model and unwind financial transactions because it
needs to free cash all would go smoothly, the sophisticated banks
would generate fantastic returns by inventing complex derivatives
and even the less sophisticated banks would make good money, so
why bother?
However, it did not go at all smoothly in the summer of 2007, so
now we have to bother and examine why.
COMPARING THE MEASUREMENT OF LIQUIDITY AND OTHER

RISKS
We shall measure illiquidity risk a little differently from how we
measure normal risks: market, credit or operational risks are loss
risks (or better, value risks) that deal with expected losses which are
captured by directly estimating a detrimental events probability
of occurrence, or sometimes by assessing the worst event which is
likely to happen with a certain probability.
For this purpose, the value of a portfolio is constructed as a func-
tion of market and counterparty variables. Any realisation of such a
variable results in a corresponding value that can be seen as a loss
or profit compared with the current value. As not all possible mar-
ket variables will occur with identical probability, probability dis-
tributions need to be estimated, usually by projecting historically
observed distributions into the future (and often calibrating them
to fit risk neutrality). Insertingthese distributions into the value
function gives the sought value distribution. From this we can derive
typical results, such as
the probability of losing more than 1 million is X,
the probability of this client defaulting is Y,
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INTRODUCTION
given an error probability of 0.5%, the maximum loss in this

portfolio will not exceed Z.
In illiquidity risk, however, we will not be able to give comparable

answers like The probability of the bank becoming insolvent is X.
The reasons are manifold, and include the following:
providing such a probabilistic answer would require the esti-

mation of an overwhelming number of stochastic variables
together with their interactions;
many variables, eg, a counterpartys willingness to supply
additional funding, cannot be deduced from statistics and
expressed in probability distributions;
in illiquidity risk, we are particularly interested in changes
of market regimes and would therefore need to explicitly
model erratic changes in the probability distributions (other
than in market/credit risk, where we normally assume the
distributions to be invariant over time);
the impact of illiquidity risk is almost binary: a cash shortfall
as crystallisation of illiquidity risk is not detrimental as long as
the bank can compensate it with additional borrowing; if the
shortfall, however, reaches the tipping point and becomes too
large to be offset, the damage is huge, whereas even a small loss
stemming from the crystallisation of market risk is detrimental.
For market and credit risk the detrimental events themselves are
less interesting, as an events impact is measured in terms of poten-
tial losses (or at least missed profit opportunity). For operational
risk, however, it is less straightforward to express harmful develop-
ments in losses. Problems regarding a banks reputation, for exam-
ple, are clearly damaging in themselves, but the effects might be
very difficult, if not impossible, to quantify, even after they have
occurred.
For illiquidity risk, liquidity events can even result in profits,
although they are undoubtedly of a generic disadvantageous
nature. It is undeniably a detrimental effect if, for example, a coun-
terparty misses a payment to the bank; but if the bank has at that
time an excess of liquidity, the missed payment reduces the banks
risk of earning only a lower than normal interest rate. If, however,
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LIQUIDITY MODELLING
the bank has short liquidity, the non-payment could stir a serious liq-
uidity problem, potentially including negative profit and loss (P&L)
effects and even illiquidity.
WHAT IS COVERED BY THIS BOOK?

Liquidity, or liquidity risk measurement and management, is a wide
field, which so far is only scarcely covered with publicly revealed
concepts. The most forthright approach has been to apply statistic
methods (VaR) stemming from the concepts developed since 2000 for
measuring value risks like market and credit risk in order to cover
liquidity risk. Although many banks hoped for the development
of such an LaR concept, which covers their complete liquidity risk
measurement, it turned out that these concepts can only be applied
to liquidity-induced value risks that stem from increasing funding
costs or from decreasing saleability of financial assets.
Here, instead, our focus is on illiquidity risk: the risk of a bank
becoming unable to satisfy its contractual obligations. The forward
liquidity exposure, which is the forecasted balance the bank has with
its central bank (nostro), is used as an indicator of its future cash
liquidity situation. The concept is kept flexible enough to produce
different possible versions of the future (scenarios) instead of trying
to approximate a conjectured single version of the truth. As capital
cannot be used as a buffer for illiquidity risk, the banks ability to
generate new inflows (the counterbalancing capacity) is estimated
using a specific strategy for offsetting potential liquidity squeezes.
In Chapter 2 we explain how a banks economic success is mea-
sured and steered and why liquidity is an essential prerequisite for
the functioning of this approach. The role of capital for other risk
types is explained, and we establish why capital cannot be used
as buffer for liquidity risk and why the counterbalancing capacity
needs to be introduced.
Chapter 3 defines what is understood as liquidity risk in this book
and separates the different types of liquidity risk from each other.
The suitability of established statistical measurement techniques for
different liquidity risk types is analysed, with the conclusion that
none really fit for illiquidity risk.
The foundations of modelling liquidity risk are laid out in Chap-
ter 4. The elements in a banks existing balance sheet that influ-
ence the liquidity forecast are more formally introduced: the nostro,
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INTRODUCTION
transactions and its cashflows as forecasts for future payments, as

well as asset flows (which can constitute collateral) and option flows
(which might institute new financial transactions). The forward liq-
uidity exposures uncertainties are separated into those that depend
on the variation of the cashflows of existing transactions and those
which stem from transactions that do not yet exist. Illiquidity is mea-
sured with a basal inequality that disregards uncertainty; this is later
enhanced step by step to cover uncertainties.
In Chapter 5, uncertainties are modelled in more detail. We
explain how cashflows of existing transactions are first considered
as deterministic but are then adjusted due to influencing market
factors (variable cashflows) or due to the counterpartys exercise of
options (contingent cashflows). The inappropriateness of the for-
ward rates as predictors of future interest rates is discussed and we
outline a possible solution which quantifies the resulting uncertainty
(forecast-at-risk). We then explain the kind of optionality by which
the generation of hypothetical transactions is driven and the choices
that the bank faces in influencing its future balance sheet, going
beyond the established concepts of financial options and considering
breach options and rejectable options.
In Chapter 6 the different components of the analysis and concep-
tions are synthesised in order to describe how a bank can develop
a process that models illiquidity risk and build a solution which
systematically gathers the necessary information to measure and
manage illiquidity risk.
The main element of this solution is the simulation of scenar-
ios. Exposure scenarios simulate situations that the bank could
encounter, without assuming that it would modify the situation,
whereas strategy scenarios describe measures which the bank
actively tries to execute in order to avert perils. We show how the cre-
ation of scenarios can be systematised to simplify and structure the
variety of scenario assumptions. All transactions that are assumed to
behave similarly in a scenario are aggregated into a liquidity, which
allows us to handle the aggregated transactions jointly instead of
individually. Liquidity units give a birds eye view of the balance
sheet and isolate the drivers of liquidity.
After some technical indications of how to methodically set up
portfolios and hierarchies, we extend the concept of cashflows and
inventories to asset and option flows and inventories, which enables
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LIQUIDITY MODELLING
us to describe the mechanics of future balance-sheet progressions

consistently. To finalise this modelling we produce a taxonometry
which methodically explains how the exercise of various option
types can result in transactions and cash, asset and option flows.
In Chapter 7 we give a detailed plan of how the counterbalanc-
ing capacity can be implemented in practice. The abstract problem of
how the bank can mitigate illiquidity risks by engendering hypothet-
ical transactions that create additional cash liquidity is examined and
broken down into its components. For practical reasons the problem
is then restricted to the hypothetical repo or sales of unencumbered
liquid assets. First, the banks ownership and possession of a secu-
rity need is constructed from the existing transactions of the security
and projected into the future. Then the securities are segmented into
liquifiability classes, special liquidity units that comprise all securi-
ties that behave similarly in a scenario. The liquification algorithm
creates cash inflows in a thought experiment which goes forward in
time step by step: the securities of each liquifiability class are sold
and their reduced inventories are repoed until the next business day,
until the next portion is hypothetically sold, etc. Finally, we explain
how the counterbalancing capacity (CBC) fits technically into the
forward liquidity exposure (FLE), which assesses the problem in a
wider perspective.
In Chapter 8 the liquidity risk that has been modelled before is
enhanced by refining the time granularity from daily to continuous,
which allows integration of the payments of today into the FLE.
The liquidity risks related to the payment process which have so
far been ignored are classified and investigated, which leads to a
broader and deeper analysis of the liquidity risk measurement pro-
cess. The idealised payment process which was previously sufficient
is represented in greater complexity, and information risks are con-
sidered. Risks that stem from the payment services carried out by
the bank for others, as well as the idiosyncratic risk of the payment
processes (or venues), are considered and we analyse their possible
mitigation.
In Chapter 9 we give a brief overview of practices used by
banks to price internal deals (funds transfer pricing). The most
enhanced method, individual transfer pricing of single transactions,
is described and we sketch the inclusion of components of uncer-
tainty (premiums for different risk types). The cost effects that are
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INTRODUCTION
specific to liquidity risk are modelled and integrated, allowing the

transfer-pricing process to be complemented with the upcoming
requirements that stem from adhering to the rules of Basel III.
In Chapter 10 the liquidity regulations of Basel III at the time
of writing are outlined and we investigate their impacts on banks
forthcoming business models. We evaluate how a bank can improve
detrimental short-term and longer term liquidity ratios and the con-
sequences for its balance sheet and its business model. The result-
ing cost effects are scrutinised, referring to the previous chapter on
transfer pricing.
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Setting the Scene: Why Liquidity Is

Important in a Bank
Banks play a central role in the management of liquidity and its

risk: on the one hand they act as payment agents and providers
of funds for individuals, corporates and other banks; on the other,
they are subject to liquidity risk themselves. While the granting of a
loan reduces the recipients liquidity risk, it generates liquidity risk
within the bank, for which the bank seeks economic compensation.
In this chapter we briefly describe how banks measure and manage
their economic success and the associated risks. We progress from
an ex post view of income and expenses to a forward-looking per-
spective that describes the banks earnings in the future as well as
their aggregation over time to values that can be attributed to arbi-
trary points in time. Because these values are determined by future
events, they are uncertain in nature and thus bear the risk of possi-
ble detrimental deviations (value risk). Banks have to accept risks,
as they are an integral part of their value creation process, but this
raises the necessity of managing them. We discuss how capital is
perceived as a buffer for value risks.
BANKS, FINANCIAL TRANSACTIONS AND BALANCE SHEETS

Banks are very specific enterprises: unlike most normal corporates
they can generate present returns by taking risks which will only
materialise in the future; on the other hand, they can generate liq-
uidity relatively easily through their access to the central bank
money-generation system. But there is a flip side: the risks may lead
to higher losses than expected and the seemingly endless liquid-
ity can suddenly dry out. In order to understand why banks do
what they do and the role played by liquidity, we explain the basic
concepts of a banks business.
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LIQUIDITY MODELLING
Achieving high expected returns in banking is (in contrast to com-

mon belief) very simple: investing in high-yielding assets or giving
loans to risky customers who will tolerate high interest rates will eas-
ily do it. The flaw in this concept is that such investments propose
high returns, but only if they are carried out as planned: if the plan
does not work, they create losses. This does not mean that investors
will always lose money or that such an investment is necessarily
bad: it could be worthwhile doing it.
The critical question for the bank is: Is it worth doing it: does the
expected return cover the expected risk? Which leads directly to
the next question: How big is the risk and, if it crystallises, can the
bank bear the resulting loss?
Unfortunately history tells us that banks are, from time to time, not
very successful in their judgement of the involved risk; the resulting
loss turns out to be larger than expected. If it is even bigger than the
banks reserves, the bank becomes illiquid, other banks lose money
as well and a threat for the whole banking system might evolve. In
order to avoid this, regulators require banks to hold minimum levels
of financial reserves and capital.
Before we can describe how the concept of capital works in more
details, we need to explain some basics.
The banks relation to the outside world is established by financial
transactions that constitute either claims (assets AM ) or obligations
(liabilities LN ). The list of all assets and liabilities is called the banks
balance sheet. If we add the derivative transactions, we can speak
of the extended balance sheet. For the sake of simplicity we ignore
in this chapter the fact that some transactions can result in a mix of
assets and liabilities, or that they may only create assets/liabilities
in the future.
INCOME, EXPENSE AND EARNINGS

Banks want to generate profits with their undertakings. Therefore, it
is of utmost importance for them to anticipate the financial outcome
of potential transactions. Every transaction can, after its maturity, be
described as a series of payments that the bank has made or received.
If, in hindsight, the sum of these payments is positive (or negative)
we can speak about an income (or expense) which is specific to this
transaction. For example, a loan of 100, at a rate of 7% which is paid
back at maturity, has produced a (specific) income of 7% of 100 =
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SETTING THE SCENE: WHY LIQUIDITY IS IMPORTANT IN A BANK
7; whereas a deposit of 100 taken at a rate of 4.5% has produced a

(specific) expense of 4.5% of 100 = 4.5.
This does not, however, give a good view of the real economic
situation, as it neglects the fact that money has a time value; the
incentive to give money to a counterparty is that it is paid back at
maturity, together with a premium: the interest. Paying out money
and receiving just the same amount in return is regarded as a loss
because the interest amount is lacking.
In order to correctly reflect the time value of money, banks do
not measure specific income or expenses but rather compare trans-
actions with real or symbolic counter-transactions reflecting this
interest value.
For example, if the above loan was given and repaid when the
market interest rate level was 5%, it should be benchmarked
against its hypothetical funding: deposit with an interest rate of 5%.
The relative income is 7 5 = 2 (or 2% of 100); the above
deposit is likewise benchmarked against a loan at market rate of 5%
and its relative income is 4.5 + 5 = 0.5 or 0.5% of 100.1
In order to cope with different maturities and/or odd payment fre-
quencies, earnings are appropriately defined for standardised time
periods (eg, yearly or quarterly).
The concepts that look at historic earnings traditionally ignore
a potentially material detail: the earnings are simply added, disre-
garding the fact that an earlier (incoming) payment can create more
interest income than a payment that occurs only later (and vice versa
for outgoing payments).
THE TIME VALUE OF PAYMENTS

Naturally, banks are highly interested in comparing not only transac-
tions that have already matured, but also future transactions before
they are closed. In order to do this we need to forecast the future
payments of a transaction; we call them cashflows. Once the cash-
flows of a transaction are generated, its future income and expenses
and thus its future earnings can be generated. The mechanics are the
same as with payments, but a complication becomes apparent: two
payments with the same nominal do not normally have the same
value if they occur at different times in the future, because they
can in theory be sold or bought at prices that are determined by the
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LIQUIDITY MODELLING
future (or forward) interest rate curve (see page 57). The differ-
ence becomes material if the earnings are uneven, eg, lower earnings
at the beginning, due to a discount, which are nominally compen-
sated by higher earnings at the end, stipulate relatively high-interest
expenses which are not matched.2
In order to circumvent these problems, we introduce the value
of a financial transaction that is determined by its cashflows, which
may be scheduled for different dates and can thus not be just added.
The concept of time value of payments uses the interest rate curve
(in a currency) to discount a future cashflow, transforming it into its
present value as of today. In contrast to the cashflows themselves,
their present values can be simply summed to constitute a value
which is thus independent from time.
Let us look at a simplified example: the bank assumes an inflow
of +100 on a future day and therefore borrows a smaller amount of,
say, +99 today, until then. If the difference (+1) correctly reflects
the applicable interest rate, the bank will have to pay back the
loan (99) plus the interest rate (1), which matches exactly the
expected inflow from the original transaction, giving zero as a result
(99 1 + 100 = 0). In this example, the future value (expected
inflow) of +100 has been discounted into a present value (actual
inflow) of +99.
Implicit assumptions in the present-value concept

If we regard the case where the bank discounts a future outflow of
100 by giving a loan of 99 now, the bank has to find a counterparty
which is willing to borrow the discounted amount and pay back
the full amount later. This transaction involves credit risk for the
bank, but none for the counterparty, which therefore should have
no objections to execute the transaction (assuming that both parties
agree on the same discount factor). From the banks perspective,
however, the flip side of the liquidity risk arises: counterparty credit
risk. It could be that the counterparty is unable to pay back in time
(or at all) the +100 that should offset the 100.3
If the bank alternatively wants to convert a future inflow, the sit-
uation is quite different: the potential counterparty might require
compensation for the credit risk before it enters into the transac-
tion. This might be unproblematic in times of ample cash liquidity
in the market and little attention to counterparty credit risk, but not
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always. To state it more explicitly: a necessary condition to make

the present-value concept work for an inflow is that the bank has
unlimited access to liquidity (borrowing).
The feasibility of the present-value concept is not the same for
credit risk as it is for liquidity risk: the bank is always able to make
the concept work by lending the money and thus accepting the credit
risk; the bank may, however, not always be able to circumvent its
own liquidity risk and enforce the necessary borrowing from a coun-
terparty. We could say that the bank is long the option to enter into
credit risk but short the liquidity risk, which is inevitable.
In some practical situations we can elude this problem by using
derivative instruments that involve dramatically smaller nominal
flows and thus reduce the importance of liquidity/credit issues.
A net present value is the sum of the discounted cashflows of more
than one instrument, eg, a portfolio. The present value may discount
inflows and outflows and so involves different risks. Its calculation
can thus be a little problematic: the discounted value of a sum of
cashflows at a future date, for example, is not always equal to the
sum of the individually discounted cashflows.4
CAPITAL
Capital is in finance and economics still an opaque concept. In the
simplest case we can think of founding a bank, when investors pro-
vide funds (sometimes other goods as well), called capital, which
represents the value of the bank at the start. Moving forward in
time, the bank creates income and expenses and its capital (value)
fluctuates accordingly.
From a liquidity risk perspective the initial capital can be seen as
initially surplus funds, which can be regarded as a cash reserve for
eventually necessary payments (rent, salary, etc), until the sum of
these payments becomes greater than the capital. At that point the
bank needs to create additional inflows by taking deposits. Unfor-
tunately, there is no meaningful way to map some of the outflows
to the capital and others to the new deposits. At that point in time it
does not make any sense to connect the deposited capital to specific
cash outflows or the corresponding assets or cost.
We go back to the idea of capital as accumulator of profits
(or, respectively, losses) and describe for our purposes capital in
a way which is derived from accounting (which goes back to
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LIQUIDITY MODELLING
such authorities of classical economics as Max Weber and Werner

Sombart):
The very concept of capital is derived from this way of looking at
things; one can say that capital, as a category, did not exist before
double-entry bookkeeping. Capital can be defined as that amount
of wealth which is used in making profits and which enters into
the accounts.5
To quantify this idea, we assume that the balance sheet of a bank is

fully described by its assets A1 , . . . , AM and liabilities L1 , . . . , LN . We
assume furthermore that we can assign a value v() to every asset
(respectively, liability), which is denoted by v(A1 ), . . . , v(AM ), the
values of the assets, and v(L1 ), . . . , v(LN ), the values of the liabilities.
Let vA = v(A1 ) + + v(AM ) and vL = v(L1 ) + + v(LN ) denote
their sums.
The number c := vA vL is called equity capital and indicates
insolvency: a bank is called insolvent if the value vA of its assets is
less than the value vL of its liabilities (vA < vL ), which is equivalent
to vA vL = c < 0.
VALUE, RISK AND CAPITAL

The calculation of capital is not straightforward. The above deter-
mination of capital (c = vA vL ) is formally correct but ignores the
practical problem of determining the individual value of each asset
or liability.
As only very few assets, eg, cash balances with the central bank,
have an indisputable value, all other values are merely theoretical. A
value is assigned to an asset by either relating to the future payback
or assuming that the asset could be sold at a certain market price.
Both cases are uncertain by design. We cannot be absolutely sure
that the payback will occur or that the bank will find a counterparty
that is willing to buy at that price. A liability is less cumbersome in
that respect, as the bank has to assume that it will pay it back fully
at maturity.6
Therefore, in the world of the regulators, the theoretical value is
corrected to the downside by accounting for uncertainties or risk.
The risk-adjusted asset value (vA rA ) is composed of the theoretical
value vA minus the asset risk and the risk-adjusted liability value
(vL + rL ) analogously (rL is the liability risk). Unfortunately, the
risk cannot also be determined unequivocally.
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Regulators primarily want to ensure that a bank stays solvent or,

equivalently, that the sum of the risk-adjusted values is non-nega-
tive: (vA rA ) (vL + rL ) > 0.
By rewriting the inequality as vA vL (rA + rL ) > 0 and sub-
stituting vA + vL = c, we get c (rA + rL ) > 0 or c > rA + rL (the
capitalrisk inequality).
This means that the capital should not be less than the sum of the
asset and liability value risks.7
By obverting the above arguments we come to the following con-
clusion: If the capital of a bank is greater than its value risks, the
bank is solvent and, if there is no need to change the valuation, it
will remain solvent in the future.
CONCLUSIONS
The central steering parameter of a bank should be the forecasted
economic value of potential new transactions. Values are often
regarded as an advancement of the earnings concept: while the earn-
ings of two transactions can only be matched within certain time
periods, the value concept disintegrates the term structure and thus
allows a direct comparison of financial transactions. It is neverthe-
less an oversimplification to regard the present value as completely
independent from time, because its calculation presupposes that all
potential counterparties will ignore the banks credit risk, which
is illiquidity risk from the banks perspective and thus has a term
structure.
As the value involves future cashflows and as yet unknown mar-
ket rates, it is uncertain by design. We call this uncertainty risk if it can
be detrimental for the bank. We distinguish in the next chapter the
parts of liquidity risk which fit into this value risk concept (liquidity-
induced value risks) and those parts which do not fit (illiquidity risk)
and discuss how the illiquidity risk can be defined and measured.
The conquering success story of values culminated when risks (to
be more precise: value risks) were expressed in value distributions
(VaR). The underlying idea was to simulate many future values of
a portfolio of transactions, representing possible states (with equal
probability) of the future reality. The crucial simplification is then
to use the additivity of the elements of the distributions (the future
values) and calculate statistical moments like expected values and
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LIQUIDITY MODELLING
quantiles. We will find that these methods can be applied to liquidity-

induced value risks, but not to illiquidity risk.
Value risks like market and credit risk are assumed to be compen-
sated by capital. We will explain in the next chapter why this does
not work for illiquidity risk and describe the substitute for capital:
the counterbalancing capacity.
1 If the deposit is taken at 5.5%, its relative income is negative: a relative expense.
2 The underlying problem is that an intuitive mathematical order (a b) can only be estab-
lished for real numbers a and b; if n-dimensional vectors (earnings) have to be compared,
the ordering is rather technical and the outcome is somehow counter-intuitive; it may still be
geometrically understandable for complex numbers (n = 2).
3 Note that there is also liquidity risk for the bank: making the payment earlier requires that
the corresponding funds are available for the bank.
4 If an inflow of +100 and an outflow of 100, both scheduled for a future day, are simply
added, the resulting net present value equates to zero independently of the discount factor.
If, however, each flow is discounted with its individual discount factor, the sum is not equal
to zero.
5 Attributed to Werner Sombart.
6 There can be uncertainties as well, if, for example, the redemption amount of an own issue
(ie, a security issued by the bank itself rather than another issuer) depends on market factors
(inflation-linked bonds, etc).
7 We have so far omitted two risk aspects: (i) the correlation between asset and liability risk
tends to result in lower overall risk, (ii) the above risk estimation is uncertain in itself; we
might question the results and add a model risk premium.
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What Is Liquidity Risk?
We have already intuitively used the expression liquidity risk but

not yet properly explained what we mean by it. We have consid-
ered market and credit risk, which result in a loss or a profit and
do not have a time structure (or at least the current measurement
methods bypass this by working with present values). Obviously,
liquidity risk has some similarity to these value risks (it can, for
example, result in comparative funding losses) but some if its per-
ils go beyond just losing money. We will distinguish in this chapter
between liquidity risks that are value risks and those which cannot
be expressed simply as expected profits or losses.
The difference is important, not only because liquidity does not fit
into value risk measures such as VaR, but, more importantly, because
it cannot be held against capital as a buffer.
As a starting point, we examine concepts like illiquidity, insol-
vency and default and establish a common usage of these through-
out this book. Advancing this we describe liquidity/illiquidity for
financial instruments and markets as well as financial institutions
(banks). Finally, we outline liquidity-induced value risks.
ILLIQUIDITY
A bank enters into relations with the outside world through enter-
ing into contracts with counterparties. These contracts may include
payment obligations between the counterparties, which are settled
by transferring assets (normally central bank funds) at a given date
to a specified nostro account the counterparty holds with another
bank.
As long as a bank fulfils all of its contractual payment obligations
that fall due, it is liquid.
If at some point in time (now or in the future) the bank does not
execute one (or more) of these payment obligations, the bank has
defaulted on the payment and thus becomes illiquid.
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LIQUIDITY MODELLING
Illiquidity has no time dimension: an illiquid bank will stay illiq-

uid in the future. The risk of becoming illiquid in the future, however,
has a term structure, because the bank may stay liquid for a certain
period until possibly becoming illiquid at a future point in time.
We define illiquidity risk as a banks risk of not staying liquid in
the future, or, as we assume that a bank will always try to avoid
illiquidity by all means, as the risk of the bank being unable to stay
liquid.
Liquidity is a unitary concept: a bank is only liquid if it fulfils
all payment obligations, possibly in different currencies, countries
and nostro accounts. In order to simplify things, we assume in this
book, where not otherwise specified,1 that the bank itself has only
one nostro account with its local central bank and all payments have
to be made to nostros that counterparties have with the same central
bank.
Generally speaking, a bank can also become illiquid if it is unable
to accomplish the contractually agreed delivery of an asset. In prac-
tice, we have to distinguish different asset obligations. If the bank
has received an asset as a loan, it is unconditionally obligated to
deliver; the failure to do so is equivalent to illiquidity. If the bank,
however, has sold an asset, the counterpartys corresponding pay-
ment will only become effective if the asset has been delivered in
due time (payments versus delivery). If the bank defaults in deliver-
ing the asset in this sales transaction, the situation is less dramatic,
because cash compensation will not be executed in return, and thus
the damage to the counterparty is relatively minor.
INSOLVENCY AND ILLIQUIDITY

Although liquid and solvent (respectively, illiquid and insol-
vent) are often used as synonyms, they represent different views
on the ability of a bank to execute contractually required payments.
As discussed for capital in the preceding section, a bank is insol-
vent if the value of its assets is less than the value of its liabilities,
or in other words If the capital of a bank is greater than its value
risks, the bank is solvent. Insolvency risk is the peril that the bank
becomes insolvent, ie, that its value risks prevail over its capital.
Things would be quite simple if we could only replace the word
solvent by liquid and expand the statement a little: If the capital
of a bank is greater than its value risks, the bank is liquid and if
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WHAT IS LIQUIDITY RISK?
there is no need to change the valuation it will remain liquid in the

future and could put down illiquidity risk to a problem of valuation
risks and capital.
Unfortunately, the concepts of illiquidity and insolvency are inter-
woven but are not equal.
Example 3.1.
(i) The capitalrisk inequality. Assume that a bank was founded
with an equity capital of 10. To start its business, it acquired a
deposit of 100 and gave a loan of 100. The value of the loan is
103 and the value of the deposit is 102. The capital equates to
c = 10 + 103 102 = 11.
Assume further that the credit risk is rA = 100 6% = 6 and,
for the sake of simplicity, that there is no risk on the liability side:
rL = 0.
The capitalrisk inequality obviously holds
rA + rL = 6 + 0 = 6 < c = 11
(ii) Insolvent and illiquid. If we change the credit risk in (i) to rA =

100 12% = 12, the capitalrisk inequality no longer holds: rA +
rL = 12 + 0 = 12 > c = 11, meaning that the bank is insolvent.
However, this does not mean that the bank is necessarily illiquid: it
will have a surplus of 10 at least until the deposit matures.
What is the reason for the above differences? Solvency is a theoret-

ical concept which mitigates positive liquidity effects from assets
with negative liquidity effects from liabilities, regardless of the
term structure of these assets and liabilities. It ignores the fact that the
banks scheduled incoming and outgoing payments might lead to
temporarily underfunded situations. The solvency model assumes
that the bank will be able to acquire temporary deposits if the asset
values outweigh the liability values. We could argue that a potential
depositor should use the same method to assess the banks solvency
and then would come to the conclusion that the bank is solvent and
make the deposit.
In practice, however, things might be very different for many
reasons:
the depositors value and risk models might deviate from our
method;
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LIQUIDITY MODELLING
the depositors value and risk models might require input

about the banks assets and liabilities which is not available
publicly;
the banks information about its assets and liabilities is not
trusted;
the potential depositor could assess the risk situation differ-
ently from how the bank assesses its own risks;
the potential depositor has already used their limits for the
bank and does not want to exceed their credit concentration
risk, or has no money to deposit or is unsure about their cash
needs and withholds the money.
Solvency is not identical to liquidity, and insolvency is not identical
to illiquidity but they are strongly connected:
insolvent banks (firms) will not inevitably become illiquid
immediately (eg, Enron), but it is very unlikely that they
can stay liquid for a longer time, as counterparties can stop
payments to an insolvent company;
banks that are not yet insolvent can nonetheless become
illiquid and as a result will have to declare insolvency;
almost illiquid banks might not be insolvent now but, as
they might be forced to sell assets or acquire liabilities at
unfavourable prices to avert the danger of illiquidity, they can
become insolvent in the long run.
LIQUIDITY RISK OF FINANCIAL INSTRUMENTS AND

MARKETS
A financial market is often regarded as being liquid if it con-
tains liquid financial instruments. Strictly speaking, markets con-
tain liquid and less liquid or illiquid instruments. Consequently, we
should not speak of the liquidity of a market but of a market for
an instrument.
A financial instrument is regarded as being liquid if it can be
turned into cash (liquified) easily. It can be liquified either by being
sold (finally or only for a certain time period) or by being accepted
as collateral for a new liability.2
On the other hand, an instrument is less liquid if it can only be
liquified
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with a price decay (less than the expected fair price),

with a time delay (not as fast as desired),
in smaller amounts than envisaged,
in big blocks (in larger amounts than available).
The above observations state the effects of lesser liquidity but they
do not explain them.
If we think about assets in particular, a potential buyer could
refrain from buying an asset because the desired price is perceived
as too high to compensate for its possible detriments, such as the
following.
It is not fully fungible: it is more complex and time-consuming
to transfer the ownership of a registered bond than to transfer
the ownership of a bearer bond.
Its price is likely to be very volatile and/or it cannot be hedged
straightforwardly.
It is (generally) of no or limited use for the buyer: a pension
fund might be restricted to unstructured securities with a rat-
ing of at least AA and thus cannot buy a security rated B or
one with an inflation-linked cashflow structure.
It belongs to a class of assets which is perceived as being less
liquid: in a crisis, for example, assets which do not qualify
for the Basel III category HLA (high-quality liquid assets)
might be regarded as illiquid. More generally, non-HLA eli-
gible assets might be less liquid than HLA eligible ones (in a
normal situation). In a crisis, however, they might quickly
become totally illiquid.
One way to quantify a financial instruments liquidity is to construct
a theoretical price that should reflect all components determining
the price, including credit, market and operational risk (but not liq-
uidity risk) and interpret the difference between theoretical and exe-
cuted price as a measure for the liquidity of this instrument. Unfor-
tunately, it is impossible to unequivocally determine in advance the
correct price which would qualify the asset as liquid in the above
sense, because correctness here is in the eye of the beholder.
A related method is to quantify liquidity risk by the spread
between bid and offer price: assume the discounting of the trans-
actions cashflows with a unique yield curve gives a gross price PG .
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LIQUIDITY MODELLING
Assume further that the following adjustments are made: (rC ) for
credit risk, (rM ) for market risk and (rR ) for all other residual risks
except liquidity risk. The theoretical price PT of the instrument
should be PT = PG rC rM rR .
The potential counterparties that are not investing but trading
will not buy or sell at this price even if they all completely agree
on the above valuations. These traders propose two prices to the
other participants: a bid price PB at which they are willing to buy
the instrument, and an offer price PO at which they are willing to
sell it. Both bid and offer price are nudged a little bit around the
theoretical price PT : PB = PT sB (respectively, PO = PT + sO ).
The sum of the (positive) numbers sB + sO = sBO is called bid
offer spread. The rationale behind it is that a trader possibly buys
an instrument at PB and then sells it at PO , thus realising a profit
of (PT sB ) + (PT + sO ) = sB + sO = sBO (the bidoffer spread). If
the realisable sales price moves detrimentally for the trader, the bid
offer spread should be at least large enough to avoid a loss. Therefore,
a trader naturally wants to quote a wide spread, whereas potential
counterparties would reject trading at excessive bidoffer spreads.
Therefore, the trader has to find a balance between attractive pricing
(narrow spreads) and avoiding excessive risks (wide spreads).
Example 3.2. Assume a trader calculates the theoretical price of a
bond as 98.50 thus and quotes 98.45 to 98.55. This means that the
trader has set both bid and offer spread to 0.05 or 5 basis points (bp)
and calculated the bid price
PB = PT + sB = 98.50 0.05 = 98.45
and the offer price
PO = PT + sO = 98.50 + 0.05 = 98.55

If the whole market moves up 3bp, the quote would be 98.48 to
98.58 and if it moves down again 6bp the quote would be 98.42 to
98.52.
Assume now that new negative information about the bond or
the market is published and the trader equates the new theoretical
price as 98.15. Because the new price calculation has involved strong
assumptions about the driving factors, the trader is unsure whether
the new price is appropriate and therefore doubles the spread to
98.05 to 98.25 in order to account for the uncertainty. In principle,
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the spread should narrow again if the uncertainty reduces. In such

a case the liquidity of the instrument is not threatened in principle.
Another important aspect of the bidoffer spread is that traders

try to find the best possible theoretical price, but also have their own
expectation about the future movement of the price (both absolute
and relative to the market). Consequently, they will quote a bid and
offer not around the theoretical price but rather a little bit biased
towards their expectation. In Example 3.2 a trader expecting or esti-
mating a high probability that the price of the bond will fall mas-
sively will expand the bidoffer spread asymmetrically. The offer
will still be 98.25 (because this is the correct theoretical price), but
the bid price will be dramatically reduced, to, say, 97.55, and thus
reflects the traders aversion to purchasing this bond, which is per-
ceived to be too risky. Other than in the transitory widening of the
spread, this pricing reflects a fundamental illiquidity of the example
bond.3
Remark 3.3. A widening of the bidoffer spread reflects an increas-

ing illiquidity of the financial instrument and/or the financial
markets.
If assets are traded through venues (such as market makers or

exchanges), the average spreads between bid and offer price are
taken as a measure of the liquidity of the venue. There are, however,
additional indicators for liquidity:
the tradable amounts need to be sufficiently large, otherwise

the instrument will only be liquid in small amounts;
if the tradable amounts are not big enough, a sufficient num-

ber of other potential counterparties in the venue should be
willing to quote similarly narrow bidoffer spreads to allow
subsequent selling or buying.
A market for a financial instrument can be liquid at one time but

become less liquid if external conditions are changing. Liquidity
can therefore be either temporary or more fundamental (the liquid-
ity under many conditions will be considered below in different
scenarios).
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LIQUIDITY MODELLING
LIQUIDITY OF MARKETS FOR CENTRAL BANK FUNDS

Another aspect is the connection of the market of financial instru-
ment with the market of central bank money (cash). An instrument
could be liquid in principle in the above sense, but the potential
counterparties are not able or willing to purchase it because they do
not own sufficient cash or at least are uncertain if they will not fall
short later (eg, on the payment day). There is a lot of confusion in
the public perception of cash-poor/cash-rich market situations: if it
is said that a lot of cash in the hands of investors is waiting to be
invested, investors obviously fear to invest in assets (because, for
example, they expect stock markets to fall or interest rates to rise,
etc) and thus park their liquidity in cash or near-cash instruments
which either mature or can be withdrawn in the short term.
It cannot be deduced, however, that investors in such a situation
are more willing to provide cash liquidity to the market participants
or buy assets more easily: they have the cash because they have
been very aware of the risk.
The money supply of a central bank is perceived as low if
a larger number of market participants are seeking central bank
money, which does not necessarily mean that the central bank has
given too little money to the market. The amount of central bank
money in the banking system is (apart from the minimum require-
ments) a constant sum which is very carefully and acutely well man-
aged by the central banks. If banks are lacking central bank funds,
then this is due not to the absence of such money but to a distorted
distribution mechanism within the system: the owners of surplus
cash do not pass it on to the banks in need.
The reason for the distortion can be manifold, as the owners of a
surplus might
only recognise their long position when it is already too late to

pass on the funds to the cash short banks,
know their position but suspect that it could be unstable and
possibly change detrimentally,
fear the credit risk of the potential takers of funds.
From the above, we can conclude something important: central

banks are for technical reasons forced to steer the total amount
of central bank funds4 within a narrow band, which means that
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is almost impossible for them to help the markets in critical situ-

ations with excess liquidity. But even if they did so, it is highly
questionable whether they could produce the desired effects: if in
an unproblematic market situation the central bank allots liquidity
generously to the markets, more banks will have excess in excess and
thus the price for it might drop, allowing the seekers to get funds
more easily. In an already troubled market situation, however, the
owners of surplus funds will still be selective and avoid passing on
liquidity to the seeking banks. Their reason not to give money to the
seekers has been and will be credit risk and not the availability or
price of the funds. If the rumour gets around the market that the cen-
tral bank is trying to bail out troubled banks by adding surplus funds
into the market, the oversupply can even increase the competition
for the takers of funds.
The underlying problem is that the central bank is not able to give
cash to a bank directly but only able to give it against eligible collat-
eral of sufficient quality. If a bank is unable to fund itself sufficiently,
it obviously does not have enough of such collateral, otherwise it
would have used it to solve its funding problems beforehand. Con-
sequently, the central bank cannot help troubled banks directly; it
can, however, provide the market with ample liquidity and thus try
to convince the cash-rich bank to give to the banks in need. If, how-
ever, the cash-rich banks suspect that they are being gently forced
to solve the liquidity problem of the banks in need, they might be
alarmed about the severity of the problem and stop such interbank
lending. In a crisis situation the weighting between earning high
interest and being exposed to counterparty risk might topple and
cause a complete halt in interbank lending.
As central banks are well aware of this threat, they do not flood
the markets with liquidity but instead try to flood the markets with
empathy to reassure the banks that ample liquidity will be provided
if it is really needed. This was, for example, done (and turned out to
be sufficient) during the 9/11 crisis. In the crisis of 2008 the central
banks could not get away with that and finally extended their list of
eligible collateral in an unprecedented manner.
In the following chapter we will not develop a theory of the liq-
uidity risk of financial instruments or financial markets, but we will
assess the banks abilities to take measures against impending cash
shortages and therefore deal with their ability to convert certain
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LIQUIDITY MODELLING
assets into (temporary) cash inflows in order to offset potential future

cash deficits (we will call this process counterbalancing capacity).
LIQUIDITY-INDUCED VALUE RISK

There are value risks which stem from illiquidity risk but are not
illiquidity risks:
the bank is short of cash liquidity, which can possibly lead to

higher funding costs;
if the bank has excess liquidity it might face comparative
losses because it needs to give cheap cash to the market or
encounter unwanted credit risk because there are not enough
riskless takers of cash in the market, etc.
We will not treat liquidity-induced value risk explicitly in this book.

If the bank needs to pay up for deposits because it or the markets
are less liquid, we can speak of a value risk and apply the concept
of statistical moments. Illiquidity risk, however, is substantially dif-
ferent from value risk and cannot be treated with distributions. If
it is forecasted in 99 simulations to end up with +100 in its central
bank account, and in one simulation to end up with 100, it does not
make any sense to analogously argue that the bank will on average
end up with +98. The (singular) illiquidity (100) cannot be com-
pounded with the (many) successful cases (+100). Illiquidity risk is
not an additive value risk, and the statistical treatment of value risks
can therefore not be simply carried forward.
One application of liquidity-induced value risk is the concept of
value-liquidity-at-risk (VLaR), where the risk of increasing funding
costs is measured. For the following example compare Table 3.1.
The banks assets and liabilities are ordered by their maturities
t1 , t2 , t3 , . . . , tM1 , tM and cumulated over time (if there is no asset or
liability maturing at tm we set Am = Lm = 0)
sA
1 = A1 ,
sA A
2 = s1 + A2 ,
sA A
3 = s2 + A3 ,
..
.
sA A
M = sM 1 + AM
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Let us assume for the sake of simplicity that for every day from
tomorrow (t1 ) until maturity (tM ) of the last element of the banks
balance sheet there is an Am (we add a 0 if there is none). We do the
same for the liabilities and get L1 , L2 , L3 , . . . , LM1 , LM (respectively
sL1 = L1 , sL2 = sL1 + L2 , sL3 = sL2 + L3 , . . . , sLM = sLM1 + LM ).
The differences FLEm = sA m sm between the cumulated sums of
L
assets and the cumulated sums of liabilities express an overfunding

(sA L A L
m > sm ) or underfunding (sm < sm ) of the bank in tm . We fur-
5
ther assume that the bank will lend out any overfunded amount to
earn interest (respectively, that it needs to borrow any underfunded
amount as its nostro cannot become negative), always assuming that
no new financial transactions have been done between t0 and tm .
If the banks FLE is positive in tm , we assume that it can be placed
on the current risk-neutral forward interest rate curve (fm ) and thus
the income from the surplus funds equates to FLEm fm .
If, however, the FLE is negative in tm , we assume that the bank
has to pay a liquidity premium (m ) on top of fm (see the section on
the structural liquidity premium on page 226) and the expense for
the lacking funds equates to FLEm ( fm + m ).
If we now apply a funding scenario in which we assume that
the funding spread has widened to m + m (leaving the forward
interest rate unchanged), the income from the surplus funds (where
FLE > 0) is unchanged and the new funding (for FLE < 0) equates
to FLEm ( fm + m + m ).
The difference is given by
m = FLEm ( fm + m + m ) FLEm ( fm + m )
= FLEm m
(or 0 in time buckets where the bank is overfunded). It can be inter-

preted as the additional cost of funding if the liquidity premium
rises in a scenario.
As the m occur in different time buckets, they should not be
summed directly but, as before, appropriately discounted with the
forward curve. If we ignore this small discounting effect, the result
is independent from the forward curve and depends only on the
changed premium.
If we consider scenarios 1 , 2 , . . . , M , where every m shifts the
funding premium by 1bp (1bp = 0.01%) in tm , we can interpret the
result FLEm 1bp as the sensitivity of the liquidity-induced value
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LIQUIDITY MODELLING

Table 3.1 VLaR example calculation for a given FLE with the historic yield curve as of January 1, 2006
Funding (%) Stressed (%) Costs

Forward Position
Date Years f (%) ( ) f + f ++ FLE f + f ++
01/01/06 now
01/01/07 1 3.74 0.08 3.82 0.11 3.93 2,230,000 85,290 87,743 2.453
01/01/08 2 4.04 0.10 4.14 0.14 4.28 1,740,000 70,222 70,222 0
01/01/09 3 4.31 0.12 4.43 0.17 4.60 2,243,000 96,572 96,572 0
01/01/10 4 4.53 0.14 4.67 0.20 4.87 1,833,000 85,545 89,211 3.666
01/01/11 5 4.72 0.16 4.88 0.23 5.11 539,000 26,305 27,545 1.240
01/01/12 6 4.90 0.18 5.08 0.26 5.34 1,741,000 88,371 92,898 4.527
01/01/13 7 5.04 0.20 5.24 0.29 5.53 991,000 49,955 49,955 0
01/01/14 8 5.17 0.22 5.39 0.32 5.71 788,000 40,706 40,706 0
01/01/15 9 5.29 0.24 5.53 0.35 5.88 354,000 19,593 20,832 1.239
01/01/16 10 5.40 0.26 5.66 0.38 6.04 1,077,000 60,978 65,071 4.093
VLaR 17.217
All nominals are in (thousands).

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Table 3.2 VLaR sensitivities as in Table 3.1 but with 1bp change per key interest rate
Funding (%) Stressed (%) Costs

Forward Position
Date Years f (%) ( ) f + +s f ++ FLE f + f ++ VLaR
01/01/06 Now
01/01/07 1 3.74 0.08 3.82 0.01 0.09 3.83 2.230.000 85.290 85.513 223 215
01/01/08 2 4.04 0.10 4.14 0.01 0.11 4.15 1.740.000 71.962 71.962 0 0
01/01/09 3 4.31 0.12 4.43 0.01 0.13 4.44 2.243.000 99.263 99.263 0 0
01/01/10 4 4.53 0.14 4.67 0.01 0.15 4.68 1.833.000 85.545 85.728 183 154
01/01/11 5 4.72 0.16 4.88 0.01 0.17 4.89 539.000 26.305 26.359 54 43
01/01/12 6 4.90 0.18 5.08 0.01 0.19 5.09 1.741.000 88.371 88.545 174 131
01/01/13 7 5.04 0.20 5.24 0.01 0.21 5.25 991.000 51.937 51.937 0 0
01/01/14 8 5.17 0.22 5.39 0.01 0.23 5.40 788.000 42.440 42.440 0 0
01/01/15 9 5.29 0.24 5.53 0.01 0.25 5.54 354.000 19.593 19.629 35 22
01/01/16 10 5.40 0.26 5.66 0.01 0.27 5.67 1.077.000 60.978 61.086 108 64
All nominals are in (thousands).

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LIQUIDITY MODELLING
relative to a change of 1bp per tm . This is similar to the measures

used to express the sensitivity of the banks interest rate exposure
relative to interest rate changes of 1bp, also known as price value
per basis point concepts pV01 or pVbp (see Table 3.2).
If we multiply the pV01 figures by the probability of their occur-
rence, we can approximate the value liquidity risk. By generating
many possible scenarios for the liquidity premium, we obtain an m-
dimensional distribution of profits/losses; using the usual statistical
concept of the -quantile (q ), we can determine a value-liquidity-
at-risk, VLaR ,m which essentially states that with probability the
liquidity-induced value change (loss) in tm will not be worse than
VLaR ,m .6 If for every scenario the results are compounded with the
forward curve to t0 and then added, the result VLaR expresses the
liquidity-induced value change (loss) from t0 to maturity tM .
We have so far assumed that in time buckets where the bank is
overfunded it can place the money at the forward rate. In scenarios
with high counterparty risk, however, the bank may be unable to
find appropriate counterparties and thus accept unfavourable rates
when dealing with acceptable counterparties. We can reflect such
comparative losses by adding stressed rates for funds placed in the
above calculation.
CAPITAL AS A BUFFER FOR LIQUIDITY RISK?

Earlier (see page 15) we saw that capital is a cushion for value risks,
and naturally applies to liquidity-induced value risks.
We will explain why capital cannot be used as a buffer for
illiquidity risk as well.
Capital is in practice not kept under wraps until risks materi-
alise. Capital is not constantly held as a reserve on the banks nostro.7
It is normally (for performance reasons) invested in assets, but cum-
bersomely there is no unique way how this is executed. Some banks
symbolically attribute a certain percentage of capital to every indi-
vidual asset, which is a burdensome method because assets and
equity do not necessarily develop in synchronisation, and therefore
the bank might keep some residual capital which is not yet assigned
to assets. If the percentage is determined in such a way as to avoid
residuals, a fluctuation of the balance-sheet volume requires contin-
uously changing the percentage on the fly. Other banks assign the
capital to physical investments, which raises the same problem.8
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All in all, the term structure of capital cannot be determined unam-

biguously because knowledge of exactly which assets it is invested
is indefinite. Capital is somehow agglutinated to the cashflows of
the banks assets. If we used capital as a buffer against the risk of
becoming illiquid, we are exposed to double counting the cash side
of capital because we would need to extract from every cashflow the
fraction of assigned capital, which is cumbersome if not impossible.
From the perspective of value risks, the lack of term structure is
not a problem; it is even regarded as an advantage because value
and risk are treated as if they have no term structure either. This
is, however, not fully correct: some risks may materialise at short
notice (eg, operational risks like fraud or incorrect payments) and
might need to be covered immediately by converting capital into
cash, which is not so straightforward if the capital has been invested
in long-term assets. In such a case the unspoken assumption has been
made that funding the loss is always possible. On the other hand,
the credit risk of, for example, long-term loans would require that
the capital currently available will still be available in, say, 20 years.
If we return to the liquidity risk point of view, we need to cover
a potential future underfunding when it materialises, which princi-
pally means at any future point in time. This also disqualifies capital
as a buffer against illiquidity risks.
Finally, we need to understand that a future underfunding can
occur without any attributed losses; a simple one day delay between
large outflows and large inflows can create a material shortage. If
the underfunding is the result of a loss, we need of course to cover
this with capital, but this can be done, eg, in credit or market risk,
independently of illiquidity risk, unless the loss is so paramount that
it creates a funding problem.9
CONCLUSIONS
Illiquidity risk is the danger of the bank not being able to fulfil all
contractually required payments, whereas insolvency risk is the peril
that the value risks of the bank outweigh its capital. Although both
risks are closely interwoven, they are not the same. We cannot use the
insolvency approach to solve the problem of illiquidity risk. There-
fore, we need to work out a theory of illiquidity risk in the following
chapters.
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LIQUIDITY MODELLING
The liquidity-induced value risk is more a combination of illiquid-

ity risk (when funding rates rise) and counterparty risk (when the
rates of the banks investments decrease due to the inability to find
appropriate counterparties). It can be integrated into the existing
concepts of value risks, as we have outlined it for VLaR.
Capital can be used as a buffer for market and credit risk, includ-
ing liquidity-induced value risks, but not for illiquidity risk. Capital
lacks a term structure and can thus not be held against liquidity
risks, which have a distinct term structure. As a result, for illiquidity
risk we shall need a substitute for capital, which we will formulate
in Chapter 7.
Now that we have defined the different liquidity risks and the
counterbalancing capacity, we need to put some flesh on the bone
and create concepts that allow us to model the banks illiquidity
risk in a quantitative way. Although we can convey the exposure
to illiquidity and the CBC with future cashflows, uncertainties can
only be modelled at the balance-sheet level. Thus, we shall describe
scenarios which will simulate the generation of cashflows from exist-
ing transactions and (more complicated but also more realistic) the
generation of new transactions and its cashflows.
1 In particular, in Chapter 8 we look at the complications that arise from multiple nostros with
central banks and correspondent banks, different countries and time zones.
2 A security can also be used as collateral for a security borrowing transaction, which shifts the
problem to the liquification of the borrowed security.
3 If the market conditions or the individual circumstances of the bonds price decay change, it
may nevertheless recover from illiquidity.
4 The total amount of central bank funds equals the sum of credits on all nostro accounts that
banks have with the central bank.
5 Assuming we have started today (t0 ) with a balanced nostro.
6 However, we cannot try the following approach: if we try to simulate the LVaR by repeatedly
generating stochastic interest rate curves and calculate the corresponding VLaR numbers,
we get a distribution for which we could determine a quantile. This approach would, however,
mix up things: the FLE is not equal to the interest rate position of the bank (because non-
liquidity-bearing interest rate instruments are not included) and a change of the underlying
yield curve thus possibly does not influence expenses and costs correctly.
7 We could declare a part of the capital as a cash reserve which is held at the nostro. Every time
the nostro balance falls below that number, we assume that (a part of) the reserve has been
used. In fact, at every day end the residual nostro balance will be invested for performance
reasons. In practice, an excess nostro balance is rather a result of the operational inability to
square the nostro rather than a wilfully held reserve.
8 Some banks invest their complete capital in a separate capital portfolio, normally of high
quality bonds. In such a case the term structure of the bonds determines uniquely a term
structure of the capital.
9 For value-risk-type liquidity risk it is possible to use capital as a buffer; the problem is to
discern liquidity risks that materialise, eg, in losses from normal market risks.
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Illiquidity Risk:
The Foundations of Modelling
In this chapter we describe an approach to measuring illiquidity.

After fixing some technical notation we shall describe the banks
vulnerability to illiquidity in a cashflow model: the forward liquidity
exposure (FLE). The banks ability to counterbalance a detrimental
FLE is then modelled as the counterbalancing capacity (the substi-
tute for capital if compared to value risks). We initially reduce the
complexity of the problem by simply ignoring all uncertainties. To
account for the ambiguity of the reality we will in Chapter 5 describe
step by step the modelling of more complex uncertainties and cat-
egorise them according to their different sources. The uncertainties
materialise in cashflows that either change according to changing
generation rules or stem from changing or new transactions.
DESCRIBING THE BANKS BALANCE SHEET

Before we model uncertainty we need be able to describe the mech-
anics of a banks balance sheet and therefore introduce the necessary
technical concepts as briefly as possible. We further fix some notation
around uncertainty, risk and scenarios in order to have them at hand
when we come to develop our approach to illiquidity risk.
Financial transactions, payments and nostro accounts

The bank interacts with the outside world through financial trans-
actions (or covenants). These transactions ultimately result in the
exchanging of assets. We shall focus for the time being on the most
relevant asset transactions: payments that transfer credits between
accounts.
Later we will use the expression transactions to describe agree-
ments between the bank and other parties which will or can result
in payments.
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LIQUIDITY MODELLING
In order to describe the bank as a whole we shall look at the

extended balance sheet comprised by the comprehensive list of
transactions the bank has entered into (some of these transactions
might only appear off rather than on the balance sheet).
For simplicity we will ignore for now the fact that the bank can
have a variety of nostro accounts with other banks and possibly in
different currencies.
We will instead focus on the nostro account the bank has with its
home central bank.
We are particularly interested in external payments between the
bank and an external party. Both parties need a nostro account1 with
a third bank, the payment agent. The nostro of the payer is debited,
while the nostro of the receiver is credited in return.
For simplicity we will ignore internal payments between entities
of the bank or for a client for the time being.2
There is a strong asymmetry between outgoing payments, which
are (principally) under control of the bank, and incoming payments,
which cannot be enforced by the bank as they are controlled by the
paying counterparty.
Cashflows
A cashflow is a forecast of a future payment that may or may
not happen. Payments need to be very specific, including exact
instructions how to pay, whereas a cashflow represents the idea of
a payment and can be generated when, for example, the payment
terms are not already fully known.
Every payment is engendered by a financial transaction that has
been completed before the payment. If we want to forecast today
the payments on a specific day in the future, we need to consider
the existing transactions (which have already been concluded) as
well as as yet non-existent, hypothetical transactions which may be
concluded by the bank before the payment.
For simplicity we will ignore for now cashflows which stem from
hypothetical transactions.
In the covenant which describes the underlying transactions, the
resulting payments can be as follows.
Unequivocal (1 million Euro on January 1st): this is the
simplest case; we have to generate the cashflows according
to the contractual schedule. For simplicity we will ignore for
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ILLIQUIDITY RISK: THE FOUNDATIONS OF MODELLING
now the fact that counterparties might be unable or unwilling

to perform the payments as agreed and thus breach covenants.
Dependent on future values of market variables (three-
months Libor). For simplicity we shall use the risk-neutral
market variables (the forward rates).
Dependent on decisions of the counterparty or the bank to
execute options callable within two business days.
The latter (options), in particular, makes it cumbersome to develop

cashflows from transactions. We will return to this when we talk
about scenarios.
Uncertainty and risk

The expression uncertainty has different meanings: we might, for
example, be uncertain about facts because we do not know them,
although they can be known in principle (eg, cashflows of a portfolio
that have been calculated but not submitted).3
In the context of liquidity risk we mainly have to deal with facts
we do not know because they will only materialise in the future and
thus cannot be known in principle now (eg, tomorrows exchange
rate). If we estimate a single expected or most likely result, we
suppress other possible (although less probable but eventually very
material) outcomes. Therefore, we shall simulate different possible
future results (scenarios).
Uncertainties that can lead to detrimental results for the bank are
called risks.
In our forecasting method we have to deal with two different
classes of uncertainty:
1. existing transactions have scheduled cashflows which de-

pend, for example, on the development of market parame-
ters, counterparty decisions or its willingness to perform the
covenant;
2. hypothetical transactions depend on the banks wish and
ability to execute the transactions and also on a potential
counterpartys willingness to agree.
If we try to convert these uncertainties into risk we see that there are
different types of illiquidity risk in our forecasts.
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LIQUIDITY MODELLING
Risks stemming from uncertainty about the initial value. If the

starting nostro at t0 is incorrect, all following nostros will also be
incorrect; although a central bank nostro is correct by design, a
received payment might have been paid by the sender in error and
thus will be recalled the next day, which will either require a back-
ward correction of the starting nostro or the generation of a hypo-
thetical correction transaction. An uncertainty in the initial value
leads to a risk only if it materialises in a detrimental initial value.
Risks stemming from uncertainty about the forecasting process.

Our prediction can be wrong for a variety of reasons: we might
have missed or misinterpreted or double counted financial trans-
actions; perhaps their cashflows have been wrongly generated, etc.
The uncertainty is related to the forecasting process itself.
Risks stemming from uncertainty about the exposure. If we were

able to make exact forecasts, we would have no uncertainty about the
banks future liquidity situation, but this does not necessarily mean
that there is no liquidity risk. For a future date, assume we know
with certainty a banks nostro. If the nostro is massively negative,
there is illiquidity risk due to the uncertainty about the banks ability
to counterbalance the deficit.
Uncertainty is often used as a synonym for risk, but these terms
are not identical.
Uncertainties can lead to both detrimental and beneficial sit-
uations. If the uncertainty about the future credit on a nostro
realises detrimentally, it will originate another uncertainty: the
doubt whether the bank will be able to meet its contractual payment
obligations, which we will consider as illiquidity risk.
Forecasts and scenarios

Its hard to make predictions: especially about the future.4
We want to predict the upcoming payments stemming from

the banks existing transactions (which we should know). In addi-
tion, we have to speculate on non-existent hypothetical transactions
and their future payments. From todays point of view the future
can have different possible outcomes, which makes a single fore-
cast unlikely to match future reality. We therefore use scenarios to
simulate diverse predictions.
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Before we examine scenarios, we model the generation of cash-

flows and the spawning of hypothetical transactions.
Cashflows of existing transactions can be scheduled uncondition-
ally (eg, the nominal of a money market deposit which will be paid
back at maturity), depend unequivocally on market variables (eg, a
Libor-related coupon payment) or even depend on decisions to exer-
cise options (which themselves may or may not depend on market
variables).
The cashflow-generating function of a transaction can be an
unequivocal function of one variable5 or a more complex func-
tion of several variables; in both cases the result is a vector of
cashflows. Transaction-generating procedures also use variables,
but their product is a (set of) hypothetical transaction(s) that
require(s) cashflow-generating functions to finally produce cash-
flows.
In risk management the expression scenario is often used in the
sense of an alternate possibility which relates to a certain base case
that is more-or-less assumption free; for example, in market risk it is
assumed that the value is given by applying risk-neutral forward
rates to the elements of a portfolio. In additional scenarios the
potential deviation from that benchmark is then simulated.
In liquidity risk, however, it is problematic to determine a base
case forecast as, in order to generate future cashflows we need
to know the banks existing transactions and decide which types
of potential new transactions we want to model. From these, it
becomes clear which functions and procedures are needed to gener-
ate the cashflows of these transactions. Finally, we have to deter-
mine or assume the value of the obligatory input variables for
the above required functions and procedures. Consequently, even
the simplest forecast entails a variety of assumptions and thus
can be seen as a scenario rather than the base case liquid-
ity forecast. If we neglect all cashflows stemming from hypothet-
ical transactions or from exercised options, we still need to make
assumptions about market variables that will prevail in the future.
Even if we abandon these variable cashflows and concentrate on
transactions with contractually scheduled cashflows, we need to
assume that the payments will flow as scheduled, which contra-
dicts, for example, what happened in the autumn 2008 banking
crisis.
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LIQUIDITY MODELLING
The underlying matter of the problem is that there are no known

future cashflows, but only predictions of payments which may or
may not happen.
Notwithstanding the above, some cashflows are more likely than
others. To account for this, we will generate scenarios. A scenario
describes a set of assumptions which are used as input variables
for the scenario functions and procedures. The results of the cor-
responding calculations are cashflows that are conditional on the
scenario assumptions.
The usability of a scenario does not greatly depend on the likeli-
ness of the assumptions: if we want to model business as usual,
we shall of course need to estimate the most probable extrapolation
of prevailing business processes and cashflow generation; if, how-
ever, we want to model a potential crisis, we are much more free
to make assumptions about detrimental developments. If scenarios
are properly set up, they preclude the user from making inconsis-
tent assumptions that will lead to unreliable results. Quite often, the
estimation of the scenario variables can be painstaking but yields
information on which assumptions have to be valid in order to gen-
erate a certain result. In particular, business as usual or going
concern scenarios require highly complex assumptions, whereas
worst case scenarios (no inflows/full outflows) are technically
much simpler to reproduce (another difference between market and
credit risk).
Scenarios can model passive or active future behaviour by the
bank. An exposure scenario displays only results which might hap-
pen to the bank, whereas a strategy scenario models the banks
potential management of exposures (eg, balancing cash shortages
and excessive surpluses). Strategies are thus much more realistic
than exposures, which should nonetheless not lead to the premature
judgment that realistic scenarios are better than unrealistic ones.
If we model first the banks exposure and (if the result is
detrimental), additionally, the banks strategy to counterbalance this
exposure, the resulting strategy will indisputably give a more real-
istic picture of what can happen than the exposure alone. On the
other hand, the realistic scenario might be too realistic, which is
explained by the following example.
Today the exposure indicates a future cash deficit and the strategy
scenario will simulate repo transactions of the bank that generate just
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enough cash to counterbalance the deficit in due course. Tomorrow

the exposure shows a larger deficit, which is counterbalanced by
appropriately more repo transactions. The results will be, in both
cases, small surpluses. On the third day, however, the deficit has
become greater than the amount of liquidity the bank is able to cre-
ate by repoing assets, meaning that the strategy cannot be executed
successfully. The result of the strategy on days 1 and 2 did not show
how likely its execution was on the third day.
A more appropriate approach than modelling realistic results as
above could have been the following: first, model the exposure; then
model in a separate scenario the banks maximal counterbalancing
capacity. Both scenarios are unrealistic if considered independently,
because the bank would not leave the exposure unmanaged; nor
would it create as much liquidity as possible if only a fraction
was sufficient to counterbalance the deficit. Adding the exposure
and the strategy answers the most important question: does the
counterbalancing capacity far exceed the exposure deficit or is there
hardly any difference?
MEASURING ILLIQUIDITY RISK

We now model the measurement of illiquidity risk with the banks
forecasted cash balance at its nostro. To keep things simple, uncer-
tainty is initially ignored, but as the model is further developed, it
will be integrated step by step. The substitute for capital, the coun-
terbalancing capacity is introduced, but because it is too early to
model its dynamic character properly, we will need to return to the
CBC several times to refine the concept.
The forward liquidity exposure

We measure illiquidity risk by forecasting the banks FLE, which pre-
dicts how forthcoming payments (stemming from the banks finan-
cial transactions) will change todays nostro balance in the future.
The nostro of a future day will obviously be decreased by the out-
going payments and increased by the incoming payments on that
day. We will reflect this by building the FLE with cashflows which
are forecasts of payments.
In fact we cannot take all forecasted payments of the underlying
transactions, but need to distinguish between external payments
(that have a direct effect on the nostro accounts) and internal
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LIQUIDITY MODELLING
Figure 4.1 Example of the forward liquidity exposure
20
10
0
10
20
30
CF in
40 CF out
CF net
50 FLE
60
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
payments (which debit or credit only internal (loro) accounts). These

internal payments can of course have a secondary effect, as they
might lead to subsequent external payments (which we will ignore
for the moment).
Todays starting balance of the banks nostro with the central bank
is equal to its final balance as of the end of yesterday. If we add all
the cashflows that are scheduled for today, we have the forecasted
balance as of the end of today, which we will call the FLE of today.
Assume the FLE could correctly forecast reality. As the central
bank does not pay interest, a (larger) positive balance would incur
substantial interest losses for the bank. A negative balance, however,
would signify illiquidity. In both cases (especially in the latter) the
bank would try to take all necessary action to achieve a slightly
positive balance at the end of the day.
For now, we assume that positive or negative balances are simply
taken to the next day and appear as the starting balance of tomorrow
(and, in general, for the next day). We can interpret this technically:
the bank will deposit the surplus (or fund the deficit) for exactly
one day so that the funds are returned (respectively, have to be paid
back) the next morning and thus constitute the starting balance.
Starting with the FLE of today, we add all cashflows that are
scheduled for tomorrow and get the FLE of tomorrow.
If we subsequently apply this time-cumulation process for the
following days we get the banks forward liquidity exposures
FLE1 , FLE2 , FLE3 , . . . , FLEN for the future days t1 , t2 , t3 , . . . , tN .
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Table 4.1 Example of the forward liquidity exposure shown in Figure 4.1
Time t Cashflow Cashflow Cashflow

(days) in out net FLE
t0 3.2
t1 3.8 10.2 6.4 3.2
t2 3.9 14.6 10.7 13.9
t3 5.1 8.2 3.1 17.0
t4 3.6 9.4 5.8 22.8
t5 6.5 13.6 7.1 29.9
t6 13.7 10.0 3.7 26.2
t7 6.2 1.3 4.9 21.3
t8 12.5 5.5 7.0 14.3
t9 7.5 7.3 0.2 14.1
t10 10.3 14.2 3.9 18.0
t11 11.0 12.7 1.7 19.7
t12 11.8 13.0 1.2 20.9
t13 11.3 3.3 8.0 12.9
t14 1.1 4.1 3.0 15.9
t15 0.2 7.9 7.7 23.6
t16 5.9 5.4 0.5 23.1
t17 12.1 1.1 11.0 12.1
t18 7.1 11.2 4.1 16.2
t19 3.8 9.2 5.4 21.6
t20 14.5 11.1 3.4 18.2
t21 3.1 5.9 2.8 21.0
t22 1.9 8.9 7.0 28.0
t23 3.0 14.6 11.6 39.6
t24 2.7 5.0 2.3 41.9
t25 2.1 5.3 3.2 45.1
t26 2.7 2.4 0.3 44.8
t27 6.3 11.7 5.4 50.2
t28 11.1 4.4 6.7 43.5
t29 11.9 3.8 8.1 35.4
t30 4.3 3.1 1.2 34.2
All nominals are in (billions).
Note that we can interpret the sequence
FLE(t0 ), FLE(t1 ), FLE(t2 ), . . . , FLE(tN )
not as a realistic forecast of the banks future nostro balance, but only
as the result of a thought experiment (see Table 4.1).
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LIQUIDITY MODELLING
Interest rate effects in the FLE

Although the interest cashflows of transactions are included in the
forward liquidity exposure, interest rate effects that arise as a con-
sequence of the FLE itself are traditionally neglected: if, within
a time bucket, the FLE is negative (positive), the lack (surplus)
of liquidity needs to be acquired (placed) and thus interest will
be paid (received) by the bank. Depending on the time horizon
and interest rate level, this effect can be material and should be
considered.
The FLE in different currencies

If the bank has cashflows in different currencies, a separate FLE
is needed for each currency. Usually the FLE is established in the
banks home currency (normally the currency of the country in
which the bank is located) by converting the foreign currency cash-
flows into home currency cashflows. If this is done simply by mul-
tiplying the currency cashflows by the forward foreign exchange
(FX) rates, the implicit assumption is made that the respective cur-
rencies can always be exchanged at the prevailing rates. The cri-
sis of 2008, on the other hand, showed that the FX markets can be
disrupted, which can lead to the consequence that the bank ends
up illiquid in one currency although it has sufficient funds in
another currency which, however, cannot be exchanged in reality.
To deal with such effects, the applicable FX rates should be biased.
If, for example, the exchange rate between currencies A and B is
FXA/B = 1.5, (that is 1.0A = 1.5B) the outflows in the home currency
A should be converted with a risk-adjusted rate (eg, 1.4 instead
of 1.5) and the inflows similarly should be converted with a higher
rate (eg, 1.6 instead of 1.5). Thus, the bank has accounted for the
risk that it will possibly have to pay more in A to redeem its liabil-
ities in B and alternatively will get a bit less in A from its inflows
in B.
More generally, offsetting one cashflow with another is a specific
illiquidity-risk-mitigation transaction; it should be absolutely clear
that this can be realised. If the bank produces the FLE in a consoli-
dated view for its diverse legal entities, it may be necessary to discern
internal transactions between different entities because regulations
might impede the free flow of funds.
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The first illiquidity inequality

The role of the FLE is straightforward: if FLEt is greater than or equal
to zero for all future days t from now to the end of the time horizon tH
FLEt 0 for all t [t0 , tH ]
then the bank will not face illiquidity risk within the chosen time
interval in our model.
It is unclear what happens if the above inequality does not hold.
We cannot reverse the conclusion and interpret and deduce from a
negative FLE that the bank will become illiquid because the bank
could still be able to counterbalance the forecasted deficit.
We will call this ability of the bank to carry out measures which
will potentially change things for the better a strategy. The FLE
describes (as its name suggests) only the (passive) exposure to things
that could happen to the bank.
Strategies can result in counterbalancing forecasted deficits into
surpluses but can also be more complex.
The bank will, for example, also try to avoid nostro balances that
are higher than the required minimum reserve, as they lead to com-
parative interest losses, and try to deposit the surplus funds where
they earn interest.
Potential strategies are ignored when calculating the above in-
equality.
The counterbalancing capacity

Compensation of risk exposures in general
The result of the measurement of risk is almost meaningless if we
cannot relate it to the banks potential compensation ability. Market
and credit risk are expressed as potential losses which are compared
with the banks capital. As briefly outlined above, the capital can be
seen as a cushion, which should be larger than the potential losses
to avoid a distress in the balance sheet. The general idea of this
concept is that a potential loss can be offset against the capital, which
is regarded here as something similar to an accumulated historic
profit. This offsetting process is, however, a little bit unclear, as the
losses will happen at a definite point in time, whereas the capital is
somehow imagined without a term structure, or is available at any
moment within the considered risk management time horizon.6
From an illiquidity risk perspective, however, we cannot assume
that a lack of cash at a given instant can simply be offset by capital:
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LIQUIDITY MODELLING
capital is normally not held as cash at the central bank or the payment
agents, but, for profitability, is invested in assets. All the cashflows
of these assets should already be considered in the FLE, and thus
cannot be used a second time.
It is therefore obvious that capital does not play such an important
role in liquidity risk as it does in market, credit and operational risk7
and needs to be substituted.
Counterbalancing of liquidity risk

Let us start from scratch for illiquidity risk.
Assume we have forecasted our future liquidity FLE(t) over time
on the basis of the set of existing transactions and assumptions spec-
ified in a certain scenario with the result that FLE(t) is negative at
one or more points in the future.
Let us concentrate on the first point in time tN with a negative
forecast: FLE(tN ) < 0.
If the bank did not enter into any as yet unknown transactions
and our forecast was fully appropriate, the bank would be illiquid
in tN .
This leads to the following question. Can the bank successfully
carry out a strategy to generate net cashflows
CFO O O O
1 , CF2 , . . . , CFN 1 , CFN
until tN , which are sufficient to counterbalance the forecasted cash

deficit FLE(tN )
1 + CF2 + + CFN 1 + CFN + FLE(tN ) 0?

CFO O O O
To answer this question, we first examine potential transactions

which diminish the deficit. The bank can generate a cash inflow
before tN through contracting one of the following:
(i) a new liability, which starts before or at tN and matures after tN ;
(ii) an asset sale, against cash which is effective before or at tN and
is not reversed before tN .
The first alternative increases the balance sheet, whereas the second
alternative decreases it (a third alternative does not exist8 ).
Both enlargement and reduction of the balance sheet can be con-
tractually guaranteed, eg, if the bank is long the contractual option
to expand the maturity of a bond it has issued or, alternatively, if
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it has the contractually guaranteed option to sell an asset. In both

cases the premiums for these options should be substantial, as the
potential counterparty is entering either into credit risk (liability) or
into price risk (sale of asset).
If the bank has not purchased such enforceable contractual
options, the alternatives are not void but are more insecure: the
bank cannot enforce them and is dependent on the potential depos-
itors will and ability to close the transaction as preferred. Nor-
mally, acquiring funds as well as selling assets is not contractually
guaranteed but uncertain in principle.
We note that there can be subtle uncertainties even in contrac-
tual options. The banks drawing under a credit facility it has taken
or the selling of an asset under a put option can be rejected if the
counterparty is unable or unwilling to perform the corresponding
transactions. Although the bank could try to enforce the transaction,
it will not succeed if the counterparty is unable to execute the trans-
action or it might only be able to enforce the transaction with a time
delay. On the other hand, the option to expand the maturity of an
issued bond cannot be breached by the counterparty as the bank
would simply exercise the option and not pay back the money at the
early redemption date. The asymmetry stems from our supposition
that the bank is unable to breach contracts whereas counterparties
could do so.
Additional considerations
Because illiquidity risk is not a value risk, it cannot be offset by capi-
tal. If we measure it, we have to consider that both the exposure and
the counterbalancing capacity are uncertain, whereas for other risk
types at least the offsetting factor (capital) is thought to be known.
Moreover, in liquidity risk both the exposure and the counterbalanc-
ing capacity have a term structure, whereas for other risk types the
exposure and the counterbalancing capacity are time-independent
values.
We try to order the different alternatives of the bank to cre-
ate additional liquidity by their enforceability and their likeliness,
respectively.
At the top we have enforceable transactions like
irrevocable credit facilities taken,
contractual put options on assets purchased by the bank,9
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LIQUIDITY MODELLING
the banks own issues with expandable maturities.
Unenforceable liabilities can have different credit risks in the view

of the counterparty.
Liabilities replaced by existing counterparties are normally

more likely than those from new counterparties: although the
credit risk of the bank should in principle be the same in the
view of existing and new counterparties, the new counterpar-
ties might need to establish credit limits for the bank before
they can deposit money.
Collateralised borrowing (repos) exposes the counterparty to
less credit risk than uncollateralised borrowing.
Unenforceable asset reductions bear price and credit risks for the
counterparty:
securities are in general more fungible than, for example, loans,

and therefore come with less price risk for the counterparty,
which is not always true in particular cases;
final sales transactions bear less credit risk for the counterparty
than temporary sales (sell-and-buy-back) transactions, which
contain conditional price risks for the counterparty in case the
bank is unable to buy back the assets.
Strictly speaking, we will have to simulate all these sources of liq-

uidity. In practice, however, most banks concentrate on modelling
the part of the CBC that stems from contractual options (irrevoca-
ble credit facilities, expandable bonds and put options if there are
any) and securities they consider to be liquid. Up until the time of
writing in summer 2011, the view on securities excluded equities (as
they are, in a market risk perspective, much more risky than bonds)
but since even the credit quality of the US is in doubt, equities are
increasingly considered as possible sources of liquidity.
Repo and sales transactions of securities. The bank can generate

liquidity from a security it owns in two ways:
1. it can use it as collateral for a deposit (a repo transaction);

2. it can sell it (finally or in a combined sale-and-buy-back
transaction).
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In this context, several security transactions can be of interest (with

start date tS and maturity date tM ).
Final (or irrevocable) sale: on tS the security is exchanged
against cash; the bank receives the cash and simultaneously
its ownership of the security ceases (there is no maturity date
tM ).
Temporary sale (sell-and-buy-back): a sale on tS is combined
with a subsequent re-purchase on tM ; the banks ownership
and possession ceases at tS when it receives the cash and both
are reinstalled when the bank pays back the cash at tM .
Temporary purchase (buy-and-sell-back): a transaction that
is a sell and buy back from the counterpartys point of view: a
purchase on tS is combined with a subsequent re-sale on tM ; the
banks ownership and possession starts at tS when it receives
the security and both cease again when the bank gets back the
cash at tM .
Repo:10 the bank receives a deposit on tS until tM ; the security
is transferred to the giver of the deposit as collateral on tS ;
the ownership is still with the bank, but the possession of the
security ceases at tS and is reinstalled at tM when the loan is
paid back by the bank; as the notation of repo and reverse repo
is not consistently used, we will use to repo in the security
or to repo out the security if clarification is needed.
Reverse repo: a transaction which is just a repo if seen from the
counterpartys point of view; the bank places a deposit with
the counterparty and receives in exchange the security.
So-called central bank repos: the bank receives a loan from the
central bank which is collateralised by a (part of a) portfolio of
securities it has deposited with the central bank. In the case of
the European Central Bank (ECB), for example it impossible to
identify the single securities (or parts) which serve as collateral.
The bank borrows or lends a security: on tS the possession (not
ownership) of the security changes until tM ; this transaction
is not directly relevant for the CBC as it does not generate
significant cashflows, but it changes the banks possession of
this security and can thus indirectly increase or decrease the
CBC as more or fewer securities are available.
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LIQUIDITY MODELLING
Ownership and possession of a security. An important differen-

tiation between the above types of transactions is that in a repo
transaction the bank keeps the ownership of the repoed security but
loses possession, whereas in a sales transaction it loses both own-
ership and possession (if the sale is only temporary, it regains both
when the security is repurchased at the transactions maturity).
Obviously, it does not make any sense for a bank to sell or repo
a security which it does not possess in order to generate liquidity:
when the security shall be exchanged against cash, the bank will be
unable to deliver the security which it does not possess; therefore, it
will not receive the desired cash (if it instead buys or gets the lacking
security through a reverse repo, it would just afford the cash which
should be gained by the transaction).
The bank could on the other hand try to repo a security it possesses
but does not own: it should, however, possess the security during
the full time span of the repo (the repo will terminate before the
banks possession terminates).
If the bank, however, tries to sell a security it possesses but does
not own, it will run into the problem that it has to buy back the
security before the redemption date (and in the meantime receives
the security through a reverse repo, eventually revolving).
The second illiquidity inequality

We start with the FLE as above but add the CBC to it.
If the FLEt plus the CBCt is greater than or equal to zero for all
future days t from now to the end of the time horizon tH
FLEt + CBCt 0 for all t [t0 , tH ]
the bank will not face illiquidity risk within the chosen time interval.
If, however, the CBCt cannot compensate a negative FLEt at least
on one day so that
FLEt + CBCt < 0 for one t [t0 , tH ]
the bank will be illiquid in our model.

We have sharpened the first inequality so that we can describe
illiquidity and not only liquidity, but we have not explained how
we will deal with all the uncertainties involved.
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CONCLUSION
In this chapter we have framed our subject: illiquidity risk. After
describing the basic set of tools we described illiquidity risk as the
banks potential problem of not having sufficient funds on its nos-
tro and formalised the relation between transactions, payments and
nostro accounts. We installed cashflows and cash inventories as fore-
casts for payments and nostros. The forward liquidity exposure is
introduced as a prognosis for the future nostro. The first critical illiq-
uidity condition describes the circumstances under which the bank
is not illiquid in our model: FLEt 0. In a second step we have intro-
duced the banks counterbalancing capacity as its ability to compen-
sate unfavourable liquidity situations. This enables us to introduce
the second critical illiquidity condition, which allows us to sharpen
the first inequality and describe when a bank is illiquid in our model:
FLEt + CBCt < 0.
At this stage the application of the inequalities requires that all rel-
evant future payments of the bank are unequivocally and correctly
anticipated by cashflows. This is, however, not realistic, because we
know that the forecasting process contains uncertainty. To be able
to apply the illiquidity conditions in practice we need to specify in
detail how the constituent parts of the FLE and CBC should be mod-
elled. Only once we have specified the conditions and assumptions
of our modelling will we be able to evaluate its results appropriately.
In order to do that we will examine the forecasting process and sep-
arate and classify its sources of uncertainty. Because this process is
very complex we will start with the simplest possible model and
assume that we only have to consider transactions that exist already
and that we can forecast their payments with cashflows that do not
bear any ambiguity. We then will improve this by introducing non-
deterministic cashflows and later hypothetical transactions that do
not yet exist.
1 A nostro (from the Italian ours) account is, from the banks perspective, an account it
holds with another bank; from the other banks perspective, the nostro account would be a
loro (or vostro, from the Italian yours) account.
2 An internal payment is a balance brought forward between an own account of the bank
and another own account (or a vostro account) the client has with the bank.
Internal payments (eg, paying out a mortgage to the customers account with the bank)
might result in external payments (the customer pays the money to the sellers account with
another bank). Crediting a loro account creates a payment option by which the bank is short.
See Chapter 8 for more details.
3 We also refer to the latter type of uncertainty in Chapter 8.
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LIQUIDITY MODELLING
4 Attributed to Robert Storm Petersen.

5 An example is the variable leg of an interest rate swap, eg, interest(tn ) = nominal Libor(tn )
time factor.
6 This makes perfect sense from an accounting perspective, which tries explicitly to reduce the
dynamic time element to fixed (yearly) accounting periods or omits it completely (mark to
market).
7 It is worthwhile considering whether operational risk should be split into two parts: one
which can be offset by capital and one where the immediate availability of cash is required.
On the other hand, if we could treat liquidity-induced value risk here, it would make sense
to hold capital against it and split liquidity risk similarly into a part which can be buffered by
capital and the remainder (the illiquidity risk).
8 The only remaining possibility would be that the balance sheet stays unchanged, which would
not have any liquidity effects at all. In an intra-day view, liquidity effects can occur without a
related alteration of the balance sheet: a customer can, for example, initiate a payment to the
bank to credit their loro (payment) account which is temporarily short. If the bank, however,
created an intra-day balance sheet, the short position would be reflected by a loan to the
customer which is reduced by the incoming payment.
9 The ability to enforce some transactions might be a bit unclear, eg, credit facilities which are
conditional on market changes, downgrades, etc.
10 The terminology used by practitioners is somehow confusing: repo is an abbreviation of
repurchase agreement, which would actually be the same as our sell-and-buy-back trans-
action. In practice, however, a repo means a secured loan (or deposit). In a repo the coupon of
a bond is due to the bank, which is still the owner, whereas in a sale-and-buy-back transaction
it belongs for this period to the temporary owner of the bond.
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Capturing Uncertainties
According to a quote attributed to Albert Einstein, a theory should

be as simple as possible, but not simpler.
At the moment we do not actually know how simple or sophis-
ticated the above described illiquidity conditions are, as we have
so far only symbolically set the FLE and CBC in mathematical rela-
tionships (such as adding and comparing given numbers) without
properly describing how we determine both FLE and CBC.
We will start with the simplest theory and only consider deter-
ministic cashflows of existing transactions; thus, the FLE can be
unequivocally determined.
If we compare the results with reality, we are likely to find differ-
ences between our forecasts and the actual results, which means that
either we have modelled the problem inadequately and thus need to
change our approach completely (hopefully not), or we have over-
simplified the problem and thus need to refine the modelling. If our
theory is adequate we will be able to decrease its deviation from
reality step by step and thus continually improve its results.
If the cashflows of transactions are univocally preassigned and
known, we call them deterministic cashflows; they bear no uncer-
tainty. We further distinguish between stationary uncertainty, where
we regard the set of transactions as time-invariant and dynamic
uncertainty, where we also regard transactions that do not yet
exist but will emerge in the future. Stationary uncertainty results
from variations of existing contracts scheduled cashflows which are
either due to fluctuations of market rates or stem from the exercise of
options within existing transactions.1 Dynamic uncertainty encom-
passes changes which are caused by unscheduled alterations of exist-
ing contracts (breach of contract, credit events) as well as changes
which are due to as yet non-existent transactions (new business).
As an opening we simulate the banks future nostro in the sim-
plest possible way and consider only stationary transactions with
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deterministic cashflows. In a technical sense the modelling of the sta-

tionary element is straightforward, as we simply ignore the fact that
the bank will enter into other transactions than those it has already
concluded. Although this approach is unrealistic (only a dead bank
will have no future business), we know at least what we have
omitted.
The deterministic assumption is a little more cumbersome from
the start: assume a transaction exists and is known but we cannot cal-
culate its cashflows (eg, savings deposit). If we rely only on determin-
istic cashflows, we can merely ignore these incalculable cashflows
that possibly give a completely skewed picture of the transaction.
If we try to repair this problem and substitute these cashflows
by expected or most likely cashflows, we have already left the
path of deterministic modelling and should consequently look at
cashflows that are variable (depend on future market parameters)
or contingent (depend on future decisions to exercise optionality
embedded in the transaction).
Next we relinquish the stationary restrictions and consider in add-
ition hypothetical transactions which do not yet exist. To describe
the rules of how the hypothetical transactions can be generated by
the bank or by a counterparty or by an agreement between bank
and counterparty, we need to examine the role of optionality. We
consider classic financial options but also liquidity options, which
are derived from the concept of real options, and analyse breach-of-
contract options.
Finally, we model the generation of new transactions as a con-
sequence of exercising (and sometimes refusing the exercise) of the
different option types.
STATIONARY MODELLING
Let us start in a world without uncertainty and refrain from mod-

elling any as yet non-existent future business. Therefore, we will
assume for now that the banks balance sheet is stationary and
thus is only constituted by transactions into which the bank has
already entered. Moreover, these transactions do not bear any
optionality which enables them to create any new transactions
themselves.2
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Deterministic cashflows
If one of the above transactions does not bear any embedded
variability or optionality and thus will only generate payments
which are today unequivocally determined by the underlying trans-
action, we call the cashflows forecasting these payments determin-
istic.
For the sake of our model we assume for the time being that both
the counterparty and the bank are financially and operationally able
and willing to execute all cashflows, as they have been contractu-
ally agreed. We also presuppose that all information that is relevant
for the generation of cashflows is available to us and that we are
technically able to generate them when we need them (today).
We do not claim that deterministic cashflows exist in reality; it is
only an abstract concept which allows us to start with a clean mod-
elisation without uncertainty. Strictly speaking, we cannot know
the future and thus we cannot make deterministic forward-looking
statements. In practice, we might nevertheless regard, for example, a
deposit the bank has to pay back as a (quasi-)deterministic cashflow
because we know that the bank will do everything that is possible
to fulfil contractual obligations. We can say that in this model we
regard these cashflows as deterministic, although we know that in
reality there is always some remaining uncertainty. In this sense we
can declare that, in a certain model, reimbursements of loans are
regarded as deterministic, whereas in another model we might
want to explicitly correct them with a credit risk adjustment.
The biggest practical problem with deterministic cashflows arises
if we start to model the FLE with them: either we omit them from the
calculation, which would possibly distort the FLE forecast substan-
tially, or we substitute them by expected cashflows, which makes it
obvious that they are not deterministic. When modelling a scenario,
we will simply regard those cashflows which are not modelled any
further in this scenario as deterministic.
Obviously, inflows and outflows have different grades of deter-
minism: a deterministic inflow needs to be initiated by the counter-
party; it can fail if the counterparty is either unable or not willing to
perform its payment obligations, whereas a deterministic outflow
is less uncertain by design because it is in the banks discretion to
execute it as it is scheduled.3
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Non-deterministic cashflows
We still consider only existing transactions but we now acknowledge
that some cashflows depend on the future realisations of market vari-
ables or on optionality and thus release the above restrictions extend-
ing the set of admissible cashflows by integrating non-deterministic
cashflows.
Seen from today, a future cashflow which is non-deterministic
can have more than one value; but of course only one value is pos-
sible when the cashflow occurs. We will make use of scenarios to
reflect this indecisiveness regarding the future.4 Having different
scenarios will allow some cashflows to vary by amount or timing or
both, whereas other cashflows may not change in some or even all
scenarios. We will take into consideration not only cashflows that
depend on market variables but also transactions and their cash-
flows which stem from the counterpartys exercise of optionality in
existing transactions.
To start by integrating two uncertainties into the modelling we
add:
1. variable cashflows which are influenced by the fluctuation of
market variables (eg, index linked payments);
2. contingent cashflows which are generated by a counterpartys
exercise of options which are a feature of existing transactions
(eg, a clients drawing under a given credit facility).
These cashflows include elements of variability and optionality and
therefore play a very important role in market risk because they
generate the linear and non-linear market risk.
In illiquidity risk, however, their role is much smaller: they might
be important in a profit view but are normally far less material
for illiquidity risk, notwithstanding the fact that large losses can
potentially trigger consequential illiquidity risk.
Variable cashflows
Variable cashflows differ from deterministic cashflows in only one
aspect: some financial variables which determine the cashflow calcu-
lation are unknown today. Once these variables are known (what we
can expect), the variable cashflows are unequivocally determined.
The indeterminacy of these variables results in uncertainty about
the amount or (to a lesser degree) about the timing. For example, the
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unknown future reference rate of an interest payment of a floating

rate note or the maturity of a bond which depends on the sum of the
floating coupons paid so far.5
Variable cashflows can be forecasted but will ex post usually differ
from reality, like all other cashflows. We can, however, try to estimate
the forecasting error ex ante and thus assess the expected quality of
the forecasting process.
The uncertainty of a variable cashflow does not stem from option-
ality in the underlying transaction; the variable cashflow would be
completely determined if the future values of the constituting mar-
ket variables were known, whereas optionality is linked to the option
holders act of will to exercise it.
Example 5.1 (interest rate swap). The underlying reference rate r
(eg, Euribor) of the interest rate swap (IRS) is a well-defined function
in time r = r(t). Every floating interest payment P(tn ) of the IRS is the
value of a function f that depends on the reference rate P(t) = f (r(t))
and thus on time t. The payments will happen only on scheduled
days t1 , t2 , . . . , tN in the future (P(t) = 0 if t is not a scheduled day).
If, on a day tn , the reference rate has been fixed as r(tn ), it is
related to the time interval from tn to tn+m (with the payment nor-
mally at tn+m ). Then the argument of f and thus the payment is also
unequivocally determined: P(tn+m ) = f (r(tn )).
The forward rate and forecast-at-risk

In the section on the time value of payments (see page 13) we used
the forward interest rate curve to calculate the present value of a
cashflow without explaining in detail how we can derive it.
To simplify things, we assume that banks quote par rates as
prices for loans (respectively, deposits) to each other. The par rates
are quoted for key rate maturities which are not uniquely deter-
mined, say 1, 2, 3 and 6 months or 1, 2, . . . , 10, 15, 20, 30 years. It is
assumed that the interest is due at the end of the monthly periods and
at every end of year. If, for example, a three-year par rate is quoted
for the period from January 1, 2011, until December 31, 2013, inter-
est rate payments are assumed on December 31, 2011, December 31,
2012 and December 31, 2013. The problem with the par rates is that
they do not allow the exact calculation of internal rates of return
because we know, for example, the interest rates for the two-year
and the three-year par rates but not how the interest paid should be
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accumulated between years 2 and 3. Applying the so-called boot-

strapping algorithm, we can determine the forward rate (tn1 , tn )
which prevails between the key rate maturities tn1 and tn . The for-
ward rates are unequivocally determined by the par interest rates
(which are quoted in the interbank market) and thus describe the
interest rates for future periods (tn1 , tn ] which need to prevail in
order to avoid arbitrage possibilities.
Example 5.2 (IRS continued). Today, t0 , we denote the forward rate

by 0 (tn1 , tn ) and forecast the floating payments of the IRS with its
values
P(tn+m ) = f (0 (tn1 , tn ))
If we were to do the same tomorrow, t1 , we would need to calculate

tomorrows forward rate 1 which is now going one day less far into
the future, and so on for the following days.
Technically it is feasible to use the forward rates to forecast future

interest rates. The question is, however, how good is the forecasting
quality of the forward curve?
In order to estimate a priori the quality of a forecast which has
been made with the forward curve, we create retrospective forecasts
with the forward curve. Let us assume that today, t0 , we forecast the
one-month interest rate which will prevail in three months by using
the equation for the forward rate 0 (t3m , t4m ) from the 3-month and
the 4-month par rates.
We then look at the historical par rates for, say, the last 16 months
and simulate the same procedure starting 16 months in the past: we
create the then prevailing forward rate 16m (t3m , t4m ), and compare
it with the historical one-month par rate on t13m (the forecasted rate)
and denote the difference by 13m .
We repeat this for every subsequent historical date until we reach
t1m , which is the last point in history at which we can compare the
forecasted forward rate with the known rate.
If we omit the time order of the sequence of differences
13m , 13m+1d , . . . , 1m
and order it by value
1 < 2 < < K
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we have created a distribution of deviations between the forecasted

and the realised rates for a historical time span of 12 months. Analo-
gously to the procedures in market risk, we estimate the parameters
of the distribution of the forward rates with the historically quoted
rates and simulate a future distribution. The upper and lower -
quantiles FaR +
and FaR are interpreted as the upper and lower
forecast at risk (of this forward rate); it essentially states that the
expected deviation between the rates forecasted and to be realised
will, with probability , be within FaR +
and FaR .
Contingent cashflows
Assume that the banks existing transactions contain explicit or
implicit (embedded) options.
If certain market variables prevail, the party which is long the
option can decide to exercise it and thus cause an exchange of the
option underlying against cash. Sometimes the value of the asset is
held against a strike price and only the difference is (unilaterally)
paid.
A contingent cashflow stems from the exercise of an option.6 As
we consider here exposures but not strategies, we shall not model
the potential decision of the bank to exercise a long option.
In contrast to variable cashflows, there is no direct mathemati-
cal relationship between market variables and cashflows, although
the counterpartys decision to exercise can in some cases be strongly
influenced by market variables. Options where a decision to exercise
is not necessary (automatic exercise) will be modelled like trans-
actions with variable cashflows and are thus not regarded as options
in a liquidity sense.
Example 5.3 (drawings under a credit facility). The bank has pro-
vided a credit facility of 100 to a client. The client can draw from the
facility in tranches, depending on their cash needs (eg, depending
on the progress of a building project) which might be independent
from market rates.
If we assume today that the client will at t1 withdraw 30% of the
outstanding facility of 100, we need to generate a contingent cash
outflow of 30 at t1 . If the forecast is correct and the client withdraws
30 at t1 and 70 of the facility are still open to be withdrawn, then
we might assume that again 30% of the undrawn amount (70) will
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be drawn in t2 and generate another contingent cash outflow of 21

in t2 .
If the estimation is again correct, it will diminish the open facility
to 49 and we can estimate how much will be drawn in t3 , etc.
For the sake of simplicity, we assume that, if necessary, embedded

or complex options can be decomposed into simpler options that can
be classified as long or short.
We shall later refine our data model and simulate with contingent
transactions (not with contingent cashflows!) the uncertainty that
stems from transactions that bear optionality.
The cashflows themselves will be categorised as deterministic
or variable, but they inherit the type contingent from the trans-
action they stem from. The template for an illiquidity risk solution
given later (see page 80) describes various types of options and
resulting cashflows.
Cashflow at risk
Some parts of the risk management community have been searching
for the holy grail of liquidity risk management, a single number that
describes liquidity risk: liquidity at risk. As we pointed out earlier
(see page 28) a single number is only possible for value risks.
A related concept is cashflow at risk (CFaR): if we have forecasted
a cashflow, we might want to quantify how large a deviation from the
unknown realisation is to be expected. We can look for upper and
lower -quantiles, C FaR+
and C FaR , which can be interpreted
as upper and lower bounds for the deviation of the realised pay-
ment from the forecasting cashflow. For variable cashflows we have
solved the problem with the concept of forecast at risk. For other (eg,
contingent) cashflows the solution is not so straightforward.
If a payment deviates from its forecasting cashflow, eg, because
of the exercise of optionality or credit events, it might change not
only in size but also in timing. Assume we use stochastic credit risk
calculations simulating that only a certain percentage of the repay-
ment of a loan will occur: the result is unusable as we are not able
to predict when it will occur. For value risk calculations this is not
a problem, as the discounting makes it far less necessary to model
when payments are realised.
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Figure 5.1 Types of hypothetical transactions
Existing Hypothetical
transaction transaction
Anticipated
transaction
Exogenous
transaction
Endogenous
transaction
Unenforceable Conditional
transaction transaction
DYNAMIC MODELLING AND HYPOTHETICAL TRANSACTIONS

We shall still ignore two uncertainties: we model only stationary
transactions and we consider exposures but not strategies. Mod-
elling only existing transactions means that the bank will not enter
into any new business after now (when we look at the scenario),
which in fact means that the bank is winding up its operations.
If, however, we want to model a banks future balance more realis-
tically, we have to allow for hypothetical transactions (see Figure 5.1)
which have not yet been concluded.7
In the case of anticipated transactions (eg, a loan proposal that
has been informally accepted but not yet contracted), it is diffi-
cult to decide if they already exist or are still hypothetical. For the
sake of simplicity, we regard anticipated transactions as hypotheti-
cal, notwithstanding the fact that a grey zone between existing and
hypothetical transactions can exist in practice.
Hypothetical transactions
When modelling hypothetical transactions we could be tempted to
simply allege that the bank will enter into them. This would, how-
ever, ignore that the bank has different levels of freedom to initi-
ate or reject them. Instead, we examine how they come into exis-
tence, and start by splitting hypothetical transactions into two types:
endogenous and exogenous.
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Endogenous transactions
Endogenous transactions are derived from existing transactions,
which we call parent transactions; the corresponding child trans-
actions are generated by three different mechanisms.
Replacement transactions. Replacement transactions substitute

or change parent transactions. These come into existence by the
agreement between the bank and the counterparty of the parent
transaction, but without any existing contractual right or obligation.
Examples could be the renewal of a loan or deposit (with equal
or reduced or increasing amount), or the expansion or abbreviation
of an agreed tenor.
Although replacement transactions are related to a parent, they
also resemble exogenous hypothetical transactions. Nevertheless,
we treat them as a separate class of transactions because they are so
convenient in practice: it is simple to model, for example, that 10%
of a portfolio of loans is assumed to be renewed at maturity.
Conditional transactions. Conditional transactions are generated

by the exercise of existing contractual options which are able to
spawn new transactions (eg, the drawing under of a credit facility).
They depend on the decision of the counterparty or the bank to
exercise, which itself can depend on market variables.
Unenforceable transactions. Unenforceable transactions stem from

a counterpartys breach of existing transactions.8
Since the counterparty is normally only able to withhold own
payments and cannot enforce payments from the bank, we need to
model, for example, the inability (or unwillingness) of a client to pay
back a loan as scheduled, or to pay in a deposit as agreed. We can
model this as a new, enforced loan with a nominal of the current
outstanding and a maturity which goes beyond the scenarios time
horizon.
A similar situation is given if a client urges the bank to modify an
existing transaction. In the crisis of autumn 2008 for example, some
banks were urged by institutional investors to shorten the tenor of
existing fixed-term deposits. Some banks were afraid to renounce as
they feared otherwise to get no future deposits again.
Unenforceable transactions have so far been treated a little neg-
ligently by other risk methods, although they are fundamental for
credit risk: the risk of a client which is able but unwilling to pay
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is usually neglected in credit risk because the bank can enforce

the payment by legal means. The fact that the payment might be
delayed is not substantial in credit risk. A similar view is predomi-
nant in market risk: apart from eventual credit risk, a counterparty
is always assumed to complete transactions as scheduled. Failing
to comply with the contractual requirements would only cause a
claim for indemnification, which is more detrimental than paying
in the first place. In liquidity risk, however, the period of deferment
between the scheduled payment and the legally enforced payment
or the indemnity payment can be vital.
The endogenous transactions could be modelled as alterations of

existing transactions. We have, however, chosen to leave the existing
part unaffected and express the changes with hypothetical trans-
actions which will allow us to better keep track of the changes
and make the driving factors transparent. If an existing transaction
is changed (eg, the extension of a loan), we introduce a counter-
transaction, which neutralises the existing transaction, plus a new
transaction (the extended loan). If, due to the exercise of an option
which is embedded in a transaction, its cashflows change, we will
regard the transaction itself as unchanged.
Exogenous transactions
Exogenous transactions (eg, a completely new loan or deposit) are
not related to any existing business, nor do they stem from an exist-
ing generation process. They are created simply via the simulation
of the banks choice to do some new business in the future. There is
nevertheless an optional element, which we shall now discuss.
THE ROLE OF OPTIONALITY

One of our major tasks is to understand and systematise the mechan-
ics that can lead to the generation of hypothetical transactions. A new
loan which simulates the growth of the banks business (an exoge-
nous transaction) has so far been modelled likewise to a loan which
is drawn by a client under an existing loan facility. Although in nor-
mal scenarios the two transactions might be equivalent, in a stress
scenario the bank can, on the one hand, simply stop growing its
business, but will, on the other hand, still be obliged to respect con-
tractual options in the existing credit facility and pay out the loan
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Figure 5.2 Transactions as a result of options
Existing Parent
transaction Hypothetical
transaction
transaction
Anticipated
transaction
Exogeneous
Child transaction
transaction
Contractual Rejectable
Breach liquidity
liquidity
option option
option
Unenforceable Conditional Replacement

transaction transaction transaction
tranche. In order to be able to distinguish such effects, we introduce

the concept of liquidity options and rejectable and non-rejectable
options.
If we look at the concept of real options9 we find something which
can be used for our purposes: a real option gives the buyer the right
(but not the obligation) to undertake some business decision, typ-
ically the option to make, or abandon, a capital investment. Obvi-
ously the term real option is a misnomer because the option is not
real but only assumed: the implicit assumption is made that if
a bank uses a real option, it can enforce its business decision; how-
ever, in reality, the bank is dependent on the will of the potential
counterparty to accept the decision and its terms. Nevertheless, the
principle of how to model the banks future balance sheet is embed-
ded in real options: the bank wants to make a business decision (eg,
give a loan or take a deposit, sell an asset) which is described by
the real option but then the potential counterparty can accept the
transaction and its terms, or it can reject it. Before we specify the
concept of rejectable options, we differentiate between normal
financial options and those options which are relevant for illiquidity
risk. Figure 5.2 describes transactions which can be generated from
other transactions through the exercise of options.
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Financial options and liquidity options

The seller of a financial option grants to the buyer the right (but not
the obligation) to sell or purchase in the future a certain financial
asset (underlying) at a price which is fixed when the option is con-
tracted (strike price). If the buyer exercises the option, the underlying
is usually not physically exchanged against money but instead the
strike price is compared with the prevailing market price of the asset
and the difference is paid to the buyer. The money exchanged might
be material in terms of profit or loss, but not normally in illiquidity
risk terms.
For example, the bank has sold an option and the counterparty
exercises the right to buy 100 million of the underlying bond at 99.8
when the market price is 100.3. The profit is
100, 000, 000 (100. 3% 99. 8%) = 500, 000
This could be a considerable loss for the bank, but not in illiquidity
terms.
If, however, the bond needs to be exchanged in the transaction,
the consequences can be manifold: the bank can, for example, be
forced to take the bond out of its central bank account and move
it to its trading account. If the buyer then for whatever reason fails
to deliver the 9.98 million cash, the exchange transaction cannot be
completed on that day and the bond cannot possibly be used to serve
as collateral for a repo with the central bank.
A liquidity option is a specific financial option where the asset is
in fact exchanged against money which is material in illiquidity risk
terms.10
A credit facility, for example, is the archetypical liquidity option.
A savings deposit contains the clients liquidity option to withdraw
its money, but also the banks option to change the interest rate of
the deposit. The interest rate option, however, is exterminated if the
client exercises their withdrawal option, eg, when the bank decreases
the deposit rate too drastically. Obviously the banks interest option
is somehow not fully contractual, as it can be offset by a counter-
option of the client.
If the bank wants to grow its business, it always has the possi-
bility of granting a new loan; this is a liquidity option which is not
explicitly granted and there is as yet no existing counterparty. The
bank can nevertheless enforce the exercise of this liquidity option by
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LIQUIDITY MODELLING
ignoring credit risk and desired margin and just give the money to
someone. On the other hand the bank would not be able to enforce
the acquisition of a new deposit, as it is fully at the discretion of the
potential counterparty to pay out money or not.
We refine the concept of liquidity options and introduce a distinc-
tion between rejectable and non-rejectable liquidity options. Liq-
uidity options can be rejectable (acquisition of new deposit) as
well as non-rejectable (drawing under contractual credit facility),
whereas financial options are always non-rejectable: each counter-
party would only exercise the option if it is economically benefi-
cial, whereas the other counterparty would always be unwilling to
encounter a loss and thus always reject the exercise.
Example 5.4 (loan facility). A loan facility is a non-rejectable option

(and comes with a service charge as premium).
Example 5.5 (loan within business plan). A loan which was given
to adhere to a business growth plan stems from a rejectable option
(the bank is short the option to execute its business plan), which
can be rejected (but not in certain scenarios).
Example 5.6 (counterbalancing capacity). The CBC is perhaps the

most important rejectable liquidity option. The bank can try to exe-
cute the rejectable option liquefy appropriate assets and, for exam-
ple, sell or repo a security against cash, but any potential counter-
party always has the right to refuse this sales or repo transaction. In
normal scenarios though, highly liquid and unencumbered securi-
ties (eg, central bank eligible securities) create almost non-rejectable
liquification options, while in stress scenarios the liquification might
be impossible.
Breach options
Each contract (transaction) the bank has entered into can be breached
by the counterparty. The most widespread breach is credit risk: the
counterparty might be willing but, due to lack of funds, is unable to
exercise its contractual obligations. A more subtle situation arises if
the counterparty has the ability to fulfil its liabilities but is unwilling
to do so.
After the peak of the liquidity crisis in 2008 the group treasurer of
a large bank in fact said:
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if you have taken loan facilities from other banks, simply expect
that they are worthless in such a situation.
The background was that some banks that had taken large credit
facilities from other banks wished to make drawings under these
facilities and were rejected.
The rationale for the breaching banks was obviously that they
estimated the probability of the drawing bank to become insolvent
and thus not pay back the money to be so high that the potential
damage from not serving the contract and therefore being forced
by a court to do so looked less threatening. Ignoring moral aspects,
the decision to breach a contract can make economic sense if the
expected gain is greater than the expected setback.
Example 5.7 (Barings). On Friday, February 24, 1995, the London

management of the legendary British Barings Bank realised that Nick
Leeson, one of their traders in Singapore, had fled to Malaysia, leav-
ing the bank with an open futures position of roughly US$60 bil-
lion, which equated to a loss of US$1.4 billion. On the Saturday, a
phone conference between the major London banks was full of gos-
sip, which turned to panic when the Bank of England corroborated
the loss and alluded to the fact that Baringss equity capital was only
worth around US$0.6 billion. The treasurer of a major bank called on
the other participants to join him in freezing payments to Barings:
I will definitively encounter technical payment problems with Bar-
ings on Monday, and I reckon you [will] too. A high official of
the Bank of England (BoE) replied: I know who said that and I can
assure you that if you stop payments on Monday morning I will do
my best on Monday afternoon to [make you go ] to jail.
The Bank of England attempted an unsuccessful weekend bailout
and Barings was declared insolvent on Sunday evening. Appointed
administrators took over and all due payments were settled on
Monday.
If the counterparty breaches the execution of an option in which

the bank is long, we have to make sure that possible transactions that
stem from the option are not generated; if the counterparty breaches
an existing transaction, we model the breach as an inevitable antic-
ipated transaction which is forced on the bank. It offsets (partly)
the transaction we expect to be breached: on the modifying date, a
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LIQUIDITY MODELLING
counter-transaction which mirrors all flows of the original transac-

tion (after the modifying date) offsets the original transaction com-
pletely. If the modification not only prematurely terminates the orig-
inal transaction but effectively changes it, a modifying transaction
takes the place of the original transaction.
Example 5.8 (borrower with problems/badly performing loan).
50% of a loan of 100 is due to be paid back at tM . Therefore, a cash
inflow is scheduled. Assume that the client is unable to repay at tM
the 50. In order that we might mimic the behaviour of the bank which
will be willing to give a bridging loan of 50 at tM (hoping that the
client will be able to repay in, say, six months), we can introduce
an anticipated loan transaction which pays out 50 at tM , eg, for
another +6 months.
The anticipated payment of 50 matches the scheduled inflow of
+50 at tM , reflecting the expected economic reality.
Example 5.9 (insolvent borrower/dead loan or bad debt). A

loan is due to pay back +100 at tM which is not expected to be ever
repaid. This can be modelled as a new transaction where the bank
pays out 100 at tM with no redemption maturity itself, marked
internally as buying the dead loan with equity capital.
At tM , the anticipated internal outflow of 100 matches the
scheduled inflow of +100 and thus reflects the economic reality.
Example 5.10 (expected credit loss). A portfolios expected credit
loss of x% could be modelled by an anticipated loan with x% of the
portfolios face value. The start date depends on the credit risk model
(eg, one year; there should be no redemption maturity as above).
Finally, modified transactions display situations where the bank
accepts a counterpartys request to terminate or alter existing
transactions.
A client might ask the bank to alter an existing transaction, eg, by
withdrawing a deposit before maturity. The bank could accept the
modification although the direct effects might be detrimental, eg,
because the bank might expect other, potential investors to refrain
from placing new funds, if the banks unwillingness to allow this
early withdrawal becomes public knowledge.
Example 5.11 (unscheduled early repayment of debt). A client
deposits 100 at t0 until maturity tM but requests at tm (which is before
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tM ) an early withdrawal. If we model a bank accepting the with-

drawal, we simulate a counter-transaction which pays out 100 at
tm and schedules a repayment of +100 at tM .
The original transaction plus the counter-transaction represents
the early repaid debt. We can make the counter-transaction smaller
if the client wanted to reduce the amount rather than a complete
withdrawal.
Covenants: options on options

If rejectable liquidity options are accepted by the counterparty, they
can generate or modify transactions or they can spawn options
covenants which generate transactions (exogenous or endogenous;
rejectable or non-rejectable).
We can, for example, model new credit facilities or the extension
of existing facilities.
Both might be exercised and will thus generate new drawings.
This is due to the dual role of a credit facility as existing transaction
and as non-rejectable liquidity option which generates conditional
transactions. A similar effect occurs if we model the generation of
hypothetical savings deposits: a hypothetical deposit is a transaction
as well as an option which can create transactions (withdrawals) that
trigger outflows.
This problem arises, for example, if a bank strategy is to grow
its loan portfolio and refinances this by acquiring additional sav-
ings deposits. The primary uncertainty concerns the banks ability
to acquire sufficient new savings deposits to fund the new loans; but
even if this works, the existing savings deposits themselves create
insecurity, as their withdrawal option could be exercised.
Example 5.12 (forced buy back of own debt). The bank decides
to buy back own issues which are offered for sale in the secondary
market because it wants to prevent their price from falling (which
would raise the rate the bank has to pay for further debt issues).
Example 5.13 (existing deposits). An individual deposit with a fixed
maturity is either paid back when it is due, or (partly) renewed
(assuming it has not been withdrawn early).
A portfolio with a large number of such deposits, however,
behaves more subtly. The natural run-off by maturity is compen-
sated by renewals of maturing deposits and by new deposits from
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new depositors. In a going concern, the sum of the compensation

effect matches the loss of maturing deposits.
MODELLING OPTIONALITY
The final targets of our modelling are cash inventories and cashflows.
The uncertainty of cashflows stems from diverse sources.
Cashflows of existing scheduled transactions are uncertain if

their amount or date depends on market variables (eg, interest
rates like Libor).
Contracts where the bank is short a liquidity option create con-
tingent transactions which are uncertain by design, because
certain market variables must prevail and the counterparty
exercises the option only at its discretion.
Contracts where the bank is long a liquidity option are less
uncertain because the bank can exercise the option at its dis-
cretion; it cannot, however, be completely certain that they can
be exercised as planned.
If we also consider cashflows stemming from as yet non-
existent transactions (which the bank will only be able to
avoid if it is illiquid or insolvent), we must ponder uncertain-
ties stemming from sources which go beyond variability and
optionality.
Although the banks nostro is determined only by external
cashflows, we cannot neglect internal cashflows fully: they
result in balance flows which might cause external cashflows.
If a client has a credit on their account, the bank is short an
option, as the client can withdraw (part of) their money.11
A scheduled cash inflow of an existing transaction does not fea-
ture any variability or optionality but still might diverge from
the payment it predicts if the counterparty does not execute it
as scheduled; reasons could be the counterpartys illiquidity
(credit risk), its operational problems (malfunction of internal
systems), distortion of payment systems, etc, or simply the
counterpartys unwillingness to pay (breach of contract).
We are ultimately interested in future cash inventories and/or

cashflows but they cannot exist in their own right but are always part
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Figure 5.3 Example: simplified data model of a credit facility
Active contract
Active credit facility
Contractual option
Drawing of advance
Actual transaction Contingent transaction

Actual drawdown Future drawdown
Scheduled Scheduled
fixed repayment fixed repayment
Variable interest Variable interest
of more complex financial transactions. A bank cannot, for example,

receive cash without increasing a liability or decreasing an asset.12
As we want to manage scenarios as they progress in time, we must
keep track of the development of assets, liabilities and outstanding
options. Figure 5.3 gives an example of how transactions (drawings)
and their payments are generated by the exercise of the optionality
in a credit facility.
The data model might look a little complex if used in the sim-
ple deterministic and stationary situation. If we progress to more
dynamic simulations, however, its benefits should become apparent.
Contractual options and contingent transactions

We will now formulate the concept of options in a more formal
manner.
A contractual option gives one party (the long counterparty) the
right (but not the obligation) to stipulate the execution of a particular
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financial transaction (a contingent transaction) with the other party

(the short counterparty) at an agreed price and date. Contractual
options are always non-rejectable.
A bank will only exercise an option if it is beneficial to itself, which
means in return that the counterparty is forced to execute a trans-
action which is detrimental from its point of view. The mechanics
of market risk require that the counterparty executes the contingent
transaction exactly as scheduled in accordance with the conditions
of the option. In a profit view this makes perfect sense: if the coun-
terparty breaches the contract, the bank can claim compensation for
loss suffered, which will put the counterparty in a worse situation
than if it had paid in the first instance. The credit risk view, however,
deals with the possibility that the counterparty is unable to execute
the corresponding transaction. But there is a third possibility: the
counterparty could be simply unwilling to execute a detrimental
transaction. This wilful breach does not seems to make any sense
at first sight, but in extreme stress situations it might be economi-
cally comprehensible that the counterparty declines, eg, paying out
a drawing which the bank has executed under a credit facility: if the
counterparty strongly suspects that the bank will become illiquid, it
may rather wait until it is forced by legal action to pay out the funds
(which it expects to be non-collectable) than unresistingly give up
the money.
If the bank is short a contractual (non-rejectable) option which is
exercised, it must execute the contingent transaction (eg, pay back
savings deposits) if it is able to do so, because otherwise it would vio-
late a contractual obligation, which we shall not consider for ethical
reasons, and because it would destroy the banks reputation.
If, however, the bank is long the option, we cannot completely rule
out that the counterparty will violate its obligations and the bank
might not always be able to enforce the execution of the contingent
transactions.
We describe below the mechanics of a simplified contractual
option in more detail.
A contractual option is a contract between the short party and the
long party. The long party pays the option premium and receives
in return the option right, possibly subject to option conditions. The
short party receives the option premium and grants in return the
options right to the long party.
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Figure 5.4 Typical life cycle of an option: scheduled version
if
Condition option
is variables
Decides performed prevail
Long
to
party t2 t3 tn
exercise
Exercise
Grants of
Pays contractual
option Contract conditional tn option
right
premium
t1 Short Short Long
party under-
lying cash
t0 under-
cash lying
End End
tn + 1 tn + m
An option condition is described by the value of an option variable

that has to prevail at a future point in time.13
The option right allows the holder to require the generation of
a financial transaction between the two parties in the future: the
contingent transaction. The strictures of the contingent transaction
are specified as option parameters.
Assume, for the time being, that the transaction is comprised of
assets or debt and cash.
Let us look at the typical life cycle of a simplified option, as shown
in Figure 5.4.
At t0 both parties agree on the terms of the option and conclude

the option contract, which terminates at tN .
At t1 the long party pays the option premium, and the short
party in return is obliged to grant the conditional option right
to enter into a specific transaction (if requested by the long
party).
From t2 to tN : if the condition is satisfied (that is, the specified
variables prevail), the long party may exercise the option right.
If the long party exercises its right before tN , and requests the
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generation of a transaction, the short party is obliged to agree

and to carry out the desired transaction.
At tn+1 the transaction commence with the exchange of the

underlyings specified by the parameters; it also terminates at
tn+1 if it is single-ended.
A structured transaction might have exchanges of underlyings

between tn+1 and tn+m .
At tn+m a reversal transaction matures with the reverse ex-

change of the underlyings.
At tM the option finally reaches maturity.
Contractual liquidity options

In order to distinguish between simple transactions, which generate
only cashflows, and more complex transactions that can engender
transactions themselves (which can have cashflows), we have intro-
duced the concept of liquidity options. A contractual liquidity option
can create future (as yet non-existent) transactions. Normally, two
counterparties are involved in an option contract: the option buyer is
long the option because they have the choice (but not the obligation)
to initiate (exercise) one or more possible underlying transactions
which are preassigned by the conditions of the option (eg, receive
money for a certain time period at a certain interest rate); whereas
the option seller is short the option because they have the obligation
to enter into the mirror transaction (eg, pay out the money for the
agreed or chosen time period and rate), but only if the buyer decides
to exercise the option.
For liquidity risk purposes we will only consider options with
underlying transactions which could be material in terms of liquid-
ity. Let us take the example of an option which allows the buyer to
sell a security on a future date at a pre-agreed strike price: if the
seller is only obliged to pay the difference between the prevailing
price and the strike price, we would normally consider the resulting
payment as immaterial in terms of illiquidity (although it could be
very material for the seller in terms of a financial loss14 ); if the option
contract, however, determines the exchange of cash against security,
we will normally consider it as material in terms of illiquidity risk.
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Liquidity option covenants

Liquidity options incorporate both a pure element of choice (the abil-
ity to engender a transaction, or not) and a component encompassing
the transactions already exercised.
If necessary, we might differentiate between the liquidity options
as elements of choice and the complete liquidity option covenant,
which also includes the already exercised transactions.
Liquidity covenants can involve a more complex relationship
between the initial option amount, the (partial) exercise resulting
in a transaction and eventually additional exercises of remaining
option amounts leading to more transactions, etc.
We describe this structure using an example of a credit facility
(given to a counterparty) which is in its simplest form a covenant
that contains an option allowing the counterparty to elicit a loan
drawing. The sum of the loans already drawn adds up to the drawn
part of the credit facility; the difference between this sum and the
maximum amount which can be initially drawn gives the undrawn
part of the credit facility which can be exercised and will thus lead
to additional drawings.
Rejectable liquidity options

With contractual liquidity options we are able to explain how trans-
actions emerge from the exercise of an existing liquidity option. Most
transactions, however, are generated without any foregone exercise
of an option within a formal contract; we will find, for example, loans
or deposits or derivatives which just exist. We could accept this
little roughness in our methodology and discern between the exist-
ing transactions which stem from parent covenants (child transac-
tions) and parentless (or orphan transactions), which are somehow
naturally given.
If, however, we want to simulate the forthcoming generation pro-
cess of as yet non-existent transactions, we will find that a great
variety of potential transactions could exist in the future; but not
every transaction which is thinkable is possible. The bank cannot,
for example, sell a security it does not own15 or which does not exist.
Other transactions vary gradually in their likelihood of coming to
existence; even one transaction might differ in different scenarios.
Abstractly speaking, the building of the future balance sheet can
be separated into two processes:
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LIQUIDITY MODELLING
(a) the bank tries to initiate new business, or

(b) existing or new counterparties try to initiate new business with
the bank.
We can interpret (a) as the bank being long an informal option
which will result, if exercised, in the new transaction, but only if
the potential counterparty is willing to accept.
In a thought experiment we can decompose the above mechanics
into a rejectable liquidity option (which the bank is long):
(i) the bank buys from the counterparty an initial option (and
pays a premium) which gives the bank the right to initiate the
desired transaction;
(ii) at the same time the counterparty buys a consequential option
which gives them the right to reject the requested transaction
(and pays the same premium to the bank).
As the premium is paid back and forth concurrently, we can simply
omit it.
In the case when the counterparty tries to initiate transaction (b),
the bank is short a rejectable liquidity option which induces an
exactly symmetrical situation: the counterparty is long the option
to request the transaction and the bank is long the option to reject it.
Let us examine the differences between non-rejectable and re-
jectable liquidity options: by agreeing to enter in a liquidity option
covenant and paying the option premium, the buyer of a contrac-
tual non-rejectable liquidity option purchases the irrevocable right
to exact the execution of future transactions which comply with the
option conditions. On the other hand, the seller of the option is com-
pensated by the premium for accepting the obligation to execute
the transaction, if prompted by the buyer. For a rejectable liquidity
option, conversely the buyer has not paid a premium and the seller
therefore always has the right to reject the exercise of the option. We
should therefore better not speak of buyer and seller but instead of
requestor and acceptor of the rejectable option.
CONCLUSIONS
First, we modelled illiquidity risk by considering only determin-
istic cashflows that predict scheduled payments of existing trans-
actions. The next step, non-deterministic modelling of cashflows,
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followed the well-worn paths of value risk simulation with some

kinks: the risk-neutral future curve is a bad prediction for future
rates and therefore, it is questionable to use it for forecasting cash-
flows; furthermore, actual options exercises might differ from the
economically correct exercise behaviour of counterparties.
Subsequently the model was adapted to reality by including
hypothetical transactions, which makes it less abstract, but, as a
consequence, also makes it dramatically more complex. To restrict
the possible creation of transactions without horizon and limits,
the rules of how a bank might enter into future transactions were
described and modelled. We introduced liquidity options which
have (material) liquidity effects and breach options that allow mod-
elling the rationale of a counterparty breaching existing contracts
transactions.
Next we introduced rejectable options that describe how a bank
tries to steer its future balance-sheet progression by trying to create
assets and acquire liabilities at its conditions, and how the potential
counterparties accept or reject this.
Finally, we formalised the definition of options so that we may
apply these concepts in the following chapter, where we will outline
a model for a liquidity risk solution that can be implemented in a
bank.
1 The modelling of stationary uncertainties is the usual approach, for example, for market risk,
where as yet non-existent transactions are assumed to be acquired at market price (without
any profit or loss effects) and are thus ignored.
2 Notwithstanding that, the transaction itself (eg, the drawing of a loan) could have been gen-
erated as a result of another financial transaction (eg, a credit facility), which might bear
optionality. We ignore in this case the credit facility and thus any new drawings under it.
3 The bank itself needs to be able and willing to perform its payment obligations as well, which
we will assume throughout this book.
4 An alternative way to deal with this problem would be analogous to market or credit risk
management.
We could estimate the cashflows distribution and make a conservative assumption about
its size (lower/upper quantiles for inflows/outflows). Unfortunately, the correspondence
between in- and outflows as well as the correlation in time between cashflows is extremely
complex.
5 For example, Targeted Accrual Redemption Notes (TARN).
6 The contingent cashflow might be connected to the simultaneous exchange of the underlying
asset and thus change the banks asset inventory.
7 Existing transactions with a deferred start are not new business in this sense.
8 We do not consider the possibility that the bank will breach existing contracts.
9 In corporate finance a real option is the right, but not the obligation, to undertake some
business decision; typically the option to make, or abandon, a capital investment. For example,
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LIQUIDITY MODELLING
the opportunity to invest in the expansion of a firms factory, or alternatively to sell the factory,
is a real option. The term real option was coined by Professor Stewart Myers at the MIT
Sloan School of Management in 1977 (Wikipedia, accessed October 6, 2008).
10 The definition of the liquidity option depends of what we consider as material in an

illiquidity risk sense.
11 But even if the client withdraws money, it is not entirely certain what will happen to the nostro
account: the money could be spent or paid to somebody with an account with the bank. We
look at the following example to illustrate the problem from a slightly different view: the bank
credits a mortgage to the clients vostro account, which creates an internal cashflow with no
external effect in the first instance. It is, however, likely that the client will use the positive
account balance to pay the mortgage amount to the seller of the real estate, thus creating
an external cashflow (if the seller has an account with another bank); strictly speaking, the
latter payment is a contingent transaction under the clients long option ability to pay from
a positive account balance.
12 This is not fully true if the bank does business on behalf of a client. A bank which is, for
example, a cash clearer for a client, might, during the daily payment process, receive monies
on its central bank account from another clearing bank that belong to the client and thus do
not generate a liability. If the client, however, decides at the end of the payment day to leave
the funds in their account, it will create a liability. The same is true, eg, for custody business.
13 It is important that the variables of an option condition can be determined unambiguously,
eg, market rates.
14 We acknowledge that a substantial loss could stimulate rumours about the banks financial
soundness and thus generate a consequential illiquidity risk.
15 Strictly speaking the bank can sell a security it does not own but will be unable to deliver it,
unless it is willing to endlessly borrow the security in the market.
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A Template for
an Illiquidity Risk Solution
This chapter and the following one are based on solutions the author
has developed and implemented in several banks. In the earlier
chapters we have substantiated our approach to the problem and in
Chapter 5 we have described how we want to measure liquidity risk,
how we can forecast the banks future liquidity situation and what
the bank could do in case the forecast was unfavourable. We dealt in
principle with the logical interconnectedness between the different
uncertainties, and the potentials ways to map them accordingly into
the concept of optionality. Now we want to implement this.
In this chapter we first deal with scenarios and strategies as sys-
tematic assessments of possible future developments from the mate-
rialisation of the previously described optionality. Because scenarios
by definition allow simulating almost anything in the future, it is
essential to specify which scenarios should be created and how their
results should be interpreted, especially if compared with other sce-
narios. We establish rules for the creation of scenarios like unique-
ness and consistency of variables. In order to restrict calculation
efforts, we systematise the driving factors of scenarios by introduc-
ing liquidity units which allow pooling of all transactions in the
balance sheet that behave the same in a scenario.
After that we outline the data model of a possible technical illiq-
uidity risk solution and describe the mechanics of the interactions
between the objects involved. Although cashflows and inventories
are what we are after ultimately, we have to understand that they
signify only the possible outcome of our modelling and thus repre-
sent the effect but not the cause. Transactions are consequences of
more basal objects: covenants. The cause-and-effect chain between
covenants, transactions and cashflows is interwoven with the dif-
ferent types of options. Getting this right will put us in a position
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to model the future development of the banks balance sheet in a

realistic and meaningful way.
SCENARIOS
We have so far intuitively used the expressions scenario or sim-
ulation to reflect the fact that we have to make some assumptions
in our modelling which influence the outcomes. In this chapter we
will fix some notation around scenarios and then develop concepts
that allow the consistent and manageable simulation of scenarios.
We will define classes of transactions (liquidity units) which are
assumed to behave similarly in a scenario and thus allow a simpli-
fied calculation of the scenario results. Starting from liquidity units,
we identify the underlying sources of scenario behaviour: liquidity
drivers.
Furthermore, we have seen that some scenarios (the FLE) are
assumed (in our modelling) to be passively borne by the bank, while
other scenarios (the CBC) simulate the actions the bank will take in
order to avert or overcome future detrimental situations.
Scenarios and simulations

If a future development is uncertain, we might look at the expected
or most likely result, if there is one, but we can never be sure that
our forecast and the realised result will be identical.
Therefore, we want to try out how different assumptions (causes)
generate different possible results (effects) to better understand the
cause-and-effect chain.
A scenario encompasses
the scenario assumptions (a set of parameters describing the

causes),
the scenario simulation, which uses the scenario assumptions
to generate the scenario result, transactions and/or cashflows.
Example 6.1 (rising/falling yields). A scenario rising yields

assumes that a potential future yield curve prevails which if
inserted into the appropriate simulation triggers those cashflows
of existing transactions, which depend on forward interest rates; as
well as possibly conditional transactions, which stem from option
exercises due to rising interest rates, together with their cashflows.
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A TEMPLATE FOR AN ILLIQUIDITY RISK SOLUTION
In another scenario, falling yields, the same simulation would

create a different result.
A scenario might comprise many simulations. Under the above
rising yields scenarios, the same yield curve might be used inde-
pendently, for example, to generate variable cashflows in a portfolio
of bond floaters and to spawn hypothetical drawings in a portfolio
of credit facilities.
Uniqueness and consistency

Ascenario is a potential realisation of the future. It is therefore impos-
sible that a variable has more than one value under one scenario.
Two different realisations of the yield curve, for example, cannot
exist at once and we therefore cannot use, for example, one future
yield curve for the generation of cashflows and another yield curve
for the simulation of drawings.
For this reason all variables need to be unique and consistent. A
variable would be not consistent if in one scenario different values
would be used for simulation. Any two variables are not allowed to
have contradictory values: if, for example, in one scenario the mar-
ket price of a bond is low and simultaneously the interest rate level
is low, the variables are not consistent, assuming that the reason for
the low price of the bond does not stem from other factors (like credit
risk). In practice, it will be quite cumbersome to set up consistent sce-
narios and, respectively, to verify that given scenarios are consistent.
For market variables, we might consider no-arbitrage conditions, but
even the existing reality can be inconsistent as arbitrage opportuni-
ties do exist. We should normally try to set up scenarios with as few
values as necessary for performing the simulations. If we add too
many variables, we automatically run the risk of over-determination
(and if we make the additional variables consistent we could
have omitted them in the first place).
Comprehensiveness
For practical reasons, banks often model only the parts of their bal-
ance sheet that are considered as being problematic in a liquidity
perspective. This practice can lead to inconsistent results: normally,
parts of the balance sheet of a bank cannot exist individually but
only as a whole. Therefore, the entire business of a bank (all on- and
off-balance-sheet items) should be modelled in each scenario. If we
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do not want to model certain parts of the balance sheet, we should

make the explicit assumption that these parts remain unchanged
under the respective scenario.
The null scenario

Large parts of the balance sheet might be simulated once and then
remain untouched in most other scenarios. Deterministic cashflows,
for example, will normally be generated in the beginning and then
scarcely change. In order to avoid unnecessary recalculation of such
cashflows, an initial null scenario is set up. In this null scenario,
all deterministic cashflows (and some others) will be simulated.
Although it is of very limited explanatory power in itself, the null
scenario will serve as a construction kit for the real scenarios and
simplify their production.
Liquidity units
On the one hand, we would like to be able to trace back the simu-
lation of every single transaction, but on the other hand, we should
think how to simplify the generation of scenarios in order to save cal-
culation effort and storage capacity: transactions which are treated
similarly in a simulation can be grouped to a subset if the sum of the
individual simulations corresponds to the result of the simulation
of the complete subset. In order to exploit this effect, we will call a
subset of transactions which behave in a congeneric way a liquidity
unit.
If, for example, we assume that every individual retail deposit of
a certain type is renewed at maturity with 80% of its outstanding
nominal for one month, we can pool these deposits in a liquidity
unit, calculate the maturity profile of this liquidity unit and renew
80% of the aggregated maturing sums for one month. In particular, if
we have, for example, millions of deposits (with a small outstanding
nominal each) the amount of necessary calculations is dramatically
reduced.
As another example we can think of credit facilities of a congeneric
type. Instead of assuming 10% drawing of the remaining undrawn
amount of each individual credit facility, we simply sum up the
outstanding and assume 10% drawing in total.
In both examples, the diverse transactions lose their individuality
as they are subsumed into one liquidity unit and the results can no
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longer be apportioned to the single transaction. Note that we have

implicitly made the assumption that the transactions can be added
up to one transaction; otherwise the simulation would not work so
simply.
There is, of course, a certain fuzziness in the concept: what do
we really mean if we talk about congeneric types? If we have,
for example, identified a type of savings deposits as one liquidity
unit, a refined analysis might suggest that certain age clusters of
the holders imply different behaviour. We can, of course split up
the envisaged liquidity units in smaller ones, accounting for age
bands but then again a refined analysis might suggest that certain
geographic patterns imply different behaviour, etc.
As this problem will generate endless repetition we have to turn
it upside down and put it on its feet: a liquidity unit encompasses
all transactions which we consider to behave in a congeneric way in
a scenario.
Scenario dependency
Liquidity units might change from scenario to scenario.
We might, for example, assume that in a business-as-usual sce-
nario all retail deposits behave in the same manner (they grow 5%
per year). In a stress scenario, however, they fall into three types:
1. the unaffected, which still grow by 5%,
2. the concerned, which lose 10% per year and
3. the catastrophic, which flow out in less than a month.
We have two possibilities to deal with this:
(i) we make the liquidity units variable from scenario to scenario
or
(ii) we take the decomposition of the list of transactions into the
largest possible sets that still allow the individual modelling
in all scenarios.
In our example we simply need to dissect the overall liquidity unit
from the business-as-usual scenario into the liquidity units (1)(3)
which can be used across all scenarios (we have only two in this
example). We would in the a business-as-usual scenario calcu-
late the results for the liquidity units (1)(3) separately although we
could have done it in one step.
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In more generic cases, however, it can be less easy to keep a single

structure of liquidity units across all scenarios.
Disjunct and complete hierarchies of liquidity units

It is obvious that liquidity units should be disjunct: if a transaction
was in two liquidity units, its cashflows would show up twice and
thus be double counted.
We therefore require that liquidity units do not overlap:
LUX LUY , = needs to hold for any two liquidity units LUX
and LUY .
On the other hand, the scenario modelling should give a complete
picture of the extended balance sheet. Therefore, the union of all
liquidity units
LU1 LU2 LUN
in a scenario should give the complete list of transactions.

A practical way to generate disjunct and complete liquidity units
is to start with the complete extended balance sheet (EBS) and dissect
it into disjunct liquidity units plus a residuum.
Let us look at the following example.
Example 6.2 (liquidity units hierarchy). With LU1 = assets, LU2 =
liabilities and LU3 = others, we get
EBS = LU1 LU2 LU3 = assets liabilities others
In the next step we dissect the LU1 = assets into LU1.1 = loans,
LU1.2 = bonds, LU1.3 = derivatives and LU1.4 = others
LU1 = LU1.1 LU1.2 LU1.3 LU1.4

= loans bonds derivatives others
The loans, for example will then be intersected in LU1.1.1 = stand-

alone and LU1.1.2 = under credit facility given; LU1.1.1 again is
intersected in
LU1.1.1.1 = to central banks

LU1.1.1.2 = to governments
LU1.1.1.3 = to banks
LU1.1.1.4 = to corporates
LU1.1.1.5 = to retail clients
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Figure 6.1 Liquidity units: an example of a possible hierarchy
and finally
LU1.1.1.6 = others
The virtue of this approach is that the construction mechanism

allows a structured construction of disjunct and complete liquidity
units which are the leaves of a hierarchy tree. The fact that we can
only separate in one dimension (eg, loans versus bonds instead of
long versus shorter maturities) is a caveat though.
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Liquidity (risk) drivers

With the description of a scenario (falling yields, inflation,
Lehman revisited, etc) we describe what we want to simulate;
the exact meaning, however, of, for example, falling yields is
unclear until we quantify it. We can, for example, specify a concrete
future yield curve and apply it in all liquidity units where it can
be applied. In the remaining liquidity units where the yield curve
change cannot be applied, no generation of transactions or alterna-
tive cashflows will happen. This approach is appropriate for specific
scenarios, where we want to turn the spotlight on the effect of very
specific potential changes, like the yield change.1 If we look at infla-
tion it is of very limited explanatory power to simply evaluate, for
example, the prices of inflation-linked bonds.
We have to explain how we generate the results of generic scenar-
ios. In the scenario inflation, other variables are likely to change:
interest rates generically go up (depending on the prevailing eco-
nomic theory) or the yield curve steepens, the loan demand is reduc-
ing, deposits are also decreasing, etc; but many other variables are
still unaffected by the definition of the scenario.
One technique is reverse engineering: we go through the balance
sheet and ask the question how would the scenario inflation affect
the different parts of the balance sheet? As a result we get a hierar-
chy of liquidity units, where each unit requires the setting of values
for the variables (the liquidity (risk) drivers) which are needed to
simulate the resulting transactions and cashflows. Quite often the
liquidity risk drivers will be factors like willingness of a depositor
to renew and not ostensive variables like inflation indices or yield
curves, etc. Conversely, scenarios like inflation which at first sight
appear to be clearly described, will turn out to be quite vague in
respect to liquidity risk, because it is quite unclear if, for example,
the availability of more money due to inflation will increase bank
deposits or is more likely to decrease them because more money is
needed to purchase physical assets.
Technically speaking, the liquidity risk drivers are fully defined
by the values of the variables which trigger the simulation in the
liquidity units. If we look, for example, at a liquidity unit containing
retail deposits, the liquidity risk drivers are fully determined if 85%
of the maturing deposits are renewed within an average tenor of two
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months. The primary drivers behind the drivers, such as the over-
all economic situation, the rating status of banks (in general and
in particular), the return differential of stock markets and interest
rates, the likeliness of a banking crisis or central bank interventions,
etc, surely playing an important role in the decision of a potential
depositor to renew, have not so far been measured in our model. It is
difficult to evaluate how long it will take until econometric models
become sufficiently appropriate to explain and successfully fore-
cast the relationships between the primary driver and our drivers.
From a practitioners point of view it is clear that there is no such
model publicly available which has been backtested and commonly
agreed between banks and regulators. Therefore, it seems viable to
estimate and forecast the liquidity risk drivers instead of analysing
more primary drivers.
How realistic should scenarios be?

At first sight it seems to be natural to model the most likely or realistic
scenario. But what does this mean? In the banking society dominant
paradigms2 usually describe what the majority thinks is most likely.
Usually, dominant paradigms are conservative in the sense that they
tend to extrapolate existing trends and if reality proves them wrong,
they try to perseverate, but they can also swing to the opposite view.
On the other hand, dissident beliefs are generally (not always) more
reliable than the dominant view because they are more regularly
challenged and tested against evidence.
We shall try to set up our liquidity risk model in such a way that
we are able to reflect not just one dominant paradigm but many
different possible developments in the future.
In Europe, for a very long period, starting in the 1970s, markets
allowed easy access to cheap funding. Even banks with a weaker
standing were funding at Libor flat because banks in general were
regarded as riskless.
Before, say, 1996, the empirical analysis of the short- and even-
longer-term history of spreads clearly did not indicate the risk of a
possible increase in funding spreads. Within the paradigm of empiri-
cal analysis it was almost impossible to foresee that in the second half
of the 1990s the funding spreads of banks increased overall. Clearly,
the development of quantitative credit methods which led investors
to treat banks like any other company was not part of the model,
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and thus unforeseeable. At that time it was almost impossible for

the few qualitative risk analysts to convince the others to consider
scenarios reflecting a potential upsurge of funding spreads. At that
time everything which was not based on quantitative facts was
regarded as being subjective and was rejected in favour of statistical
methods.
We conclude that empirical analysis can be very useful to forecast
developments as long as certain situations prevail for a longer time
and remain unchanged; but if the paradigms are changing, they can
be misleading or even wrong.
The idea of realistic scenarios is to mostly rule out specific
scenarios which are believed to be unrealistic, which does not nec-
essarily mean that they are impossible. On the other hand, we also
want to regard scenarios which are unrealistic by design: some-
times it is more enlightening to understand what can happen to
the bank without modelling the possible actions of the bank against
detrimental situations. A scenario which, for example, simulates the
funding needs of a new business line can be very informative for the
management to understand the consequences of the new venture,
but is extremely unrealistic, as, in reality, the bank will always try
to fund the business lines cash deficit, as otherwise the bank would
become illiquid.
We therefore discern between exposure scenarios and strategy
scenarios. Exposure scenarios are unrealistic by design because
in reality the bank will always try to execute strategy scenar-
ios that neutralise these exposures. For that purpose we shall
construct the scenarios based on developments that can happen
to the bank and which the bank will passively endure. Con-
versely, the strategies simulate the active execution of the banks
potentials to influence these developments to achieve its own
goals.
Exposure and strategy scenarios

If we think of the types of transactions we need to model, we have to
go to the different sources of cashflow and, respectively, transaction
generation. We have to take into account the following.
Cashflows that stem from contractual transactions (without
non-rejectable liquidity options): fixed3 cashflows and variable
cashflows (depending on market variables).
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Cashflows of conditional transactions that are generated by

non-rejectable liquidity options,4 but only the ones that are
exercises by counterparties: most apparent are drawings under
existing credit lines that the bank has given to counterparties.
Cashflows of unenforceable transactions that are generated by
breach options:5 loans which are not repaid, assets which are
not delivered as agreed, intra-day payment limits which are
violated, etc.
Cashflows that are generated by rejectable liquidity options
which are executed by the counterparty and not rejected by
the bank: loans which are given by the bank in order to keep
its franchise or to fulfil its business plan; requests to pay back
deposits early which the bank thinks it cannot reject, etc.
Exposure scenarios model the uncertainties that a bank could
encounter from transactions with no or short optionality:
fixed and variable cashflows which stem from scheduled
transactions
fixed cashflows bear no uncertainty (unless we inte-

grate breach of contract),
variable cashflows bear uncertainty (variability) but no
optionality;
contingent cashflows that stem from non-rejectable options the

bank is short, eg, a client withdraws his savings deposit;
hypothetical cashflows from anticipated contracts which stem
from rejectable options the bank is short, eg, if the bank gives
new loans due to the execution of its business plan.
The FLE is the archetypical exposure scenario.
Astrategy is the banks active approach to influencing the future
in a dedicated way. A strategy needs a target. We regard strategies
as specific scenarios.
Banks can have various targets: eg, improve their return or the
quality of their credit portfolio (which are normally mutually exclu-
sive); try to gain greater geographical coverage (which will in the
short run be detrimental for both return and asset quality), etc.
In respect to liquidity risk we deal with only two possible strategy
targets: reducing surplus liquidity without incurring (comparative)
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losses or generating additional liquidity (at normal prices) in case

of a shortage. Both scenarios can only be achieved by generating
liquidity bearing transactions either through exercising contractual
options or through rejectable options: in both cases the bank needs
to be long the options. In this book we concentrate on illiquidity risk
and therefore we will suppress the discussion of scenarios which
deal with surplus liquidity and concentrate on the generation of
liquidity.
Contractual liquidity options can be liquidity facilities that

the bank has unequivocally received, deposits the bank has
made but which are cancellable, unencumbered credit bal-
ances the bank has on other nostro accounts or guaranteed
repo facilities with central banks or central counterparties.
Rejectable liquidity options refer to the banks ability to

acquire additional funding uncollateralised or collateralised
(repo) or to sell assets (finally or at least temporarily).
Both approaches can be averted by counterparties that can breach

the covenant if the bank exercises a contractual option (eg, not pay
out a drawing the bank tries to make under a credit facility) or that
reject the banks effort to execute a rejectable option (the bank tries to
sell or repo a security in order to generate liquidity but is incapable
of finding a counterparty which is able and willing to make the
envisaged deal).
Counter-strategies are special strategy scenarios which simulate
the reaction of the bank to the outcome of a scenario. They have
dependent targets that require the results of other scenarios as input.
For example, a strategy which simulates the refinancing of a certain
portfolio needs the simulated exposure of this portfolio as input
before it can be executed.
The strategy which simply maximises the banks refinancing does
not require the result of a scenario as input; its target is called inde-
pendent. Another independent target could, for example, be to
acquire as many funds as possible without paying more than a pre-
defined funding spread. In a mathematical sense we can interpret
the above maximisation of funds as an optimisation problem with
the constriction of the funding spread as its boundary condition.
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Example 6.3 (renewal of existing deposits (endogenous)). In a

going concern situation we can assume that a large part of the
depositors will renew their deposits with the bank.
Example 6.4 (new deposits (exogenous)). We might assume that a

portion of the deposits in Example 6.3 which are assumed not be
renewed will be substituted by new deposits from new depositors.
Example 6.5 (renewal of credit facilities given). We reflect the

likely renewing behaviour of maturing credit facilities by gen-
erating anticipated (new) credit facilities.
TECHNICAL IMPLEMENTATION
We have so far looked at the bank as a whole, which is in our model
represented by a given list of financial transactions. In practice, the
bank will have nostro accounts at more than one central bank and
in different currencies. If we generalise our approach in enabling us
to model the cashflows for an individual nostro, we can calculate its
FLE. By converting the individual balances and cashflows into one
base currency we can determine the FLE of the combined nostros.6
Portfolios, selections, inventories and flows

A sub-set of the complete list of financial transactions the bank has
entered into is called a portfolio. Examples could be business lines,
trading books, legal entities and other constructs, as long as the con-
stituting transactions can be unequivocally assigned. An existing
financial transaction between two portfolios A and B should turn
up twice, eg, as A gives to B and B takes from A. It makes
sense to talk about the cashflows of a portfolio, as every underlying
transaction can be identified and spawns cashflows.
It is, however, not always feasible to speak about a portfolio which
is constituted by a currency, as, for example, the cashflows of a cross-
currency swap can fall into different currency portfolios. Here we
need the slightly more general concept of a selection by certain crite-
ria. Any selection of transactions is simply a portfolio, whereas, for
example, a selection of cashflows in a certain currency would solve
the above problem.
We regard a selection of cashflows where we are able to identify
the starting balance at t0 of this selection. The future cash inventory
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FCI of this selection is the projection of todays cash inventory into

the future.
We sort the cashflows of the financial transactions in the chosen
selection by future days t0 , t1 , . . . , tn .7
The net cashflow NCFn at tn is the sum of all inflows and outflows
on that specific day.
If we denote todays starting balance by FCI1 (because it is the FCI
of yesterday (t1 )), we can add todays net cashflow to it and thus we
have determined8 todays cash inventory as FCI0 := FCI1 + NCF0 .
Generally we generate the sequence of future cash inventories
step by step
FCI0 := FCI1 + NCF0

FCI1 := FCI0 + NCF1
..
.
FCIN := FCIN 1 + NCFN
If all cash inventories FCI0 , FCI1 , . . . , FCIn were already known, we

could reverse this process and determine each net future cashflow
as the difference of two subsequent cash inventories
NCFn = FCIn FCIn1
There are subtle differences between cashflows and cash invento-

ries.
Future cash inventories and cashflows hold slightly different

information.9
To generate the cash inventories from the cashflows we need
the starting point FCI0 .
The cashflows can be calculated from the cash inventories
directly.
If a transaction has more than one cashflow in a day (inflows
or outflows, principal or interest flows, etc), we can store these
cashflows and sum them up when we need to generate the
cash inventory.
If we have already generated the inventories, we can go back
to the net cashflow but not to the individual cashflows.
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Sometimes we might not be able to decompose the starting

point FCI0 into sub-nostros (eg, for different business lines,
because they stem from FCI1 , the banks nostro as of yester-
day, which is only available in one lump sum), so we cannot,
strictly speaking, generate the cash inventories (for this busi-
ness line) although the cashflows are available (at a business
line level).
If we want to provide the forward cash inventories techni-
cally, we have to define a FCI for every day in the future;
whereas we need only future cashflows for the days where
the cashflow is not zero (for the other days the cashflows are
not defined/zero).
Instead of trying to solve all these problems in one go, we will

first provide a solution for the simplest case and then improve this
solution step by step.
If the bank is seen as a portfolio, its forward cash inventory (FCI)
is identical to its FLE. We will throughout the book reserve the name
FLE for the view on the full bank.
Selections and hierarchies

We regard the bank (or a part of it, eg, a child entity) and assume
that for our purposes it is constituted by a set of covenants C1 ,
C2 , . . . , CM =: C.
A selection S of covenants is a sub-set of C.
A hierarchy level (of a selection S, eg, the bank) is a set of hierarchy
nodes which are disjunct sets S1 , S2 , . . . , SN spanning the selection
S1 S2 SN = S
A hierarchy node Sn is a selection and can itself be decomposed

into k hierarchy nodes Sn1 , Sn2 , . . . , Snk which span the selection
Sn1 Sn2 Snk = Sn
If we apply this process repeatedly, we arrive at a hierarchy tree

with the initial selection S as the top level of the hierarchy. There is
not always a lowest level hierarchy (where all leaves of the hierarchy
tree (selections that are not further decomposed) reside); the leaves
can reside at different levels.
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The bank and its hierarchies

In our approach, the bank itself is represented by the complete list
of transactions.
We regard the bank as one legal entity which can be a part of
another entity (parent entity) or may itself own separate legal entities
(child entities).
Liquidity flows between the bank and a child entity may be
subject to different laws or regulations and therefore should be
differentiated from flows between the bank and a pseudo child
entity.
The bank might want to sub-divide its business into hierarchies.
A hierarchy is, mathematically speaking, an ordered set (or a tree).
If we assume that every transaction can be attributed to exactly
one subset Tn of T, the bank can be decomposed into the sub-
sets T1 , T2 , . . . , TN , which represent the complete list of transactions
T = T1 T2 TN and all subsets are mutually disjunct:
Tk Tm = 0 for any Tk and Tm . We will call this a decomposition
and denote it by T = T1 + T2 + + TN .
If every Tn can accordingly be decomposed into mutually disjunct
subsets Tn,1 , Tn,2 , . . . , Tn,K with Tn = Tn,1 + Tn,2 + + Tn,K , we have
created the next level of the hierarchy. We go on decomposing until
a Tn,m,...,x cannot be decomposed any further: we will call it a leaf (of
the tree).
Transactions
A transaction is created and stipulated by its parent covenant.
Transactions are the links between liquidity option covenants and
cashflows.
In practice it is simpler, however, to look upon every transaction
as formally stemming from the execution of an option and distin-
guish only between scheduled transactions, which already exist, and
contingent transactions, which can come to existence in the future
through the potential execution of an option.
Although transactions are characterised by their cashflows (and
are often sloppily identified with their cashflows), they contain more
structure than just cashflows.
On-balance-sheet transactions can have future asset or liability
flows which determine the resulting cashflows.
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Off-balance-sheet transactions can have future off-balance-sheet

or collateral flows which have no or only minor resulting cashflows.
Example 6.6 (credit facility from Example 6.5). The client drawing
at t1 is reflected by a transaction T1 with an asset flow of FAF(t1 ) =
+30 moving the asset inventory up to FAI(t1 ) = 0 + FAF(t1 ) =
0 + 30 = 30; as a mirror image of the asset side there is a cashflow of
CF(t1 ) = 30 moving the cash inventory down to
FCI(t1 ) = 0 + FCI(t1 ) = 0 30 = 30
At the same time the asset flow diminishes the unused option
inventor
FUI(t1 ) = FUI(t0 ) + FAF(t1 ) = 100 + 30 = 70
At maturity we have two components: the asset will mature (a
flow of 30); the option will also mature (a flow of +100); this gives
FOI(tM ) = 70 30 + 100 = 0
Example 6.7 (loan given). A vanilla loan of 100 can be seen as a
short option of 100 at t0 which is immediately exercised by the
counterparty.
If we look at the loan after t0 , it is constituted by an asset flow of
FAF(t1 ) = 100 at t1 (the payout date of the loan) and an asset flow
of FAF(tM ) = 100 in tM (the maturity of the loan).
The option is constituted by an option flow of FOF(t1 ) = 100 at
t1 plus an option flow of FOF(tM ) = 100 at t1 .
As at t1 the option flow of FOF(t1 ) = 100 is immediately coun-
terbalanced by the asset flow of FAF(t1 ) = 100, the option is de facto
inactive for the lifetime of the covenant.
Note that if a contingent transaction turns into a scheduled
transaction through the actual exercise of an option, no uncer-
tainty stemming from optionality remains. If we assume the exe-
cution of options to simulate the generation of potential transac-
tions, the transactions that are contingent before the simulation pro-
cess become scheduled thereafter and can only artificially be distin-
guished (eg, with a simulated earmark) from the real scheduled
transactions.
This means that the uncertainty stemming from optionality can be
ring-fenced into the transaction-generation process which happens
in the option and does not need to be sought in the transaction or
the cashflows.
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Scheduled transactions
A scheduled transaction is predetermined, together with its sched-
uled cashflows, by the real or formal execution of a parent option
under its parent covenant.
Acovenant can relate to either a single scheduled transaction (such
as a money market deposit) or more than one transaction (such as
an interest rate swap or secured borrowing).
Each scheduled cashflow, including, of course, its parameters, has
been determined by concluding the terms of the transaction.10
Example 6.8 (fixed deposit taken). A deposit taken by the bank

consists of a single scheduled transaction:
start: +nominal (deterministic cash inflow)

maturity: nominal interest (deterministic cash outflows)
The transaction comes into life through the formal execution of an

option which allows generating exactly the considered transaction
and nothing else: the depositor executes their option to offer the
deposit to the bank and the bank does not reject this offer. In practice,
the depositor might have offered the deposit at a certain rate to the
bank and the bank might have negotiated this rate, but this is not
relevant for our view.
There are no further uncertainties because we do not assume that
the bank can breach the covenant.
Assuming neither party will breach the covenant, there is no

uncertainty remaining at the transaction level even though some
of its cashflows can depend on as-yet unknown values of market
variables.
We therefore differentiate between variable cashflows (which
depend on market variables) and deterministic cashflows (which
do not).
Breach of covenant
Scheduled inflows are only deterministic (respectively, variable) if
we can assume that the counterparty will exercise them exactly as
they are scheduled, which is never definite. If the counterparty fails,
or is not willing or not able to execute the payments, the forecast
will deviate from the realisation. This deviation, however, stems not
from a miscalculation or incorrect forecast of the cashflows itself, but
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from the fact that the counterparty has breached the transaction and
thus the covenant.
We use a little trick to correctly reflect the consequence of a breach
of a covenant on a cashflow: we leave the scheduled cashflows at
the transaction level unchanged, but as a substitute for the effect of
the change we generate anticipated transactions which simulate the
breach of covenant instead.
Example 6.9 (loan given (counterparty becomes illiquid)). A
money-market loan of 100 given by the bank to a counterparty is
modelled by a scheduled transaction with the following cashflows
(t0 = start, tM = maturity)
t0 : 100 (nominal) (deterministic cash outflow)

tM : +100 (nominal) + 4 (interest) (deterministic cash inflows)
If the counterparty breaches the covenant because it is illiquid, this
will be simulated by an anticipated transaction with the following
anticipated cash cashflows (tM = start; tM+1 = maturity)
tM : 100 (nominal) 4 (interest)

t M +1 : +100 (nominal) + 4 + x (x is the extra interest at tM+1 )
The sum of both transactions in tM reflect the real situation:
tM : +100 100 + 4 4 = 0
We might eventually introduce another transaction which reflects

that, say, 15 months after the insolvency, 30% of the nominal
outstanding can be retrieved from the insolvency proceedings
tM+15 months : +30% 100 = +30 (nominal)
Example 6.10 (loan given (counterparty has operational problems

to execute payment)). If the counterparty in Example 6.9 is not
illiquid, but has an operational payment problem, the anticipated
transaction will have the following anticipated cashflows:
tM (start) : 100 (nominal) 4 (interest)
The sum of both transactions reflect the real situation in tM :
tM : +100 100 (nominal) + 4 4 (interest) = 0.
At tM+1 it is correctly reflected that the counterparty will execute the

deferred transaction next day (plus an extra interest effect of x).
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The outcome of this little dodge is that uncertainty which stems

from non-contractual behaviour can be completely separated from
the uncertainty which is caused by the change of market variables.
Contractually contingent transactions

Covenants with embedded optionality incorporate one or more
options enabling the option holder to execute transactions, eg, to
draw advances under a credit facility.
If the bank is short the option, the uncertainty arises from the as-
yet unknown decision of the counterparty whether or not to exer-
cise the option. The exercising decision of the counterparty does not
necessarily depend on market variables, but it can: in this case the
decision is not an automatism which follows from the prevailing
of certain market variables but a clearly distinct act of will of the
counterparty.
In order to simulate the behaviour of the covenants optional-
ity we will model anticipated transactions with a certain start date,
amount and maturity date. As the counterpartys drawing behaviour
is not independent of the undrawn part of the option, we define
the undrawn inventory, FUI as the difference between the forward
option inventory (FOI) and the forward asset inventory (FAI) of the
transactions.
Example credit facility

At the end of the chapter we want to describe the data model of a
credit facility which starts at t0 and allows the drawing of a loan up
to 100 until its maturity tM .
Before t0 the FOI is zero, at t0 it jumps to 100 and stays constant
at 100 during the lifetime of the facility; at maturity tM it goes back
to 0 again.
For the simulation we divide the period between start and matu-
rity into four periods: (t0 to t1 ), (t1 to t2 ), (t2 to t3 ) and (t3 to
t4 = tM ).
The situation before the simulation is shown in Table 6.1.
In the next step (see Table 6.2) we look at the situation when the
counterparty has already made one drawing (here a loan of 30 from
t1 to t3 .
Next we simulate that at the beginning of each period (starting at
t1 ), the client will draw 40% of the undrawn inventory and create a
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Table 6.1 The scheduled flows and inventories before the simulation
Nominal Cash

Time Action FOF FOI FCF FCI
< t0 Before start 0.0 0.0

t0 Start of option 100.0 100.0 0.0
Premium at 2% 100.0 2.0 2.0
..
. 100.0
tM Maturity of option 100.0 0.0 2.0
> tM After maturity 0.0 2.0
All nominals are in (millions).
transaction with a tenor of two periods (the last drawing only with
a tenor of one period).
We model the FUI as the difference between the FAI and the option
inventory FOI.
The simulation is shown in Table 6.3.
INVENTORIES AND FLOWS

We want to describe how each component of the extended balance
sheet (assets, liabilities and derivatives and, in particular, options)
evolves in time. We can do this directly by specifying the inventory
of a component at every regarded future point in time (the amount
outstanding for a loan or deposit, the open amount of an option,
etc). Alternatively, we can describe the change of the inventory over
time indirectly by means of flows.
Inventories and flows of option covenants

A covenant may include one or more options which, if executed,
generate transactions.
The option specifies which type of transactions can be generated,
as well as its parameters like start date, maximum amount, maturity
and other conditions. The ability to execute new transactions under
an option may depend on the transactions that have already been
initiated.
We illustrate the concept using an example of a credit facility
(given by the bank to a client) which is in its simplest form a covenant
that contains an option allowing the client to elicit a loan drawing.
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Table 6.2 Multiple drawings of 40% of the remaining option
Action Option: Transaction: Option:

Nominal Asset Undrawn Cash
Option Transaction
Time (%) (%) FOF FOI FAF FAI FUF FUI FCF FCI
<t0 Before start 0.0 0.0 0.0 0.0

t0 Start 100.0 100.0 0.0 100.0 100.0 0.0
Premium 2% 100.0 0.0 100.0 2.0 2.0
t1 Drawing 1: 40% 100.0 40.0 40.0 40.0 60.0 40.0 38.0
t2 Interest 1: 6% 100.0 40.0 60.0 2.4 35.6
t3 Interest 1: 6% 100.0 40.0 60.0 2.4 33.2
Redemption 1 100.0 40.0 0.0 40.0 100.0 40.0 6.8
tM Maturity 100.0 0.0 0.0 100.0 0.0 6.8
>tM After maturity 0.0 0.0 0.0 6.8

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Table 6.3 The counterparty has made one drawing of 40 from t1 to t3 (premium and interest cashflows disregarded)
Action Option: Transaction: Option:

Nominal Asset Undrawn Cash
Option Transaction
Time (%) (%) FOF FOI FAF FAI FUF FUI FCF FCI
< t0 Before start 0.0 0.0 0.0 0.0

t0 Start 100.0 100.0 0.0 100.0 100.0 0.0
Premium 2% 100.0 0.0 100.0 2.0 2.0
t1 Drawing 1: 40% 100.0 40.0 40.0 40.0 60.0 40.0 38.0
t2 Interest 1: 6% 100.0 40.0 60.0 2.4 35.6
Drawing 2: 40% 100.0 24.0 64.0 24.0 36.0 24.0 59.6
t3 Interest 1: 6% 100.0 64.0 36.0 2.4 57.2
Interest 2: 7% 100.0 64.0 36.0 1.7 55.5

Redemption 1 100.0 40.0 24.0 40.0 76.0 40.0 15.5
Drawing 3: 40% 100.0 30.4 54.4 30.4 45.6 30.4 45.9
t4 Interest 2: 7% 100.0 54.4 45.6 1.7 44.2
Interest 3: 8% 100.0 54.4 45.6 2.4 41.8
Redemption 2 100.0 24.0 30.4 24.0 69.6 24.0 17.8
Redemption 3 100.0 30.4 0.0 30.4 100.0 30.4 12.6
tM Maturity 100.0 0.0 0.0 100.0 0.0 12.6
> tM After maturity 0.0 0.0 0.0 12.6

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Assume the client can draw up to 100 of loans under the facility; this
amount stays constant from start tS until maturity tM .
We define the forward option inventory (FOI) as a function of time
t, which is negative if the bank has sold the option and positive if it
has purchased it. For the counterparty it is just the other way round,
but we will always take the view of the bank.
In our example the forward option inventory is

0,

t < tS (zero before the start)
FOI(t) = 100, tS t < tM (100 between start and maturity)

0, t tM (zero again after maturity)
If we try to express this fact for every single day
tI , tI+1 , . . . , tS1 , tS , tS+1 , . . . , tM1 , tM , tM+1 , . . . , tH1 , tH
of the time horizon we are considering, we will get a bulky
expression
FOI(tI ) = 0
FOI(tI+1 ) = 0
..
.
FOI(tS1 ) = 0
FOI(tS ) = 100
FOI(tS+1 ) = 100
..
.
FOI(tM1 ) = 100
FOI(tM ) = 0
..
.
FOI(tH 1 ) = 0
FOI(tH ) = 0
Dealing with inventories in practice can become cumbersome, as
we need to define an FOI for every future point in time we want to
consider. Therefore, it is simpler to describe only the changes of the
option inventory, the forward option flow (FOF).
The option flow is a function of time, which is only defined
for those points in time (in this example tS and tM ) when the FOI
changes: FOF(tS ) = 100 and FOF(tM ) = +100.
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If we introduce the general rule
FOI(tx ) = FOI(tx1 ) + FOF(tx )
and at the beginning of the time horizon set FOI(tI ) := 0, we can

calculate the forward option inventory exactly at the points in time
when it changes
FOI(t) = 0 before tS ;
FOI(tS ) = FOI(tS1 ) + FOF(tS ) = 0 + (100) = 100 until
FOI(tM ) = FOI(tM1 ) + FOF(tM ) = 100 + 100 = 0.
If the inventories are given, we can conversely calculate the flows

from the changes of the inventories directly
FOF(tX ) = FOI(tX ) FOI(tX1 )
(The flows that are zero may be ignored.)

In other words, if the flows are given (which are normally fewer
data points than the inventories would require), we can unequiv-
ocally determine all inventories, but only if we have a starting
point: the inventory at the beginning of our consideration period.
Conversely, we can determine every flow as the difference of two
consecutive inventories.11
If in our example the bank had purchased the option, the option
flows and inventories would have been reversed (positive instead
of negative):
FOI(t) = 0 before tS ;
FOI(tS ) = FOI(tS1 ) + FOF(tS ) = 0 + 100 = +100 until
FOI(tM ) = FOI(tM1 ) + FOF(tM ) = +100 100 = 0.
In our model, the option does not directly generate cashflows

but generates transactions which are constituted of asset or liability
flows, mirrored by cashflows.
INVENTORIES AND FLOWS OF TRANSACTIONS

Assets and liabilities
Although cashflows and cash inventories are perhaps the most
important parts of a transaction, they are not identical to it.
If we were to describe, for example, a money market deposit sim-
ply by a cash inflow at the start plus a cash outflow (including interest
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payments) at the end, we would neglect the fact that the bank has
created or increased a liability inventory between these two dates.
This may be of no interest if we only want to see the current liq-
uidity profile. If, however, we want to simulate the banks ability to
raise funds in the future, we need to know the term structure of out-
standing liabilities. Therefore, we first have to extend the concepts
of option flows and inventories to assets and liabilities.
Assume that in the above example (see page 98ff) of a credit facility
the client exercises the option and draws a loan of 100 at tS1 ; thus, an
asset (in the view of the bank) comes into existence.
The FAI of this loan is determined by the FAF.
In this example, FAI(t) = 0 before tS1 ; it increases at tS1 by
FAF(tS1 ) = +100 to FAI(tS1 ) = 0 + 100 = 100; at the maturity tM1
of the loan is formally reset, by FAF(tM1 ) = 100, to zero again
FAI(tM1 ) = +100 100 = 0.
By convention, we set liability flows as negative asset flows. If in our

example the bank had purchased the option and made a drawing,
the resulting loan would have been a liability from the banks per-
spective: FAI(t) = 0 before tS1 ; it decreases at tS1 by FAF(tS1 ) = 100
to FAI(tS1 ) = 0 100 = 100; at the maturity tM1 of the deposit is
formally reset, by FAF(tM1 ) = +100, to zero again
FAI(tM1 ) = 100 + 100 = 0.
Interaction between asset and option inventories/flows

Assume in the above example the bank is the seller of the option
again and, at tS1 , the client would have drawn a loan of 30 (instead
of 100).
The FOI increases to 100 at tS but drops at tS1 to 100 30 = 70. In
this case the loan drawn can be deducted from the option amount
FOI(tS1 ) = FOI(tS1 1 ) + FAF(tS1 ) = 100
If the loan matures at tM1 (which is before tM ), there is an asset

flow of FAF(tM1 ) = 30 which offsets the asset inventory of the loan
and in parallel resets the option inventory to
FOI(tM1 ) = FOI(tM1 1 ) + FAF(tM1 ) = 70 30 = 100
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Asset-flows, cashflows and inventories

A simple asset transaction can be described by a positive asset flow
at the start (asset inflow) and a negative asset flow at the maturity
(asset outflow). If the asset is straight, the flows will offset each other
and thus reset the asset inventory to zero at maturity. We denote an
asset by a plus sign because it has a positive value in the balance
sheet, while a liability is denoted by a minus sign because it has a
negative value in the balance sheet.
The purpose of a loan is, however, not to generate asset inventories
in the banks balance sheet but to provide money to a client that will
pay interest for the time of the usage and reimburse the outpayment.
We have to model this mechanism with cashflows.
Consider a simple asset, eg, a loan of 100 at 8% for two years.
At the start tS the forward asset flow FAF(tS ) = +100 corresponds
to a forward cashflow (FCF) of FCF(tS ) = 100. At maturity tM
the forward asset flow FAF(tM ) = 100 corresponds to a forward
cashflow of FCF(tM ) = +100. The asset- and cashflows offset each
other, cancelling to zero, but if we consider the interest payments of
FCI(tS+1y ) = FCI(tS+2y ) = 8 at the end of the first and second years,
the structure becomes unbalanced as there are two corresponding
elements on the asset side. The interest rate can be interpreted as a
premium that the loan taker has to pay in order to compensate the
bank for its risk of eventually not getting back its money.12
The forward cash inventory (FCI) of the loan is zero before start
time tS
FCI(tS ) = 100
FCI(tS+1y ) = FCI(tS ) + FCF(tS+1y ) = 100 + 8 = 92
FCI(tS+2y ) = FCI(tM ) = FCI(tS+1y ) + FCF(tS+2y ) + FCF(tM )
= 92 + 8 + 100 = 16
The result of 16 can be interpreted as the gross income from the loan.
Remark 6.11. if we generate cashflows of asset and liabilities as

above, we automatically include income from assets and expenses
for liabilities which will only match meaningfully if assets and liabil-
ities match throughout the consideration period. Any (future) gap
between maturing assets and liabilities should be compensated by
additional expenses (or income).
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The cashflows and inventories of a liability are constructed in a

corresponding way, with reversed plus and minus signs: each asset
inflow creates a cash outflow (the payout of the loan) engendering
a negative cash inventory which is finally reset by the cash inflow
mirroring the asset outflow.
Example 6.12 (drawing under a credit facility given (without cash-
flows)).
Before start: asset inventory = 0.
At start: asset flow = +100; asset inventory = 0 + 100 = 100.
After start/before maturity: asset inventory = 100.
At maturity: asset flow = 100; asset inventory = 100 100 =
0.
After maturity: no further asset flows; asset inventory remains
zero.
Example 6.13 (drawing under a credit facility taken (without cash-
flows)).
Before start: liability inventory = 0.
At start: liability flow = 100; liability inventory = 0 100 =
100.
After start/before maturity: liability inventory = 100.
At maturity: liability flow = +100; liability inventory = 100+
100 = 0.
After maturity: no further liability flows; liability inventory
remains zero.
The cashflows and inventories of this transaction are (almost) the
mirror image of the asset flows and inventories: each asset inflow
creates a cash outflow (the payout of the loan) engendering a nega-
tive cash inventory which is finally reset by the cash inflow mirroring
the asset outflow.
Example 6.14 (drawing under a credit facility given (including
cashflows)).
Before start: asset inventory = 0; cash inventory = 0.
At start: asset inflow = +100; asset inventory = 0 + 100 = 100;
cash outflow = 100; cash inventory = 100.
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After start/before maturity: asset inventory = 100; cash

inventory = 100.
At maturity: asset outflow = 100; asset inventory = 100
100 = 0; cash inflow = 100; cash inventory = 100 + 100 = 0.
After maturity: asset inventory = 0; cash inventory = 0.
The cashflows are not exactly equal to the asset flows multi-
plied by conversion factor of 1: at the start, the conversion fac-
tor could, for example, be the purchase price of a bond (during the
lifetime of the bond, coupon payments do not have respective asset
flows), whereas at maturity we could need to model, for example,
the principal plus an interest payment.
The asset flows and liability flows at the beginning and end of a
normal transaction cancel out; that is, the inventory of the transac-
tion has vanished, whereas the cashflows tend to leave a (hopefully
positive) inventory at the end of the transaction: its P&L.
The separation between the asset (liability) flows and their corre-
sponding cashflows will be shown to be quite powerful when we
start to model scenarios.
Collateral and securities flows and inventories

In Chapter 7 we shall deal with collateralised loans and thus need
to model the future development of liquefiable securities which will
either be sold or used as collateral for deposits taken. In principle the
same mechanics as in Chapter 7 will be needed, with the refinement
that the bank can use a security as collateral, which does not change
the banks ownership of the security but only its possession (for
the period of collateralisation). On the other hand, the bank can
possess for some periods more securities than it owns if it lends
money against collateral in the form of securities.
TAXONOMETRY
Taxonometry of covenants
An internal covenant is made between counterparties within a bank;
intra-entity covenants are made within one legal entity, whereas the
inter-entity covenant is made between two legal entities of one bank.
An external covenant is made between the bank originator and
an external counterparty.
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We assume that covenants between more than two counterpar-

ties (meta-covenants; eg, a syndicated loan with optional parts)
can be deconstructed into separate covenants (involving only two
counterparties each).
We shall concentrate on active covenants (which will mature in
the future), but in order to model the behaviour of certain transac-
tions, we may want to make use of the exercise behaviour of historic
covenants (which have maturities in the past).
Furthermore, we shall need to consider potential future coven-
ants. For example, we want to model the fact that the bank will not
stop the issuance of new credit facilities in the future.
A covenant is characterised by a particular set of data. For our
purposes, we will try to use the fewest parameters (dimensions in a
database) which will still allow the required modelling.
The main parameters are initiating party and counterparty, start
and maturity date, nominal amount and price (including possible
initial discounts and interest payments).
A set of covenants might be too large to treat (eg, all consumer
loans), so we shall concentrate them in a covenant group. The
covenant group contains all transactions of its covenant type.
We can further distinguish covenants with embedded optionality
and without optionality.
Taxonometry of transactions
Pseudo-transactions
Transactions are mostly symmetric in two regards: assets (or liabili-
ties) are exchanged against cash outflows (or inflows) at the start of
the transaction; at the end of the transaction the exchange is more
or less reversed: the difference is the profit. However, asymmetrical
transactions also exist, for example, a tax payment is paid out but
there is no maturity because it is not liable to repayment.
To capture these effects, we introduce pseudo-transactions relat-
ing to non-financial cashflows, such as the payment of salaries, taxes,
etc, which stem from pseudo-covenants as they cannot be attributed
to actual covenants.
Active transactions
We are mainly interested in active transactions which have cashflows
in the future.
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If a transaction is active, its parent covenant is also active.

Historic transactions with no future cashflows, however, can be
of use when analysing behavioural patterns, eg, to parameterise
simulation models.
Aggregated (summarised) transactions within one covenant

We want to aggregate multiple transactions residing in one covenant
in a summarised transaction. As the name indicates, we simply
sum all asset or liability flows of an individual transaction (per
day), which is straightforward (as long as transactions do not bear
embedded optionality).
Example 6.15 (multiple drawings under a credit facility). Given a

credit facility of 100 starting at t0 with maturity tM , from the banks
view the option inventory is negative (the bank is short the option).
Before the start (t < t0 ) the option inventory FOI(t) = 0.
At t = t0 the option inventory jumps to FOI(t) = 100.
During the lifetime of the facility (between t0 and tM ), the

option inventory stays constant at FOI(t) = 100.
At maturity t = tM the option inventory falls back to FOI(t) =
100.
At t1 the client makes a drawing A of 30 until maturity tM .
At t2 the client makes another drawing B of 50 until t3 , which

is before maturity.
The option/asset flows and inventories are
t0 : no asset flow, FAIA+B (t0 ) = 0; FOF(t0 ) = 100, FOI(t0 ) =

100;
t1 : FAFA (t1 ) = 30, FAIA+B (t1 ) = 30; FOI(t1 ) = 100 + 30 = 70;

t2 : FAFB (t2 ) = 50, FAIA+B (t2 ) = 30 + 50 = 80; FOI(t2 ) = 70 +
50 = 20;
t3 : FAFB (t3 ) = 50, FAIA+B (t3 ) = 80 50 = 30; FOI(t3 ) = 20
50 = 70;
tM : FAFA (tM ) = 30, FAIA+B (tM ) = 30 30 = 0; FOF(tM ) = 100,
FOI(tM ) = 70 30 + 100 = 0.
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Aggregated (accumulated) transactions across covenants

In a specific security,13 the bank might have done different security
transactions, such as purchase, sale, repo, buy/sell back, borrowing
etc.
If we want to create a position or forward asset inventory for
this security, we need to generate accumulated transactions which
aggregate transactions across covenants.
Example 6.16 (securities position). Assume a security S matures at

tM . The bank buys an amount of 5 with value date t0 and another 10
with value date t1 and then sells 3 in t2 which it buys back at date t4 .
At t3 it sells 7. What is the forward inventory in t3 ?
t0 : FAF(t0 ) = 5, FAI(t0 ) = 0 + 5 = 5,
t1 : FAF(t1 ) = 10, FAI(t1 ) = 5 + 10 = 15,
t2 : FAF(t2 ) = 3, FAI(t2 ) = 15 3 = 12,
t3 : FAF(t3 ) = 7, FAI(t3 ) = 12 7 = 8,
t4 : FAF(t4 ) = 3, FAI(t4 ) = 8 + 3 = 11,
tM : FAI(tM ) = 11 11 = 0.
A complication of securities transactions is that they might have

amounts which are unsettled at the time we calculate the position; as
a result we have to consider that our future position is not constant
as of now but changing as a result of transactions we have already
done.
Furthermore, buy-and-sell transactions (and combinations of
these) change the banks ownership of this security by creating asset-
and cashflows.14 Repo, reverse repo, borrowing and lending trans-
actions, however, only change the availability of the security (for a
certain time period); the ownership remains unchanged. Therefore,
we need to distinguish between ownership and possession of
forward asset inventories (FAIs); see also page 129ff.
Taxonometry of cashflows
Cashflows can be classified in many ways.
Practically, a cashflow is characterised by its amount, date and
sender account (which normally determines the currency) plus the
receiver account and the beneficiary.
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Other information like originator, counterparty, interest or princi-

pal flow are inherited from the transaction but may also exist at the
cashflow level (eg, interest or principal flow).
One important practical characteristic is the scenario in which
the cashflow has been created, as in different scenarios a transac-
tion might have different cashflows. This applies to asset and option
flows as well.
Scheduled cashflows stem from (a part of) a transaction with-
out optionality.
Deterministic cashflows are unequivocally determined

by the terms of the transaction: all relevant variables are
known today, so we regard them as known in our model.15
Variable cashflows are very similar to deterministic cash-
flows except that some market variables are not known
today, which causes uncertainty about the amount (eg,
the unknown reference rate of an interest payment on a
floating rate note) and the timing (eg, a target redemp-
tion mote (TARN) is redeemed once a predefined accu-
mulated coupon payment is reached). Once, however, the
variables are known, they unequivocally determine the
variable cashflows, which then transform into determin-
istic cashflows. Note that although there is uncertainty
in variable cashflows, the underlying related transaction
has no optionality.
Contingent cashflows relate to transactions which stem from

the execution of liquidity options embedded in the contracts
(which themselves can, but do not need to, be influenced by
market parameters).
We distinguish between:
short contingent cashflows, in which the counterparty

has the right to exercise the liquidity option (eg, savings
deposits, drawings under credit facilities, prepayment of
mortgages, etc);
long contingent cashflows, in which the bank has the right
to execute the liquidity option (eg, loans with cancellation
right, withdrawal of cancellable deposits).
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Anticipated cashflows relate to transactions stemming from

contracts that do not yet exist but will exist in certain scenarios.
External and internal cashflows

External cashflows represent bookings between the banks central
bank account and another account at the central bank; they are also
referred as payments. An inflow (outflow) credits (debits) the banks
account with the central bank (its nostro account) and in return debits
(credits) another banks central bank account.
As future outflows (payments) have to be originated by the bank,
they can be regarded as being under the full control of the bank
(assuming the bank is always able to generate them).
Future inflows cannot be initiated by the bank but have to be ini-
tiated by the counterparty and are thus out of the banks control.
This is notwithstanding the fact that the bank can claim compensa-
tion if a contractually scheduled payment has not been made by the
counterparty, but this can only be made only after the fact.
Internal cashflows are made between two accounts within the
bank. If an internal cashflow arises from an external transaction,
one account will be a vostro account16 which the bank holds for an
external counterparty. If the cashflow arises from an internal trans-
action, the nature of the relevant accounts will depend on whether
it is an intra-entity transaction or an inter-entity transaction.
The lack of proper distinction between these types of cashflows
in many bank systems is a constant source of misunderstandings
between liquidity risk systems and payment systems.
For our purposes we will pick up all types of external and internal
cashflows but possibly filter some types out in certain views, espe-
cially internal cashflows that either lead to double counting or offset
other cashflows.
Cashflows as a function of time

Transactions are usually symmetric but if we look at a transaction
in the middle of its lifetime, the situation is asymmetric since (seen
from today) the transactions scheduled cashflows are either realised
cashflows that have already occurred or future cashflows that have
not yet occurred but are expected to occur.
From a liquidity risk viewpoint, we are less interested in the
realised cashflows since their unalterable nature cannot constitute a
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risk (which only arises out of uncertainty), but we might use them to
backtest predictions we have made in the past (analysing the model
risk).
Time-correlated cashflows
It is apparent that the behaviour of the correlated cashflows in the
above examples can be very different.
If the counterparty is illiquid, the expected cashflows will be zero.
After becoming insolvent, however, the counterparty might be able
to pay them in part or in tranches some months later.
If the cashflows are not executed because a payment system failed
to work, they are very likely to flow the next payment day, etc.
The deviation of a cashflow from its scheduled value can result in
further deviated or potential cashflows. The conditions under which
such time correlated cashflows come (or come not) into existence
depend not only on the deviating cashflow but on the governing
transactions or covenants.
CONCLUSION
In this chapter we have outlined a comprehensive and consistent

framework which will allow practitioners to capture the relevant
aspects of a banks illiquidity risk. The vast majority of the existing
liquidity risk measuring/monitoring systems will start the neces-
sary forecasting with the cashflows and try to change these cash-
flows according to the scenarios. If our methodology is consequently
applied and implemented, the capture and modelling of existing and
hypothetical transactions of the bank stand at the beginning and the
cashflows will be derived from these. The transactions are the cause
of payments. The payments are the effects and are uncertain because
they will occur in the future; we model them as (future) cashflows.
Consequently, we do not represent the uncertainties by just varying
the cashflows but we instead treat the alteration as being driven by
the underlying transaction. The variation can originate in the trans-
actions built-in variability or optionality but it can also stem from
external events such as the inability or unwillingness of a counter-
party (credit or operational risk) to execute the transaction as it was
originally scheduled.
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To implement the mechanics of the banks balance-sheet progres-

sion, we introduced scenarios and systematised their creation pro-
cedures. To simplify and structure the variety of scenario assump-
tions, liquidity units comprise transactions which behave similarly
and allow the aggregated transactions to be treated jointly instead of
individually. Liquidity units allow us a birds eye view of the balance
sheet and to isolate the liquidity (risk) drivers.
Finally, the view on scenarios is refined: exposure scenarios reflect
potential situations that the bank could encounter, assuming that it
would not take actions to modify the situation in any way; strategy
scenarios, on the other hand, model the measures which the bank
could take to change the course of things.
Next we addressed the uncertainty stemming from the origination
of the transactions itself. On the one hand the bank might be urged to
generate new transactions or change existing transactions due to its
contractual obligations (because it is short contractual options) but
it may also be unable to discard new transactions due to softer types
of commitments. On the other hand, if the bank is long contractual
options which can be executed, it might also simply try to create new
transactions. We introduce rejectable options that reflect the banks
possibilities of modelling its balance sheet. Rejectable options are
trivial in a market risk sense because the potential counterparty
can always reject them, thus making it quite unlikely to create a
profit, as the counterparty is normally not willing to accept the recip-
rocal loss. Although a potential counterparty is able to reject any
individual transaction, possibly not all counterparties will reject all
proposed transactions. If a banks business model is, for example,
to grant loans, it can reject every individual client, but is short the
rejectable option to grant loans in general and thus needs to accept
some of them (unless it decides to modify its business model). On the
other hand, clients can discard a certain bank as a potential receiver
of their deposits, but most of them will finally have to choose a bank
(or more than one) in order to invest their surplus money.
A future transaction is not independent from the balance sheet:
ideally speaking, it will either originate a future mirror transaction
(eg, the refinancing of a loan) or change the existing balance sheet
(eg, the sale of a bond reduces the banks ownerships of this bond).
The concept of asset flows and inventories allows these effects to be
monitored.
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Disclaimer: as every bank is different in its business model, posi-

tioning in the market, credit standing and its strategy, it is impossible
to give an exact implementation plan here. The concepts described
here are highly complex and there is no textbook way to apply them.
Thus, relying on so-called best practice is not a good idea for the
following reasons. Concepts should be fully understood before they
are used; a sophisticated concept is a bad concept if it is poorly imple-
mented: a less complex concept could be more suitable and thus
better. The best practice as of late 2008 was obviously not good
enough for the not so few banks that went under, were taken over
or could only survive with the help of regulators and governments.
Even some of the survivors were just lucky. Quite often banks that
have realised that they have to do something in this field are trying
to skip the theory and start to build systems that should mea-
sure liquidity risk without clearly understanding what they want to
measure exactly. Maybe going back to the basic discussions as they
are outlined in the previous chapters will not waste time but save
time, as changing the measuring strategy can be avoided. Finally,
banks should bear in mind that the trivial things like data mod-
els, the collection of transactions and generation of cashflows are
the biggest part, or at least the foundation, of the solution, although
they are only treated cursorily in this book.
A result of the preceding disclaimer is that we cannot model the
future behaviour and status of the banks balance solely by focusing
on value (and the corresponding risks, as is done, for example, in
market and credit risk) but rather we need to simulate the full set of
transactions and consequential cash- and asset-flows within the cho-
sen observation period. This outcome cannot be compressed in one
single number like VaR. As a consequence, capital cannot mitigate
illiquidity risk and therefore we need to add a model for the imple-
mentation of the counterbalancing capacity, which we describe in
the next chapter.
1 The result of such a scenario is, in comparison with other scenarios, not very material in
respect to liquidity.
2 A paradigm is a theoretical framework, within which empirical hypothesis are drawn
and theories developed. In sociology, a dominant paradigm describes the collectivity of
prevailing opinions (see Michael Parentis speech Lies, Wars and Empire at http://
www.youtube.com/v/CZTrY3TQpzw).
3 Fixed does not impose the condition that the cashflows are known before they happen;
this is impossible.
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LIQUIDITY MODELLING
4 We neglect cashflows from financial options (other liquidity options) because they are not
substantial for liquidity risk.
5 Breach options can only be exercised by counterparties because (as discussed before) we do
not model the bank breaching contracts.
6 This process only makes sense if we can assume with sufficient confidence that these
conversions could be performed in reality (the prevailing money and FX markets).
7 Our shortest time step is a day. We will release this constraint when we come to intra-day
cash management, where we will develop the cash inventory during the payment day.
8 We have made some simplifications: short/long positions on nostro accounts will always be
due the next day and no interest will be paid/received. We will address this later and treat a
nostro like a financial transaction with interest rate payments and daily maturity.
9 If we have the future cashflows, but not the (sub-) nostro of, eg, a portfolio, we cannot deter-
mine if this portfolio is a liquidity consumer or provider, as the cashflows only do not allow
constituting a surplus or lack of liquidity in this portfolio relative to the bank.
10 In reality the parameters might only be known in principle; although date, amount and
currency of a scheduled cashflow are determined, for example, the target account will only
be specified later.

11 Note that the described processes closely resemble mathematical integration ( f (x) dx =
F(x) + C) and differentiation (F (x) = f (x)); the antiderivative f (x) dx can only be fully
determined if the integration constant C can be eliminated at the boundaries of a definite
integral.
12 In fact, the bank wants more than just to be compensated. If the risk and even potential direct
costs the bank incurs while giving the loan just evens out with the interest rate, there would be
no impetus for the bank to enter into the loan transaction. Karl Marxs Mehrwert (surplus
value) drives the banks appetite to give loans.
13 We might identify the security uniquely, eg, through its International Securities Identification
Number (ISIN) code.
14 Repo transactions not only change the availability of a security (for a certain time period) but
also create a loan or deposit.
15 They can change if the counterparty is not able/willing to execute them as contractually
agreed (cf breach of contracts).
16 Vostro (yours in Italian) accounts are sometimes called loro accounts (theirs in Italian).
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The Counterbalancing Capacity
We introduced the counterbalancing capacity in Chapter 4 (see

page 45) as a part of the illiquidity risk measurement process. Now
we will develop a model of the CBC that can be practically imple-
mented in a bank.1 This is crucial because, while previous chapters
have focused predominantly on measuring illiquidity risk, we also
need to know what to do to protect against it and manage it. This
chapter provides solutions to this problem.
From an illiquidity risk perspective, we have to deal with two
different uncertainties.
The factual future nostro balance may deviate from the forecasted
FLE, which, in an illiquidity risk view, can be a risk but also a chance.
Assume we have managed to bypass the above problem, and
know that the bank will, on a day tF in the future, inevitably end
up with a cash deficit FLE(tF ) on its nostro. An uncertainty now
arises as to whether the bank will be able to generate enough cash
until tF to counterbalance the forecasted deficit and finally end up
with a non-negative nostro.
In order to answer this question we will determine the banks
counterbalancing capacity (CBC(tF )) until a future day tF in the
following thought experiment.
Assume that the bank has used all its means to generate as much
additional cash liquidity CBC(tF ) as possible until tF . If CBC(tF ) +
FLE(tF ) < 0, the bank is unable to counterbalance its position until
tF , and thus will in our thought experiment become illiquid at tF at
the latest.
If, however, CBC(tF ) is greater than the deficit FLE(tF ), we can
interpret the positive difference FLE(tF ) + CBC(tF ) as a measure of
the banks distance to illiquidity.2
As the bank has to avoid illiquidity on every single day within
our time horizon, we need to describe the above process as a func-
tion in time t and call it the counterbalancing capacity. Its results are
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LIQUIDITY MODELLING
hypothetical transactions which lead to inflows and thus improve

the banks cash liquidity.3 As with most thought experiments, we do
not interpret the CBC as a process which is likely to happen in the
future exactly as it was scheduled, but instead use it as an estimate
of how far the bank is away from future illiquidity. We chose to
use the strategy try to generate as much cash as fast as possible,
which is in the sense unrealistic as no bank will generate billions of
inflows if it only needs a million. If we instead model the situation as
realistically as possible (eg, simulating that the bank will create just
enough CBC to offset the future deficit), the result would be bor-
ing: every time the CBC successfully offsets the anticipated deficit
the only additional information given is yes, it is possible to com-
pensate the deficit, until one day the answer will possibly be no,
it is impossible to compensate the deficit.
If we compare this with credit or market risk, we see a major
difference: if the CBC is large enough to neutralise the cash deficit,
the bank will have no illiquidity problems on that day (aside from
eventual higher-than-normal refinancing costs) and there will be no
remaining disadvantage other than the losses which can be consid-
ered as insubstantial in the context of illiquidity. If, however, we
consider credit or market risk, a materialising loss is held against
the capital and can only be neutralised by diminishing the capital.
Capital which cannot be used as a buffer for illiquidity risk is
substituted by the CBC, which, however, does not neutralise losses
but is also not impaired by losses.
We will develop methods which allow us to simulate how much
liquidity the bank could create to counteract a potential future lack
of cash liquidity, regardless of whether it would in reality actually
create that much liquidity. The result is the CBC, which if held against
the FLE will indicate the banks distance to illiquidity, a cushion for
unforeseen additional outflows or lesser than expected inflows.
We further disregard other restrictions the bank might have, such
as the cost of liquification, accounting issues, balance sheet or tax
constraints, etc.
LIQUIDITY RISK REQUIREMENTS

In our liquidity risk solution we express the illiquidity risk of a bank
as its possible forward liquidity exposure, which is constituted by
cashflows with varying grades of uncertainty, stemming from the
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THE COUNTERBALANCING CAPACITY
different contracts the bank has already agreed on or is likely to

enter into.
We differentiate between contracts with cashflows which
are assumedly fixed or variable (scheduled cashflows),

stem from exercising options the bank has already entered into
(contingent cashflows),
are created by contracts the bank has not yet entered into
(hypothetical cashflows).
Therefore, there cannot be just one single forward liquidity exposure:

the FLE depends on scenarios under which not only the cashflows
themselves may change but also the underlying contracts might be
altered, cancelled or newly created.
In order to control the magnitude of possible scenarios we distin-
guish (as discussed in the section on exposure and strategy scenar-
ios on page 88 onwards) between exposure scenarios and strategy
scenarios.
Exposure scenarios simulate what can happen to the bank and
therefore model the creation and behaviour of variable, contingent
and hypothetical cashflows, but only from options the bank is short
and only from new contracts that are generated in the normal
course of the business. Strategy scenarios, on the other hand, sim-
ulate what the bank could do in a certain liquidity situation and
therefore cover the categories which are lacking from the exposure
scenarios.
CBC: THE PROBLEM

We consider a certain scenario, which we call the base scenario.
Assume the result of the base scenario is that the banks forward
liquidity exposure FLE is less than zero at a future day t: FLE(t) < 0.
We shall call t a short liquidity day.
How can this be interpreted?
We digress for a moment from the uncertainties related to scenario
simulation and make the bold assumption that the scenario perfectly
forecasts the future reality: consequently, on the short liquidity day,
the bank will have a net cash outflow on its nostro account (or insuf-
ficient net inflow to cover the underfunded nostro account if there
was a preceding short liquidity day).4
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LIQUIDITY MODELLING
Definition of the CBC strategy

A strategy scenario simulating the banks possibilities of generating
positive future cashflows is called a counterbalancing capacity.
It is defined for every future day t and predicts whether the bank
will be able to compensate the future shortage at a future point in
time, t
FLE(t) + CBC(t) > 0
As the CBC should reflect the various possible changes in the

liquifiability of assets, the availability of refinancing sources, etc, it
needs to be not just one scenario but a set of scenarios.
There are different possible CBC scenarios.
In the simplest CBC scenario (CBC0 ) we assume that all
redemption and coupon cashflows of the banks liquefiable
securities will take place as scheduled; the scenario target is to
exercise all scheduled cashflows as planned.
We could simulate whether the bank can generate just enough
cash to balance its negative nostro account. The result of the
strategy would be achieved or not achieved, but would
not allow to distinguish whether achieved means far more
than just enough cash or just able to generate enough cash,
etc.
Normally we will use a maximum cash strategy, that is to say
we calculate how much cash the bank could generate, regard-
less of whether it will really need it (or a fraction would have
already been sufficient).
Therefore, we define the target CBC strategy differently: What is
the maximum amount of cash the bank is likely to be able to generate
in the future?
The result, of course, depends on the assumptions we make.
As we want to compare the FLE of the base scenario with the CBC,
we cannot make assumptions for the CBC which contradict those of
the base scenario.
Assume, for example, that we have simulated a going concern
in the base scenario; thus, it would not make any sense to assume a
fire sale for the CBC.
If, however, a negative result (FLE(t) + CBC(t) < 0) forces us to
do so (because we cannot create sufficient liquidity with a going
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concern sale only) we have to realise that the going concern was
not an appropriate scenario for the bank to start with.
Thus, we allow for strategies only different sub-scenarios to
be mixed; for example, assume FLE in idiosyncratic stress with
the strategy CBC only with repos, and additionally CBC with
fire-sale because we want to be able to illustrate the results of the
different strategies the bank could use. Normally, we will reuse the
parameters of the base scenario, apart from the very parameters
that change in the strategy: the base scenario assumes no use of
optionality, whereas the CBC models the use of optionality.
Other parameters that are not essential for the base scenario
require specification in the CBC. The repo or sale of assets or the
use of credit lines the bank has taken might encounter real or oppor-
tunity cost; therefore, the modelling of these transactions depends
on the willingness of the bank to bear these costs, which would be
very different, for example, in a going concern scenario compared
with a Lehman Brothers meltdown type of scenario.
The components of the CBC

The counterbalancing capacity encompasses the most important liq-
uidity options in which the bank has a long position: those which
allow the bank to generate cash inflows. We can distinguish between
the contractual options to generate cash, which can be exercised
without complications, and the rejectable options, which are more
complicated to execute because the potential counterparties can
always reject the banks execution.
There are, generally speaking, three possibilities for a bank to
increase its time-cumulated cash inflows: it can shorten the sched-
uled tenor of assets, it can generate new, additional, liabilities and it
can elongate the tenor of existing liabilities.
Contractual elements of the CBC

Credit facilities the bank has taken. The contractual elements are
normally mostly credit facilities which the bank has taken (is long).
The counterparty has the legal obligation to execute the consequen-
tial transactions but might be unable or unwilling, so there is still an
element of uncertainty for the bank. A credit facility spawns a new
liability in the banks view.
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LIQUIDITY MODELLING
Guaranteed but not paid in capital. If an investor has guaranteed

but not fully paid in an amount of capital, it can be regarded as a non-
rejectable option to receive cash the bank is long. It is important that
the lender has no possibility to hold payment back if is requested by
the bank (eg, to wait until the bank has declared insolvency).
Extendable bonds issued by the bank. The most certain option is
an extendable bond that the bank has issued. These bonds bear the
option for the bank to push its maturity ahead. If the bank exercises
the option of such a bond, the counterparty has no chance to with-
hold the cash (because it has already flown to the bank). Even if the
counterparty is convinced that it will go bust without the paid-out
liquidity and thus would be prepared to breach the contract because
it strongly believes that the bank will go bust, there is no possibility
to do so. Although they were initially planned to protect the issuer
against high interest rates, extendable bonds were used in the 2008
crisis to elongate an existing liability. They can also be regarded as
spawning a new liability (in the banks view).
Cancellable loans. If the bank has paid out a loan where it is explic-
itly long to cancel (or shorten) the maturity, it can move the redemp-
tion cashflow nearer to today. Again, the counterparty could breach
the contract and not repay as early as requested.
From the banks perspective it is an asset with a shorter-than-
scheduled maturity.
Assets with guaranteed saleability (asset put options). If the bank
is long an option to sell an asset (at a pre-specified price), it can
generate an inflow which comes earlier than reflected initially in the
FLE. Again, the counterparty could breach the contract and refuse
to exchange the asset against cash as contractually agreed.
From the banks perspective it is an asset with shorter-than-
scheduled maturity.
Rejectable liquidity options in the CBC

Sale of assets from the balance sheet. The bank can try to sell
assets that it owns. This option is rejectable, as no potential buyer
is obliged to agree on the sales the bank is proposing. If assets are,
however, widely accepted as being of high quality and liquidity,
the probability that the bank is not able to execute the sale might be
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small but the bank is not able to force the counterparty to enter into
the sales transaction.
From the banks perspective this is an asset with shorter-than-
scheduled maturity, but it changes the stock of securities owned by
the bank (ie, it affects both final and temporary sales).
Shortening of the maturity of assets (loans given). The bank can try
to convince a counterparty to pay back a loan earlier than scheduled.
The counterpart is always free to refuse the early redemption.
From the banks perspective this is an asset with shorter-than-
scheduled maturity.
Extension of the maturity of existing liabilities. The bank can try to
convince a depositor to lengthen the tenor of liabilities. The situation
is the same as for the acquisition of new unsecured liabilities.
From the banks perspective this is a new liability.
Acquisition of new unsecured liabilities. The bank can try to acquire
new liabilities without offering collateral. It is at the discretion of
the potential counterparty to reject this. The reasons could be that
the counterparty does not have sufficient liquidity available or is
insecure about the availability or is not willing to enter into the credit
risk with the bank (or does not accept the credit risk premium the
bank is willing to pay).
From the banks perspective this is a new liability.
Acquisition of new secured liabilities (repo). The bank can try to
acquire new liabilities (repos) by offering collateral. It is at the dis-
cretion of the potential counterparty to reject this. The reasons are
the same as above but the credit risk issue should be smaller. The
counterparty is, however, still free to judge that the quality of the
offered collateral is not good or liquid enough. It may equally fear
the uncertainty about the ownership and usability of the collateral
in case the bank becomes illiquid.
From the banks perspective this is a new liability which addi-
tionally changes the possession but not the ownership of the banks
securities.
Practical considerations
For the following development of the model we slightly restrict the
above categorisation.
In the view of optionality we distinguish between
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LIQUIDITY MODELLING
(i) the generation of transactions under existing options and

(ii) the creation of new contracts through rejectable options.
In a balance-sheet view, positive liquidity effects can come either
from
(i) the reduction of assets or
(ii) the growth of liabilities (no third is given).
We can order the constituent elements of the CBC as follows.
Non-rejectable options:
reduction of assets;
growth of liabilities.
Rejectable options:
reduction of assets:
unconditional sale of an asset;
sale and predetermined buy-back of an asset (tempo-
rary reduction);
growth of liabilities:
unsecured funding (eg, new term or savings de-
posits);
secured funding (eg, a repo or a covered bond issue).
Although this is a logically complete list of all possibilities to

improve the liquidity directly, we might want to additionally con-
sider contracts or transactions that change the inventory of liquefi-
able assets and thus indirectly influence the banks liquidity. These
include, for example, security borrowing and lending as well as secu-
ritisation of assets (which does not change the amount of assets but
changes their availability for sales or repo transactions).
FLE and CBC

The relationship between the FLE and CBC is sometimes confusing.
The FLE is normally defined for the whole balance sheet, includ-
ing the parts which constitute the CBC; therefore, an FLE sce-
nario going concern/scheduled would comprise the simplest
scenario CBC0 .
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Figure 7.1 Dismantling of the balance sheet into disjunct liquidity units
for the CBC
All existing contracts Not yet existing

Contracts with scheduled CFs contracts
Contracts Contractual Rejectable

Contracts with with optionality optionality
scenarios
Exposure
fixed CFs variable (short/ (short/
CFs liquidity) liquidity )
CBC0 Security
contracts
Contractual Rejectable
optionality optionality
scenarios
(long/ (long/
Strategy
CBC liquidity +) liquidity +)
CBCn
A practical way to circumvent this problem is the following. In

the scenario going concern/scheduled, for example, we will gen-
erate the redemption and coupon cashflows of the banks liquefiable
securities not in the FLE but instead separately in CBC0 . In order to
get an overall view of the balance sheet we will have to add both
views, that is, we shall always consider the sum FLE + CBC0 instead
of FLE only.
We shall in general split the contracts that are used for the gen-
eration of the CBC from the rest, which are used for the FLE only
(without the CBC) but then look at FLE + CBC if we want to have
the full balance-sheet view.
In order to avoid the repeated calculation of cashflows that do not
change in multiple scenarios, we generally dismantle the balance
sheet in disjunct selections of contracts/transactions as shown in
Figure 7.1.
CBC in a narrower sense

Each individual CBC strategy models certain liquidity-improving
measures such as balance-sheet expansions (secured or unsecured
refinancing) or balance-sheet contractions (reduction of assets)
which can be interpreted as the banks response to a potential
liquidity shortage.
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LIQUIDITY MODELLING
For technical reasons we will restrict ourselves to modelling the

CBC only on the basis of transactions being security related. The rest
of the transactions will be treated in the general scenario modelling.
In detail we will consider the following types of transaction:
buy-and-sell;
sell and buy back, and buy and sell back;
repo and reverse repo;
security lending and security borrowing.
BUILDING BLOCKS OF A TECHNICAL SOLUTION

Determining the admissible portfolio of securities
First we have to determine the admissible portfolio, which is the
portfolio of securities we want to consider as the underlying scenario
selection for the CBC. It normally contains (parts of) liquidity units.
We include securities in which we have a zero inventory at t0 or
which are fully blocked at t0 , as they might have an inventory in the
future.
Basis of the CBC for a single security

If in the past, the bank has done deals (purchase, sale, repos, borrow-
ing, etc) in a certain security, one might speak about the position in
this security. In fact the position is a fuzzy description of the situa-
tion, as the bank might need to distinguish, for example, between the
ownership and the possession of the security. Pending transactions
are deals which are not fully executed today (eg, a forward sale or a
repo). They can change todays ownership/possession in the future
so we need to introduce a term structure of the position.
For our purposes we therefore need to refine the concept of
position which is what we will do in the following.
Forward asset inventory

For each security in the admissible portfolio we have to generate the
term structure of its forward asset inventory FAIt .
1. As of close of business yesterday (t 1) we determine its cur-

rent asset inventory FAIt1 excluding unsettled legs of pending
transactions (FAIt1 is only a point in the term structure).
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Table 7.1 Transactions, forward asset flows and inventories of an

example bond
Security OLO BE0000295049

Maturity 28/09/10
Coupon 5.750% act/act
Price 105.180%
23/09/2009 = today
Settlement
date Transaction FAF FAI
22/09/2009 As of 170.00
23/09/2009 Sell 20.00 150.00
24/09/2009 Buy 15.00 165.00
25/09/2009 Repo 5.00 170.00
28/09/2009 Coupon date 170.00
29/09/2009 170.00
30/09/2009 Reverse repo 20.00 150.00
30/09/2009 Sell back 20.00 130.00
01/10/2009 130.00
02/10/2009 130.00
05/10/2009 Buy back 100.00 230.00
06/10/2009 230.00
07/10/2009 230.00
08/10/2009 230.00
09/10/2009 230.00
28/09/2010 Coupon date 230.00
28/09/2010 Maturity 230.00 230.00
2. We generate the asset flows of the unsettled legs of the pending

transactions; this will give us a series of forward asset flows
FAFt+0 , FAFt+1 , . . . , FAFt+N .
3. We build the forward asset inventory FAIt in time (current asset
inventory plus unsettled parts of the open transactions)
FAIt+0 = FAIt1 + FAFt+0 ,

FAIt+1 = FAIt+0 + FAFt+1 ,
..
.
The above process is outlined in the example in Table 7.1.
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Table 7.2 Forward cashflows and inventories establishing the basic

counterbalancing capacity scenario CBC0
Security OLO BE0000295049

Maturity 28/09/10
Coupon 5.750% act/act
Price 105.180%
23/09/2009 = today
Available assets Cash

Settlement
date Transaction FAF FAI Price FCF FCI
22/09/09 As of 170.00 105.18 178.81

23/09/09 Sell 20.00 150.00 105.18 21.04 157.77
24/09/09 Buy 15.00 165.00 105.18 15.78 173.55
25/09/09 Repo 5.00 170.00 105.20 5.26 178.80
28/09/09 Coupon date 170.00 0.06 9.78 169.03
29/09/09 170.00 0.00 169.03
30/09/09 Reverse repo 20.00 150.00 105.21 21.04 147.99
30/09/09 Sell back 20.00 130.00 105.20 21.04 126.95
01/10/09 130.00 0.00 126.95
02/10/09 130.00 0.00 126.95
05/10/09 Buy back 100.00 230.00 102.34 102.34 229.29
06/10/09 230.00 0.00 229.29
07/10/09 230.00 0.00 229.29
08/10/09 230.00 0.00 229.29
09/10/09 230.00 0.00 229.29
28/09/10 Coupon date 230.00 0.06 13.23 216.07
28/09/10 Maturity 230.00 230.00 100.00 230.00 13.94
Forward cash inventory

In order to determine the impact of the above asset flows and inven-
tories on the FLE, we will calculate the future cashflows FCF and
establish its corresponding cashflow inventories FCI (compared in
Table 7.2).
1. We determine the securities current cash inventory FCIt1

as of close of business yesterday, excluding cashflows from
unsettled legs of pending transactions.
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2. We generate the forward cashflows of the unsettled legs of the

pending transactions
FCFt+0 , FCFt+1 , . . . , FCFt+N
3. we build the corresponding forward cash inventory FCIt in

time
FCIt+0 = FCIt1 + FCFt+0

FCIt+1 = FCIt+0 + FCFt+1
..
.
In the basic FLE scenario FLE0 we assume that all scheduled

cash and asset flows will occur as planned and no options will be
executed. This means that by calculating the forward cash inven-
tories we have determined the basic counterbalancing capacity
scenario CBC0 .
Splitting the FAI into possession and ownership

A repo and a sell/buy-back transaction can both have the same
impact on the asset inventory, although the sell/buy-back changes
the ownership which is reflected on the balance sheet, whereas the
repo only changes the possession without a balance-sheet impact.
In fact, the FAI in the way we have previously used it equals the
possession FAIt .
The repo5 transactions FAIRt do not change the ownership but
constitute the difference between the ownership FAIO
t and the overall
possession
FAIPt + FAIRt = FAIt
Note that the repo transactions can decrease the overall possession
of a bond, but can increase it as well (see Table 7.3).
Short positions
The bank has a short position in a security today or at a future point in
time tn (n = 0, 1, . . . ) if this securitys asset inventory FAIn is negative
at tn , which means that more bonds have to be delivered at tn than are
then available (at least in possession but possibly also in ownership).
Although the formal description of the FAIn is correct, it does not
properly describe what can happen in reality, as a short position in
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Table 7.3 Forward asset inventories split into parts referring to ownership and possession
Available assets Ownership Possession

Settlement
date Transaction FAF FAI FAF FAI FAF FAI
22/09/2009 As of 170.00 155.00 15.00

23/09/2009 Sell 20.00 150.00 20.00 135.00 15.00
24/09/2009 Buy 15.00 165.00 15.00 150.00 15.00
25/09/2009 Repo 5.00 170.00 150.00 5.00 20.00
28/09/2009 Coupon date 170.00 150.00 20.00
29/09/2009 170.00 150.00 20.00
30/09/2009 Reverse repo 20.00 150.00 0.00 150.00 20.00 0.00
30/09/2009 Sell back 20.00 130.00 20.00 130.00 0.00
01/10/2009 130.00 130.00 0.00
02/10/2009 130.00 130.00 0.00
05/10/2009 Buy back 100.00 230.00 100.00 230.00 0.00
06/10/2009 230.00 230.00 0.00
07/10/2009 230.00 230.00 0.00
08/10/2009 230.00 230.00 0.00
09/10/2009 230.00 230.00 0.00
28/09/2010 Coupon date 230.00 230.00 0.00
28/09/2010 Maturity 230.00 230.00 230.00 0.00
Security OLO BE0000295049; Maturity 28/09/10; Coupon 5.750% act/act; Price 105,180%; 23/09/2009 = today. All nominals are in (millions).
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Table 7.4 Example security XYZ
Security XYZ
Coupon 4.000%
Base 365 days
Last coupon 12/02/09
Maturity 12/05/09
Ownership (FAIO ) 100.000
Possession (FAIP ) 80.000
Average price 101.870%
Cash (FCI) 81.496
a bond is technically not possible: at tn the bank has to deliver the

bonds or will be liable for a breach of contract and therefore will
have to either buy or repo in the necessary securities.6
Therefore, for each security, we have to assume that at the first
short date tk in the future the bank will buy or borrow the necessary
amount at least until the next business day.
In the CBC0 which contributes to FLE0 , as a consequence, the
scheduled cash inflows from the original transaction(s) leading to
the short position need to be corrected by the cash outflows of the
hypothetical buying or borrowing transaction.
From a technical point of view, we will introduce a zero-floor
algorithm which will look up each day in the future to see if the
FAI is negative and, if so, create a hypothetical overnight borrowing
(zero-floor transaction) which will balance the FAI to zero for a day.
If on the next day the FAI is still negative, another zero-floor
transaction will be created, etc.
The forward cashflows FAF of all zero-floor transactions represent
a correction of the cash side of the CBC and thus have to be added
to the calculation.
Impacts of admissible transactions (deals) in a single security

We will explain the effects an admissible transaction has on the
position in detail.
In Table 7.4 we take the example of one security XYZ, where we
own 100, of which we possess 80 and simulate all admissible trans-
actions with a nominal of 25. We assume there is no other transaction
in this security pending. For the sake of simplicity we assume that
there is no coupon flow.
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Table 7.5 Example security XYZ: impacts of a purchase/sales

transaction
Buy Sell
Tenor 07/04/09 07/04/09
Deal Nominal 25.000 25.000
Price/Rate 101.500% 101.500%
Haircut
Start/end Start/end
Price Clean 101.500% 101.500%

Accrued 0.592% 0.592%
Dirty 102.092% 102.092%
Security Ownership FAFO 25.000 25.000
Possession FAFPO
Cash FCF 25.523 25.523
Leg Leg
After Ownership FAIO 125.000 75.000

deal Possession FAIP 105.000 55.000
leg X Cash FCI 107.019 55.973
We set the average price to 101.870%. We can calculate the FCI as

80 101.870% = 81.496.
Purchase/sale. Buying (selling) of a security increases (decreases)

the ownership by the nominal amount of the transaction.
The cashflow is determined as the nominal times the dirty price
(dirty price = clean price + accrued interest)
There is no adjacent asset or liability effect as, for example, for repos
(see Table 7.5).
Maturity of a security (long/short) Because we calculate the forward
asset inventory at maturity tM as
FAI(tM ) = FAI(tM 1) + FAF(tM )
we cannot just set the FAI(tM ) equal to 0, but need to express the
maturity of a security as a sale at maturity date, generating the
technically necessary forward asset flow FAF(tM ).
If we are short a security at maturity we need to generate a
hypothetical purchase of the lacking amount on that day. For short
positions in general see pages 129ff.
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Figure 7.2 Example security XYZ : purchase/sale transaction: impact

on asset- and cashflows/inventories
Cashflow Asset flow

Buy Maturity
asset of
asset
Pay Receive
cash cash
Asset inventory
tN tF
Cash inventory
Sell-and-buy-back versus buy-and-sell-back transactions. Sell-

and-buy-back and buy-and-sell-back transactions consist of consec-
utive buy-and-sell transactions. These change the ownership by the
nominal amount of the transaction, but only until the end of the
transaction, when the change is reversed.
Both cashflows at the start and the end are determined as nominal
times the agreed dirty price
(dirty price = clean price + accrued interest)
Normally the rate of the virtual money market deal which is consti-
tuted by the buy/sell transaction is quoted and the dirty price at the
start is agreed, then the dirty price at maturity can be determined.
There is no adjacent asset or liability effect as, for example, for
repos (see Table 7.6).
Repo/reverse repo. A repo (reverse repo) transaction is a cash

deposit (loan) which is secured by the security as collateral. It
creates a liability (asset) on the balance sheet.
It does not change the ownership but changes the possession of
a security by the negative nominal amount (nominal amount) of
the transaction, until the end of the transaction, when the change
is reversed.
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Table 7.6 Example security XYZ : impacts of a sell-and-buy-back and a

buy-and-sell-back transaction
Buy and Sell and

sell back buy back
07/04/09 15/04/09 07/04/09 15/04/09
Deal Nominal/tenor 25.000 8 days 25.000 8 days
Price/rate 101.500% 2.000% 101.500% 2.000%
Haircut
Start End Start End
Clean 101.500% 101.545% 101.500% 101.545%

Price Accrued 0.592% 0.679% 0.592% 0.679%
Dirty 102.092% 102.224% 102.092% 102.224%
Ownership FAFO 25.000 25.000 25.000 25.000
Security Possession FAFP
Cash FCF 25.523 25.556 25.523 25.556
Leg 1 Leg 2 Leg 1 Leg 2
Before Ownership FAIO 100.000 125.000 100.000 75.000

deal Possession FAIP 80.000 105.000 80.000 55.000
leg X Cash FCI 81.496 107.019 81.496 55.973
After Ownership FAIO 125.000 100.000 75.000 100.000
leg X Cash FCI 107.019 81.463 55.973 81.529
Figure 7.3 A repo is a collateralised borrowing

Cashflow
Asset flow Cashflow
Pay
Receive
Cash inventory back
cash
cash
Debt flow
Repay/
Issue Negative (debt) inventory buy back
debt
debt
tN tF
Asset flow
Asset flow
Pledge Retrieve
Collateral (asset) inventory
collateral collateral
(off b/s) (off b/s)
Cashflows at both the start and the end are not related to the
security transaction but stem from the cash deposit (loan) which
is capped by the nominal of the collateral times the clean price
eventually minus a haircut (see Table 7.7).
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Table 7.7 Example security XYZ: impacts of a repo/reverse repo

transaction
Repo Reverse repo
Start/end 07/04/09 15/04/09 07/04/09 15/04/09
Price/Rate 101.500% 2.000% 101.500% 2.000%
Haircut 8.000% 8.000%
Start End Start End
Price Clean 101.500% 101.545% 101.500% 101.545%

Accrued 0.592% 0.679% 0.592% 0.679%
Dirty 102.092% 102.224% 102.092% 102.224%
Ownership FAFO
Security Possession FAFP 25.000 25.000 25.000 25.000
Cash FCF
Loan/ Loan 23.345 23.345
deposit Deposit 23.345 23.345
Cash 23.345 23.355 23.345 23.355

leg X Cash FCI 81.496 58.151 81.496 104.841
leg X Cash FCI 58.151 81.506 104.841 81.486
Table 7.8 Example security XYZ: impacts of a security borrowing/

lending transaction
Borrow Lend
Tenor 07/04/09 15/04/09 07/04/09 15/04/09
Price/rate 101.500% 2.000% 101.500% 2.000%
Haircut 8.000% 8.000%
Start End Start End
Price Clean 101.500% 101.545% 101.500% 101.545%

Accrued 0.592% 0.679% 0.592% 0.679%
Dirty 102.092% 102.224% 102.092% 102.224%
Ownership FAFO
Security Possession FAFP 25.000 25.000 25.000 25.000
Cash FCF

leg X Cash FCI 81.496 81.496 81.496 81.496
leg X Cash FCI 81.496 81.506 81.496 81.486
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LIQUIDITY MODELLING
Security borrowing and security lending. A security borrowing

(lending) transaction is a deposit (loan) taken (given) in the form
of a security which is not collateralised. It creates a liability (asset)
on the balance sheet.
It does not change the ownership but changes the possession
by the nominal amount (negative nominal amount) of the trans-
action, until the end of the transaction, when the change is
reversed.
There is no cashflow at the start and the cashflow at the end stems
from the borrowing (lending) fee (see Table 7.8).
Blocked securities
Asecurity (or parts of it) can be owned and possessed by the bank but
might nevertheless be unavailable for certain transactions, which is
sometimes expressed by blocking the security.
In practice, however, blocking is often used in a fuzzy sense,
usually meaning not available for trading activity. For the CBC
purpose, however, we have to distinguish between available for
trading and available for CBC, which are not necessarily the
same.
For example, a security which has been delivered in the gen-
eral collateral pool of EUREX might be described as blocked
although we can use it for other purposes at any time until it becomes
designated as collateral for a specific repo transaction.
The security deposit which is required by EUREX for participating
in this business is blocked as well, but cannot be touched by the
bank (until the bank would stop the EUREX activities).
Physical delivery of repo trading in baskets (tri-party)

At t + 0 assume we trade a bond set in tri-party repo (bond A
and bond B) with the value date t + 1 and maturity t + 8.
At t + 1 we do not know which bonds will physically be
delivered.
At t + 2 the tri-party agents allocation of A/B is known and
should be reflected by a blocking until t + 8 in the bond trading
system. Instead, the inventory of these two bonds is accord-
ingly reduced for an undetermined period (no term structure),
whereas there should be a reversing asset flow in t + 8.
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At t + 9, however, the stock monitoring (as per t + 8) will

suddenly show the reversing asset flow.
Repos in synthetic bonds (ie, with London Clearing House (LCH)

or EUREX)
The clearing house, for example, decides (and informs the bank)
which bonds are used to physically deliver the transactions in the
synthetic bond. The bank should reflect this delivery by blocking the
used bonds in the systems.
Blocked bonds are unusable for trading but they can be used in
the CBC if a substitution in non-CBC eligible bonds is contractu-
ally possible. This substitution can be represented via hypothetical
transactions.
Expressing blocking with securities lending

If a security (or a part of it) is blocked because it is used as a collateral
given to an external counterparty, we lose the possession (but not the
ownership) of this security for the time of the blocking. Therefore,
we describe the blocking of a security as a lending to an external
counterparty (the collateral taker).
If the blocking has no explicit maturity, the lending transaction
consists of one asset flow at the start describing the transfer of the
security from a free account to a blocked one.
If the blocking has a maturity, the lending transaction has a second
asset flow at the maturity reversing the initial asset flow.
Here we encounter an effect we cannot deal with correctly at the
level of a single bond: if the blocked bond has a short maturity, it
is very likely that it will be replaced by another one; consequently,
the real expected blocking of securities the bank has to take care
of lasts longer than the maturity of this specific bond.
SOLVING THE PROBLEM FOR CLASSES OF SECURITIES

Liquifiability classes/liquidity units
As we have seen with a blocked security, some problems cannot
be solved at the level of a single security. Furthermore, it would be
quite laborious in practice to separately determine the liquification
parameters for each single security of a large portfolio.
We will apply the same principle as for the scenarios in gen-
eral and introduce specific levels within the liquidity unit tree: the
liquifiability classes.
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LIQUIDITY MODELLING
A liquifiability class comprises all securities which we assume to

behave homogeneously in a specific CBC scenario.
Stepwise solution to the problem

For the CBC in a narrower sense we will have to perform the
following 10 steps:
1. for CBC0 , derive or calculate all scheduled cashflows of each

security;
2. define a CBC scenario strategy (which is different from CBC0 );
3. determine the qualifying attributes of a securitys liquifiability;
4. group non-distinguishable securities in liquifiability classes;
5. determine the average saleability and repoability of each
liquifiability class;
6. derive the FAF of each security in a liquifiability class;
7. simulate the hypothetical transactions according to the sale-
ability and repoability of the chosen scenario and determine
the corresponding new asset flows per liquifiability class;
8. determine the market value of each liquifiability class;
9. calculate the new FCF of the liquifiability class by multiplying
the FAF with the market value and determine the FCI;
10. compare the result with the CBC0 (and possibly with prede-
fined limits).
Implementation
The basis counterbalancing capacity CBC0
The CBC0 is special as we simply assume that all scheduled
cashflows will occur as scheduled.
For short positions (see page 129) in securities we will have to
correct the FCI outcome by the FCF of the zero-floor algorithm which
will look up each day in the future to see if the FAI is negative and,
if so, create a hypothetical overnight borrowing (or reverse repo).
We have to make sure that the FLE0 part which stems from CBC0
is properly separated in the liquidity risk system from the rest, ie,
we exclude all security related cashflows from the part of the FLE
which is non-CBC related.
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Defining a CBC strategy

Any other CBC strategy than CBC0 needs to reflect that securities
might not flow as scheduled but are sold or repoed in order to gen-
erate surplus liquidity for the bank. In fact, no real new cash-
flows are created but the assumed cash inflows from the maturity or
the respective pending transactions are moved nearer to today (but
might be a bit reduced).
Any CBC strategy should be compatible with the overall FLE sce-
nario it is part of; eg, a CBC which assumes going concern does
not fit to a basis FLE scenario or to an FLE stress test.
The qualifying attributes of a securitys liquifiability

Each security will be identified by its ISIN code.
The following attributes of a bond are required in the course of
the full CBC implantation and will therefore have to be identified in
the banks systems:
ISIN code;
issuer;
issuer country;
issuer guarantor;
currency;
issue type (government, supra, covered, financial, corporate,
ABS);
issue size;
maturity;
rating (Fitch, Standard & Poors (S&P), Moodys);
coupon/day count;
ECB eligibility (or, more generally, central bank eligibility);
structure (warrant, convertible, redemption, callables, interest
rate structures);
senior/subordinated;
amortising;
perpetual bond;
zero coupon;
depositary account(s).
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LIQUIDITY MODELLING
Table 7.9 Rating and initial liquifiability class
S&P rating
Liquifiability
From To class
AAA 4
AA+ AA 5
A+ A 6
BBB+ BBB 7
Rest 8
Table 7.10 Bonus points
Issue type Supra Govt Regions Covered Fin Corp ABS
Bonus 3 2 1 1 0 1 2
Special rules
USA & 3
Germany
EBRD/ 2
World Bank
not IBRD
State-owned 1 1
agencies
Liquifiability classes
The following describes the mapping algorithm of securities in
liquifiability classes as a concrete example to illustrate the procedure.
In practice, however, we might do the actual assignment differ-
ently.
Mapping of credit ratings. We map the rating of each security to the

S&P scale (if a security has different ratings we will take the lowest
one).
Initial liquifiability classes. We group the securities into liquifiability

classes as in Table 7.9 (not scenario dependent).
Bonus points. We use the issue type according to Table 7.10 to

assign bonus points (scenario dependent).
We add the bonus point to the initial liquifiability class, which has
the effect that the affected security migrates to another class.
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Table 7.11 Handicap points
Criterion
Supra Govt Regions Covered Fin Corp ABS
Issue size <1bn 1 1 1 1 1 1 1

Structured Low 1 1 1 1 1 1 1
High 2 2 2 2 2 2 2
Currency Non-domestic 1 1 1 1 1 1 1
Exotic 2 2 2 2 2 2 2
Not central bank eligible 1 1 1 1 1 1 1
Government-type agencies (which in reality are state-owned

agencies) will get handicap points. For example,
a triple-A supra is mapped into liquifiability class 4 3 = 1,
Belgium is AA+ and government and therefore mapped into
liquifiability class 5 2 = 3,
KfW is AAA and government (Germany) but a state-owned
agency, therefore it is mapped into liquifiability class 4 3 + 1 =
2.
Handicap points. As a result of the above steps we have determined

the maximal reachable liquifiability class for a specific bond. We
assign handicap points (also scenario dependent):
For example, a highly structured coupon (exotic) issued in Hun-
garian forint by EIB (supra): 4 3 + 2 + 2 = 5 (see Table 7.11).
Sorting into liquifiability classes

If we first sort a security dependent on its credit rating in the ini-
tial liquifiability classes and then apply the bonus and (additive)
handicap system, we will arrive at the final liquifiability classes.
For the target solution we envisage approximately eight liquifi-
ability classes stemming from the above process (we will cap, if
necessary at class 8).
The following list gives an indication of example liquifiability
classes shortly after the Lehman collapse:
1. Bund, US-Treasuries, top supranationals (eg, EU, IBRD, EIB);
2. AAA-Government Bonds: France, Austria, Netherlands, UK,
Japan, Switzerland, Canada; German Laender jumbo, Pfand-
brief and Obligations Foncires (minimal AAA and jumbo);
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LIQUIDITY MODELLING
3. Euro-Government Bonds <AAA: BTP, Bono, PGB, OLO, GGB,

other supranationals (other World Bank entities, EBRD, etc);
Pfandbrief and Obligations Foncires (<AAAand jumbo); cov-
ered bonds (Cooke ratio 10% and AAA); European Regions
(minimal AA and jumbo);
4. other (East-)European countries (European Union members):
covered bonds (Cooke ratio 10% and <AAA); covered bonds
(Cooke ratio 20% and Jumbo); European regions (minimal AA;
jumbo if <AA);
5. rest of covered bonds, financials and corporates (minimal A+
and Jumbo); Local Authorities (minimum Investment Grade
and Cook ratio = 20%), eg, US municipal bonds, Canadian
provinces, European regions;
6. financials and corporates: minimum investment grade;
7. emerging markets government bonds: eg, Republic of Korea,
Brazil, China, India, Russia; senior ABS tranches (= AA);
8. the rest.
The liquification
We shall apply an algorithm which simulates the liquidity gen-
eration by repoing and selling securities per liquifiability class
according to their repoability respectively saleability.
Therefore, we have to apply a term structure of repoability and
a term structure of saleability to each liquifiability class in each
scenario.7
In this chapter we describe two possible approaches to simulate
the liquification.
(i) We add all securities of a liquifiability class into one synthetic
security which represents the whole liquifiability class. Conse-
quently, the hypothetical sale and repo transactions are done
in the synthetic security and can therefore not be attributed
to single securities. This makes the simulation quite simple
but comes along with minor losses in the precision of the
calculation (especially interest cashflows).
(ii) Another technique to simulate the liquification assumes we
individually sell and repo the separate securities per liquifia-
bility class in a certain order. This requires a more sophisticated
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liquification algorithm but gives a more accurate result plus a

more tangible representation of the liquifiability algorithm. We
have not outlined this technique here.
Before the liquification: the null-scenario CBC0

As we know the securities in each liquifiability class, we can deter-
mine their principal and coupon cashflows,8 assuming that all sched-
uled cashflows will occur as planned: being equal to the scenario
in which we do not sell or repo anything and no disturbance of
scheduled cashflows will happen. This we will call the null-scenario:
CBC0 .
CBC0 has the FAI = [FAI0 , FAI1 , . . . , FAIH ], where tH denotes the
scenario time horizon, and the FCI = [FCI0 , FCI1 , . . . , FCIH ].
General settings
In order to make the results of the CBC comparable across scenarios,
we define one unique time bucket structure for all scenarios and all
liquifiability classes: we intersect the future at t0 , t1 , . . . , tH , where
t0 is today and tH is the end of the scenario simulation horizon; a
time bucket Th = (th1 , th ] starts at th1 /24h00 (which is identical to
th /00h00) and ends at th /24h00.
The algorithm itself should run on a daily term structure (per
business day). Therefore, we have to distribute the parameters to
the finer term structure.
The synthetic security of a liquifiability class

For each scenario and each liquifiability class we construct a syn-
thetic security SLC by adding all FAIs (all FCIs) of the individual
securities,9 after having them eventually transformed into our base
currency (), using the current FX rate (without term structure).
We can differentiate between the owned and the possessed FAIs
of SLC .
The clean price PhC of SLC in th is depreciated or appreciated during
the remaining lifetime to reach the redemption value (normally 100)
at maturity.
As the security might lose value in the future one normally cor-
rects the clean price with downside price risk measure: if VaR (t2 )
is the market value at risk of SLC at t0+2 , the VaR in h days is
approximated by
VaR (th ) = VaR(t2 ) v( 12 (th t2 ))
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Table 7.12 Security SA (to be done analogously for SB , SC )
th FAI P Ch (%) P *C
h (%) Accrued FCF FCI
5/11/09 100.000 99.000 99.000 1.688 1.688 97.312

6/11/09 100.000 99.018 99.018 0.005 0.005 97.307
7/11/09 100.000 99.035 98.936 0.005 0.005 97.301
8/11/09 120.000 99.053 98.913 0.005 19.782 117.083
9/11/09 120.000 99.070 98.899 0.007 0.007 117.077
10/11/09 120.000 99.088 98.890 0.007 0.007 117.070
11/11/09 120.000 99.105 98.884 0.007 0.007 117.063
12/11/09 120.000 99.123 98.880 0.007 0.007 117.057
13/11/09 120.000 99.140 98.878 0.007 0.007 117.050
14/11/09 80.000 99.158 98.877 0.007 39.558 77.492
15/11/09 80.000 99.175 98.878 0.004 0.004 77.488
16/11/09 80.000 99.193 98.879 0.004 0.004 77.484
17/11/09 80.000 99.211 98.881 0.004 0.004 77.479
18/11/09 80.000 99.228 98.884 0.004 0.004 77.475
19/11/09 80.000 99.246 98.888 0.004 0.004 77.471
20/11/09 100.000 99.263 98.892 0.004 19.773 97.244
21/11/09 100.000 99.281 98.896 0.005 0.005 97.238
22/11/09 100.000 99.298 98.901 0.005 0.005 97.233
23/11/09 100.000 99.316 98.906 0.005 0.005 97.227
24/11/09 100.000 99.333 98.912 0.005 0.005 97.222
25/11/09 100.000 99.351 98.918 0.005 0.005 97.216
.. .. .. .. .. .. ..
. . . . . . .
31/12/09 100.000 99.982 99.241 0.005 0.005 97.019
01/01/10 0.000 100.000 99.252 0.005 99.246 2.227
Previous coupon 01/01/09; maturity 01/01/10; coupon 2.000%, 0.005%;

clean price P 99.000%; VaR 0.100%; haircut 0.500%; structural FAI
100.000 as of 20/11/09. All nominals are in (millions).
Consequently the risk-adjusted clean price PhC of SLC in th is

determined as
PhC = PhC VaR(th )
For the cashflows we need to split between interest and notional

cashflows for each security and show this split in the FCF/FCI of
the synthetic security. For calculation reasons it is much simpler
(although not completely correct) to assume that the coupons are not
accrued and paid on single payment dates but are proportionately
paid out every single day. With this trick, the dirty price PhD of SLC in
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Table 7.13 Synthetic security SLC as sum of individual securities SA ,

SB , SC
Security SA SB SC
Previous coupon 01/01/2009
Maturity 01/01/2009
Coupon (%) 2.000 8.000 5.000

Clean price 99.000 108.000 102.000
P (%)
VaR (%) 0.100 0.150 0.150
Haircut (%) 0.500 1.000 0.500
Structural FAI 100,000 20/11/09 50,000 06/12/09 30,000 17/11/09
Today = 06/11/2009; Synthetic security SLC = SA + SB + SC . All nominals

are in (millions).
th is always identical to the clean price PhC as interest do not accrue

but are paid out every single day.
The FAF, FAI, FCF and FCI of the synthetic security are the sums
of those of the individual security; the clean price PhC of SLC in time
is the FAI-weighted clean price of the individual securities.
We will use a simplified example in Table 7.12 to illustrate the pro-
cedure: we assume three securities SA , SB and SC , which are added
to form the synthetic security SLC .
Once we have the relevant parameters of the synthetic security,
the liquification procedure is exactly the same as it would be for a
single security (see Table 7.13).
Structural position in a synthetic security

We define the structural position FAISP of a security S as the own-
ership FAISP (tL ), where tL is the point in time after which the last
pending ownership-changing transaction has been executed;10 it is
equal to the forward asset flow FAF(tM ) of the synthetic sell trans-
action we generate at the maturity tM of the security, multiplied by
1, ie
1 FAISP = FAF(tM )
Therefore, we have
FAI(tM ) = FAI(tM1 ) + FAF(tM ) = FAISP +(1) FAISP = 0
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LIQUIDITY MODELLING
Table 7.14 Synthetic security SLC as sum of individual securities SA , SB , SC

SA SB SC S LC
Structural
th FAI PC
h (%) FCI FCI PC
h (%) FCI FAI PC
h (%) FCI FAI FAI PC
h (%) FCI
05/11/09 100.000 99.000 97.312 50.000 108.000 50.964 40.000 102.000 39.436 180.000 190.000 102.000 187.712
06/11/09 100.000 99.018 97.307 50.000 107.909 50.953 40.000 101.983 39.430 180.000 190.000 101.982 187.690
07/11/09 100.000 98.936 97.301 50.000 107.656 50.942 35.000 101.813 34.326 180.000 185.000 101.837 182.569
08/11/09 120.000 98.913 117.083 50.000 107.499 50.932 35.000 101.732 34.321 180.000 205.000 101.488 202.335
09/11/09 120.000 98.899 117.077 50.000 107.357 50.921 35.000 101.666 34.316 180.000 205.000 101.434 202.313
10/11/09 120.000 98.890 117.070 20.000 107.223 18.703 25.000 101.608 24.145 180.000 165.000 100.312 159.917
11/11/09 120.000 98.884 117.063 20.000 107.094 18.698 25.000 101.555 24.141 180.000 165.000 100.284 159.903
12/11/09 120.000 98.880 117.057 20.000 106.969 18.694 25.000 101.505 24.138 180.000 165.000 100.258 159.888
13/11/09 120.000 98.878 117.050 20.000 106.847 18.689 25.000 101.458 24.134 180.000 165.000 100.235 159.874
14/11/09 80.000 98.877 77.492 20.000 106.727 18.685 20.000 101.413 19.058 180.000 120.000 100.608 115.235
15/11/09 80.000 98.878 77.488 20.000 106.609 18.681 20.000 101.369 19.055 180.000 120.000 100.582 115.224
16/11/09 80.000 98.879 77.484 20.000 106.492 18.676 20.000 101.327 19.052 180.000 120.000 100.556 115.212
17/11/09 80.000 98.881 77.479 20.000 106.377 18.672 30.000 101.287 29.182 180.000 130.000 100.590 125.334
18/11/09 80.000 98.884 77.475 20.000 106.263 18.668 30.000 101.247 29.178 180.000 130.000 100.565 125.321
19/11/09 80.000 98.888 77.471 20.000 106.150 18.663 30.000 101.208 29.174 180.000 130.000 100.541 125.308
20/11/09 100.000 98.892 97.244 20.000 106.038 18.659 30.000 101.170 29.170 180.000 150.000 100.300 145.073
21/11/09 100.000 98.896 97.238 20.000 105.926 18.654 30.000 101.133 29.166 180.000 150.000 100.281 145.059
22/11/09 100.000 98.901 97.233 20.000 105.816 18.650 30.000 101.097 29.162 180.000 150.000 100.262 145.045
23/11/09 100.000 98.906 97.227 20.000 105.706 18.646 30.000 101.061 29.158 180.000 150.000 100.244 145.031
24/11/09 100.000 98.912 97.222 30.000 105.596 29.212 30.000 101.025 29.154 180.000 160.000 100.562 155.587
25/11/09 100.000 98.918 97.216 30.000 105.488 29.205 30.000 100.991 29.150 180.000 160.000 100.538 155.571
. . . . . . . . . . . . . .
. . . . . . . . . . . . . .
. . . . . . . . . . . . . .
31/12/09 100.000 99.241 97.019 50.000 101.764 49.743 30.000 99.911 29.002 180.000 180.000 100.053 175.764
01/01/10 0.000 99.252 2.227 50.000 101.664 49.732 30.000 99.883 28.998 80.000 80.000 100.996 76.503
. . . . . . . . . . . . . .
. . . . . . . . . . . . . .
. . . . . . . . . . . . . .
28/02/10 30.000 98.415 28.759 30.000 30.000 98.415 28.759
01/03/10 0.000 98.391 0.770 30.000 0.000 98.391 0.770

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We then define the structural position (cf. Table 7.14) of a synthetic

security SLC as the sum of the individual structural positions (each
starting at its individual tL and ending at its maturity tM ).
Term structure of saleability

For each time bucket Th we define for SLC the saleability sh and the
upper sale limit S+
h.
The saleability sh is interpreted as the percentage (between 0%
and 100%) of the structural position of SLC that we assume to sell
during the time bucket Th .
The upper sale limit S+ h is interpreted as the nominal amount up
to which we assume to sell the synthetic security during the time
bucket Th .
Term structure of repoability

For each time bucket Th we define for SLC the repoability rh and the
upper repo limit Rh+ .
The repoability rh is interpreted as the percentage (between 0%
and 100%) of FAI(th ) of SLC we assume to repo until the end of the
time bucket Th .
The upper repo limit R+ h is interpreted as the nominal amount up
to which we assume to repo SLC until the end of the time bucket Th .
The liquification algorithm

We describe two approaches per liquifiability class: the liquification
of its synthetic security and the liquification of parts of its individual
securities.
The beauty of the synthetic security concept is that we simply sell
and repo parts of one security; however, this comes with consid-
erable technical difficulties determining the future coupons after a
partly sale.
The individual securities concept works with an additional algo-
rithm allotting tranches of the individual securities within one
liquifiability class. This requires assumptions about the priority in
which individual securities should be liquified.
In a nutshell: the synthetic security concept is easier to explain
but quite abstract for a liquifiability class with a large number of
securities because in reality we cannot sell that many small amounts
of individual securities.
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In both concepts we will go from time bucket to time bucket and

first sell sh (the saleability in percentages) of the structural position,
but not more than the upper sales limit S+ h and then repo rh (the
repoability in percentages) of the rest, but not more than the upper
sales limit R+ h.
Liquification of the synthetic security. At t0 the ownership FAIO 0

shows the current ownership of SLC , whereas the possession FAIP0
reflects the availability of SLC ; the change stems from the pending
transactions of SLC that change the possession but not the ownership.
The structural position FAIS0 = FAIS represents the structural own-
ership of SLC , ie, the amount we can sell without being short the
security at maturity.
For t0 :
(i) we first sell
min[s0 FAIS0 , S+
0 ] =: S 0
(s0 of FAIS0 but not more than S+

0 ); the remaining structural
position is FAIS0 S0 ;
(ii) we then repo
min[r0 (FAIP0 S0 ), R+
0 ] =: R0
(r0 of the remaining possession FAIP0 S0 but not more than R0+ );
the remaining possession is FAIP0 S0 R0 .
For t1 :
(i) the new structural position is
FAIS1 = FAIS0 S0 + (FAIO O

1 FAI0 )
(FAIO O
1 FAI0 is the change of ownership at t1 ); we first sell
min[s1 FAIS1 , S+
1 ] =: S 1

1 ); the remaining structural
S
position is FAI1 S1 ;
(ii) as we assume that the repo transaction at t0 reverts at t1 , the
new available position is
FAIP1 = FAIP0 S0 R0 + R0 + (FAIP1 FAIP0 )

= FAIP0 S0 + (FAIP1 FAIP0 )
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(FAIP1 FAIP0 is the change of possession at t1 ); we then repo
min[r1 (FAIP1 S1 ), R+
1 ] =: R 1
(r1 of the remaining possession FAIP1 S1 but not more than

R+ P
1 ); the remaining possession is FAI1 S1 R1 , etc.
We shall repeat this until we have reached tH .

As a consequence we have created a series of hypothetical sales
and repo transactions in t0 , t1 , . . . , tH , where we know the future asset
flows
FAF(t0 ) = S0 R0
FAF(t1 ) = S1 R1
..
.
FAF(tH ) = SH RH
Thus, the remaining forward asset inventory in th is
FAI(th ) = FAI(t0 ) + FAF(t0 ) + FAF(t1 ) + + FAF(th )
In order to derive the cashflows of these transactions we will have

to make a more sophisticated calculation.
Liquification of parts of the individual securities. The description

of the procedure is in principle the same, as FAIs of the synthetic
security are equal to the sum of the FAIs of the individual securities
which are contained within it.
Within each liquifiability class we order all securities S1 , S2 , . . . , SN
in sequences which are valid for saleability and for repoability
SSR SR SR
1 , S2 , . . . , SN
(first sell/repo SSR SR SR

1 , then S2 , etc, until we finally sell/repo SN ).
After having done this we are able to describe the algorithm as
follows.
At t0 :
(i) we consecutively sell securities SSR SR SR
1 , S2 , . . . , Sn until we have
reached
S +
SSR SR SR
1 + S2 + + x0 Sn = min[s0 FAI0 , S0 ]
=: S 0
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(s0 of FAIS0 but not more than S+0 ; 0 < x0 = 100% because selling
SSR
n fully would eventually exceed S0 ); the remaining structural
S
position is FAI0 S0 ;
SR
(ii) we then consecutively repo securities SSR SR
n , Sn+1 , . . . , Sm until
we have reached
(1 x0 ) SSR SR SR
n + Sn+1 + + y0 Sm
= min[r0 (FAIP0 S0 ), R+
0]
=: R0
(r0 of the remaining possession FAIP0 S0 but not more than R+

0;
0 < y0 = 100% because repoing SSR m fully would eventually
exceed R0 ); the remaining possession is FAIP0 S0 R0 .
At t1 :
(i) the new structural position is
FAIS1 = FAIS0 S0 + (FAIO O

1 FAI0 )
(FAIO O
1 FAI0 is the change of ownership at t1 ); as the bonds
repoed at t0 come back at t1 , they are available for sale again
SR
in this step; we consecutively sell securities SSR SR
n , Sn+1 , . . . , Sm
until we have reached
S +
(1 x0 ) SSR SR SR
n + Sn+1 + + x1 Sm = min[s1 FAI1 , S1 ] =: S1

1 ; 0 < x1 = 100% because selling
SR
Sm fully would eventually exceed S1 ); the remaining structural
position is FAIS1 S1 ;
(ii) as we assume that the repo transaction at t0 reverts at t1 , the
new available position is
FAIP1 = FAIP0 S0 R0 + R0 + (FAIP1 FAIP0 )

= FAIP0 S0 + (FAIP1 FAIP0 )
(FAIP1 FAIP0 is the change of possession at t1 ); we then con-

SR SR
secutively repo securities SSR m , Sm+1 , . . . , Sk until we have
reached
(1 x1 ) SSR SR SR
m + Sm+1 + + y1 Sk
= min[r1 (FAIP1 S1 ), R+
1]
=: R1
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(r1 of the remaining possession FAIP1 S1 but not more than R1+ ;
0 < y1 = 100% because repoing SSR k fully would eventually
exceed R1 ); the remaining possession is FAIP1 S1 R1 .
We get the same results in terms of FAI as with the liquification of

the synthetic security, but in addition we have the FAIs of the indi-
vidual securities, which will make the calculation of the associated
cashflows easier and more accurate.
Treatment of short positions. By restricting the hypothetical sales

to the structural FAI, we avoid selling more than we have and thus
need to buy back the position at maturity. This is called the bear
squeeze, as a shortening trader can get trapped because a security
ceases to be available for trading during a certain period before its
maturity.
We have, however, not ruled out that we could lose a part of the
ownership or possession (by temporarily selling or repoing) and
thus create a temporary short position, which then will force the
bank to borrow the security until the position turns non-negative
again.
If we want to avoid even temporary short positions, we need to
add another restriction. This becomes quite complex because we
have to check before we generate a hypothetical sale or repo trans-
action that it will not create temporary future short positions and
thus if necessary reduce the planned hypothetical transaction by the
maximal future short position it would induce.
Haircuts for hypothetical repo transactions. For the above time

bucket structure t0 , t1 , . . . , tH we define for each security and each
scenario a repo haircut term structure H0 , H1 , . . . , HH .
We assume that during the time bucket th a potential repo coun-
terparty will only be willing to give us (1 Hh ) FAIh PhC cash if
we give them FAIh of the security as collateral.
For synthetic securities we calculate the FAI weighted average
repo haircut.
Potential price decline for hypothetical selling transaction. For the

above time bucket structure t0 , t1 , . . . , tH we define for each security
and each scenario a price decline term structure D0 , D1 , . . . , DH .
We assume that at th the forward clean price PhC is diminished by
(1 Dh ) in order to reflect downside market and credit risk. If, for
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example, VaR is the value at risk of the security we can assume that
the price decline Dh can be estimated as Dh = VaR (v(th t0 )).
The achievable price in a sales transaction in th would then be
PhC Dh = PhC VaR (v(th t0 ))
For synthetic securities we calculate the FAI weighted average
price decline.
Resulting cashflows (FCF of CBC) for the synthetic security. For

the synthetic security we determine in th :
the future cashflows FCFSh of the hypothetical sales transaction
FCFSh = FAFh PhSD (1 Dh )
the future cashflows FCFRh of the hypothetical repo transaction

FCFRh = FAFh PhSD (1 Hh )
Then we add the cashflows related to the hypothetical liquification

transactions
FCFh = FCFRh + FCFSh
If we simply added the correspondent additional cash inflows to
the FCI of the null scenario, we would suppress the cash effects that
stem from the change of the asset inventories after the hypothetical
liquification transactions.
Therefore, we have to adjust the changed coupon and notional
cashflows or recalculate them from scratch.
Example 7.1 (bond 4% coupon, maturing 31/12/2009).
10/11/2009 (yesterday): we purchase 100 of this bond at
103.95%.
11/11/2009 (today):
in the null-scenario CBC0 we assume that all scheduled

cashflows will occur as planned; today the cash inven-
tory is FCI0 = 103.95, which will remain constant until
maturity (tM ), where the bond pays back nominal plus
interest FCFM = +100 + 4 = 104.
As a result the cash inventory at maturity will be
FCIM = FCI0 + FCFM = 103.95 + 104 = +0.05
(see Table 7.15).
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Table 7.15 CBC0 : null scenario
Asset Cash
Time Dirty
Date t FAF FAI price FCF FCI
10/11/09 t1 100.00 100.00 103.95% 103.95 103.95

11/11/09 t0 100.00 103.95
12/11/09 t1 100.00 103.95
..
.
30/12/09 tM1 100.00 103.95
31/12/09 tM 100.00 0.00 104.00% 104.00 0.05
Table 7.16 CBC1 : first scenario
Asset Cash
Time Dirty
Date t FAF FAI price FCF FCI
10/11/09 t1 100.00 100.00 103.95% 103.95 103.95

11/11/09 t0 100.00 103.95
12/11/09 t1 40.00 60.00 103.88% 41.55 62.40
..
.
30/12/09 tM 1 60.00 62.40
31/12/09 tM 60.00 0.00 104.00% 62.40 0.02
In the first-scenario CBC1 we assume that we sell 40 of

this bond tomorrow (t1 ) at a dirty price of 103.87
FAF1 = +40 103.87 = +41.55
The asset inventory drops tomorrow to
FAI1 = FAI0 + FAF1 = 100 40 = +60
the cash inventory goes up to
FCI1 = FCI0 + FCF1 = 103.95 + 41.56 = 62.38
In addition to the above, the asset- and cashflows at maturity have

changed as well: the inventory is as of now FAIM = 60 and the final
asset flow is thus only FAFM = 60.
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Table 7.17 Illustration of liquification algorithm: CBC1 scenario 1: going concern
Sale Repo Cash

s h (%) S+
h FAI start FAF P SC
h dh (%) FCF FAI end r h (%) R+
h FAF (%) Haircut FAF(S 1 ) FAI(S 1 ) FCF(S 1 ) FCI(S 1 )
104.340
0 35.000 80.000 0.000 105.180 0.000 80.000 20 16.000 95 15.200 64.000 36.236 68.104
0 35.000 95.000 0.000 105.127 0.000 95.000 80 76.000 95 72.200 19.000 41.223 26.881
20 35.000 100.000 32.000 105.106 33.634 68.000 95 64.600 95 61.370 3.400 17.544 9.337
20 35.000 68.000 32.000 105.062 33.620 36.000 95 34.200 95 32.490 1.800 10.490 1.153
10 35.000 36.000 16.000 105.051 16.808 20.000 95 19.000 95 18.050 1.000 2.368 3.521
10 35.000 0.000 16.000 105.041 16.807 16.000 95 16.000 95 15.200 0.000 4.599 8.119
36.000 0.000 105.041 0.000 36.000 95 36.000 95 34.200 0.000 2.040 10.159
10 35.000 36.000 16.000 105.031 16.805 52.000 95 52.000 95 49.400 0.000 1.605 11.764
10 35.000 52.000 16.000 105.022 16.804 68.000 95 68.000 95 64.600 0.000 1.604 13.368
5 35.000 32.000 8.000 104.998 8.400 24.000 95 22.800 95 21.660 1.200 7.680 5.688
5 35.000 24.000 8.000 104.990 8.399 16.000 95 15.200 95 14.440 0.800 1.179 6.867
3 35.000 16.000 4.800 104.983 5.039 11.200 95 10.640 95 10.108 0.560 0.707 7.574
2 35.000 11.200 3.200 104.976 3.359 8.000 95 7.600 95 7.220 0.400 0.471 8.046
2 35.000 8.000 3.200 104.970 3.359 4.800 95 4.560 95 4.332 0.240 0.471 8.517
4.800 0.000 104.168 0.000 4.800 95 4.560 95 4.332 0.240 9.200 17.717

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As a result the redemption cashflow is as of now only +60 (instead

of +100). Furthermore, the coupon will be only 60 4% = 2.40
instead of 4.00 (see Tables 7.16 and 7.17).
It might look seductive to skip the complete new calculation of the
cashflows (and inventories) and instead simply adjust the remaining
cashflows of the null scenario: as the FAI has been reduced to 60% of
its initial value, all future cashflows of CBC0 are simply multiplied
by 60%:
FCF1M = 60% FCF0M = +60% (100 + 4) = 62.4
In reality it is not a good idea to recycle the adjusted null-scenario

cashflows because things can be more complex: the ownership FAI
can change often, which forces us to repeatedly adjust the initial
null-scenario cashflows (both redemption and coupon).
As a consequence it will be much simpler to completely recalculate
all components for the first scenario independently from the null
scenario.
Resulting cashflows (FCF of CBC) for the individual securities. We

take the same approach as above but the hypothetical transactions
are available on an individual transaction level, which means that
we can generate the asset flows and inventory accordingly. Thus, we
can generate all cashflows with a much higher precision.
Treatment of specific transactions

Certain transactions such as repos with central banks, tri-party repos
and repos in synthetic bonds may require a specific treatment. With-
out going into details we can note that the following information is
necessary:
identification of the bonds used in the transaction and ear-

marking in the relevant system;
start and end date of the repo;
an eventual correction of the FAI with virtual bond-lending
transactions which replicate the specific repo transaction;
availability of the bonds in the CBC through exchange of
securities (if contractually possible).
In the following a few examples are outlined.
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ECB open market operations

Before first bidding at the periodic ECB open market operations (ten-
ders), the bank needs to transfer eligible bonds to its ECB account.
The maximum bidding amount is determined as the sum of the
delivered bonds individual inventories at market price, applying
the appropriate haircut.
After allotment of the tender, its value reduces the maximum bid-
ding amount, until new eligible securities are delivered or current
tenders come to maturity.
The ECB does not identify single securities versus tender allot-
ment.
Handling in the systems of the bank. A blocking of an individual
security in the systems of the bank is impossible, and not necessary.
As long as the initial business rule enough collateral to cover the
tender(s) is respected, all bonds on the ECB account are available
for trading and in this case available for CBC as well. This means that
the correct FAI can only be built at portfolio level, not at security
level. The part of the portfolio serving as collateral is temporarily not
available for CBC, which can be expressed by a synthetic bond-
lending transaction until the maturity of the tender.
EUREX: description of the general collateral pool business.

The bank sends deliverable bonds which satisfy certain conditions
into its EUREX account (general collateral pool); they are all ECB
eligible.
Repo transactions between the bank and EUREX are done in a
synthetic bond [DE000A0AE077/Deutsche Brse] which at the end
of the day is substituted by actual bonds out of the banks general
collateral pool.
The substitution mechanism is up to the EUREX. Once it has been
done, the bank receives a statement of the corresponding asset flows
on its EUREX account.
Remark 7.2. The synthetic bond position is treated like a normal

bond, which means a positive inventory increases and a negative
value decreases CBC: the assumption of daily short coverage (zero-
floor algorithm; see page 129ff) is not applied to this bond!
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Tri-party repo. This can be described as follows:

(i) two counterparts agree on the cash leg of a repo transaction and
jointly engage the tri-party agent to execute the transaction;
(ii) the collateral giver mandates the tri-party agent to transfer
the corresponding amount of securities to the collateral taker
representing the cash amount agreed between the two parties;
(iii) the agent takes the necessary steps to arrange this transfer tak-
ing eligible bonds out of the collateral givers main account
following an internal distribution algorithm.
FURTHER ISSUES REGARDING THE CBC

The CBC and the FLE
Assume we have simulated the FLE and then generated the CBC.
We are predominantly interested in whether the total simulated liq-
uidity (TSL = FLE + CBC) is negative, as this is the indicator for
illiquidity. If we, however, simply add FLE and CBC as done above,
we implicitly make the assumption that they are independent, which
is not true because the hypothetical repo and sales transactions of
the CBC change the possession and ownership of securities and thus
can change cashflows that are a part of the FLE. For example, selling
a bond at t0 omits its redemption cashflows, which are part of the
FLE.
Technically, we can solve this problem in two ways. We identify
within the FLE all CBC related transactions. Then we assume a zero-
CBC scenario: no securities transactions other than those already
scheduled will happen; their cashflows constitute the cumulated
CBC0 . If we delete these cashflows from the FLE, we get FLE0 , as
outlined before.
The total simulated liquidity TSL0 in the zero-CBC scenario
equates then to
TSL0 = FLE0 + CBC0
If we want to create the TSL in a normal scenario, we calculate the

normal CBC and equate TSL = FLE0 + CBC.
Alternatively, we calculate both the FLE and CBC in a normal
scenario but we then need to subtract the surplus CBC0 cashflows
within the FLE
TSL = FLE CBC0 + CBC
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Remark on cashflows that stem from short selling

Assume the bank owns a bond. In a stationary scenario all the trans-
actions already scheduled regarding this bond (future purchase or
sales, repos or reverse repos, lending and borrowing, including the
final redemption) are assumed to be known and the correspond-
ing cashflows are presumed to occur as scheduled. No hypothetical
transactions in this bond are modelled.
If the scheduled future transactions lead to a short inventory in
this bond, the result will be a corresponding positive cash inventory
in the FLE. In this case, our stationary modelling approach antici-
pates a situation which is impossible in reality: a short position in
a security can only exist in the future. If the transaction which will
establish the short position is due to be executed, it will be rejected by
the counterparty (or the agent) and the anticipated cash inflow will
not occur. FLE should therefore exclude the corresponding positive
cashflow of a short selling transaction.
The short selling highlights the problem of the stationary scenar-
ios: the results may be derived with simplified means but the result
can be over simplified.11
The above applies not only to bonds but to the shortening of
securities in general.
Survival horizons
We consider a certain scenario where today, t0 , the nostro of the bank
is (at least slightly) positive: FLE(t0 ) > 0.
Let tS+1 denote the first future day with a cash deficit on the nostro:
FLE(tS+1 ) < 0 (if such a day does not exist within the considered time
horizon tH , we set tS+1 := tH ).
For all days t0 , t1 , . . . , tS the FLE is non-negative, which means
that the bank will survive liquidity-wise until tS (in this specific
scenario). The last day tS where the FLE is not negative is called the
survival horizon.12 If the scenario is a pure exposure, we talk about a
passive survival horizon, meaning that the bank can survive in our
model until tS without taking any countermeasures. If, however, the
scenario comprises the counterbalancing capacities, we change the
condition to
FLE(tS+1 ) + CBC(tS+1 ) < 0
and the interpretation is that the bank will become illiquid at tS+1 in
our model even it has carried out all possible countermeasures.
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Figure 7.4 Survival horizon
100
80
60
40
FLE(S)
20
0
20
40
60
0 5 10 15 20 25 30 35 40 45 50 55 60
t (days)
Figure 7.5 Change in survival horizon
100
FLE(S) FLE(S' )
80
60
40
20
0
20
40
60
80
0 5 10 15 20 25 30 35 40 45 50 55 60
t (days)
The result of such a plain measure is simply a number of days.

Some banks use it to internally communicate their liquidity status.13
Adownside is that small changes in the cashflows within the survival
horizon can result in dramatic changes in the measure.
In the example in Figure 7.4, the FLE falls until it almost reaches
the zero line at t21 ; it climbs again but finally falls and breaks through
the zero line on day t53 , which defines the survival horizon as tS = t52 .
The example in Figure 7.5 shows the same situation as before
with almost undetectable relative changes to the situation before.
The new FLE (grey line), however, breaks through the zero line on
day t21 , which changes the survival horizon dramatically from t52 to
t20 , although the change of the FLE has only been minor.
A different approach for the survival horizon would be to
evaluate whether or not the FLE on that day can be counterbalanced
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by the liquidity buffer on a predefined survival horizon tS . This

method is used in Basel III in the liquidity coverage ratio (LCR)
with tS = 30 days.
The problem with this measure is that even if the equation
FLE(tS ) + CBC(tS ) = 0
holds, we do not know what happens between t0 and tS .
The CBC in Basel III

The CBC is substituted in the Basel III regulation by a rather basic
concept: the stock of high-quality liquid assets (HLAs). In the LCR,
the banks assets are classified in two groups (i) HLA and (ii) the
rest which can be regarded as a simplified version of the liquifiabil-
ity classes. It is furthermore checked whether or not the individual
securities are unencumbered over a time period of 30 days. Finally,
the anticipated liquidity creation is simulated by multiplying the
assets outstanding nominal by its current market price, reduced by
two different haircuts (for Level-1 and Level-2 assets, respectively).
This method does not simulate the liquification of the assets by repo
or sale or other liquification channels nor how long it takes to liquefy
them.
The HLA is held against the net cash outflows,14 a rudimentary
FLE which is also only defined for a single point in time (30 days
from now). If the HLA is greater than the net cash outflows, the
regulation is within the desired headroom.
For another time horizon (one year) abidance by the net sta-
ble funding ratio (NSFR) is required by the regulation. The avail-
able amount of stable funding shall not be less than the required
amount of stable funding. The required stable funding is given
by the assets of the bank which are diminished by their own coun-
terbalancing capacity. Effectively, Basel III assumes that the bank can
fund the portion of an asset which is assumed to be liquefiable in the
CBC with non-stable liabilities and is only obligated to cover the
difference between the nominal value and CBC (the haircut amount)
with stable liabilities.
Extension of the CBC concept

During the development of the CBC algorithm we have ignored
some elements of the CBC and instead focused on securities and
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their liquification. If we want to reincorporate these other elements,

we must distinguish between non-rejectable and rejectable option
parts of the CBC as outlined on page 75.
For the contractual elements (credit facilities taken, guaranteed
capital, extendable bonds issued, cancellable loans and assets with
guaranteed saleability), the contractually possible exercise can be
simulated. According to the idea of the CBC to create as much liquid-
ity as possible as quickly as possible, the exercise should comprise
the earliest maximal possible amount. Apossible exemption could be
where the liquidity creation is only possible for a certain time span:
if, for example, under a credit facility a deposit can be drawn once
for one month, it does not make sense to draw the loan now if the
liquidity need will only come up in a months time. For such issues
the decisions have to be made manually or a (quite sophisticated)
optimisation concept needs to be developed.
For the rejectable options which have not been considered in the
CBC so far (shortening of the maturity of assets, extension of the
maturity of existing liabilities and acquisition of new unsecured lia-
bilities) banks can normally only make rough guesses. It makes sense
to keep track of the banks investors and the money market coun-
terparties to derive from these historical activities an estimation of
the maximal amount of new unsecured liabilities that the bank can
acquire. However, we should be acutely aware that such extrapola-
tions of historical trends might work well for long periods but cannot
be used to reflect shifts of paradigm.
Lastly, assets that are not immediately liquefiable (eg, retail loans)
can eventually be transformed into securities, for example, into asset
backed securities (ABSs). In such cases the as yet non-existent hypo-
thetical ABS needs to be captured with a zero FAI which will only
become greater than zero once the security is usable for liquifi-
cation. If other assets will be used to generate this security, their
FAI/un-encumberedness then needs to cease accordingly.
Reduction to liquidity buffers

Some banks use liquidity buffers which are quite similar to the HLA
approach. Securities which are assumed to be eligible and unencum-
bered are added to the stock of the liquidity buffer. The hypothetical
cashflows stemming from the liquidity buffer are generated by mul-
tiplying each assets outstanding nominal with its current market
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price, reduced by an individual haircut. Assumptions about liquifi-

cation venues and term-structured liquidity generation are normally
not made.15
Liquidity buffers come often in two classes: the core buffer, which
comprises solely the securities which are owned or at least under
direct control of the liquidity managing department (treasury), and
the general buffer, comprising other securities as well. The inten-
tion behind this is to differentiate between expected liquidity
exposures, which are match-funded (at least in principle with inter-
nal deals), and unexpected potential liquidity exposures, which
require additional coverage by the buffer. The concept fits into the
market and credit risk concepts of expected losses, which have to
be deducted from the expected value of a transaction, and unex-
pected losses, which need to be covered by the banks capital (and
display nicely the duality of capital and CBC). Applied properly to
illiquidity risk, however, the concept does not really fit:
(i) as opposed to the other risks, the expected value is not dom-
inating but is only a small part of the simulation of the future;
even a simple going concern scenario makes extensive use of
estimates, especially regarding the hypothetical transactions;
(ii) from an overall bank perspective, it does not make any dif-
ference whether an asset is controlled and potentially sold or
repoed by the treasury or by an independent department; it
is, however, important that the bank has installed a process
which hands over the control of the liquid assets in certain
(stress) scenarios to the treasury;
(iii) the buffer relies on creating liquidity from repos, particularly
by the central bank: this is a going concern assumption in
the sense of the willingness of the central banks to provide the
necessary liquidity if the market is in dire straits; the central
banks want to avoid this kind of reliance.
A liquidity buffer is a special case of the general CBC process and
can thus be derived from the CBC.
Conclusions
In this chapter we have outlined in detail how a bank could imple-
ment the CBC concept in practice. First, it is advisable to disregard
realistic strategies like squaring the position and instead to adopt
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the maximum cash generation strategy because it highlights the

problem and shows in the simulation how much headroom the bank
has to manoeuvre, or how far it is away from illiquidity. Next, the
fuzzy components of the strategy (like unsecured funding) are
ignored and only potential sales and repo transactions of an admis-
sible portfolio are regarded (the CBC in a narrower sense). Then
the technicalities of the securities inventories were described and
appropriately treated: the position was refined in its time struc-
ture and the difference between ownership and possession was
explained.
Securities with comparable saleability and repoability in a sce-
nario are mapped into liquifiability classes, which are special liq-
uidity units. The basis is the underlying rating, and positive (and
negative) bonus points describe the migration of securities between
liquifiability classes due to their liquification characteristics.
Finally, a liquification algorithm was proposed which allows us to
mimic the potential reactions of the bank to detrimental illiquidity
risk situations.
In addition we look at specific issues around the CBC. We explain
how the CBC can be integrated into the FLE, avoiding double count-
ing of scheduled and hypothetical redemption flows and which
extensions or reductions of the concept can be made.
At this point, we may ask ourselves why we have made things so
complicated with the CBC and do not just use the buffer concept.
The buffer concept addresses the problem adequately if a liq-
uidity shortage in the next days can be compensated through the
overnight facility of the central bank. From a risk management
point of view, however, a bank should not rely on the assump-
tion that the central bank will always keep the overnight facility
open for them and accept the current broad range of collateral.
It is the outspoken intent of the regulators that banks should be
able to demonstrate how they would weather further crisis situa-
tions without falling back on (almost) unlimited central bank liq-
uidity supply. Banks normally fear the selling of securities, as they
have to either unlock profit reserves or, conversely, realise losses,
whereas, by repoing, such effects are watered down. On the other
hand, repoing does not lock in the liquidity irrevocably (like sell-
ing does) but needs continuous maintenance to avoid the level
of liquidity falling short again. To find the best way out of this
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dilemma, banks need to simulate different solution strategies which

require a complex methodology like the CBC. Risk management
entails solutions for immediate problems (which are addressed by
the liquidity buffer) but also requires strategies for avoiding these
or similar problems in the future. A change of the central banks
collateral rules (eg, securities that have been included during the
crisis are struck off the list) can only be properly simulated by a
broader CBC approach with liquifiability classes. If really different
scenarios (like going concern versus market turmoil) need to
be calculated, even the liquifiability classes need to become scenario
dependent.
Finally, the buffer concept is too rough, lacks a real term structure
and does not reflect the dynamics of a changing balance sheet to
be compared against the sophisticated FLE concept we developed
earlier. On the other hand, the CBC fits very well into the previ-
ously developed methods like hypothetical transactions, rejectable
options, exposures and strategies.
1 In fact, the author has implemented this model, or derivatives of it, in several banks.
2 Sometimes distance to illiquidity is understood as a distance in time (cf the section on
survival horizons on page 158). In this context we mean the distance in money at a given
day tF in the future.
3 The improvement is only temporary, at least for the part of the CBC which stems from the
sale or repo of securities. The CBC process prompts cashflows which would have happened
anyway (eg, the redemption of a bond in five years) to an earlier point in time (eg, by selling
it within a week) but does not create liquidity because these cashflows will no longer exist at
their originally scheduled later point in time (as the cashflow from the sales transaction will
be added to the CBC in a week but the original redemption in five years will cease to exist in
the FLE).
4 This does not necessarily indicate that the bank will become illiquid on that short liquidity
day, as we have not modelled the banks active use of optionality.
5 The borrowing/lending transactions have the same effects on the asset inventory as the repo
and should therefore also be included in the generation of the overall position FAIt .
6 If the bank is not able to buy or repo the full amount and deliver in due time, the counterparty
can require the delivery of the amount lacking and potentially claim compensation for dam-
age. If the counterparty is a clearinghouse it might stock up the missing securities by enforced
borrowing or, if the bank is not able to deliver the lacking securities for a longer period, it
might even decide to go for enforced buying. In both cases the bank cannot necessarily assume
to get the cash without delivering the securities.
7 We will not distinguish by currency.
8 The variable cashflows of floaters depend on future interest rates like Euribor, Libor, etc,
which we do not know today: we substitute them by the corresponding forward rates or we
assume they are constant (flat yield forward curve) or we set it at zero.
9 We can determine the FAFs (FCFs) from the FAIs (FCIs) by calculating the differential FAFh =
FAIh FAIh1 (FCFh = FCIh FCIh1 ).
10 The structural position is also used as the basis of the legal credit risk calculation, eg, for
Basel II.
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11 In practice, we shall borrow the short position from day to day until the end of the short
period; if this is the redemption date, we need to purchase back the bond before maturity.
When we discuss the counterbalancing capacity later in more detail, we interpret the short
position as a reduction of the overall amount of liquefiable securities. If we incorporate the
scheduled positive cashflows from short selling, we implicitly assume that they represent a
part of the liquefying capacity of the remaining portfolio which is liquefied at 100% of its face
value: a not-so-straightforward assumption.
12 If you survive a certain period liquidity-wise, you can also state that this is the distance to
illiquidity, which is possibly a more accurate description.
13 Bankers Trust, for example, has expressed its liquidity risk since the early 1990s with the
Liquidity Barometer, which was composed of a massively stressed FLE (no backflow from
assets, no new liabilities) and a moderately stressed CBC.
14 It should be better worded as cumulated net cash outflows.
15 The only term structured element is the reduction of the buffer when one of its securities
matures.
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Intra-Day Liquidity Risk
This chapter describes liquidity risks that can arise as results of a

banks cash payment and securities settlement processes and is an
addition to the previously formulated ideas. We shall talk about
intra-day liquidity risk (ILR) in distinction to illiquidity risk which
is captured by the forward liquidity exposure and compensated for
by the counterbalancing capacity.
In the course of developing our model, this chapter could have
been placed at the very beginning of the book as it describes the risks
which may emerge and realise before the strategic illiquidity risks
come into play, which we capture in the FLE. We have nevertheless
decided to position this chapter near to the end as it goes deeper into
the mechanics of the banks nostros and requires an overall under-
standing of where we want to go in our modelling. Furthermore,
intra-day liquidity risks are a hot topic for the regulators, who are
starting now to issue their ideas on how these risks should be cap-
tured and managed. Unfortunately, the concepts are still quite basic
at the moment and we want to help to define them more thoroughly.
In order to avoid double counting the liquidity risk we already
include in our FLE approach, we first need to find a proper defini-
tion which discriminates ILR from other liquidity risks. To do this we
need to go a little deeper into the process of risk generation and man-
agement, distinguishing between the origination and the realisation
of risks. We will define intra-day liquidity risks as those liquidity
risks which not only occur intra-day but are originated intra-day.
In the previous chapter it was sufficient to deal with rather abstract
payments: if the cash balance is sufficiently high on the banks nostro,
payments are executed and thus reduce the nostro balance appropri-
ately. To be able to deal with risks that stem from aberrations of this
ideal process like lacking or incorrect payments, we need to describe
the payment process in more detail, including payments via third
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parties and those that the bank is executing for clients, together with
their additional risks.
Then we discern between those intra-day risks which can be
treated by enhancing our FLE concept and those which cannot be
captured even by an enhanced FLE and thus need to be described
separately. We investigate how liquidity risks can be mitigated:
between currencies, across time and with the CBC.
Finally, we look at the idiosyncratic risks of the payment pro-
cess itself and give an overview of how the realisation of payment
risks has influenced the development of (risk-mitigating) payment
techniques.
LIQUIDITY RISK AND INTRA-DAY LIQUIDITY RISK

Liquidity risk ultimately materialises in the form of payments which
are executed during the payment day. We will call this period intra-
day.
Although all risks materialise intra-day, this does not necessarily
mean that they necessarily originate intra-day: a loss from an option
we have written, for example, might be due to be paid today but
already occurred a few days ago when the counterparty exercised
the option, or can even be attributed to a previous day when the
exercise value became negative for us.
A similar situation is given when a drawing under a credit line
the bank has given generates cash outflows; the realisation is intra-
day but the origination commenced when the credit line had been
granted (or, at the latest, when the receiver has made a drawing):
when the bank granted the credit line, it originated potential coun-
terparty risk as well as liquidity (FLE) risk. The clients exercise of
the drawing option converted these potential risks into real ones;
the latter might have to be counterbalanced (CBC).
For that reason we discern between intra-day liquidity risks,
which originate from the intra-day payment or settlement processes
themselves, and strategic liquidity risks, which were originated
before today (although they might only become visible intra-day).
If, for example, the bank does not receive a scheduled large inflow
because of erroneous payment or securities settlement problems,
it is exposed to an unwanted short position leading potentially to
surcharges, interest opportunity losses or even illiquidity. This is
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INTRA-DAY LIQUIDITY RISK
Figure 8.1 Strategic and intra-day liquidity risk
Time of risk origination

Past Yesterday Today
Strategic liquidity risk management system

ILMS
Strategic Intra-day
liquidity liquidity
risk risk
Today
Time of risk materialisation
an intra-day liquidity risk, whereas, for example, a large cash out-

flow due to a generally skewed balance-sheet structure is part of
strategic liquidity risk.
In order to be able to express this difference more clearly, we dis-
tinguish between the risk forecast which we do today (t0 ) for a future
date (tF ) and the risk materialisation at tF (or between t0 and tF ). Once
we have reached tF the risk originated at tF can be distinguished
from the risk which was originated before tF . In this nomenclature
the risks materialising today can be separated into those which have
been originated (and hopefully forecasted) before today and those
which have only been originated today: the intra-day risks.
The illiquidity risk measurement system of the bank currently
measures the future liquidity risks only: in the examples in Figure 8.1
it would, for example, show the potential consequences of a credit
line given or a skewed balance-sheet structure in certain scenarios,
but would not account for the erroneous execution of scheduled
payments.
In order to avoid double counting, we need to properly segregate
the strategic liquidity risks (which are currently measured in the
FLE system) from the intra-day liquidity risks which are currently
measured in the intra-day liquidity management system (ILMS).
The answer to the question of why all liquidity risks are not cap-
tured in one system gives us a hint as to why intra-day and illiquidity
risks are so hard to integrate in practice.
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LIQUIDITY MODELLING
Although all risks finally materialise during a payment day,

some risks can be determined well before their manifestation
and should thus be measured when they become visible and
not only intra-day.
If, on the other hand, a risk is originated only shortly before it
substantiates, it needs to be tracked with systems that capture
data on very short notice: real-time systems.
Intra-day liquidity risks are instigated by concrete payments
which may or may not occur as planned, whereas strate-
gic liquidity risks stem from potential forthcoming detriments
which can materialise in payments and are thus forecasted
with (future) cashflows. Payments are tangible with high gran-
ularity in details, whereas cashflows represent the idea of a
payment and are thus much more abstract.
Consequently, payments possibly involve multiple parties and
thus are largely exposed to operational and credit risks, while
cashflows neglect these types of risks or represent them in a
more non-specific manner.
We distinguish different liquidity risk types: liquidity-induced value
risks, which occur frequently, and pure illiquidity risks with lower
probability but sometimes extreme effects.
Intra-day liquidity risks that cannot be measured, even with an
enhanced FLE encompasses include
deals that are originated intra-day or contain options which
might lead to intra-day payments,
uncertainties regarding the receipt and identification of the
beneficiary of payments,
operational problems, eg, own incorrect payments,
breach of contract, eg, if counterparties wilfully postpone or
even cease payments.
We can segregate between strategic and intra-day liquidity risk in
different ways.
(i) The underlying parts of the banks business. The strategic
system should in principle cover all cashflows of all financial
transactions by the bank.1 The ILMS also contains the loro
payments which the bank executes or receives as payment
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agent for clients. Capturing those loro payments in a strate-

gic system is almost impossible, as the necessary information
is typically not available beforehand but arises only during the
intra-day payment process.
(ii) External payments versus internal transfers. The ILMS con-
centrates on external payments and ignores internal transfers
(if they do not lead to payments), whereas an illiquidity risk
management system needs to incorporate in principle both
external and internal cashflows.2
(iii) The dichotomy of cashflows and payments. The ILMS han-
dles payments, whereas the illiquidity risk management sys-
tem deals with cashflows which can be interpreted as forecasts
of future payments but only contain considerably less granular
specifications of the anticipated payments.3
(iv) The payment process in time. The illiquidity risk management
system normally does not process intra-day information, nor
does it handle more granular time units than a day. Payments
(as opposed to cashflows) can require more timely informa-
tion, such as execution deadlines during the payment day, and,
moreover, depend on liquidity coverage on certain accounts
(and thus on other payments). In principle, these non-existent
elements could be added to the strategic system. For practical
reasons, however, so far it has been considered as inappropri-
ate to add such complexity to the strategic system, as this is
already complex enough.
(v) Lack of theoretical superstructure. There is as yet no compre-
hensive theory in the literature that describes how the strategic
and the intra-day view interact. It is the purpose of this book
to redress this lack.
THE MEASUREMENT OF LIQUIDITY RISK

In order to be able to make a clear distinction between illiquidity
risk and intra-day liquidity risk, we will delve further into the risk
management process.
Quite often it is argued that liquidity risk is a consequential risk
in the sense that it appears when the losses from other risks ulti-
mately materialise in the payment process and stop payments. In
this sense, all risks ultimately end up as intra-day liquidity risks. We
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LIQUIDITY MODELLING
Figure 8.2 Financial risk as a process
2 Cashflow
Uncertainty
Benefit
3
Value (payment)
Value (cashflow)
Financial 7 8
contract
variables
Market
Optionality
contract
Breach of
Detriment
9
1 4 5 6 Payment
Origination Future
will, however, only regard those risks that have not been originated
before today as specific intra-day risks.
Financial risks
Financial risk can be regarded as a process which is depicted
schematically in Figure 8.2.
1. The bank decides to enter into financial transactions which
generate payments.
2. Not-yet-executed payments are forecasted by (future) cash-
flows and thus establish together with a valuation mecha-
nism (eg, the risk-neutral yield curve) the financial value of
the transaction (eg, the net present value).
3. As the future is unpredictable by design, the payments can-
not yet be known. Therefore, cashflows necessarily comprise
uncertainty which can stem from various sources, such as those
given below.
4. Transactions may depend on market variables such as inter-
est/FX rates, securities prices, volatilities, etc (which them-
selves possibly depend on other market variables).
5. Transactions may (or may not) contain optionality which is
exercised by the counterparties.
6. If the counterparty breaches the contract (eg, credit risk in a
generalised sense), realised payments can deviate from the
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forecasted cashflows even if the underlying transactions lack

the above dependencies.
7. Thus, the materialisation of the sources of uncertainty might
deviate from its prediction.
8. The result for the bank can be a (comparative) benefit, or a
detriment.4
9. When cashflows materialise in payments, the net present
value of the cashflows can be compared with the value of the
payments. The result establishes a comparative profit in the
beneficial case (a comparative loss in the detrimental case).
As the results of these risks can be expressed as profits or losses, we

name them value risks.
If a bank wilfully enters into a venture with such uncertainty
because it hopes that reality will deviate beneficially, we speak of
a risk; whereas, if the bank is unable to avoid the uncertainty, it is
called a hazard.5
There are, however, detriments which cannot be directly quanti-
fied in P&L: eg, payment problems of the bank might result in no
or small losses; if these problems become publicly known, however,
the banks ability to raise unsecured funds in the markets might be
weakened. The detriment generates new uncertainties but not nec-
essarily new detriments (paying up for the funds or even illiquidity)
directly.
Risk as a result of uncertainty

Risk as above described stems from uncertainty about future devel-
opments.
In market risk, for example, we would try to identify the sources
of uncertainty (eg, the as-yet-unknown future price) then estimate
their magnitude and thus determine the results, which will finally
lead us to a (comparative) profit or loss. We regard the potential
future loss as a risk we have today.
In the above definition we have conceded that we do not know the
future development of risk parameters (eg, rates, prices and default
probabilities) but we have implicitly assumed that we know our
recent position or exposure. In practice, however, we often do not
know our recent exposure exactly in time.
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We will use the term information risk to describe the risks

stemming from the uncertainty about our position.
Future and intra-day risks have different time deferrals between
origination and materialisation. Future uncertainty stems from
prospective developments which cannot yet be known.
Present uncertainty arises from the absence, insufficiency or
inconsistency of information about the current status which can be
known in principle. One part of liquidity risk originates from prin-
cipally known factors, such as the relation between long-term assets
and short-term funding, scheduled large payments, etc.
Other drivers (eg, client behaviour, development of market rates)
are not yet known but are substituted by assumptions leading
to expected liquidity exposures (which are as appropriate as the
assumptions).6 Finally, we have to deal with disruptive factors (erro-
neous data, insufficient or untimely information, etc) which are not
really liquidity risks but lead to uncertainty about them.
Liquidity risk as a result of uncertainty

For liquidity risk, the chain of effects from uncertainty to losses is
similar but more complex.
Assume the uncertainty about future cashflows results in a
decrease in the banks liquidity position. This is a detrimental liq-
uidity effect, but is not automatically identical to a detriment for the
bank: if the bank was supposed to be cash rich (long) on that day,
the decrease leads to a smaller long position and thus eventually
decreases the losses incurred with the squaring of the long position.
This effect comes from the fact that less liquidity does not
necessarily mean more value risk (and vice versa).
If, however, we look only at the risk of having insufficient cash,
we can simply say that less liquidity is generally worse and more
liquidity is generally better. In this sense, negative cashflow effects
are always detrimental for the bank and we can talk about a risk.7
Types of liquidity risk

We recapitulate the distinction between illiquidity risk and liquidity-
induced value risk types, as in Chapter 3 and add liquidity informa-
tion risk as a third type.
(i) The illiquidity risk of the bank is its inability to exercise all nec-
essary payment and security settlement transactions in order
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to fulfil its contractual obligations.8 The potential detriment is

the bankruptcy of the bank or a subsidiary.9
(ii) Liquidity-induced value risk is a (comparative) loss arising

from the necessity to cover future liquidity deficits (indicated
by the FLE), still successfully but only at a high price:10 finan-
cial loss which could finally result in illiquidity if excessive and
long lasting.11
(iii) Liquidity information risk stems from the uncertainty about

the banks liquidity situation. The bank could take a decision to
change its assumed current or future liquidity position, which
turns out to be counterproductive because the assumptions
were incorrect. This can cause second-order and, in extreme
cases, first-order liquidity risks.
The continuous/enhanced FLE

In our FLE concept, we have so far used the notation tn without
clearly specifying that we mean single days as the smallest time
unit. To make this clear we will in this chapter use the notation D0
for today, Dm for the mth day before today and Dn for the nth day
after today. We considered a complete series of consecutive points
in time
. . . , Dm , Dm+1 , . . . , D1 , D0 , D1 , . . . , Dn1 , Dn
with nothing in between. In order to gain a more granular (intra-

day) view we want to investigate what can happen within a day
and thus denote a point in time t by its date and time (eg, April 20,
2010, 15h43).12 As a consequence, time buckets can be infinitesi-
mally small and we no longer have a complete series of consec-
utive points in time, because between two times we can in theory
always insert another point in time.
Consequently, a time bucket Tm = [tm s e s
, tm ) starts at tm and ends
e
at tm . A full day ranges from 00h00 (which is included) until 24h00
(which is not included because it is identical to 00h00 tomorrow).
We can define shorter periods, eg, a payment day could, say, start at
s
tm = 08h00 and end at tm e
= 18h00, etc.
The concept of the FLE is currently defined for the series of future
days D0 , D1 , . . . , DH 1 , . . . , DH , starting today (D0 ) and ending with
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the time horizon DH (which hopefully comprises the banks last cash-
flow). Per transaction, we generate for each day Dn a forecasted cash-
flow CFOn (with a zero value if there is no cashflow on that day) and
calculate the FLE of the transaction
FLEn = FLEn1 + CFO

n
where FLE1 is the banks nostro balance at the end of yesterday

(D1 ). The FLE of a set of contracts is the sum of the FLE of each
individual contract.
In order to enhance the FLE for a denser set of points in time, we
consider each forecasted (non-zero) future cashflow and collect its
date and time tn . The consecutive series t0 , t1 , . . . , tN 1 , tN marks the
times when the FLE will change. Next, all cashflows that happen at tn
are added (CF(tn )) and the continuous FLE is calculated recursively
as above
FLE(tn ) = FLE(tn1 ) + CF(tn )
Technically we can say that the FLE is defined for the time intervals
[tn1 , tn ): it is constant from tN 1 onwards until it jumps at tN . If we
recalculate the FLE with changed parameters or transactions, some
new points in time might emerge, while others may cease.
The old daily FLE is usually not set up to be continuously recal-
culated and therefore possibly uses data which is not fully up-to-
date. Todays FLE is calculated on the basis of all contracts that
are available in the source systems as of close of business yester-
day (D1 ). Transactions which have been booked after the cut-off
time (which is technically required) are not included. The continu-
ous FLE will be continuously recalculated by comparing the set of
old transactions with the current ones and calculating the FLE of
the new transactions, which is then added to the old FLE. Eventu-
ally, we need to fully recalculate the FLE and thus (re)generate the
cashflows of all transactions.
In addition to enhancing the FLEs granularity in time, as we have
described above, we might add other features such as different FLEs
for different time zones, etc. Therefore, we will in the following refer
more generally to an enhanced FLE instead of the continuous
FLE.
In Figure 8.3 we consider the days D1 (yesterday), D0 (today)
and D1 (tomorrow) which in physical time start 00h00m and last
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Figure 8.3 Timelines of contracts and cashflows
Real time
Days D1 D0 D1
Contracts CoB1 Now
Cashflows
Standard/existing Potential
until 24h00m. In the FLE, however, the days have no duration and
are expressed only as points in time d1 , d0 and d1 .
Consequently, cashflows cannot have a particular time associated
with them but bear only the day on which they are scheduled to take
place.
If we look into the FLE as it is represented in the FLE system
at, say, today 16h00, we will only find cashflows originating from
contracts which have been captured before the cut-off time COB1
(say, yesterday, 22h00).
If, in the meantime, FLE-relevant contracts have been entered into
the stocktaking systems, they are neglected in the FLE system.
There is no principal technical argument against capturing these
contracts (and thus moving the cut-off time into the payment day)
but this procedure would only make sense if all intra-day deals with
their cashflows could be captured, which is quite unrealistic.
ILR which can be captured with an enhanced FLE

We could enhance the FLE to cover the measurement of the liquidity
risks by
(i) expanding the cut-off time from close of business yesterday

to now in order to capture more recent contracts, which in
practice means that the FLE has to be recalculated almost con-
stantly (near time, we suppress here all technical difficulties
encompassed with this),
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(ii) expanding the granularity of time in the FLE from one day to
continuous time.
ILR which cannot be captured with an enhanced FLE

The expansion envisaged above of the FLE into the intra-day time
frame would, however, not measure the whole spectrum of intra-day
liquidity risks. The payments are concrete transactions which may be
carried out as scheduled, or may not (perhaps before a certain time),
and need to be remapped to the cashflows of the contracts. We will
describe in the following how the intra-day liquidity-management,
settlement-management and cash-management risks differ from the
FLE view even if extended into today.
In Figure 8.4 we imagine the physical time as continuous and
measure it in our time zone (CET).
A day Di is an interval in the physical time. The next day starts
when the preceding day ends.
A cashflow is assigned to a date but not to a certain time period
within that date.13
Payments, however, might be assigned to a certain time period.
For example, payments for securities purchases need to be exercised
before a certain cut-off time in the morning (07h30), whereas FX-
related cashflows might only be scheduled when, for example, the
US dollar payment day has started (this entails an intra-day credit
risk: euros have to be paid early in the morning while the US dollar
arrive only in the afternoon!).
During the payment day the information from the stocktaking sys-
tems can change permanently and needs to be captured in order to be
available for the updating of the payments. Intra-day payment sys-
tems focus strongly on today but can in principle replay yesterday
as well as simulate tomorrow and days further in the future.
THE PAYMENT PROCESS

We have so far described payments as well as their predictions
(cashflows) in an idealised way. In practice, there are additional
aspects like different types of payments (the banks payments from
its own nostro as well as through payment agents), different nos-
tros, different payments channels and especially payments the bank
is executing as a payment agent for third parties.
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Figure 8.4 Timelines of deals, cashflows and payments
Physical time d1 d0 d1
Days D1 D0 D1
FLE
Deals/contracts CoB1
Cashflows
Payments
Intra-day payment system
Standard/existing Potential
Settlement of debt and payments

The provision of goods or services between two parties can establish
a debt. In order to settle such a debt the debtor can either exchange a
legal tender (coins or banknotes) or transfer a credit from an account
they hold with a bank to the lenders account (provisioning).
In the following we shall use the expression payment for the
transfer of a credit (provisioning).14 The payer makes the payment,
while the payee receives the payment.
A direct payment is a transfer between accounts that both the
payer and the payee have with a third bank, the payment agent.
An indirect payment might involve more parties (see the section on
indirect payments on page 183).
Nostro and vostro/loro accounts

A bank X calls the account it has with another bank Y a nostro
(account), whereas it is a vostro or loro (account) in bank Ys view.
A credit that bank X has on its nostro with bank Y is an asset in
the view of X but a liability as seen from the perspective of Y.
The bank executes payments by transferring a credit on its nostro
at its payment agent to the nostro of the receiver. Payment agents
can be central banks (eg, the ECB) but also so-called correspondent
banks, which transfer credits on their nostro with a central bank to
another banks nostro on behalf of the paying bank. For the sake of
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Figure 8.5 Payer, agent and payee
Payment
agent
Vostro Vostro
payer payee
Bank X Bank Y
(payer) (payee)
Nostro Nostro
Debt payment payment Asset
agent agent
simplicity we initially assume that the bank has only one nostro with
one payment agent.
Processing a payment
In order to execute a payment, the following conditions are neces-
sary.
(i) The originator bank (X) and the beneficiary bank (Y) both have
nostro accounts with the same payment agent.
(ii) The nostro balance of the originator bank has sufficient cov-
erage: its credit balance plus a potential overdraft facility is at
least equal to the intended payment amount.
In the simplest version the originator bank X (payer) orders the
payment agent to credit Ys nostro on a day D (normally the next
day) and sends a copy of this order to Y.
The payment agent debits Xs nostro and credits Ys nostro in
response.
The result of the payment is a balance brought forward between
the nostros A and B have with the payment agent; it is called a credit
transfer between A and B.
If B is not the beneficiary of the payment itself, but acts as pay-
ing agent for client XYZ, the balance is passed on to XYZs nostro
with B. In this case B is the primary beneficiary and XYZ is the
final beneficiary of the payment.15 We illustrate a direct payment in
Figure 8.5.
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After the successful execution of a payment the payment agent

sends a corresponding notification to the originating bank, which
will normally reconcile it with the list of payments to be done. The
beneficiary bank will reconcile the incoming payment with its list of
outstanding invoices.
The uncertainties of payments

An incoming payment credits our account, whereas an outgoing
payment debits it and credits another banks account in response.
Outgoing payments cannot be executed if the relevant account has
insufficient coverage, which depends on the banks general ability
to generate sufficient cash balances (strategic liquidity risk) as well
as on its ability to move it at the right time to the right account
(operative risk).
Incoming payments depend on the counterpartys capability
and/or will to execute them.
We can distinguish between the following properties of the
counterparty:
(i) its general inability to generate sufficient cash balances (be-

cause it is illiquid or insolvent);
(ii) its wilful non-payment (because it assumes that the bank is
almost illiquid or insolvent; see the Lehman case discussed
on page 199 and distortion by wilful breach of contract on
page 199)
(iii) its inability to move sufficient coverage at the right time to the
right account.
We can regard (i) as credit risk, (ii) as breach-of-contract-risk and

(iii) as operational risk.
Both incoming and outgoing payments bear the risk that the pay-
ment agent is unable to execute them at the right time between the
right accounts.
Again we can distinguish between the following:
(iv) a wilful retention of a payment by the payment agent (because

it assumes that the bank is (almost) illiquid or insolvent16 );
(v) the agents operational inability to move the correct credit at
the right time between the right accounts.17
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Figure 8.6 Technical execution of a payment
Stock-keeping
systems
1 1 1 1
Counterparty
4
Payment Payment
monitoring 5 execution 2 SWIFT 2
(PMS) (PES)
6 6
2a 2b
3a 3b
Treasury
Liquidity
monitoring TARGET2 EBA
Execution of a payment in a bank

The real payment situation of the bank is, even in one currency, more
complex than that which was outlined before page 180. Figure 8.6
is an abstract schematic of the banks euro payments through the
TARGET (Transeuropean Automated Real Time Gross Settlement
Express Transfer) system or EBA (Euro Banking Association).
It shows an example from a specific bank which differentiates
between the payment monitoring and the execution; in other banks
the system architecture might vary.
1. Two business days before the payment date D, the stock-

keeping systems start sending the payment information to the
payment execution system (PES). A copy is sent to the payment
monitoring system (PMS).
2. PES sends the payment instruction as a message to SWIFT,

which decides (depending on certain fields in the message) to
forward it to the payment systems TARGET2 (2a) or to EBA
(2b). In any case a copy is sent to the counterparty (to advise
the payee in advance about the payment).
3. On the payment day after successful execution of the payment

TARGET2 (respectively, EBA) sends back a message (3a or 3b)
to SWIFT which indicates the successful payment.
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4. SWIFT sends the corresponding message the banks payment

execution system (PES) and to the counterparty (payee).
5. The payment execution system (PES) informs the PMS about
the successful payment.
6. PMS forwards the information about planned and successful
payments to both the treasury and the liquidity monitoring
group.
Indirect payments
Banks sometimes (especially for remote currencies) use corre-
spondent banks to execute and receive payments. In this case, the
exchange of credit between the payer and the receiver goes through
various steps. In each step there is a beneficiary of the credit who
passes it on to the next beneficiary until the final beneficiary (the
payee) is reached. We illustrate this process in Figure 8.7.
The bank as payment agent for clients

If the bank acts itself as payment agent for a client (bank or non-
bank) this client needs to have its own nostro account with the bank
(which in the banks view is called vostro or loro account).
The payment orders submitted by the client to the bank can be
reconciled with the payment agents notifications of successful pay-
ment execution. For the reconciliation of incoming payments with
the client as final beneficiary, however, the bank will not always have
received appropriate outstanding invoices.
Payments and cashflows

Cashflows are forecasts of future payments that may-or may not-take
place.
In the FLE concept cashflows are forecasts for scheduled future
payments which depend on the development of market parameters,
counterparty decisions, new business, breach of contracts, etc. Going
forward in time towards the scheduled cashflow date, some uncer-
tainties (like market parameters) will decrease (in principle). Once
the scheduling of the payments is considered to be fixed, the banks
payment systems18 will generate a list of payment instructions which
have to be executed and a list of payments which are expected. These
scheduled payments are still uncertain until they have been exe-
cuted, but their uncertainty is now in a different category from that
of the cashflows.
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Figure 8.7 Indirect payments
Master
payment
agent
Vostro Vostro
payment payment
agent (X) agent (X)
Payment Payment
agent of agent of
bank X bank Y
Vostro Nostro Nostro Vostro

master
bank payment client bank
X agent A Y
Bank X Bank Y
Vostro Nostro Nostro Vostro

client payment payment client
A agent agent B
Client A Client A
(payer) (payee)
Nostro Nostro
Debt bank bank Asset
X Y
In addition to the uncertainties associated with scheduled pay-

ments, the generation of cashflows depends on assumptions and is
uncertain in itself.
From a deal to a cashflow to a payment

We describe how a financial transaction is agreed and confirmed in
a contract, the cashflows as estimations of future payments are gen-
erated and the payment is finally made or received on its due date.
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Figure 8.8 Timeline of payments and cashflows
CFn(tM)
Book
Book
CFn(tM1)
source system
Assuming no errors/problems
Confirm
Discern
identity
Time rolling in t0 today
Booking in
CFn(tM2)
payment
Receive
Pay
liquidity risk system
Deal capture in

contract
Written
Discern
identity
Notice
4
CFn(t2)
2a
Receive
notice
Out
CFn(t1)
agreement
Informal
3a
I/O
Scheduling of
cashflow CFn
payment at t0
Scheduled
In
Deal
3b
1
3
2
Initially, we assume ideal circumstances and later in this chapter

we describe the uncertainties which might distort this idealistic view
and lead to detrimental consequences.
We now give a description of Figure 8.8.
1. A deal between the bank and a third party is closed by an

informal agreement which is later formalised by a (written)
contract. Usually, thereafter the contract is taken into custody
by the relevant stocktaking IT systems and captured by the
liquidity risk system.
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2. After the contract has been captured, its future scheduled cash-
flows are generated. Normally only those cashflows which are
considered as fixed are displayed. In more sophisticated sys-
tems, assumptions about the uncertain cashflows are made
and all future cashflows are generated. In order to reflect the
miscellaneous possibilities that can happen, different assump-
tions are made in different scenarios, leading to diverse sets of
generated cashflows.
As the cashflows are estimations of future payments they have

to be recalculated if/when the assumptions change.
3. Once a cashflow is only a few days ahead of today19 and

therefore can be considered as certain, the payment sys-
tems extract the necessary information from the stocktaking
IT systems in order to generate scheduled payments. These
payments are not necessarily identical with the cashflows;
therefore, both need to be reconciled.
(a) Outgoing payments are in theory under the banks full

control: the bank sends a payment notice to the receiv-
ing bank, usually a day before (D1 ) the payment date
(D0 ). Once the payment agent (ECB) has confirmed the
execution, the payment is booked as paid.
(b) Incoming payments: if a payment notice in advance is

received, the bank tries to match its identity against a list
of expected inflows; if a payment is received, the bank
tries to match the identity of the final beneficiary against
a list of expected inflows and the payment notices in
advance. Once the identity is unequivocally discerned,
the payment is booked as received.
4. The above procedure assumes that all outgoing and incoming

payments are correctly scheduled and set up and that they can
and will be executed when they fall due.
We will examine these uncertainties more in detail in the section

on intra-day liquidity risks that go beyond the enhanced FLE (see
page 191 onwards).
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Figure 8.9 Contracts and cashflow types
1 Actual Not yet

existing existing Contracts
contract 7 contract
3 6
Contingent Hypothetical
CF CF
time
4 5
Variable Optional
CF CF
t2
2 8 8
Scheduled Scheduled Scheduled
tt1 CF CF CF Late or
incorrect
9 9 9 10 contract
t0 Scheduled Scheduled Scheduled Scheduled

payment payment payment payment
Payments
Internal and external cashflows/payments

External cashflows or payments are supposed to individually20 flow
between the bank and a third party, whereas internal cashflows are
in fact balances brought forward between sub-entities of the bank
(or the entity we are looking at).21
Uncertainties in cashflows and payments

We will not go too deeply into the details of the uncertainties of cash-
flows as we did when describing the uncertainties of the cashflows
that constitute the FLE (see page 37ff), but illustrate the problem
in Figure 8.9. We first consider all existing contracts the bank has
entered into.
They bear scheduled cashflows as well as contingent cashflows.
1. The scheduled cashflows are considered as predetermined

(although in reality they might change due to, eg, credit or
operational risk).
2. The contingent cashflows are separated into variable and

optional cashflows.
3. The variable cashflows are contingent cashflows depending

on market variables.
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4. The optional cashflows are contingent cashflows depending

on counterparty decisions, which might themselves depend
on market variables.
5. If we consider as-yet non-existent transactions (eg, new loans
substituting maturing ones), we need to deal with hypothetical
cashflows.
6. If a hypothetical transaction turns into an existing transaction,
its hypothetical cashflows transform into scheduled, variable
and optional cashflows according to the transaction.
7. Variable and optional cashflows that come nearer to their
fixing/exercise date (t0 ) transform into fixed cashflows.
8. At t1 (close of business before the payment day) all cashflows
should have been fixed or exercised and thus can be converted
into scheduled payments.
9. The cashflows stemming from contracts which arrive (eg, late
or incorrect deals) after t1 are the exemption to the rule, as the
corresponding scheduled payments can only be generated (or
corrected) intra-day.
10. Cashflows that stem from contracts which are incorrect (in-
complete) or are available only too late need to be created in a
separate process, as otherwise payments would be missed.
MEASUREMENT OF ILR WITHIN AN ENHANCED FLE OR

SEPARATELY?
We come now to the point where we separate those intra-day
liquidity risks which can be captured by enhancing the existing
FLE concept suitably from those where this is not a viable strat-
egy. We investigate the main sources of uncertainty and its conse-
quences which arise because the FLE relies on insufficiently updated
information or eventually lacks certain types of information.
The uncertainties which are described in the section on uncertain-
ties of cashflows and payments (see page 187) lead to outflows or
inflows which differ from our FLE forecasts and thus might result
in unforeseen or even unwanted liquidity positions during or
at the end of the payment day. This leads to the question of whether
the existing illiquidity risk system should be enhanced to addition-
ally capture these cashflows or it would be better to somehow keep
them apart.
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Not every existing FLE system will incorporate or generate all the
cashflows in the above list.
From a theoretical point of view, however, all cashflows should
be included in an enhanced FLE system, whereas from a practical
point of view it could be extremely cumbersome to incorporate, in
particular, the cashflows listed in point 10 in the preceding section
as this would require the system to update its results in real time.
We should therefore distinguish between transactions/cashflows
which in principle can (and should) be captured in an enhanced
FLE system and those which for practical reasons go beyond the
enhanced FLE.
ILRS THAT COULD BE MEASURED WITH AN ENHANCED FLE

We consider here intra-day liquidity effects where it is straightfor-
ward to measure them within an enhanced FLE method or system.
In the next section we will deal with issues that require a separate
measurement concept that makes it inadvisable to integrate it into
the FLE concept and its corresponding system realisation in a bank.
Contingent cashflows
Options generate contingent cashflows (which might be zero). If
the option is exercised, the contingent cashflow changes its type to
deterministic and is quite likely to change its value. This needs to
be captured in the FLE system which uses the transaction data as of
t2 to make projections for t+1 .
Potential issues
If the information flow to the FLE system is delayed or the time
between the exercise of the option and its realisation in cashflows
(or asset flows) is too short, the change of the cashflows will not
materialise in the FLE in time.
Resulting detriment
The following depend on the cash position of the bank at that time:
interest loss if the bank can fund/place the money only at a

higher-/lower-than-normal interest rate;
penalty payments if the bank is unable to execute payments as
contractually scheduled;
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illiquidity if the bank is unable to fully fund the necessary

amount.
Mitigation
The bank needs to correctly capture all deals, including the late and
intra-day deals, and incorporate all non-financial transactions into
the FLE.
In the following paragraphs we treat the transactions that will not
appear or appear only incorrectly in the FLE.
Incorrectly captured deals

Incorrectly captured deals (in the stocktaking or liquidity systems)
might spawn inaccurate cashflows or payments. Although the cor-
rection of these deals is not as such an intra-day issue, if the correc-
tion is only possible intra-day, it might be counted as an intra-day
issue. In an intra-day view, only the deals with cashflows at t0 are of
interest.
Late deals
Late deals are transactions which belong to D1 but are only cap-
tured after COB1 . Consequently, they are missing in the FLE as of
today. One solution could be to extend the cut-off time to intra-day;
however, a certain time delay when capturing such deals cannot be
avoided.
Intra-day deals
Intra-day deals can principally be treated in the same way as late
deals. Most intra-day deals do not have intra-day effects (normal
deals have cashflow effects D+2 ). Therefore, it might be more appro-
priate to restrict the intra-day capture to those deals having intra-day
cash effects.
Non-financial transactions
The FLE does not incorporate cashflows from non-financial trans-
actions, as the bank normally does not create (financial) contracts
for the payments of salaries, taxes, leasing, etc, although they can
be material. The related outgoing amounts are usually processed for
payment by the responsible departments of the bank shortly before
the payment date. Incoming non-financial payments are normally
not captured or scheduled before they arrive.
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The ideal solution would be to capture these transactions well

before they fall due, create pseudo contracts in the liquidity risk
systems and finally process them into the FLE that mimics their
behaviour appropriately.
ILRS THAT GO BEYOND THE ENHANCED FLE

We investigate the main sources of uncertainty, with its conse-
quences arising from information that is principally only available
intra-day.
Payments with very short notice

Certain contracts, eg, with central banks or settlement agents, allow
these counterparties to directly debit the banks nostro (eg, the ECB
collects the repayment of a tender).
These cashflows or scheduled payments could be captured as
pseudo-contracts in the FLE (but not if they fall into the category
of intra-day short payment options (see below)).
Intra-day short payment options

These are options that the bank has granted to counterparties which
can be drawn immediately and need to be paid intra-day. The options
should be captured in the risk system and its effects be described by
a what-if scenario. The actual exercise of the option, however, can
only be modelled intra-day. This risk is in principle the same as
other outflow risks (eg, under credit lines given) but with the extra
complication that the options exercise only becomes known during
the payment day.
Potential issue: unexpected outflow of cash due to the exercise of

an option by a counterparty. There is an unexpected outflow of cash
due to the exercise of an option by a counterparty.
Resulting detriment. The following depend on the cash position of

the bank at that time:
interest loss if the bank can fund the money only at a higher-
than-normal interest rate;
illiquidity if the bank is completely unable to fully fund the
necessary amount.
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Mitigation. The bank needs to dedicate additional liquidity reserves

to cover unexpected outflows under short payment options.
Intra-day margin calls

Intra-day margin calls depend on the intra-day movement of values
of derivatives portfolios, which depend on the intra-day movement
of market rates. If the value of the portfolio drops, the bank is obliged
under such contracts to move additional collateral (in the form of
cash or securities) to the accounts of the counterparty.
Potential issue: unexpected outflow of cash. There is an unex-
pected outflow of cash due to a margin call.
interest loss if the bank can fund the money only at a higher-
than-normal interest rate;
illiquidity if the bank is completely unable to fully fund the

necessary amount.
Mitigation. The bank needs to dedicate additional liquidity reserves
(in cash or liquefiable/eligible securities) to cover unexpected
margin calls. As the quantiles of the portfolios value distribution
should normally be modelled in a market risk system, the size of the
reserve can be estimated from these distributions.
Uncertainty about payments not yet received

If the bank expects an incoming payment (and, for example, has
even received a payment notice), it has to assume that the payment
will occur before the end of the payment day. If the payment does
not arrive later in the day, this time window is closing and the bank
has to make a decision. The bank can either square the deficit or
still assume that the payment will arrive today and decide not to
cover the open amount. If the bank squares, it will eventually end
up long this amount if the payment arrives after the squaring. If
the payment does not arrive, the bank will finally have to square at
some time before the end of the payment day. In the case when own
payments are waiting to be executed, the squaring has to be done
promptly, otherwise the payment process could be disrupted.
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Potential issue: premature squaring

The payment arrives only after it has already been squared by the
bank and thus leads to an unwanted long position at the end of the
day.
Resulting detriment. The bank can only place the money at a lower-
than-normal interest rate, which leads to (comparative) interest loss.
Mitigation. The bank needs to fix with the client a deadline for the
acceptance of payments in the clients favour which is early enough
to allow the bank to place the money with other banks before the
end of the payment day and thus avoid interest losses. Alternatively,
the client can be held responsible for these interest losses.
Potential issue: belated squaring

If the bank has waited to square the missing inflow until late, when
it becomes clear that the payment will not come, the bank will end
up with an unwanted short position.
whether the bank can fund the money only at a higher-than-

normal interest rate or is still able to fund at normal rates;
interest loss.
Mitigation. The bank should fix with the client a deadline for the
acceptance of payments in the clients favour; this is, however,
impossible, as incoming payments are out of the clients control.
It can be agreed that the bank will start funding short positions on
the clients account early enough. The client has to bear losses from
potential double funding (if the payments arrive after the funding).
Uncertainty about payments already received

The bank has received a payment erroneously. As the error has been
made by the sending bank, the bank cannot be made responsible
for the consequences (in the first instance). During the day, how-
ever, the error might be detected and the payment reversed. The
responsibilities of the different parties are not always clearly laid
out.
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The bank has correctly identified a wrong incoming payment as

incorrect
Normally the payment should be sent back to the paying bank and
the scheduled FLE remains unaffected.
Potential issue: slow identification. The identification of the wrong

payment takes too long.
Resulting detriment. The bank ends up with an unwanted long

position which can, depending on how late the error is detected,
result indirectly in an interest (opportunity) loss: the bank has
possibly squared its position and is, after correcting the wrong
payment, short again and can only refinance at a higher rate.
As the initial error was made by the payer, the loss should be
recoverable.
Mitigation. Investment should be made in systems, staff and train-

ing in order to quickly detect erroneous payments to alleviate the
above risk.
The bank has mistakenly identified a wrong payment as correct

The bank mistakenly reconciles an incoming amount with an
expected payment.
Potential issue: double payment. When the correct payment arrives

and is identified, it is too late to send back the erroneous payment.
Resulting detriment. The bank can only place the money at a lower-
than-normal interest rate; thus, it will have to bear interest loss.

ing to correctly identify incoming payments.
Potential issue: reclaim. The payment agent can reclaim an erro-

neous payment if it is not too late.

if the bank can fund the money only at a higher-than-normal

interest rate it will have to bear interest loss;
if the bank is at all unable to fully fund the lacking amount it

needs to face illiquidity;
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if the bank decides not to pay back in due time it will have
to bear reputational loss (rumours about the banks ability to
pay).

ing to correctly identify incoming payments.
The bank cannot identify a payment as correct or incorrect

A counterparty detecting a payment made erroneously to the bank
can claim the payment back.
Potential issue. If the bank is unable to reconcile its payment status,

it might have mistakenly squared its position and ends up with an
unwanted short position after sending back the erroneous payment.

if the bank can fund the money only at a higher-than-normal
interest rate it will have to bear interest loss;
if the bank is completely unable to fully fund the lacking
amount it will have to bear illiquidity.22
Mitigation. Correct and reliable near-time information is needed23

to produce information to avoid identification errors.
The banks own incorrect payments

If the bank has mistakenly executed an incorrect payment, it is
obliged to correct the payment after detection. The payment which
should have been executed instead of the incorrect one has still to
be made. The main sources of errors are
incorrect details of final beneficiary,
the receiving bank is unable to discern the identity of the final
beneficiary,
wrong final beneficiary,
wrong beneficiary,
the bank has paid to bank X although the payment should
have been sent to bank Y,
wrong amount,
wrong date.
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Potential issue: cost. All costs stemming from the banks mistakes
have to be defrayed by the bank.
Payments to the wrong beneficiary bank

The incorrect payment cannot be corrected.
First, the bank has to make the correct payment. Ideally the erro-
neously credited counterparty sends back the money before the bank
is obliged to make the correct payment. In practice this might not
work, having the consequence that the bank gets its money back
after having arranged the correct payment (sometimes only some
days later).
In some cases it can be arranged that the erroneously credited bank
sends the money directly to the correct beneficiary bank, which then
eventually credits it to the final beneficiary.
Potential issue: realisation of credit risk. Although it is unlikely, it

could happen that the erroneously credited counterparty paid away
the money before becoming insolvent and thus is unable to pay back
the money.
Resulting detriment. In any case the bank will enter into credit risk
with the erroneously credited bank until the wrong payment is set-
tled, which can take only a few minutes, or up to several days in
extreme situations.
Mitigation. Incorrect payments should be avoided.
Reversed payments
The wrong receiver sends the payment back. The bank has to pay
again to the correct payee. Eventually other payment details need to
be changed as well.
Assume that, for example, the counterparty X has two standing
instructions for payments, either with bank A or with bank B.
If the banks back office has erroneously taken the payment details
of X for bank B, the payment has to be changed to the correct
payment details which X has with bank A.
Potential issue: additional payment collateral. As the bank is ob-

liged to make the correct payment but has not eventually received
the wrong payment back, it might need additional collateral (or cash
deposit) to be able to execute the correct payment.
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if the bank takes cash or collateral as a loan from another bank
it will have to bear additional cost,
if the bank is unable to cover the lacking collateral amount it
will have to bear illiquidity.
Mitigation. Avoid incorrect payments and/or hold an extra pay-

ment collateral cushion. Keep good relationships with all payment
partners and convince the erroneously credited bank to redirect the
payment directly to the correct beneficiary bank.
Potential issue: reverted payment comes too late

If the bank has made the correct payment but receives the reverted
payment too late, it ends up with an unwanted short position.
Resulting detriment. If the bank is only able to fund the lacking cash
at a higher-than-normal interest rate it will have to bear opportunity
losses.
Mitigation. Avoid incorrect payments.
Payments to the correct beneficiary bank

The payment bears incorrect final beneficiary information. It can
either be reversed (the receiving bank sends back the payment to the
bank and a correct payment has to be initiated). We have described
this situation in payments to the wrong beneficiary bank (see
page 196).
Alternatively, if possible, the payment can be corrected.
The final beneficiary information is incorrect but the amount
is correct: the beneficiary bank can redirect the payment
internally to the correct final beneficiary account.
The amount is incorrect but the final beneficiary information
is correct: only the difference has to be paid in either direction.
This is, however, only done in exceptional situations.
OTHER ISSUES
The adjustment of costs in the above situations depends on whether
the bank paid on its own behalf or on a clients behalf and, if the
latter, gave correct or incorrect payment instructions.
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Distorted payments due to breach of contract

Although the bank will not breach any contract,24 counterparties
could do so.
If a contractually scheduled payment is not received during
the day, the reason(s) could be various: mistakes, operational or
organisational inability to execute payments correctly or wilful
withholding of payments.
Distortion of payments by credit risk

Assume counterparty X is obliged to execute payments in the banks
favour today. If X is at risk of becoming illiquid, it will normally
ask for prolongations or bridge loans, etc, because of its upcoming
illiquidity. The default of X is, strictly speaking, not an intra-day risk,
although it will materialise intra-day, as only the effect is intra-day
and not the cause.
The cases where potential losses are caused by the payment or
settlement process (eg, a payment client using its intra-day payment
limits for the procuration of a loan) are discussed later, in the section
on Risks related to correspondent banks(see page 200).
Distortion by operational risk

If a counterparty envisages operational problems but is not near to
insolvency, it can be assumed that everything will normalise in very
few days.
Remark 8.1. There is, strictly speaking, no way to discriminate a
priori operational payment problems of a counterparty from its
illiquidity. But even if this were possible, it could never be ruled out
that operational illiquidity transforms into real illiquidity.
Potential issue. The bank will not receive scheduled inflows which
can be fully recuperated in subsequent days (including interest
expenses).
As a consequence, the bank might end up with an unwanted short
position which has to be funded (possibly) at a higher-than-normal
price.
interest loss, which should be taken over by the counterparty;
illiquidity.
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Mitigation. There is no mitigation.
Distortion by wilful breach of contract

During the crisis in the autumn of 2008 a large European bank was
reportedly trying to draw advances under contractually committed
credit lines.
Some counterparties breached the contracts and rejected to pay
out the advances to that bank.
A bank suffering from this wilful breach of contract could claim
for compensation but would not receive the payments in due course.
Resulting detriment. There is no interest loss, or even insolvency,

but there is illiquidity.
Mitigation. There is no mitigation.
Distortion by wilful retention of payments (the Lehman case)

On a Monday during the crisis in the autumn of 2008 the state-owned
German bank KfW made payments of some hundred million euros
to several Lehman entities.
This exposed KfW to massive public criticism because the pay-
ments had been made although the Lehman head office in New
York had evidently defaulted the evening before.
If the bank has good reasons to assume that the envisaged receiver
(the receiving bank or the final beneficiary) of a scheduled pay-
ments has defaulted, it might consider ceasing (all) payments to
the receiver.
Remark 8.2. The wilful retention of payments (which may lead to
the default of the receiver) attracts severe penalties in several juris-
dictions. The default of a company does not automatically imply the
default of its subsidiaries as a consequence.
Potential issues. Information uncertainty: the bank is uncertain if

the receiver is in fact insolvent. If the bank decides to stop payments
too late (the receiver is already illiquid) it might lose (a part of) the
paid amounts. If payments are stopped too early (the receiver is not
yet illiquid) the bank can be held responsible for procurement of the
receivers bankruptcy.
Operational uncertainty: the bank is not able to detect the relevant
payments individually or is not able to extract specific payments
from the execution list.
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If the bank does not stop all payments, it might lose (a part of) the
unstopped payments.
If the bank stops too many payments, it might need to indemnify
for unsubstantiated cease of payments.
To fully understand the different issues, it might be necessary to
distinguish whether the defaulted receiver is the final beneficiary or
only the initial beneficiary, and whether the bank is paying on its
own behalf or for a payment client.
Postponed payments
The bank can try to save liquidity/collateral during the payment
period by postponing payments until almost the last possible pay-
ment time (usually between one and two hours before the end of the
payment period).
Potential issues. By deferring payments, the bank increases its

exposure to operational risk: the beneficiary might refuse to accept
the late payment and there is no time to reschedule incorrect pay-
ments, etc. If the bank postpones payments to the last minute, pay-
ment partners and clients might postpone their payments going out
to the bank.
This could finally lead to rumours about the banks ability to
execute payments, and finally to its illiquidity.
Mitigation. The bank should not try to postpone payments in order

to create intra-day liquidity.
RISKS RELATED TO CORRESPONDENT BANKS

By executing and receiving indirect payments through correspon-
dent banks, new risks emerge.
Insufficient coverage of nostro

The correspondent bank as payment agent will demand collateral
and/or give a credit line to cover outgoing payments in case there is
not enough coverage on the nostro account that the bank holds with
its payment agent.
Potential issue: insufficient coverage

If the credit facility can be terminated at short notice and if the banks
market standing becomes doubtful, the correspondent bank might
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decide to cut it. This happened in autumn 2008, when some payment
agents in the US did cut lines and executed payments in US dollars
only against cash coverage.
Resulting detriment. Scheduled payments will not be executed if
the coverage on the nostro is not sufficient. The recipient (or the
final beneficiary) of the payment can claim compensation for that
(comparative interest cost).
The non-payment is formally a default of the bank and could fire
rumours about its ability to pay, which can in the worst case lead to
the illiquidity of the bank.
Mitigation. The deposited collateral plus the credit line should be
of sufficient size for a period which is long enough to substitute the
collateral when it ceases. This precludes collateral which the bank
only possesses in the short term (eg, securities from a reverse repo)
as well as credit lines from the correspondent bank which are not
irrevocable.
Potential issue: poor quality of collateral.

In the crisis of autumn 2008 the diminishing reputation of a bank and
of sub-prime securities prices were correlated (at least in time). In
the next crisis, correspondent banks (other than central banks) might
eventually refuse to accept even government bonds (eg, Greece).
Mitigation. The bank should post only collateral of highest quality,
which will remain sufficiently long in its possession.
Credit risk of the correspondent bank

In the crisis of autumn 2008 some large correspondent banks (espe-
cially in the UK) had to be saved from illiquidity by a government
takeover.
Potential issue
It cannot be ruled out that one of the banks correspondent banks
becomes illiquid and therefore discontinues executing payments.
Resulting detriment. Payments which the bank has instructed will
not be executed.
If the payments have been instructed on behalf of
clients: the client will default on the payment, but the bank
might be liable for damages;
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the bank itself: the bank will default on the payment and
therefore incur a loss.
In both cases, the reputation of the bank is endangered.

The bank might lose its collateral and account balance with the
correspondent bank which becomes illiquid; a certain part, however,
will possibly be recovered in the insolvency process.
Mitigation. The bank should avoid correspondent banks and in-

stead use larger payment systems. For the time being, payment
systems organised by central banks are the safest.
Time splinter risk

Correspondent banks are largely used for payments in foreign cur-
rencies (and possibly different time zones). FX spot deals, for exam-
ple, consist of two payments in different currencies. If the first pay-
ment is executed, the payer runs the credit risk that the payee will
not be able to execute the other payment of the FX deal (the payee
or their correspondent bank could default). See also the section on
the Herstatt risk (time zone splinter risk) in the next section.
Potential issue. The bank has executed the first payment and the
counterpartys correspondent bank defaults before the second pay-
ment. This is a special case of credit risk of the correspondent bank
(see the previous section).
Breach of contract by the correspondent bank

Herstatts correspondent bank for US dollar payments, Chase Man-
hattan NY, froze Herstatts US dollar depot account in New York
when they were informed by their chief dealer in Frankfurt about
the quasi insolvency of Herstatt in Frankfurt. It is open to discussion
whether or not the undertaking of Chase was legally correct (Her-
statt US had so far not declared insolvency), but as a consequence it
prevented Herstatt from making any payments in US dollars.
Potential issue. If the bank experiences massive reputational prob-

lems (but is still liquid), its correspondent banks can freeze the
deposit accounts and stop outgoing payments. This might be unlaw-
ful (if the bank has not yet defaulted) but cannot be legally enforced
(immediately).
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Resulting detriment. The bank will default on the stopped pay-

ments and therefore incur a loss (which can be claimed back from
the correspondent bank if the bank is still alive).
In unfortunate cases, the banks assumed illiquidity could finally
transform into a real illiquidity and then insolvency.
Mitigation. The bank should avoid correspondent banks and in-

stead use more official payment systems.
Payment systems organised by central banks bear only a very
small risk of breach of contract.
Risks stemming from vostro payments

If the bank is offering to execute and receive payments for a client
on a vostro account, the bank has to take various credit, information
and operational risks that can materialise as intra-day liquidity risks.
Example. We illustrate the complexity of the problem with the

following extremely simplified example.
ABC Corp uses the bank for its euro clearing.
As of close of business yesterday, the vostro of ABC Corp is
long one million.
The bank has given ABC a credit limit of 500 million which
can be used from intra-day to the next day.
Yesterday ABC sent two payment orders for today: 300 mil-
lion to bank 1 in favour of KLM Corp and 400 million to
bank 2 in favour of OPQ Corp, plus a note that ABC expects
to receive +200 million from RST Corp.
Assume that today (FLE = FLE of ABC Corp) the process listed in
Table 8.1 will happen. Amounts are in millions of euros. How will
this payment story end?
Perhaps the most probable outcome is that ABC will receive
around +100 from its other accounts or counterparts and will end
up with a small positive or negative amount. Maybe ABC ends up
short and asks for a +100 money-market loan; maybe ABC receives
even more and is required, after the end of the payment day, to give
a retroactive loan to the bank.
At the end of the payment day nobody can know. This information
has to be reconciled on a one-to-one basis. If we put the cashflows
into only the existing FLE methodology, things are simply confused.
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Table 8.1 Risks stemming from vostro payments: an example
FLE Open Waiting Expected Unknown

Time Action +/ limit out in in
09h00 Opening balance of the ABC vostro +1 501 700 +200 0

09h03 The bank decides to first pay 300 to bank 1 but cannot pay 400mn to 299 201 400 +200 0
bank 2 as this would mean FLE is 699, exceeding the limit
10h00 The bank receives +200 from bank 4 299 201 400 +200 +200
10h12 The bank matches the payment from bank 4 as in favour of ABC Corp 99 401 400 0 0
10h13 The bank pays 400 to bank 2 499 1 0 0 0
10h55 The bank receives +100 from bank 3 499 1 0 0 +100
11h06 Bank 4 recalls the payment as of 10h00; it was for ABC but should have 399? 101? 0 ? 0
gone to their other clearing account with bank 3
11h09 The bank cannot pay back 200 to bank 4 as FLEABC = 599 would 399? 101? 200 +200 0
breach the limit of 500
11h15 The bank receives +200 from bank 5 399 200 +200 +200
11h19 The bank pays back 200 to bank 4 as FLEABC = 399 will not breach 399? 101? 0 +200 0
the limit
11h22 The bank receives +200 from bank 3 399 0 +200 +200
11h25 The bank matches the payment from bank 3 as in favour of ABC Corp 199 0 0 0
12h55 The bank receives +100 from bank 6 199 0 0 +100
13h05 The bank matches the payment from bank 6 as in favour of ABC Corp 99 0 0 0

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These prospective cashflows should be captured in a cash manage-

ment system (which could be linked to or even be a part of the FLE
system), but need to be separated from the other forecasts.
Intra-day payment limits for vostro clients

The bank offers vostro clients intra-day credit limits to enable them
to execute payments if they do not have sufficient cover on their
vostro. Therefore, a clear distinction between intra-day and end-of-
day limits has to be made.
Potential issue. The vostro client does not receive sufficient pay-
ments and therefore ends up with a negative balance which might be
as big as their intra-day limit. The bank ends up with an unwanted
short position.
Resulting detriment.
The bank has to fund at unfavourable interest rates: it will
have to bear interest loss (which the bank should be able to
recuperate from the client).
Companies that are endangered by insolvency/illiquidity
could use intra-day payment limits to generate intra-day
credit; potentially they are unable to pay back: they will have
to bear credit risk which could in extreme cases lead to the
banks illiquidity.
End-of-day limits for vostro clients

In order to avoid an end-of-day limit overdraft, the intra-day limit
should not be greater than the end-of day limit. A correct monitoring
has to be ensured.
The banks assumptions about hypothetical payments on vostro

accounts
If during the payment day the balance of a vostro account is substan-
tially different from zero, the bank might wish to square it imme-
diately. If, for example, the banks own nostro, the vostro and the
money market are short, the bank might foresee a problem to fund (at
acceptable cost) later during the day and therefore want to close the
gap. The bank does not know, however, if the vostro account holder
will later square themself or will instead ask for a money-market
loan from the bank to cover the shortage.
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The bank assumes squaring of a short vostro and does not cover
We assume that the vostro client will square their account later and
therefore does not cover the intra-day deficiency of the vostro.
Potential issue. The account holder does not pay at the end of the
payment day but instead makes a money market deal to square the
vostro. The bank ends up with an unwanted short position.
Resulting detriment.
The bank has to fund at unfavourable interest rates: it will
have to bear interest loss (which the bank should be able to
recuperate from the client).
In extreme cases: illiquidity of the bank.
The bank assumes no squaring of a short vostro and covers

The bank assumes that the vostro client will not square their account
later and therefore covers the intra-day deficiency of the vostro.
Potential issue. The account holder pays at the end of the payment
day to square the vostro. The bank ends up with an unwanted long
position.
Resulting detriment. The bank has to place the funds at unfavour-

able interest rates: it will have to bear interest loss (which the bank
should be able to recuperate from the client by offering only a low
rate for the surplus funds).
The bank assumes squaring of a long vostro

Under these circumstances, where the vostro is long, the bank has
better control of the situation: usually payment orders are only
accepted until a certain deadline (x hours before the end of the pay-
ment day). The bank should have enough time to react, squaring
takes place only after the payment deadline. Any potential losses
from exceptional payments after the deadline should be recoverable
from the client.
IDIOSYNCRATIC RISKS OF THE PAYMENT PROCESSES

We have in this chapter so far analysed intra-day liquidity risks
which stem from the actions and responses of the bank and its coun-
terparts in specific situations. Now we make an abstraction from the
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specific circumstances and examine risks which are idiosyncratic to

particular payment processes.
Bilateral interbank clearing

For bilateral interbank clearing, banks exchange their payment
orders bilaterally and only settle the difference via the normal pay-
ment channels. The individual payments will only become effective
when the difference has been settled.25
Potential issue: default of the counterparty. If the bilateral coun-
terparty defaults on paying the difference, all payments that were
executed before are obsolete as they do not become effective. If it
is too late in the payment day to execute these payments in other
payment systems, or if the bank is unable to fund the necessary cov-
erage before the end of the payment day, the bank, strictly speaking,
defaulted on these payments as well.
Clearing which is only effective at end-of-day

Some payment systems collect all payments between the partici-
pants and simulate the payments intra-day. Only after a successful
final clearing at the end of the clearing day do the payments become
effective.
Potential issue: the final clearing is not successful. If the final clear-
ing cannot successfully be executed, the participants have to unwind
all payments, which obviously bears enormous systemic risks.
Real-time gross settlement systems

In order to avoid the possibly necessary unwinding of ineffective
payments which have not become effective, as above (see the sub-
section on clearing), the participants can only pay if they have
enough coverage (in central bank money or in eligible securities) on
their clearing nostro. In return, the payment immediately becomes
effective and both counterparties have to agree to reverse it.
Potential issue: postponed payments. The bank can only execute
payments as long as it has sufficient coverage. If a counterparty
postpones large amounts, no further payments can be executed. One
bank deferring large payments can result in snowball effects.
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Direct debit
Sometimes a counterparty or, eg, a securities settlement institution,
or the government (tax) has been given the right to debit money
directly from the banks account.
Potential issue: information risk. If the direct debit has not been
properly announced beforehand, the bank might not have enough
coverage to execute the debit (completely) or stops the bank from
executing further contractual payments.
Timed payments
Some payments have to be executed until a certain time, eg, securities
settlements or repayments of maturing own issues.
Potential issue: no timely coverage. If there is no sufficient coverage
on the payment account when a timed payment has to be executed,
the securities transaction cannot be settled or the bank defaults on
paying back its maturing debt.26
The Herstatt risk (Time Zone Splinter Risk)

During June 26, 1974, Germanys three largest banks could not agree
to bail out the troubled Herstatt Bank.27 The German regulators
(BAKred) finally withdrew Herstatts banking license and ordered
the closure of its counters the same day. As other German banks
realised the situation, they one by one stopped their Deutschmark
(DM) payments to Herstatt, until later in the day Herstatt itself
became unable to execute further DM payments.
As most of Herstatts inflows originated from the DM leg of FX
spot deals, Herstatt was obliged to generate massive US dollar pay-
ments which were due to be settled through its correspondent bank
Chase Manhattan NY.
Around 16h00 local time (9h00 Eastern Daylight Time) it appears
that Chase Manhattan Frankfurt came to know the problems and
arranged for to freeze Herstatts US dollar account in New York,
which prevented Herstatt making US dollar payments. As a conse-
quence, many FX deals were splintered: the DM legs had been paid
to Herstatt in the morning in Frankfurt, but the relevant counterpar-
ties did not receive the payments of the US dollar legs in New York.
This was later called the Herstatt (settlement) risk.
As a consequence of the following cross-jurisdictional implica-
tions, the Group of Ten (G10) was formed under the auspices of
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the standing Basel Committee on Banking Regulation (Bank for

International Settlements, BIS). Another outcome, with a delay of
30 years, was the creation of continuous linked settlement (CLS)
platforms which avoid the Herstatt risk by processing payments
only versus other payments (PvP).28
From a credit risk point of view, the Herstatt risk describes the risk
of a counterparty defaulting between time zones, whereas from
an intra-day settlement point of view it highlights the problems with
end-of day settlement systems.
The role of the minimum reserve

Minimum reserves are used (among other instruments) in the mon-
etary policy of central banks to influence the currencys interest rate
and restrict the amount of money banks can create.
Abanks actual minimum reserve amount is the sum of the surplus
cash amounts on its central bank account during the actual minimum
reserve period.
The banks required minimum reserve amount is determined by
multiplying the amount of its (mainly) customer deposits of the pre-
vious minimum reserve period by the minimum reserve ratio (2%
in the ECB zone at the time of writing). At the end of the period the
actual amount shall not be less than the required amount.
Although it is a cost for the bank (which it has in common with
the other banks), the minimum reserve simplifies things for the
department that is responsible for the daily disposition of the ECB
nostro.
Example 8.3 (minimum reserve as a cushion against interest

losses). Assume the banks required minimum reserve is 3 billion
in a month with 30 days, which means it has to hold 100 million on
average per day. If the bank ends up on a Monday with an unwanted
long position of 300 million it can regard the surplus of 200 million
as the minimum reserve for Tuesday and Wednesday in advance.
Without the minimum reserve, it would have been forced to place
the surplus at possibly unfavourable rates with other banks.
As a result of the mechanics described above, some banks tend

to enlarge the cushion at the beginning of the period by holding
significantly less than the average required minimum reserve. At
the end of the period, they need to hold more than the monthly
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average, which exposes them to two consequential risks:
if the interest rate level goes up at the end of the period, they
lose money compared with holding more minimum reserve
earlier in the month;
if the liquidity supply dries up at the end of the period, they
can lose money (the interest rates increase; see above) or even
run the risk of becoming insolvent.29
MITIGATION OF LIQUIDITY RISKS

In the calculation of the FLE system we made liquidity risk mitiga-
tion assumptions like the compensation of inflows and outflows in
one currency and in different currencies as well as between different
parts of the bank. In in the following we examine the mitigation in
more detail.
If the bank has one nostro account in a currency, the cash outflows
can be mitigated against the inflows on the same day by simply
adding them.
If, however, the bank uses more than one nostro and has cashflows
in more than one currency, the mitigation is not so straightforward.
Mitigation between multiple nostros in one currency

If the bank has multiple nostro accounts in a currency, the mitigation
by addition only makes sense if we can assume that cash shortages
on one nostro account can always be mitigated by cash surpluses (if
they exist) on another nostro account.
In practice, credits on one nostro cannot always be transferred
to the nostro where the funds are required, because of time con-
straints, operational problems or eventually information risk (we
do not know the accounts in which we are short/long).
Mitigation between multiple currencies

In the FLE system, all cashflows in currencies are converted into
the base currency (euro) with the appropriate forward FX rate and
thus can be netted by simply adding the euro amounts which are
scheduled on the same day.
Although this translation looks straightforward, it is only mean-
ingful if an outflow in, say euro, can be offset by an appropriate
inflow in, say US dollars. In other words: we have to presuppose
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that the euroUS dollar foreign exchange market works flawlessly,

which has not always been the case.
FX markets have been disrupted with large bidoffer spreads

(eventually even illiquid). This foreign exchange liquidity risk
exists across the full time line and is therefore not specific to
the intra-day processes.
The common time period between the payment systems of, eg,
the yen and US dollar is short; thus, offsetting credits and deb-
its in time can be impossible. This foreign exchange liquidity
is specific to the intra-day processes.
For example, if the bank lacks funds in currency X but has a sur-
plus in another currency Y, it can try to exchange the surplus in Y
to fund the shortage in currency X. This exchange is usually done
through the FX markets. Assume the bank has found a partner ABC
willing to exchange a specific amount A in Y against X at a certain
rate r and a certain date D.
On day D the bank is obliged to pay A of currency Y to ABC
(eventually to its account with DEF), who in return has to pay r A
of currency X to the bank (or eventually to its account with GHI).
If the day D is in the future, we have to deal with the usual risks.
The counterparty might be unable (credit risk) or unwilling (opera-
tional risk) to pay. Depending on the amount, the detriment ranges
from a loss (which could even be recuperated) to illiquidity if the
bank is unable to find alternative funding.
Mitigation across time

The FLE is constructed by forwarding the net cashflows in one time
bucket to the next time bucket.
If the bank forwards a credit, it might incur (comparative)

interest rate losses.
If the bank forwards a debit, it assumes it is able to generate

a sufficient credit which offsets the debit. It can, for example,
square a short position on its ECB account with hypothetical
credits from a repo transaction with the ECB. The bank also
might incur (comparative) interest rate losses.
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Mitigation of account balances and the counterbalancing

capacity
A negative account balance on the banks nostro can eventually be
compensated by converting appropriate securities into cash. This is
described in the CBC, which simulates in time the process of con-
verting eligible and unencumbered assets into cash by repo or sales
transactions. The prerequisites are that the securities can be liquified
sufficiently promptly to credit the nostro account. This imposes the
condition that the relevant securities are unencumbered and can be
moved quickly from their current depositary/custodian to where
they are needed. A similar problem appears if funds or payments
from securities transactions need to be moved from one nostro to
another.
The CBC mitigates illiquidity risk but it cannot insulate the bank
against value risks (like higher refinancing rates) stemming from its
underfunded situation. Moreover, the CBC process will normally
produce additional cost, as it will try to optimise the quantity and
swiftness of the additionally generated liquidity but not its price.
If there is no crisis and banks do not anticipate such a situation,
they will tend to target a liquidity surplus rather than an equilibrium
or even a short position at the end of the day,30 which means that
in the vast majority of the cases the problem of the bank is not that
it has insufficient liquidity, but that it has too much liquidity and
thus runs the risk of (comparative) losses. Other than for the CBC
we have not explicitly formulated a counter-absorbing capacity
(CAC), which simulates how excess funds can be neutralised quickly
while minimising counterparty credit risk as well as comparative
losses. Assuming that we could develop a CAC, we need to create
a list of admissible assets and counterparties. A minimum income
justifying the potential investment needs to be provided for every
assetcounterparty combination. Simulating how the excess funds
are invested in the future is not so straightforward, as the availability
of the admissible assets, as well as their absolute and relative price,
is not yet known.
Double counting of collateral

If the bank mitigates intra-day liquidity risks with collateral, it is not
so clear whether this collateral can be used in the CBC, which was
intended to compensate the liquidity risks of the FLE, or if a portion
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of the collateral needs to be separated to be used exclusively for the

mitigation of ILR.
If collateral to offset ILR has already been reserved, we might
argue that this collateral will be freed again the next day and can
then be used in the CBC. If, however, we want to cover ILR that
can happen (not only today but also in the future), we should block
a fraction of the total collateral, which consequently cannot then be
used for the CBC, as otherwise we would have double counted it. The
Basel Committee and other regulators are keen to avoid such dou-
ble duty collateral; further regulatory activities can be expected in
this field.
Quantifying the amount of collateral that should be set aside is
not straightforward. First, we have to go through all potential intra-
day liquidity risks (which we have described before) and decide in
each case whether collateral could be used for mitigation. Next, a
bank can make a historical analysis of the amounts of collateral it
has individually consumed for mitigating ILR. It can also estimate
the idiosyncratic payment risks by using public data. The applica-
tion of the usual statistical methods to these historical distributions
will result in an estimate of the expected future usage of collateral.
However, what are not measured in this analysis are the unexpected
intra-day risks. If, in August 2007, a bank had carried out an analy-
sis of the historical collateral requirements, the resulting expected
requirements would have dramatically underestimated the reality
of the following years.
We now also understand why it was so important to distinguish
between those risks that can (and should) be apportioned to the
(enhanced) FLE and the residual intra-day liquidity risks, which
should be treated separately from the FLE.31
CONCLUSION
Previously, we defined liquidity risks as those risks that will be
realised (or not) in the future (which, in this context, starts tomorrow
rather than today). In this chapter we have broadened the approach
by investigating intra-day liquidity risks (ILRs) which have already
been realised today. Furthermore, we have analysed the liquidity
risk process from its origination to its realisations, which enabled
us to demarcate as ILRs those risks which are originated in a very
short time span, usually today. For the purpose of developing the
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general concept it was sufficient to assume an idealised payment

process, but for the inclusion of ILR we had to lift this restriction and
model the payment process in a more realistic way, including mul-
tiple nostros in different currencies with different payment agents,
etc.
In order to avoid the double counting of risks, we differentiated
which intra-day liquidity risks could be measured with an enhanced
approach for the FLE (the continuous FLE), and which ILRs require
a separate concept. Most problems which can be captured with the
continuous FLE stem from late or incorrect capture of transactions or
cashflows. The problem of non-financial transactions is a little more
serious and we have so far intentionally omitted these; these should
therefore be integrated into the normal FLE.
The risks that go beyond what we can solve with an enhanced
FLE are manifold. One group is based on payments, such as pay-
ment options and margin calls, which cannot be captured in the
FLE because they have a very short notice period. The informa-
tion uncertainty about received or not received funds depending
on late or unidentified payments of counterparties forces the bank
into squaring its assumed cash position, which can turn out to be
inappropriate. Erroneous payments executed by the bank are only
an operative problem but cannot always be ruled out.
Another two sources for ILS are payments that the bank executes
through and for third parties. Correspondent bank payments are
less controllable by the bank than direct payments; in particular, in
stressed situations, the correspondent bank might be unwilling or
unable to pay as scheduled. If the bank carries out payment services
for external parties (banks, corporates or retail clients) on vostro
accounts, it has to deal with the information risk if the clients are
going to square their vostro accounts at the end of the day or if they
exercise their option to fund their short position with the bank but
also with the credit risk of the counterparty.
We have given an overview of the idiosyncratic liquidity risk of
the used payment method. As this has been analysed by various
regulators, we have focused on risks stemming from the use of cor-
respondent banking systems. The main issue here is that the banks
ability to execute payments lies in the hands of a third party which, in
a critical situation, might not be obliged or able or willing to execute
them.
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Finally, we considered possible liquidity risk mitigation tech-

niques that can be applied intra-day. Most importantly, the bank
needs to ensure that if it uses collateral to offset such risks, this col-
lateral is not also used in the CBC (which should cover the FLE risks).
An an appropriate portion of the collateral should be excluded from
the CBC and reserved for intra-day liquidity risks. This highlights
the importance of distinguishing the risk that can be apportioned to
the FLE from those which should be separated from it. We have not
yet discussed how much collateral should be reserved for intra-day
liquidity risks; it can be expected that this problem will be a major
issue for the regulators in the near future.
1 It should also include the banks non-financial transactions (salaries, tax payments, etc), as
these can constitute a considerable part of the banks illiquidity risk.
2 A payout of a mortgage loan to a private client having an account with the bank is an internal
transfer of credit within the banks accounts. It is not a payment and should therefore not be
picked up by the ILMS. From an illiquidity risk perspective it is nevertheless necessary to
capture this internal cashflow, as it results in a positive balance on a current account which
is an option (the bank is short) to pay to an external party (as the client is likely to use the
money to purchase a home).
3 For the forecasted cashflow from the internal mortgage disbursement (above) it is not possible
to specify the payment details (receiver, beneficiary, payment system, etc). This information
is substantial in an intra-day liquidity risk view but not for illiquidity risk considerations.
4 Sometimes the detriment is called risk and the benefit is called chance. This taxonomy
is semantically problematic, as the outcome of a process (risk) should not be given the same
name (risk).
5 Niklas Luhmanns example of umbrella-risk is famous: if there are umbrellas, we can no

longer live free of risk; the hazard of getting wet transforms into the risk of not taking the
umbrella along, but, if we take it along, we run the risk of leaving it somewhere. (Original
German: Wenn es Regenschirme gibt, kann man nicht mehr risikofrei leben: Die Gefahr,
dass man durch Regen nass wird, wird zum Risiko, das man eingeht, wenn man den Regen-
schirm nicht mitnimmt. Aber wenn man ihn mitnimmt, luft man das Risiko, ihn irgendwo
liegenzulassen.) Niklas Luhmann, Die Moral des Risikos und das Risiko der Moral, in
Gotthard Bechmann (ed.), Risiko und Gesellschaft: Grundlagen und Ergebnisse interdisziplinrer
Risikoforschung (Opladen, 1993).
6 It is not appropriate to make average assumptions about single events with large effects
(payment errors, bankruptcy of a client or payment partner, unavailability of settlement
systems, etc). We can generate what-if scenarios which seem to make more sense here.
7 For the sake of accuracy we should try to restrict usage of the term risk and instead focus
on uncertainties, their sources and their consequences.
8 Illiquidity risk is a mono-directional risk in the sense that less liquidity is directly equivalent
to a higher risk of becoming illiquid.
9 Illiquidity risk cannot be described by distribution-type historical information. On the one
hand, the number of historical illiquidity cases is (fortunately) not very large. On the other
hand, the statistical moments of distributions cannot be used as, for example, in market or
credit risk: if a simulation produces a distribution with the result of +100 cash at the banks
nostro 99 times out of 100, and 100 in cash one time out of 100, the average of the distribution
is +98, which is obviously not a useable result.
10 Liquidity-induced profit risk is a bi-directional risk: both insufficient liquidity and excessive
liquidity can cause a loss. For the sake of simplicity we concentrate here on the lack of liquidity.
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11 In contrast to the first-order liquidity risk, here we can use distributions, as the risk results
in losses that are additive. It makes sense to say that winning +100 99 times and losing 100
once makes an average profit of +98.
12 We state the time in the time zone of the head office in order to be able to describe payments
in different time zones.
13 In fact, the currency of a cashflow gives a little bit more information: eg, euro payments have
to be exercised between 07h00 and 18h00 CET.
14 Strictly speaking, both the exchange and the provisioning can be regarded as payments.
15 A bank could be the final beneficiary; however, sometimes the credit is passed on to an
ultimate beneficiary.
16 See The Herstatt risk (page 208), where reportedly Herstatts US dollar payment agent (Chase
Manhattan NY) stopped the execution of payments debiting Herstatts account.
17 In the liquidity crisis of autumn 2008, some banks were considered as being disposed to
become illiquid. Countries (governments), central banks and payment agents (systems), how-
ever, were regarded as generally safe: a collective act of good think. The discussion about
the Greek debt crisis opened up to idea that even institutions that have been regarded as
completely safe could fail.
18 Money transfer system (MTS).
19 Usually all details of a cashflow should be known two days (at least one day) before its due
date.
20 Sometimes individual payments are in practice aggregated to single net payments.
21 In reality, this distinction might not be sufficiently granular. For example, we characterise
the payment of a mortgage loan to a client as external although the money will in the first
instance be paid to the nostro account the client has with us. The client, however, will order
us to subsequently pay the money (or part of it) on to another account (eg, the seller of the
real estate), which then will create a real external cashflow (unless the seller also has an
account with us), etc.
22 As the initial error has been made by the counterparty, the degree to which the bank is obliged
to resend the mistaken payment merits discussion, especially at the end of the payment day.
In practice, however, a refusal could lead to doubts about the banks liquidity situation.
23 Near time is a substitute for real time (which is strictly speaking impossible, as the
broadcasting of information always comes with a certain time delay).
24 See also distortion by wilful retention of payments (page 199) and distortion by wilful
breach of contract (page 199).
25 Bilateral interbank clearing has developed from the clearing between the main clearing
institutions of giro networks (especially in Germany).
26 Lack of the payment with full discharge of debtor (schuldbefreiende Zahlung).
27 Herstatt had massively speculated on a strong US dollar (its open FX exposure was 12 times the
volume of the balance sheet) but was caught by a drop of the dollar against the Deutschmark.
28 The other consequences of Herstatts failure were manifold: in Germany it came to a bank
run and Herstatt had to file for bankruptcy (which could only be finally settled in 2006).
In consequence, the German banks founded the Deposit Guaranty Fund and the Liquiditts-
Konsortial-Bank as a lender of last resort. The government tightened the bank law, introduced
a ratio open FX deals/capital, changed the role of the financial regulator and ratcheted up
the insolvency law, under which the plan to file for insolvency needs to be forwarded to the
regulator.
29 After the Herstatt default, the awareness of intra-day risk rose sharply in German banks,
leading to a substantial reduction of limits for weak banks. As a result, some banks were
unable to fund enough money to fulfil their minimum reserve requirements until the last day
of the period. In order to avoid defaults, the Bundesbank remitted these banks from holding
the minimum reserve for the current period, allowing them to use the freed funds to perform
their other contractual payment obligations.
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30 Banks with excellent market standing might be tempted to speculate on the development of
funding rates during the day and leave anticipated short positions unfunded if they foresee
that funding rates will fall at the end of the day. They trust that the risk of being unable to
close their position is controllable and thus plan to fund only immediately before the close of
the payment day.
31 The Counter Absorbing Capacity deals primarily not with illiquidity risks, but with liquidity-
induced value risk (page 28ff); therefore, we do not develop this idea any further.
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Liquidity Transfer Pricing and Limits
In the previous chapters we have outlined how illiquidity risk can

be quantified and which measures can be taken to counterpoise
unwanted illiquidity risk. So far, however, we have not explained
how the bank can distinguish and prioritise individual countermea-
sures, or how it can incentivise its departments to carry out certain
good measures and minimise liquidity risks.
In this chapter we will describe how a bank can measure the
costs of counterbalancing illiquidity risk consistently and how it can
incentivise its businesses to separate equitable business from those
with depleted return or excessive risks.
Generally speaking, a transfer price is the price at which goods (or
services) are sold between divisions of a company, or between com-
panies in the same group (if they have the same parent company).
Going more into detail, we will first describe the basic transfer-
pricing concepts banks apply. For our purposes we need a method
which can be applied for each individual transaction (asset or liabil-
ity): each originated asset (or liability) is assumed to be individually
refinanced (or placed) by means of a so-called replication transac-
tion. The profit of the originated transaction equates to the deviance
of the internal rates of the originated and the replication transaction.
This replication rate is determined by the rates and prices that the
market quotes for the transaction. We shall define the usual bench-
mark interest rate curves and introduce the structural liquidity risk
premium, which depends on the standing and credit quality of the
bank, and subsequently refine this.
Next we consider the uncertainties in the cashflow projection of
the originated transaction: if the scheduled cashflows turn out to be
a bad forecast for the actual payments, the replicating transaction
emerges in hindsight only as a poor replication. In such a situation
we need to estimate a priori the potential aberration and account for
its expected or unexpected costs. If, however, credit or liquidity risk
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LIQUIDITY MODELLING
can be mitigated with collateral, we can deduct this effect from the
costs.
Finally, we look at how the costs of complying with regulatory
requirements can be integrated in the cost model.
BASIC TRANSFER-PRICING CONCEPTS

A bank needs to track the profitability of its financial transactions
but also needs to forecast and manage the future profitability of
transactions it has already entered into or is due to enter.
In a banks balance sheet, today the assets and liabilities match by
design, if we regard (paid-in) equity here as a liability. If, for example,
the bank grants a new loan of 100 which is disbursed tomorrow, a
new asset will then be created tomorrow. If this asset was created
in isolation from the rest of the balance sheet, the sum of the banks
assets would exceed the sum of its liabilities,1 which is impossible.
Therefore, the bank needs to either acquire a new liability of 100 by
tomorrow or, if possible, reduce other assets, ie, the credit balance
on its nostro by 100 (or carry out a mix of both).
The new liability increases the liabilities by 100 and thus matches
the increase of the total assets triggered by the new loan, whereas
the reduction of the credit balance is an accounting exchange on the
assets side which diminishes the existing assets by 100 and so leaves
the size of the total balance unchanged. In both cases the transaction
which counterbalances the asset, the refinancing, can bear interest
expenses.
Transfer-pricing methods
In order to calculate the profit of a loan the bank has to take into
account that, for the reasons above, the asset cannot be considered
isolated from its refinancing: the income from the asset should be
held against the expense for the refinancing. The difference between
income and expense is called earnings. As earnings have a term
structure, it is not straightforward to calculate the future profit of
the loan together with its refinancing. In order to implement this, the
income of the asset is first expressed as a yield (or rate of return) and
then benchmarked against the yield of the refinancing: the transfer
price.
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LIQUIDITY TRANSFER PRICING AND LIMITS
Funds transfer pricing: flat mixed rate

In the example above the cause-and-effect chain is explicit: the asset
is the cause for the refinancing (eg, if the business model is to grant
loans, then the refinancing is a necessary effect). A traditional way
that asset-driven banks deal with this problem is to benchmark every
single asset yield against the average yield of the banks liabilities
(flat mixed rate); because naming conventions are quite inconsistent,
we use the expression flat mixed rate, which indicates that the
method uses one interest rate with no term structure (flat) which is
derived from a mix of liabilities.
The method is straightforward but as, in practice, new deposits
can also trigger assets or new assets and liabilities can be intermin-
gled, it bears some difficulties.
It does not account for the term structure of the asset: long and
short maturities are held against the same flat rate.
The flat rate itself will quite probably change every time it
is recalculated (ie, when liabilities mature and/or are newly
created) and thus affect the profit calculation.
It is implicitly assumed that the current liability mix can be
replicated to fund every new asset and thus might give the
wrong steering impulse to grow assets which then cannot be
refinanced at the mix-rate (but only at higher market rates).
It is related to the current funding structure of the bank but
not to the prevailing price of funding in the market: a bank,
for example, with a sound retail base passes on its low liabilities
costs to refinance loans at a yield which may be comparatively
too low.
The missing term structure of the flat mixed rate concept could be
overhauled by using different flat rates in subsequent time bands,
but this would require linking individual transactions to different
refinancing rates, which is contrary to the idea of one rate.
Individual fund-transfer pricing

The consequent enhancement of transfer pricing is to progress from
the flat rate to individual transfer price rates. Every single asset is
linked to an individual refinancing transaction with the same char-
acteristics like amount and tenor. This match-funding is a thought
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experiment but one which could be executed in principle. In prac-

tice the funding will not necessarily be done in the described way
because the assets amount or tenor might be odd or too small or
too long, etc, which would make the execution in the market too
costly on an individual basis. To avoid such costs, the asset origina-
tor (the department in the bank which creates the loan) refinances
the asset not directly with an external counterparty but instead inter-
nally with the central refinancing department (let us call it the trea-
sury). The treasury makes an internal loan to the originator which
exactly matches the external loan. In the view of the originator this
internal deposit match-funds the external loan. The treasury can then
decide whether it matches the internal transaction with an external
transaction in the market, does not match, or matches only partly.
The decision of the treasury has, however, no consequences for the
originator. From the asset originators view the primary external
deal is matched with the internal liability (up to the margin between
both) and thus the profit or the earning can be ring-fenced. From the
treasurys point of view the originators internal refinancing is an
asset which could be match-funded, but not necessarily. If it decides
not to match-fund but leave the combined position open (fully or
partly), it runs an interest rate risk which can result in profits or
losses. The overall profit of the bank can be calculated as the sum
of the profits from the originating department (which are free from
interest rate risk) plus the profits of the refinancing department.
Transfer pricing for assets and liabilities

The real benefit of the individual transfer-pricing method described
above is revealed if all parts of the bank not only refinance but
also place funds centrally with the treasury: some of them might
be originating liabilities which partly match the asset position of
the treasury; thus, the overall amount of external activities can be
decreased.
In distinction to the flat mixed-rate method, which allows equat-
ing profits only for assets, the individual fund-transfer-pricing
method can also be used to benchmark the profitability of a bor-
rowing while replicating it with a matching asset. We will further
call the originated asset or liability the originated instrument and
the refinancing or placement the replication.
In more general terms, we will speak about the originated trans-
action T O and the replicating transaction T R which matches T O . The
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formalism T O = T R (or T O + T R = 0) is only correct at a symbolic

level, as the cashflows of the two transactions normally do not fully
match (this only occurs if the profit is zero).
Payments and cashflows of transactions

The economic value of a transaction T can be determined at matu-
rity by its previous payments {P1O , P2O , . . . , PN O
}. If, however, we
want to move from hindsight to foresight and determine the value
now, we need to forecast the payments with future cashflows:
{CFO O O
1 , CF2 , . . . , CFN }.
If a transaction T O = {CFO O O
1 , CF2 , . . . , CFN } is exactly match-
funded with
T R = {CFR1 , CFR2 , . . . , CFRN }
the relative value of the originated transaction T O is equal to the com-
bined transaction T O + T R = {R1 , R2 , . . . , RN } which is determined
by the residual cashflows Rn = CFO n + CFn .
R
DETERMINISTIC COSTS OF THE REPLICATING TRANSACTION

The target of (liquidity) transfer pricing in the view of the trea-
sury (or the bank) is to separate wanted from unwanted busi-
ness and incentivises the originators within the bank to acquire the
right transactions. Individual transfer methods fit this purpose
best because they allow us to differentiate granularly between dif-
ferent types of transactions in respect to the risks they inherit. The
cost of the replicating transaction is thus of paramount importance
as it will dominate the envisaged steering process: transactions with
a high cost will be less attractive than those with lower cost of
replication.
We assume in the following that the originated transaction is
unequivocally determined by its scheduled cashflows. We will first
describe how and at what rate the bank could buy the replicat-
ing transaction in an idealised risk-neutral environment and later
customise this approach to reality.
Yield curves for assets and liabilities

The set of interest rates (or yields) which are quoted by banks for
other banks for straight loans/deposits with key maturities (eg, one
month, three months, six months, one year, two years, three years)
is called the par yield curve p(t).
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LIQUIDITY MODELLING
For every maturity t1 , t2 , . . . , tN the par yield p(t1 ), p(t2 ), . . . , p(tN )

is applicable.
The forward yield curve f (t) describes the future interest rate
from one key maturity to the next key maturity (eg, from one
to three months, from three to six months or from three to four
years). In each subsequent time bucket [t0 , t1 ], [t1 , t2 ], . . . , [tN 1 , tN ]
the forward yield f (t1 ), f (t2 ), . . . , f (tN ) is applicable.
It is normally determined by a bootstrapping algorithm using the
par yield curve and represents the fair or equilibrium interest
rates for these future time periods.
In fact there is not one par yield curve but a manifold. Every asset
class or (strictly speaking) every asset or liability (retail or bank loans
or government bonds, etc) can be regarded as having a separate yield
curve. Furthermore, the yield for an asset purchased (a loan given)
can be very different from the yield of an asset sold (a loan taken),
especially if the purchaser and seller have different credit standings.
We give the following example for unsecured lending. An AAA-
rated bank will lend to an A-rated bank only at an asset rate rA which
is substantially higher than its liability rate rL at which it would
borrow from the A-rated bank in return. For the A-rated bank the
situation would be symmetrical: rA < rL ; that is it would encounter
a loss in such a transaction.
The existence of different asset and liability yield curves makes
things technically complicated. The normal bootstrapping algorithm
for the forward yield curve assumes borrowing and lending at the
same (mid) rate; if both rates are decoupled, the two forward curves
will deviate massively (related to the asset/liability par curves)
when they are determined for the future.
Risk-neutral/structural yields
All yield curves can be expressed as a curve of differences (premi-
ums) relative to an abstract benchmark curve:2 the risk-neutral or
structural yield curve (t) which stems from the abstraction that
risk free counterparties lend to each other at a fair rate, eg, the
arithmetic mean of bidoffer rates that are quoted between these
banks. In fact there is no risk free investment, as such, possible
because its recuperation is in the future and therefore uncertain.
If we want to come close to a risk-free investment, we could, for
example, take the yields of German Government bonds and correct
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them by the cost of a CDS which covers the default of Germany. If

we want to be technically correct, we should even add the cost of
the CDS for the seller of the first CDS, etc, which leads to the con-
clusion that fully risk-free investments do not exist. To circumvent
the technical problems described above, the risk-neutral mid rates
should be used to perform the bootstrapping calculations.
The structural yield curve cannot be used directly as the bench-
mark for transfer pricing: every bank is normally reluctant to lend
out money at structural yields because it will get no compensation
for the credit risk which is involved in the lending. The structural
yield curve is an abstract concept which is introduced for the con-
venience of describing funding rates as premiums relative to it; its
closest approximation is the yields that are quoted between banks
for instruments which bear (almost) no liquidity and/or no credit
risk (eg, interest rate swaps).
Discount factors, (net) present values and internal rates

To express the economic value (net present value; NPV) of the above
transaction as of today (t0 ) we cannot directly add cashflows that will
occur at different times in the future; we first have to convert every
cashflow CFO O
n occurring at tn into a cashflow CFn (t0 ) of equivalent
value that occurs at t0 .
With the discount factor n which is normally derived from the
risk-neutral or forward yield curve we can calculate CFO n (t0 ) = n
O 3
CFn .
As every CFO n (t0 ) represents the original cashflows economic
value at t0 , the NPV of T at t0 equates to
NPV(T ) = NPV(CFO O O
1 , CF2 , . . . , CFN )
= 0 CFO O O
0 +1 CF1 + + N CFN
Returning to the relative value, we can calculate the NPVs of the

originated transaction T O = {CFO O O
1 , CF2 , . . . , CFN } and its replication
R R R
T R = {CF1 , CF2 , . . . , CFN }.
If we add the cashflows of T O and T R pointwise (CFO R
n + CFn ) and
discount them, we can determine
NPV(T O + T R ) = 0 (CFO R O R
0 + CF0 ) + 1 (CF1 + CF1 ) +
+ N (CFO R
N + CFN )
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Obviously
NPV(T O ) + NPV(T R ) = NPV(T O + T R )
which represents the relative value of the originated transaction T O

together with its replication T R . If T O is an asset, it can be discounted
with the funding curve O , whereas T R should be benchmarked with
the investment yield curve R .
Obviously
n (CFO R O O R R
n + CFn ) = n CFn +n CFn
does only make sense if O n = n . Sometimes a distinction is made

R
between the present value (PV), which is applied to assets or liabil-

ities, and the NPV, which can be applied to a mixture of assets and
liabilities, netting the cashflows before discounting them.4
Different interest rate instruments can be compared directly if the
PVs of the originated transaction T O are converted into the internal
rate (of return), a flat rate which sets the NPV to zero. If the internal
rates of the originated transaction T O and the replicating transaction
T R are rO and r R , respectively, the profit rate of the transaction is
r = rO rR .
The price of the replication is of paramount importance for the
origination departments, as it drives the profit and eventually the
ability (or inability) to carry out transactions. Normally these prices
should be derived by means of an arms length standard, consid-
ering a price appropriate if it is within a range of prices that would
be charged by independent parties dealing at arms length. This is
generally defined as the price that an independent buyer would pay
an independent seller for an identical item under identical terms
and conditions, where neither one is under any pressure to act. In
practice, an arms length price may only be an array of prices rather
than an unambiguous price.
Structural liquidity premium

A potential counterparty which lends money to the bank will nor-
mally request a premium on top of the structural yield (t) as a
compensation for the credit risk it encounters; this is a liquidity pre-
mium L in the view of the bank. As the counterparty will normally
regard longer tenors as more risky than shorter tenors,5 L is time
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dependent. Thus, the overall funding yield of the bank for a tenor
tn equates to
f (tn ) = (tn ) + L (tn )
If the internal yield of the originated transaction T O is r and that
of the replicating transaction T R is f , the profit rate of the transaction
is
r f = r L
For now we regard the applicable liquidity premium as being
derived either from the banks money market borrowings (shorter
term) or from its own bond issues (longer term) and then decom-
posed against the IRS rates L (t) = f (t) (t). In theory L (t)
should increase monotonically at time t because a longer maturitys
credit risk cannot be smaller than for a shorter maturity. If in prac-
tice L (t) is not monotonically increasing (eg, because the price of a
specific bond issue is wrongly priced by the market), the liquid-
ity spread curve needs to be corrected, which is usually done by
interpolating between the correct maturities.
The issuance of new bonds is surely the most realistic way to
determine the current liquidity premium, but it is not feasible to
issue a bond for every refinancing. If prices are taken from the latest
trades in the secondary markets there is always uncertainty whether
such relatively small transactions can be regarded as characteristic of
the full issue size. Sometimes banks adjust their premiums with the
premiums of primary or secondary issues of peer banks with a com-
parable business model, rating class, etc, which might also change.
The most objective indicators are credit default swaps (CDSs). As the
CDSs are quite liquid, their price changes can be used as a correction
factor for the used liquidity spread curve. A methodological detri-
ment is that the pricing of the CDSs includes, for example, assumed
recovery rates which do not really fit in the concept of the price of
liquidity relative to the credit risk of the taking bank.6
Transactions with changing nominal amounts

If the originated transaction has volumes which change in time (see
Figure 9.1 and Table 9.1), things are more complex. Assume the bank
replicates a descending loan with a deposit D which accordingly
changes in volume
D = {D1 , D2 , D3 , . . . , DN }
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Figure 9.1 Example graph: transaction with changing nominal amounts
100 FCI(D5)
80 FCI(D4)
60 FCI(D3)
FCI(D2)
40 FCI(D1)
20 FCI(L)
0
1 2 3 4 5 6
20
40
60
80
100
Figure 9.2 Example graph: changing nominal amounts
100
80 FCI(D5)
FCI(D4)
60
FCI(D3)
40 FCI(D2)
20 FCI(D1)
FCI(L)
0
1 2 3 4 5 6
20
40
60
80
100
during future subsequent time intervals [tn1 , tn ].

For an individual volume Dn = D[tn1 , tn ] in the time bucket
[tn1 , tn ], the funding rate f (tn ) = (tn )+L (tn ) needs to be applied.
This is straightforward if the volumes are monotonically decreasing
(D1 = D2 = D3 = = DN ) as the replication can be split into
deposits
D
N = DN (D1 D2 D3 DN 1 ) from t0 to tN
D
N 1 = DN 1 (D1 D2 D3 DN 2 ) from t0 to tN 1
etc.
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Table 9.1 Example table: transaction with changing nominal amounts
Origination Replication

Loan L Deposit D 1 Deposit D 2 Deposit D 3 Deposit D 4 Deposit D 5

Time FCI(L) FCF(L) FCI(D 1 ) FCF(D 1 ) FCI(D 2 ) FCF(D 2 ) FCI(D 3 ) FCF(D 3 ) FCI(D 4 ) FCF(D 4 ) FCI(D 5 ) FCF(D 5 )
t 0 100 100 20 20 20 20 20 20 20 20 20 20
1Y 80 20 20 20 20 20 0 20
2Y 60 20 20 20 20 0 20 0
3Y 40 20 20 20 0 20 0 0

4Y 20 20 20 0 20 0 0 0
5Y 0 20 0 20 0 0 0 0

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LIQUIDITY MODELLING

Table 9.2 Example table: changing nominal amounts
Origination Replication

Loan L Deposit D 1 Deposit D 2 Deposit D 3 Deposit D 4 Deposit D 5

Time FCI(L) FCF(L) FCI(D 1 ) FCF(D 1 ) FCI(D 2 ) FCF(D 2 ) FCI(D 3 ) FCF(D 3 ) FCI(D 4 ) FCF(D 4 ) FCI(D 5 ) FCF(D 5 )
t0 100 100 45 45 35 35 15 15 15 15 20 20
1Y 80 20 45 35 15 15 0 20
2Y 65 15 45 35 15 0 15 0
3Y 80 15 45 35 0 15 0 0
4Y 45 35 45 0 35 0 0 0
5Y 0 45 0 45 0 0 0 0
Inventory Cashflow

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If, however, the volumes are uneven (Dn1 < Dn ) things are not
so simple, as at tn1 the deposit is not decreased but increased,
with the consequence that in [tn2 , tn1 ] there is a surplus amount
which needs to be neutralised. The additional deposit needs to
be neutralised (going backward) by technically required counter-
deposits to make the replication match, leading to an excess refi-
nancing which increases the balance sheet. Banks approaches to
solving this problem vary from ignoring it to constructing a perfectly
matching replication with deposits and counter deposits which
results in a chain of premiums in the bootstrapping calculation and
thus makes the constructed liquidity-adjusted forward curve differ
drastically from the sum of the components (tn )+L (tn ) (compare
Figure 9.2 and Table 9.2).
Replication of liabilities
Assume that the bank replicates a deposit by giving a loan to a coun-
terparty which likewise, as above, has to pay a liquidity premium (a
credit risk premium in the banks view). This premium depends on
the credit quality of the counterparty and thus may vary substan-
tially. It is obvious that the premium received should be corrected by
the credit risk of the counterparty, which raises the question of the
grade of counterparty risk the bank will accept in order to execute its
replicating transaction. Luckily, we can avoid this discussion here,7
as the bank can use (almost) credit-risk-free transactions to price
funds, which we will discuss in the following.
Interest rate hedging

There is an alternative to match-funding which (almost) neutralises
the interest risk but does not deactivate illiquidity risk. Let us take
the example of a five-year straight loan. The treasury can either fund
it with a matching five-year liability or hedge the interest rate risk
with an IRS, eg, with a tenor of five years, where the bank pays a
yearly fixed rate and receives a floating rate of six months Euribor.
The bank uses the interest payments from the loan to pay the interests
of the interest rate swaps fixed leg, whereas the inflows from the
floating leg are paid on to revolving six months deposits which
should yield six months Euribor rates.
For the asset owner it makes no difference whether the treasury
hedges the asset with a liability or the IRS. For the bank as a whole it
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does make a difference. The above method makes two assumptions:
(i) the bank is always able to substitute a maturing six months

deposit with a new deposit;
(ii) the new deposit can be acquired at the then prevailing six
months Euribor rate.
In our notation (i) is illiquidity risk and (ii) is liquidity-induced

interest rate risk.
The illiquidity risk can be covered by liquid assets that the bank
keeps ready for such purposes (the CBC); as costs are involved,
the funding rate should be appropriately corrected with a premium
for holding liquid assets CBC (see page 241). The liquidity-induced
interest rate risk is determined by the possible future funding pre-
mium oat the bank has to pay relative to the floating rate, which
depends on the banks own creditworthiness and on the future
money market situation. The market quotes oat as the premium
the bank has to pay for an issued floating rate note with the tenor of
the asset.
Both components should be expressed as risk premiums on top
of the structural funding rate although they are hard to quantify.
If the floating rate of the IRS does not match the banks funding
reality (eg, a three months tenor instead of six months, Libor instead
of Euribor, etc) the risk can be captured with a base swap which
comes at a separate cost base swap .
In total, the premium for IRS-hedging (instead of match-funding)
is given by
IRS = CBC + oat + base swap
The interest rate hedging illustrates how the liquidity premium is

composed of different factors. In a risk-neutral market, the premium
for IRS hedging should be equal to the structural liquidity premium,
but in reality they may differ.
Funding matrix
In reality the bank might not be able or willing to fund all upcom-
ing business with one idealised type of refinancing transaction (see
Figure 9.3). It can in principle use a variety of instruments or venues
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Figure 9.3 Example: refinancing matrix
to fund
interest rate swaps (see page 231),
uncovered refinancing (money market deposits, senior unse-
cured bonds, promissory note bonds),
short-term refinancing (repos),
benchmark bond issues or private placements,
plain vanilla or structured issues,
covered bonds,8
under country-specific legislations (ie, Pfandbriefe or Let-
tres de Gages, Obligations foncires, etc),
asset backed securities,
specials (public funds, etc).
As all these funding instruments might have differing liquidity

premiums L,1 , L,2 , . . . , L,N the bank can try to implement a mixed
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funding strategy: it estimates the total amount X to be funded in the

next, say, 12 months, and plans to refinance X = 100% in fractions
x1 % + x2 % + + xN % in the diverse funding instruments.
The liquidity premium then equates to
L = x1 % L,1 + x1 % L,2 + + x1 % L,N
The difficulties, however, are manifold: some funding instruments

are possibly not available for certain maturities (in general or because
the bank is not active in these markets); if the bank is unable to carry
out the planned funding strategy, the differences might lead either
to backdated changes of the historical transfer pricing or to synthetic
future adjustments, etc.
The benefit of this method is that it can reflect the refinancing real-
ity of the bank more realistically than the assumption of refinancing
everything at one rate.
Funding in other currencies

If the banks domiciliation currency is, say euro, it might need to
replicate transactions in another currency or a mix of currencies. For
the foreign currencies, whether or not the bank has direct access to
the foreign markets makes a substantial difference. If the bank is, for
example, an active money market participant in the US dollar and
continuously issues bonds in the US, the situation can be compared
with and thus solved with the same approach as described above for
the home currency (euro). If the bank, however, needs to refinance,
for example, in yen, it cannot directly issue bonds and has only par-
tial access to the money markets. In this case synthetic yield curves
can be used: every individual transaction is replicated in the banks
domiciliation currency as usual and the funds are converted into
the desired foreign currency. The costs are composed by the struc-
tural yields (t) plus the liquidity premium L (t) plus the foreign
exchange premium FX (t)
f (t) = (t) + L (t) + FX (t)
There are different ways to convert future payments into different

currencies.
If a matching cross-currency swap is used, the future payments
can be converted exactly between the currencies. The FX-
premium FX (t) encompasses the cost of the cross-currency
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swap (plus eventual basic swap cost between three and six
months Euribor); as cross-currency swaps not only exchange
interests but also nominal payments, the credit risk can be sub-
stantial; this might require either credit risk adjustments (see
pages 237 and 240) or the cost of using appropriate assets as
collateral (see page 241).
FX forwards can be used for less complex transactions with
shorter tenors and, as there is a broader market, they can be
cheaper; apart from that the credit risk and thus eventually the
collateral needs are similar.
The bank can also convert the interest rate risk of the transac-
tion with an IRS into a floating rate risk in the foreign currency
which is either funded in the foreign currencys money mar-
ket or it refinances appropriately in the home currency and
converts the funds with FX swaps into the foreign currency.
Finally it can swap the floating maturities into overnight matu-
rities and funds them in the short term by overnight FX swaps
or by using the standing facility of the foreign central bank
(assuming it owns appropriate eligible assets).
The above FX replication strategies encounter different risks. The
cross-currency swap and the FX swaps only contain the credit risk
of the counterparty, whereas the shorter-term strategies also include
straightforward illiquidity risk, as the counterparty is not sure that
the bank will be able to subsequently fund the maturing liabilities.
Other deterministic costs

Some deterministic cost elements can be attributed to individual
transactions. For example, fees that are paid to arrange replicating
deals via a broker can be attributed directly to the replicating trans-
action and can therefore be expressed either as a separate premium
or as a part of the liquidity premium. Bidoffer spreads can also be
attributed directly to the replication but are controversial because
they challenge the concept of a central replication via the treasury: if
the business lines pay the full bidoffer spread, they could also do the
replication directly with the market. If the treasury is compensated
for the bidoffer spread, it will be able to generate riskless profits
where it is possible to match assets and liabilities. Some banks try to
isolate these profits and recompense the originating businesses. As
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determining the riskless profits is quite complicated, other banks

split the complete profit of the treasury between the originating
businesses, which is hardly a source-related cost allocation.
Other costs, like the operating costs of a treasury, might be nec-
essary in order to run the replication process, but are not directly
related to the individual replication.
TRANSFER PRICING OF RISK

The deterministic costs describe the economic reality sufficiently cor-
rectly only if it can be assumed that the future payments of the orig-
inated transactions are unequivocally determined and will occur
exactly as forecasted by its cashflows (which might be unrealistic).
In the following we refine the approach by accounting for a potential
divergence between actual payments and their cashflow forecasts.
The price of the uncertainty of the originated transaction

Until now, the internal rate of the replicating transaction T R , and
thus of the originated transaction T O , is unequivocally determined
once the discount curve and all future scheduled payments of the
replicating transaction have been given. If, however, we backtest
the performance of our transfer-pricing method we will quite likely
experience that the payments of the originated transaction T O do
not occur exactly as scheduled. Therefore, the replicating transac-
tions will no longer match the originated transactions in hindsight,
and thus their internal rates will differ. In other words, the dissim-
ilarity between the cashflows of the replicating T R and the real
payments of the originated T O result in a deviation between the a
priori forecasted and the a posteriori realised internal rates.
As we cannot know the future, we have to account for such uncer-
tainties. In the following, we will decompose the possible deviation
from the expected value into its components. We will not exam-
ine distinct scenarios where risks materialise as individual costs, but
instead assume that the profit consequences of risks can be modelled
stochastically (as it is the best practice for market and credit risk).
Expected and unexpected risks and economic capital

Assume that, at its start, the originated transaction T O was correctly
replicated with T R in the sense that if the payments happen exactly
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as forecasted by the cashflows, the forward and the retrospective

profit calculation will match exactly.
If, however, the actual payments of T O diverge from the fore-
casted cashflows, the replicating transaction T R does not match in
hindsight.
The standard way to cope with the uncertainty of forecasted
payments is to regard every forecasting cashflow as a stochastic
variable, estimate its distribution and run an appropriate stochastic
simulation with a vector of possible future payments as a result.
For every simulation the NPV of the forecasted cashflows can be
calculated. The mean of these numbers is called the expected value
and if it deviates from the value of the scheduled replication cash-
flows, NPV(T R ), the difference is called expected risk. The lower
%-quantile9 Q of the distribution of all differences NPV(T R ) is
also determined. The unexpected risk Q can be interpreted as a
measure for the corresponding value risk: the realised loss will,
with a probability of (1 ), not fall below Q (in this thought
experiment).10
In the (expected) profit rate, only those uncertainties that stem
from expected risk need to be incorporated. If the cashflows of the
underlying transaction change due to unexpected risk effects, it is
assumed that the bank will hold capital to compensate for such unex-
pected losses. Capital held against unexpected losses is called eco-
nomic capital. In order to transform the economic capital which is
used or needed into a cost, the bank needs to estimate its assumed
income and expense. The most straightforward model is to assume
that the bank sets a planned desired return on capital rC for its
(capital) investors and decides on a maturity for a virtual risk-free
placing of the capital in the market which gives a rate for placing
+rP . The real cost of capital in this method equates to +rP rC .
Credit, operational and market risks

Credit risk materialises for a bank if a counterparty is unable to exe-
cute its contractually scheduled payments. If the scheduled cash-
flows of, for example, a loan are adjusted by expected credit risk
events, they are reduced or at least deferred and the resulting
NPV/internal rate of return is reduced. In order to account a priori
for this effect, the expected change of the loans cashflows is sim-
ulated and the changed internal rate of return r is calculated; the
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difference between r and the original internal rate r expresses the

expected credit risk premium EC = r r .
To calculate the unexpected credit risk premium UC , the expected
cashflows of the loan are simulated as stochastic variables. The inter-
nal rate of return r(S) is determined for every simulation S, which
gives a distribution for r (S) from which the -quantile Q (r) is
computed.
If the bank calculates the cost of the economic capital portion as
rC , the unexpected credit risk premium is equal to
UC = Q rC
The situation with operational risk is analogous to credit risk. We

introduce the expected and unexpected credit risk premiums EO
and UO . If the bank calculates operational risk only at a portfolio
(or even bank) level, it needs to be distributed to the individual
transactions.
The situation with market risk is different from credit and oper-
ational risks. Traditionally, expected market risk is often ignored
because it can be a negative risk.11 The unexpected market risk
stems from the change of the NPV due to changes in the market
rates. In our model, we expect that the originated transaction is
fully immunised against market risk by the replicating transaction.
If ex post the replication does not work exactly and the cashflows do
not match because of credit or operational risk, the consequences
are not due to market risk primarily, although there are secondary
effects (see page 239). Unexpected market risk, however, arises if an
originated transaction inherits optionality and has contingent cash-
flows which can deviate from the scheduled cashflows. Examples
are cancellation options of which the bank is short or the implicit
optionality of instruments like savings deposits. In order to model
these effects we need to simulate the possible changes in the market
rates simultaneously with the assumed execution behaviour of the
counterparty, which might be correlated. We derive the unexpected
market risk premium UM in a similar manner to the risks noted
above.
Liquidity risk
The situation with liquidity risk is again a little different, as the
structural liquidity premium L is not an expected cost but a fixed
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one (similar to the interest structure cost) which has to be paid ex

ante when the replication is done and thus does not change ex post.
Unexpected liquidity costs arise when the occurring payments devi-
ate from the forecasted cashflows for other than credit or operational
reasons. This is quite rare; we can think of breach-of-contract situ-
ations where the counterparty rejects the execution of contractual
payments because of real or assumed impending illiquidity of the
bank. Assume the unexpected deviation of the cashflows Q (CF)
can be calculated. As capital cannot be used as a buffer for the con-
sequences of this deviation, its substitute, the CBC needs to be con-
sidered. The cost of the CBC depends on the difference between the
yield of its constituent securities and their refinancing rates; assume
it is equal to rCBC .
The unexpected liquidity risk premium is given by
UL = Q (CF) rCBC
It should be considered that the CBC is (like capital) not always

used but nevertheless needs to be maintained; therefore its costs
should be allotted in a more sophisticated way.
Secondary risk types

If a risk type (eg, credit risk) is realised, the consequential change in
cashflows normally affects secondary risk types (eg, market risk). If,
for example, a counterparty does not pay back a match-funded loan,
the bank has to bear a credit loss. The bank is furthermore pushed
into an open interest rate position which can result in a positive or
detrimental change in the NPV, depending on the interest rates when
the credit event occurs, and thus the credit-implied interest rate loss
cannot be expressed as an expected risk12 and therefore needs to be
covered by capital.
Uncertainties from unreplicated relative values

If the bank replicates the transaction T O with T R , the cashflows
match, but not perfectly: the interest payments balance only up to a
minor difference vector
(CFO R O R O R
0 + CF0 ), (CF1 + CF1 ), . . . , (CFN + CFN )
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The relative value is calculated by discounting the above differ-

ence vector with the current discount curve
NPV(T O + T R ) = 0 (CFO R O R
0 + CF0 ) + 1 (CF1 + CF1 ) +
+ N (CFO R
N + CFN )
If changes, the relative value of T O + T R also changes. The

bank can minimise this uncertainty by replicating the above sum
of differences as well, without leaving a residual relative value.
Effects of risk mitigation

As risks can be correlated, their sum might be less than the summa-
tion of the individual risks which is used in traditional market and
credit risk analysis.
We will focus here on collateral as a mitigant for risk. Collateral
which secures credit exposures reduces the associated credit risk,
either for loans the bank gives (collateral received) or for deposits the
bank acquires (collateral given); in both cases the credit risk premium
is reduced and thus sometimes the transaction is enabled.
If the bank is trying to acquire funds from a potential counterpart
that is reluctant to do so because of the banks counterparty risk,
securing the required deposit with liquid and valuable collateral
might allow the bank to acquire the desired funds. The collateral
which is posted generates opportunity costs.
Credit risk mitigation

A loan L that the bank has given is determined by its outstanding
payments L = {L1 , L2 , L3 , . . . , LN }. Assume the loan is secured with
collateral C which has the value Cn at tn . If we separate the loan into
a secured tranche C = {C1 , C2 , C3 , . . . , CN } which is collateralised by
L and a residual unsecured tranche
L C = {L1 C1 , L2 C2 , L3 C3 , . . . , LN CN }
we need to apply the credit risk premiums EC and UC only to L C.

As a consequence, the applicable credit risk premium is reduced by
a factor C(tn ) [EC (tn ) + UC (tn )] in each time bucket [tn1 , tn ].
The corresponding credit risk mitigation C corrects the overall
costs from f = + EC + UC to f = + EC + UC C .
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Liquidity risk mitigation

Assume that the bank has given a loan of, say 100, and the match-
ing refinancing comes at the cost of structural interests plus the
structural liquidity premium: f = + L .
If the loan is securitised by a high quality, liquid asset, say a
German bund, with a value of, say 50, the bank might assume
that it can apply a haircut of 10% and thus get a cash value of
50 (100% 10%) = 45 by repoing the bund repeatedly until the
maturity of the loan. Thus, the refinancing would consist of two
components: 55 unsecured borrowing with a yield of + L (t) plus
45 secured borrowing that yield + repo ; where the repo premium
repo is determined by a swap, which converts the rolling repo rate
into a fixed rate. The overall funding rate then would be
f = 55% ( + L ) + 45% ( + repo )
= + (55% L + 45% repo )
Let us use some more definite numbers, for example, the structural
liquidity premium L = +0.780% for an A-minus bank and the roll-
over repo rate repo = +0.120%. The resulting funding rate is equal
to
f = + (55% 0.78% + 45% 0.12%) = + 0.483%
which gives an improvement of 0.297% compared with the unse-
cured funding rate. In our example, the applicable liquidity risk
premium L is reduced from +0.780% to 0.483% by the liquidity
risk mitigation.
We have so far implicitly assumed that the repoability of the col-
lateral is always given, but in times of stress repo markets can dry
out and liquid securities might become illiquid.
The corresponding liquidity risk mitigation L corrects the overall
costs from f = + L to f = + L L .
Cost of the liquidity risk mitigation

Assume the bank needs to post collateral (high quality assets) to
mitigate its own credit risk (in the view of the counterparty) in order
to acquire a deposit, as otherwise it would have to pay a higher yield
or would not be able to acquire the deposit at all. If this secured
transaction was part of a replicating transaction and the asset was
taken away from the portfolio of the CBC, a fraction of the costs
incurring for the CBC should be related to it. Assuming that the
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LIQUIDITY MODELLING
deposit was not explicitly assigned to the posted asset, the average
costs of the CBC should be taken by deducting the average cost of
funding of the CBC portfolio from its average income; the difference

is allocated as a premium CBC to the collateralised transaction.
SUMMARY OF THE PRICING COMPONENTS

In Table 9.3 we give an overview of the different pricing compo-
nents. Deterministic cost elements which can be ascribed to the
fixed replication transaction are contrasted with the expected and
unexpected risk elements attributed to the potentially changing
originated transaction.
LIQUIDITY RISK LIMITS

The liquidity transfer-pricing methods we develop in the following
incentivise the originating departments within the bank to avoid
business which is detrimental or costly in a liquidity sense and to
acquire beneficial business instead. These methods thus steer the
liquidity situation of the bank in the right direction but might not
always sufficiently prevent the bank from ending up in an unde-
sired situation. Consider the following situation: due to restricted
liquidity in the market, the treasury has to borrow at higher rates
and therefore increases the internal price for liquidity that leaves the
bank. The originating department, however, generates more loans
than before because the loan takers are willing to pay higher liquidity
premiums that more than compensate the risen internal prices. As a
result the treasury might be forced to raise internal funding premi-
ums, which might prevent other originating departments from pur-
suing their business plan. Alternatively, it could fund larger amounts
than ever, which increases the external funding rates dramatically
and expands the balance sheet, possibly beyond a sustainable level.
The most straightforward measure, however, is to impose liquidity
limits.
Limits can be set at different levels of the bank. Normally, a limit-
setting department (eg, the treasury) is enabled to impose limits on
limited departments. If a bank-wide limit is set (by the board), which
is managed by the treasury, the treasury will limit other departments
in order to ensure that it can comply with the bank-wide limit.
What should be limited?
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Table 9.3 Pricing components
Cost elements

Replication Replicated Deterministic Expected Unexpected Mitigation
Structural yield curve +

Liquidity premium +L
IRS hedging IRS = CBC + float + base swap
Other currency +FX
Regulatory costs regulatory

Liquidity risk +CBC L +CBC

Credit risk +EC +UC C
Operational risk +EO +UO
Market risk +UM
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The type of the chosen liquidity limit is conditional on the liquidity

risk that should be restricted.
If, for example, the risk of incorrect payments should be con-
strained, either the total amount or the total sum of payments
should be limited.
If the bank wants to confine its funding exposure to individual
counterparties or groups of counterparties, it might calculate
the total amount of deposits taken from this group and limit
it. A similar approach can be taken for funding venues like
wholesale funding, money market deposits, short-term repos,
central bank tenders, etc.
If the bank wants to restrict exposures in foreign currencies, it
can determine the sum of required funding (eg, the minimum
of the FLE) in a currency and limit this.
If the illiquidity risk (of the bank or a branch or a business depart-
ment) is to be restricted, it makes sense to limit the FLE as it evolves
in time. The limit is expressed as a limit inequality FLE(t) L(t),
which needs to hold within a limit horizon [tS , tH ], where L can be
a constant or a variable in time: L = L(t). If there is a tX within the
limit horizon where FLE(tX ) < L(tX ), the limit has been broken in
tX . How should the FLE limit be set?
Let us consider the following case: the group treasury of a bank
wants to impose liquidity limits on its foreign branches. The initial
situation for the treasury is the following.
It assumes the foreign branch is able to generate 0.5 billion of
uncollateralised borrowing plus 1 bn of borrowing by repo,
which means it is assumed to be able to counterbalance a total
shortage of 1.5 bn.
It has set aside 0.7 billion for the region (plus 0.8 billion it will
not explicitly reveal to the branches).
Unadjusted limit. The treasury sets a limit of 1. 5 billion + 0. 7 billion

= 2. 2 billion; the limit is breached if FLE < 2. 2 billion.
CBC-adjusted limit. The treasury sets a limit of 0.7 billion; the limit
is breached if FLE + CBC < 0. 7 billion.
The difference between the two approaches is that the unadjusted
limit is set assuming that the 1.5 billion counterbalancing capacity is
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constant, whereas for the CBC-adjusted limit the actual CBC of the
foreign branch needs to be calculated each time the adherence to the
limit is assessed.
As long as the CBC is unchanged, both approaches produce equal
results. If the CBC changes, the initial assumption for the unadjusted
limit becomes obsolete, whereas the CBC-adjusted limit accom-
modates to the new situation. If the CBC drops so that the CBC-
adjusted limit is broken, the treasury can react and either request
the instauration of the CBC or enforce the diminishment of the FLE.
Table 9.4 illustrates an example situation.
In March the branch sells a part of its repoable securities in order
to substitute it with higher-yielding but illiquid assets. This changes
the assumption of the unadjusted limit but is not detected there. The
CBC-adjusted limit highlights the change and the treasury is able to
react: it coerces the branch into complying with the limit again; for
the sake of simplicity we assume that the branch unwinds the lat-
ter transactions by selling 0.8 billion illiquid securities and purchas-
ing 0.8 billion liquid securities instead. When it comes to a regional
crisis in May, the branch would be unable (in the scenario with the
unadjusted limit) to gather sufficient funds and thus would face
illiquidity. In the scenario with the CBC-adjusted limit, the branch
would survive, although the liquidity actually available during the
crisis is less than expected in the assumptions.
REGULATORY REQUIREMENTS
Once Basel III is finalised, banks will be able to quantify additional
regulatory liquidity costs which are related to the necessity to keep
the LCR and the NSFR at 100% (plus eventually a security margin)
either tactically for the given ratios or, assuming a certain scenario for
the development of the banks business, structurally for the future
ratios. The margins cannot be attributed to individual transactions
and therefore need to be allocated on a pro rata basis. What can
be done, however, is to allocate the originated transaction into the
different classes (see page 260ff), depending on their different pos-
itive or negative contribution to the LCR (and NSFR, respectively).
It should be clear that if the steering incentives of these individual
premiums are simply added, the bank can potentially exceed the
minimal ratio needed for compliance.
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Table 9.4 CBC-adjusted limit: an example situation
Unadjusted limit CBC-adjusted limit

FLE CBC Rule FLE CBC Rule
January 2.1 +1.5 2.1 2.2 2.1 +1.5 2.1 + 1.5 = 0.6 0.7
within limit within limit
February 1.9 +1.5 1.9 2.2 1.9 +1.5 1.9 + 1.5 = 0.4 0.7
March The branch sells 0.8bn repoable and purchases 0.8 billion illiquid securities
2.0 +0.7 2.0 2.2 2.0 +0.7 2.0 + 0.7 = 1.3 < 0.7
within limit limit breach
The treasury forces the branch to comply;
the branch sells 0.8 billion illiquid securities
and buys 0.8 billion liquid securities instead
2.0 +1.5 2.0 + 1.5 = 0.5 0.7
within limit again
April 2.0 +0.7 2.0 2.2 2.0 +1.5 2.0 + 1.5 = 0.5 0.7
May Regional liquidity crisis

Available liquidity:
Uncollateralised lending +0.1 +0.1
Repo of eligible securities (CBC) +0.2 +0.5
Global treasury +1.5 +1.5
Total net position 2.0 + 0.1 + 0.5 + 1.5 = 0.2 2.0 + 0.1 + 0.5 + 1.5 = +0.1
Result Insufficient funds Sufficient funds
the branch becomes illiquid the branch stays liquid

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Another issue might be that actions the bank takes to keep the
ratios of Basel III within desired boundaries (eg, buying highly liquid
assets) are not always independent from other, economic, liquidity-
management strategies the bank is trying to carry out (eg, the pur-
chase of securities for the CBC). In such cases a double counting of
costs must be avoided.
CONCLUSIONS
In this chapter we have described the principles of transfer pricing
within a bank. Starting from simple concepts with one refinancing
rate for all assets, we formulated the idea of individual transfer pric-
ing for each asset and liability. This concept requires a central depart-
ment in the bank which match-funds every transaction with an inter-
nal replication transaction and thus isolates the originator against
profit changes that stem from the fluctuation of market rates. The
treasury aggregates all transactions and thus ring-fences all interest
rate and liquidity risks of the bank.
The accurate transfer price is given by the cost of the replication,
which is driven by several components. For every future maturity an
interest rate is given at which the bank should be able to refinance
itself. This rate can be split into a structural interest rate compo-
nent and a liquidity premium the bank has to pay because of its
credit quality and standing in the market. Consequently, the bank
can decompose its refinancing into a part which neutralises its inter-
est rate risk (an interest rate swap) and a part which covers its liq-
uidity needs (floating rate note). In addition to straight funding with
matching and interest rate hedging, the bank will in reality carry out
a mixture of different funding venues like unsecured and covered
bonds, which makes it necessary to refine the replication rate in a
funding matrix.
The above considerations for the accurate transfer price relate to
the price of the assumed replication which implies that originated
and replicating transactions match exactly. If the payments of the
originated transaction are uncertain, they might differ from their a
priori scheduled or predicted values and thus the replicating trans-
action becomes inappropriate a posteriori. This divergence can be
forecasted if the originated transaction is not completely uncertain:
the cashflows are modelled as stochastic variables and their aver-
age deviation from the forecasted payments is a priori estimated
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LIQUIDITY MODELLING
with statistical tools. Thus, the price of risk can be determined and
even split into its components: market, credit, operational and liq-
uidity risk costs. The rule is that expected risks can be priced directly,
whereas unexpected risks require us to determine the cost of the
economic capital which needs to be reserved for these risks.
If the banks behaviour towards liquidity risk cannot be influ-
enced sufficiently by transfer-pricing techniques, the treasury can
impose limits which put the originators out of action in taking excess
liquidity risks.
The regulatory requirement as outlined in Basel III will result in
regulatory liquidity costs for the bank. In the following chapter we
will give an overview of the requirements of Basel III and how they
fit into the transfer-pricing methodology.
1 Assuming no new transactions are made or existing ones mature.

2 Also called swap curve, IRS curve, Libor curve, Euribor curve, etc.
3 The discount factors are a comfortable way to represent zero yields, which describe the value
of a cashflow at tn expressed at t0 . Forward yields can be transformed into zero yields quite
simply.
4 The distinction arises from the fact that the initial outflow of an asset does not need to be
discounted and its subsequent inflows can be discounted with the same discount curve,
whereas the further inflows of a liability should be discounted with a separate discount
curve.
If we go into details, we have to admit that the discount curves stem from forward yield
curves which are derived using a bootstrapping mechanism requiring par rates for assets and
liabilities.
5 This not is only due to the counterpartys credit risk but also reflects that the counterparty
will only have the liquidity later at its disposal if the maturity is longer.
6 CDSs do not bear negative spreads: there is always a premium for insurance. Normally,
a CDS trades below the credit spreads; otherwise, investors could create profitable but
credit-risk-free transactions.
7 At least for asset-driven banks; banks with a surplus of liquidity cannot avoid working with
a policy describing the extent of counterparty risk they are willing to accept.
8 Collateral which is used for covered funding is normally not available for the CBC; this is
considered in the section on page 136ff.
9 Assume x is a realisation of a random variable X; x is an %-quantile if Prob(X < x) =

and Prob(X = x) = .
10 NPVs can always be converted into internal rates (of return).
11 If the cost of carry of a position is negative, it is a profit and would thus decrease the unexpected
market risk.
12 The expected NPV needs to be estimated as zero; otherwise a contradiction would arise in a
risk-neutral environment.
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10
The Basel III Banking Regulation
During their meeting in Seoul in November 2010 the Group of

Twenty (G20) countries approved new rules for banking regulation,
known as Basel III. In reaction to the financial crisis, the Basel Com-
mittee on Banking Supervision (BCBS) first discussed elements of
Basel III in 2009 in order to strengthen the resiliency of the global
financial industry. In December 2010 it issued a global regulatory
framework for more resilient banks and banking systems (Basel III).
While Basel II focused more on setting incentives for banks to adopt
best practices, Basel III details measures to improve overall resilience
on four fronts:
increasing the quantity and quality of capital required;
tightening the rules affecting risk-weighted assets (RWAs);
introducing short-term liquidity and long-term funding re-

quirements;
applying further qualitative rules.
These capital and liquidity requirements can be expected to signifi-

cantly lower banks returns on equity. Many bankers realise this, of
course, and are already studying how the rules will affect various
lines of business as they consider their strategic options.
Although parts of Basel III will not come into effect until 2019,
considerable investment (depending on the banks current busi-
ness model and technology standards) may be required. Busi-
ness partners, regulators and investors may view institutions that
delay implementation as less sophisticated and also riskier than
competitors who implement the changes early on.
Although Basel III is not directly a regulation, it will come into
effect via national supervisors implementation into national law.
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Figure 10.1 The structure of Basel III
B3.A B3.B
Global Capital Global Liquidity
Part 1
Framework Standard
Minimal capital
requirement buffer
B3.A.I
Definition
of capital
B3.A.II B3.B.1
Risk Liquidity coverage
coverage ratio (LCR)
B3.A.III B3.B.2
Capital Net stable funding
conservation
buffer ratio (NSFR)
B3.A.IV B3.B.3
Countercyclical Monitoring
buffer tools
B3.A.V
Leverage
ratio
LIQUIDITY RISK IN BASEL III

Figure 10.1 outlines the structure of Basel III.
There has been a lot of debate about the capital- and risk-manage-
ment-related aspects of the new rules to be applied once the Basel
Accord and its technical details have been approved and published.
Considerably less attention has been paid to the equally important
challenges for banks funding and liquidity management. As the
topic of this book is liquidity risk, we disregard here the Global
Capital Framework and focus on the Global Liquidity Standard as
it is outlined in the following overview.
The liquidity-related part (International Framework for Liquid-
ity Risk Measurement, Standards and Monitoring; see Figure 10.2)
requires the bank to satisfy both a short-term (liquidity coverage
ratio) and a longer term (net stable funding ratio) inequality (or
ratio), which set the banks potential cash outflows in relation to its
capacity to counterbalance them by creating hypothetical inflows
from assets that are believed to be repoable or saleable.
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THE BASEL III BANKING REGULATION
Figure 10.2 Basel III: the liquidity related part of the regulation
B3.B
B3.B.I
Global Liquidity
Introduction
Framework
B3.B.II B3.B.II.1 B3.B.II.2

Regulatory Liquidity coverage Net stable funding
standards ratio (LCR) ratio (NSFR)
B3.B.III B3.B.III.1 B3.B.III.2 B3.B.III.3

Available
Monitoring Contractual Concentration unencumbered
tools maturity mismatch of funding assets
B3.B.III.4 B3.B.III.5
LCR by significant Market-related
currency monitoring tools
B3.B.IV
Application
issues for
standards
THE LIQUIDITY COVERAGE RATIO

The Basel III LCR regulation requires that the bank cumulates its
total net cash outflows (TNCOs) of the first 30 calendar days and
compares them with the stock of high-quality liquid assets (HLAs).
The inequality to be met by the bank is expressed in the form of a
ratio
stock of highly liquid assets
> 100%
total net cash outflows over the next 30 calendar days
The stock of high-quality liquid assets

The stock of high-quality liquid assets1 consists of assets which
are assumed to be easily converted into cash without generating
substantial losses, within the time horizon of 30 days.
The HLAs cannot be encumbered nor rehypothecated.
The HLAs fall into two categories: level 1 assets and level 2 assets;
the latter can comprise up to 40% of the stock.
Level 1 assets are cash and available central bank reserves and
liquid marketable government-type assets with a zero RWA2
but not with a bank as issuer.
Level 2 assets (minimum haircut of 15%): same as level 1
but with 20% RWA. Also non-bank corporate and covered
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LIQUIDITY MODELLING
(mortgage) bonds are included, if their historical haircut/price

decline is not more than 10% within a 30 day period. It is par-
ticularly important to note that financial bonds and equities
are not eligible for the LCR buffer.
The total net cash outflows

The TNCOs comprise all expected cashflows derived from the out-
standing balances of the bank (assets, liabilities or OBS commit-
ments, which mature within 30 days) multiplied by expected run
off/draw down rates.3
inflows: from liabilities and OBS commitments;
outflows: from receivables;
TNCOs, defined as follows
TNCO := outflows min{inflows; 75% of outflows} (10.1)
As inflows and outflows are positive numbers here, the inequality

can be written as
stock of highly liquid assets > total net cash outflows
The rationale behind this is to require from banks a balance-sheet

structure where
HLAs + total net cash outflows > 0
It should be noted that the LCR is referring to cashflows that are

different from the cashflows we have defined before (estimates of
future payments: the LCR assumes roll-over factors for a couple
of balance-sheet positions and a cashflow is simply the adjusted
outstanding of an asset (a liability) with a plus (minus) sign and a
vague date within the 30-day horizon).
Idea and realisation of the liquidity coverage ratio

If a bank complies with the LCR rule it is supposed to stay liquid
within the next 30 days, assuming that the parameters defined in the
regulation conform to reality.
The LCR is specified as a mixture of a balance-sheet view and a
cashflow view.
The (comprehensive) set of a banks transactions (assets, liabilities
and OBS commitments) is transformed into sums of cash outflows
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and inflows which are netted at the end of the considered time hori-
zon. If the summed outflows exceed the inflows, the bank will be
illiquid unless it is able to offset the resulting deficit by hypothetical
cash inflows which stem from liquifying the HLAs. The liquifica-
tion process of the HLAs is not further specified in Basel III; it is
simply assumed that multiplying the outstanding balances of the
HLAs by their market prices (eventually reduced by a haircut for
level 2 assets) gives the values of the cash inflows.
The cash inflows are originated by the banks counterparties and
are thus more uncertain than the cash outflows which are under the
control of the bank. Therefore, the regulation caps the sum of the
cash inflows at 75% of the sum of cash outflows (see Equation 10.1).
Technically, this rule imposes that at least 25% of the part of a banks
balance sheet which is maturing within 30 days has to be covered
by HLAs. Even if a bank is perfectly match-funded (every asset is
replicated with a matching liability and vice versa), and its scheduled
cash inflows and outflows fully cancel each other out, the TNCO
does not drop to zero but is at least 25% of the outflows.
We compare the LCR with the best practice for the economic
measurement of illiquidity risk, the FLE and the CBC.
1. Today the banks assets will match its liabilities by definition.
2. If shortly before the end of yesterday the bank had a sur-
plus (deficit) of liabilities, the accompanying surplus (lack) of
cash was transformed into a credit (debit) on the banks nos-
tro account with the central bank thus making the assets and
liabilities match.
3. Going forward in time, the banks assets and liabilities will not
mature uniformly. If tomorrow more (fewer) liabilities than
assets mature, the outflows from liabilities will exceed (under-
shoot) the inflows from assets; thus, the bank will have a nega-
tive (positive) liquidity mismatch tomorrow. By netting this
mismatch with the nostro balance of yesterday, we get the
scheduled nostro balance, the FLE for tomorrow.
4. Negative balances can, however, exist only as forecasts (not
in reality) because the central bank stops payments from
the banks nostro before it turns negative. Therefore, the
bank has to ensure its ability to create enough liquidity to
counterbalance the forecasted cash deficit before it occurs.
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LIQUIDITY MODELLING
5. The bank will estimate the maximal amount of liquidity it can

create until tomorrow to counterbalance the forecasted liquid-
ity shortage (the CBC) by assuming it will sell liquid assets or
acquire secured or unsecured deposits.
6. The above procedure is repeated for subsequent days.
7. The LCR follows the same principles (adjusted by the 75%
rule) but without explicitly demonstrating how the FLE and
the CBC develop in time.
8. All cashflows maturing within 30 days are summed and con-
verted into the TNCO, which is compared with the hypothet-
ical inflows stemming from an assumed liquification of the
HLA assets within 30 days.
9. It is not specified how the qualified assets (HLAs) are trans-
formed into hypothetical inflows, but only that the resulting
cash is derived by multiplying the available amount of an HLA
by its market price (which is diminished by a haircut).
10. It is undecided in the LCR how fast the assets are liquidised.
The model specifies only what happens on the last day. There-
fore, we do not know what happens inside the time horizon
and whether the inequality in fact holds on every day of the
time horizon.
11. Due to the 75% rule, the TNCO shows a worse situation than
the corresponding FLE does. The missing term structure in
particular is not a problem if cash outflows dominate inflows
in every future day, because then the forecasted nostro balance
will decrease monotonically until on the last day of the time
horizon the worst balance is reached.
12. In reality, the balance can fluctuate from day to day and thus
the minimum balance will not necessarily occur on the last
day. In Table 10.1 and Figure 10.3 we consider an example to
demonstrates this.
The FLE as a view of the economic illiquidity risk in time more
or less drops right from the start until it reaches its minimum
(89, 9) on day 25 and recovers towards the end. With the calculation
algorithm of Basel III
LCR = outflows inflows = 249.3 177.4 = 71.9
This is obviously above the FLEs absolute minimum of 89.9.
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Table 10.1 Example: FLE versus TNCO
Time CF CF CF
(days) in out net FLE min{FLE} TNCO
0 3.2 89.9 71.9

1 5.6 9.3 3.7 0.5 89.9 71.9
2 5.5 12.5 7.0 7.5 89.9 71.9
3 11.4 13.8 2.4 9.9 89.9 71.9
4 1.4 14.5 13.1 23.0 89.9 71.9
5 11.2 8.2 3.0 20.0 89.9 71.9
6 8.4 0.2 8.2 11.8 89.9 71.9
7 1.8 5.3 3.5 15.3 89.9 71.9
8 9.4 12.5 3.1 18.4 89.9 71.9
9 10.6 3.0 7.6 10.8 89.9 71.9
10 4.8 14.8 10.0 20.8 89.9 71.9
11 0.8 7.1 6.3 27.1 89.9 71.9
12 5.5 3.9 1.6 25.5 89.9 71.9
13 1.9 7.8 5.9 31.4 89.9 71.9
14 6.3 11.6 5.3 36.7 89.9 71.9
15 0.5 14.6 14.1 50.8 89.9 71.9
16 4.9 9.3 4.4 55.2 89.9 71.9
17 10.0 13.9 3.9 59.1 89.9 71.9
18 4.6 12.5 7.9 67.0 89.9 71.9
19 2.0 6.4 4.4 71.4 89.9 71.9
20 7.8 10.8 3.0 74.4 89.9 71.9
21 10.1 11.7 1.6 76.0 89.9 71.9
22 2.4 7.1 4.7 80.7 89.9 71.9
23 4.1 8.5 4.4 85.1 89.9 71.9
24 4.7 7.0 2.3 87.4 89.9 71.9
25 5.0 7.5 2.5 89.9 89.9 71.9
26 7.6 3.2 4.4 85.5 89.9 71.9
27 8.3 6.0 2.3 83.2 89.9 71.9
28 8.5 1.2 7.3 75.9 89.9 71.9
29 5.3 2.8 2.5 73.4 89.9 71.9
30 7.0 2.3 4.7 68.7 89.9 71.9
Total: 177.4 249.3 71.9
Assets (liabilities) which were generated, for example, yesterday

and will only be paid (received) tomorrow will create future out-
flows (inflows) from todays perspective; the concept of forward
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LIQUIDITY MODELLING
Figure 10.3 Example: FLE versus TNCO
20
20 CF in
CF out
CF net
40 FLE
min{FLE}
TNCO
60
80
100
0 5 10 15 20 25 30
transactions in the LCR is asymmetric: outflows are 100% captured,

whereas inflows are not regarded (0%). We assume, until further
clarification by the regulator, that the cashflows of pending transac-
tions will be taken into account. Furthermore, the cashflow forecast
TNCO is based on existing assets or liabilities only; liabilities or
assets that do not yet exist are ignored or captured under addi-
tional requirements (credit facilities, downgrade trigger, change in
collateral value, buy backs, etc).
The strict separation between assets that are liquid (HLA) and all
other assets inherits the risk that in a crisis all non-HLA assets will
be regarded as illiquid and thus will become illiquid. The narrow
definition of the buffer also increases concentration risk in the banks
liquidity buffer towards sovereign exposure.
The consequences depend on the final definition of the HLA crite-
ria: if only AAA-rated sovereign debt qualifies for HLA1, banks will
face the following situation: more and more countries of the Euro-
zone will not be HLA1 eligible but still be ECB eligible, whereas
sovereign debt from the US, Canada or Switzerland will then be
HLA1 assets but not ECB eligible. Liquification of these assets is then
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based on access to these markets, including the central bank tender,

and on liquid foreign exchange markets. On the other hand, a con-
centration risk in highly rated corporate bonds can also be expected
(HLA2 eligible assets).
To avoid such a self-fulfilling prophecy, it would be better if the
regulation allows for more and fewer liquid assets instead.
Although the exclusion of bank bonds from the HLA is undoubt-
edly a useful measure to avoid mutual ring-financing between
banks, it might change the market for bank bonds dramatically.
Funding costs for banks will on the other hand increase, as their
own bond issues will not be HLA eligible4 and thus will be of less
use for other banks.
HOW CAN A BANK IMPROVE ITS LCR?

Reasons for a bad LCR
In order to comply with the LCR ratio of Basel III, the quotient LCR =
HLA / TNCO shall not be less than 100%. For internal reasons, a
bank might want to have a safety buffer b (eg, for miscalculations)
and thus keep a higher LCR at 100% + b.
Technically speaking, the reasons for an LCR below 100% + b can
be caused by two factors.
1. The banks TNCO is too high: too many outflows from matur-
ing liabilities, if compared with the inflows from maturing
assets.
2. The bank owns not enough HLA assets (or an insufficient
portion of level 1 assets).
Before we go deeper into the analysis, we distinguish between asset-
driven and liability-driven banks. The business model of asset-
driven banks is (in an idealised description) to give loans which
are retrospectively refinanced; whereas a liability-driven bank starts
with an excess of liquidity from existing liabilities which are subse-
quently invested in assets. Banks can be asset driven during certain
time intervals but liability driven at other times.
The banks TNCO is too high

The sum of assets and liabilities match in a balance sheet. Liabilities
with shorter tenors need to be renewed more often. If the banks
liabilities are shorter than its assets, the outflows from maturing
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liabilities exceed the inflows from maturing assets and thus increase
the TNCO.5
The liabilities of asset-driven banks tend be shorter than its assets:
why?
Banks could match-fund every asset with a deposit of equal size
and tenor, and thus insulate its profit against interest rate changes.
In a normal yield curve environment, however, the interest costs
increase while the tenor of the borrowing lengthens, which tempts
banks to refinance longer-term assets with deposits of shorter tenor
in order to reduce their interest rate expense. This so-called interest
rate gapping is of course not risk-free, as the lower expense is only
realised until the maturity of the liability; if the interest rates then
increase, the profit can turn into losses in future periods.
It is, however, possible to both match-fund and speculate on
interest rates that stay low: the bank can either match-fund6 with
a floating deposit only or with a fixed deposit and subsequently
produce the desired interest rate gap autonomously with a non-
liquidity bearing derivative like an interest rate swap. Here another
cost comes into play. The interest rates for term borrowings com-
prise not only the structural interest cost as described above (which
is reflected by almost credit-risk-free interest rate swaps) but also
a liquidity premium which reflects the counterparty credit risk of the
borrower. The credit risk (and thus the liquidity premium) increases
as the tenor extends. The bank is tempted to borrow only for a shorter
term with a lower liquidity premium, which is similar to the interest
rate gapping above. If after the maturity of the deposit the liquidity
spread has risen, the bank will incur a (comparative) loss.7
Assume that the bank is fully match-funded: every asset is indi-
vidually refinanced with a deposit of equal size and tenor.8 The pre-
dicted inflows and outflows of the bank match up to, for example,
small interest differences and generate an FLE which is almost zero.
Unfortunately, inflows and outflows do not match because of the
75% rule. The consequence is that even a fully match-funded bank
would have to hold HLAs for 25% (on average) of its maturing assets
(or liabilities) within the 30-day time horizon.
The banks HLA holdings are insufficient

High-quality liquid assets normally pay less interest than non-HLAs
and less than most banks need to spend for appropriate funding.9
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An A-rated bank, for example, pays +150bp premium on top of the

interest swap rate for, say, a six-year term funding, while a German
bund with the same tenor pays only 25bp and thus would generate
a total expense of 175bp if purchased as an HLAand match-funded;
instead, however, the bank could purchase a Spanish covered bond
which pays +200bp and the expense becomes an income of +50bp,
without accounting for risk costs.
This highlights a central problem of Basel III: its intention is to
reduce the funding risk of banks which stems from the maturity
mismatches of their assets and liabilities. The compliance with the
new rules, however, generates costs for banks that have entered into
these maturity mismatches exactly to avoid such costs. Given the
experience with other regulations, the banks with the highest fund-
ing risks will try the hardest to elude these costs. They might instead
invest in assets which are eligible in Basel III but are perilous from
an economic point of view.
As HLAs have a lower return than other investments, asset-
driven banks normally have no straight economic reason to pur-
chase HLAs.10 But why do they own such assets? Apart from tech-
nical and other regulatory reasons, these banks have understood and
accepted that they need, for economic liquidity risk reasons, HLAs
which can, if needed,11 be converted into cash easily. In phases of
ample liquidity in the market, they have acquired liquidity in excess
and accumulated it in HLAs in order to be able to convert it back
into cash when they need it.
A bank can improve its HLA by exchanging the level 2 assets (with
a haircut of at least 15%) against level 1 assets with a 0% haircut.
The possible improvement in cash, however, would be marginal: if
we assume that the HLA = 100 and all assets prices are 100: the
minimum required portion of level 1 assets is 60%, which leaves only
40% level 2 for enhancement. The resulting available cash is
60 (100% 0%) + 40 (100% 15%) = 94
If all level 2 assets are exchanged against level 1 assets, the result-
ing cash is
(100 100% + 0 85%) = 100
which gives an improvement of approximately only 6%.
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Figure 10.4 LCR: tactical improvements
Extend
tenor
Increase
liabilities
existing

liabilities
Grow
Decrease
outflows
total net

Shorten
tenor
Decrease
existing
assets

HLA/TNCO
repo
Sell
LCR
of purchased
Refinancing
HLAs
+
decrease of
Possible
HLA
Level 1
Level 2
additional
Purchase
HLAs
exchange
Asset
Non-HLA

HLA

Possible strategies to comply with the LCR

If a bank has a bad LCR, it might need or want to improve it. The
measures that can be taken to achieve tactical improvements with
immediate effect are restricted, whereas the headroom for strategic
improvements which change the banks balance sheet in a sustain-
able way is larger, which increases the complexity of such potential
management strategies.
If a department (eg, the treasury) has been nominated to ensure
the compliance of the bank with the LCR, a target needs to be
defined (eg, never let the LCR drop below 100% + b) and the set of
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admissible transactions has to be defined. Finally, the consequences

of potential steering interventions need to be known, and it should
be clear in advance how eventual costs will be charged between
departments.
Any stand-alone compliance transaction will disturb the balance
between assets and liabilities. Therefore, we assume that every asset
(or liability) enforces a replicating liability (or replicating asset)
which reinstates the balance. To avoid confusion, we define the
following: an originated transaction has its replication transaction
for transfer-pricing purposes, which neutralises dependencies from
interest rate changes and reinstates the balance; its LCR-compliance
transactions neutralise the effect of the originated transaction on the
LCR and re-reinstate the balance.
For example, a loan of 100 (originated transaction) is replicated
by a deposit of 100 (replication transaction) for match-funding pur-
poses. In order to be LCR-compliant, the bank needs to buy 25
HLA, which again needs to be funded with a deposit of 25 to
reinstate the balance (LCR-compliance transactions).
Instantaneous improvements to the LCR

If a bank simulates strategies that will improve its LCR (to comply
with Basel III), a practical problem arises: the compliance transac-
tions made by the treasury will only become effective when other
transactions which have already been originated by the banks other
businesses emerge and interfere with the compliance transactions.
In order to avoid such co-mingling effects, we assume that the bank
can execute the compliance transactions instantaneously (or at least
during a time span which is short enough to avoid the creation of
new assets and liabilities by other departments). We will call such an
unchanged balance sheet stationary, in distinction to dynamic
balance sheets which we will consider later.
Forward starting transactions are treated asymmetrically in the
LCR: outflows go with 100% into line items 143148, whereas inflows
go with 0% into line item 204 and are thus neglected.12
To improve its LCR (see Figure 10.4), a bank can either increase
the numerator (the HLAs) and/or decrease the denominator (the
TNCOs).13 Unfortunately, certain of these measures improve one
side of the fraction but can have detrimental effects on the other
side. We therefore do not take this route but derive the possible
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strategies by looking at possible changes of the banks balance

sheet instead. We avoid forward transactions as explained above
and will assume that all compliance transactions can be executed
immediately, although this might be not feasible in practice.
1. The bank increases its current balance sheet by purchas-
ing additional HLA-eligible assets with a residual maturity
of more than 30 days and refinances them: the HLA-assets
increase the numerator14 , the denominator is left unchanged.
The effects of the corresponding refinancing can change the
TNCO (cf Tables 10.2 and 10.3).
(a) If a new HLA is refinanced with a new liability, the

beneficial effect depends on the maturity of the new
liability.
(i) If the new liabilitys maturity is greater than 30 days,
no additional cashflows will occur within the 30-day
horizon and thus the positive effect in the HLA is not
lessened.
(ii) If the new liabilitys maturity is within 30 days, its
redemption flow is counted as an outflow in the
TNCO which impairs the positive effect of the HLA,
depending on the utilisation of the 75% capping rule.
(I) If the total inflows have not been capped, the
redemption flow will offset the improvement in
the HLA fully (subject to roll-over assumptions
depending on counterparty type).
(II) Buying new level 2 assets even gives a negative
effect in this situation.
(III) If the total inflows have been capped by the 75%
rule, the additional outflows allow the absolute
value of the capped inflows to increase and thus,
together with the growth in HLA, improve the
LCR overall.
2. The bank decreases its current balance sheet. It can sell assets
(other than those eligible for the HLA) in order to repay liabil-
ities that mature within 30 days and thus are detrimental for
the outflows. The benefit depends on the 75% capping situa-
tion; in the best case the TNCO is fully enhanced by the sold
amount.
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(a) If the assets are level 1 HLA eligible, the impairment

in the HLA offsets any benefit in the TNCO (a small
enhancement still can be made if the assets are only
level 2).
(b) Assets that mature within 30 days contribute to the
inflows and their sale counterpoises the benefit for the
outflows.
3. The bank leaves its balance sheet size unchanged. It can

either exchange non-HLA eligible assets against HLA assets
(or level 2 against level 1) or substitute shorter with longer
liabilities.15
(a) Existing non-HLAs are sold in exchange for new HLAs.

As no new liabilities originate, the TNCO remains un-
changed but the HLA (nominator in the LCR) increases.
(i) If the existing assets mature within 30 days, their sale
diminishes the inflows, depending on whether or not
the 75% rule is used.
(ii) It only makes sense, of course, to sell assets which
are not eligible in the HLA, or, at least, exchange
level 2 HLAs against level 1 HLAs, although the
improvement in the LCR is minor.
(b) Existing liabilities that mature within 30 days are paid
back early, with new longer-term liabilities, and thus
improve the TNCO. This depends on the ability of the
bank to acquire longer-term liabilities and the willing-
ness of the existing counterparties to accept an early
redemption of the funds.
Costs of instantaneous improvements of the LCR (banks view)

The costs of steering the LCR of the bank are given by the sum
of the costs of compliance and replication transactions. The banks
current LCR, the relation of inflows and outflows and the matu-
rity profile of assets and liabilities drive the compliance transactions
that determine their replication transactions (if we assume that the
bank match-funds every asset). Note that even if the bank were to
be fully match-funded (every outflow is mirrored by an accordant
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Table 10.2 LCR improvements: example 1
Existing New Level Value Total Improvement
LCR (%) 100.00 120.00 20.00

HLA 25.00 5.00 1 5.00 30.00
TNCO 25.00 0.00 25.00
Out 100.00 0.00 100.00
In 100.00 0.00 100.00
75% cap 75.00 75.00
Capped 25.00
LCR (%) 100.00 118.00 18.00

HLA 25.00 5.00 2 4.50 29.50
TNCO 25.00 0.00 25.00
Out 100.00 0.00 100.00
In 100.00 0.00 100.00
75% cap 75.00 75.00
Capped 25.00
inflow) the 75% rule would nevertheless require that the bank holds
an amount of HLA equalling 25% of its total outflows.
An originating departments view on costs is different: the trea-
sury has virtually match-funded every transaction.16 Consequently,
the actual compliance costs of the bank are irrelevant, and only the
costs which arise relative to the match-funding (see the section on
transfer prices for the compliance with the LCR on page 270) are
relevant.
In practice, the real costs of the LCRs improvement can be very
different from the virtual ones, depending on the (liquidity gap)
limits available to the treasury. The more the refinancing does not
match the asset (either in legal cashflows or in applicable roll-over
factors), the higher the costs for the improvement or the smaller the
improvement of the LCR will be (at least beyond the gap limit).
The income (or expense) of a transaction depends on its individual
characteristics; some of them (eg, amount and tenor) are determined
by the compliance process, while others are at the discretion of the
bank (eg, credit risk of the counterparty). It is barely possible to
give a formula; we will highlight the approach by some sample
calculations below.
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LCR (%) 100.00 100.00 0.00

HLA 25.00 5.00 1 5.00 30.00
TNCO 25.00 0.00 30.00
Out 100.00 5.00 105.00
In 75.00 0.00 75.00
75% cap 75.00 75.00
Capped 0.00
LCR (%) 100.00 98.00 2.00

HLA 25.00 5.00 2 4.50 29.50
TNCO 25.00 5.00 30.00
Out 100.00 5.00 105.00
In 75.00 0.00 75.00
75% cap 75.00 75.00
Capped 0.00
The bank increases its current balance sheet. Assume that the
bank complies with the LCR by purchasing additional HLA-eligible
assets and match-funding them, ie, 10-year asset versus a 10-year
liability, thus increasing the balance sheet.
For example, the bank has a balance sheet of 100 billion of which
on average 4% (4bn) are rolled over every 30 days. In the best
case (the bank is fully match-funded, including the modelled cash-
flows) the TNCO equates to 4 billion outflows minus 3 billion
inflows (75% rule) which equals to 1 billion every 30 days. There-
fore, the bank has to hold a stock of 1 billion HLA. If the bank is
not match-funded (say the TNCO reaches 3 billion), the bank has
to buy another 2 billion HLA to comply with the regulation.
The overall costs of the compliance with the LCR equal the dif-
ference between the income from the HLA and the expense for its
replication (refinancing) transaction. The cost impacts of an individ-
ual HLA transaction thus depend on two variables: its credit quality
and its tenor.
If the tenors of the liability do not match, we assume that the
mismatch (eg, a lower interest rate for shorter tenors) is offset exactly
by a premium for market risk, otherwise we would have detected
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LCR (%) 100.00 114.00 14.00

HLA 25.00 5.00 1 5.00 30.00
TNCO 25.00 5.00 26.25
Out 100.00 5.00 105.00
In 100.00 0.00 100.00
75% cap 75.00 78.75
Capped 25.00
LCR (%) 100.00 112.00 12.00

HLA 25.00 5.00 2 4.50 29.50
TNCO 25.00 5.00 26.25
Out 100.00 5.00 105.00
In 100.00 0.00 100.00
75% cap 75.00 78.75
Capped 0.00
a riskless arbitrage opportunity. We can therefore simplify things

and suppose match-funding, which allows us to express the costs
relative to the current interest rate curve.
The remaining driver for the income of the HLA is its credit qual-
ity, which triggers, together with the bonds residual tenor, the credit
spread (relative to the yield curve). Unfortunately, higher incomes
are strongly correlated to worse credit ratings.
If the bank buys assets that have a better credit quality than itself
(for example, an AA/Aa2-rated bank buys a risk-free bond, eg,
a Bund (HLA1), then the return from the bond is less than the refi-
nancing cost of the bank. A German government bond (bund) with
six years residual tenor, for example, trades at 25bp (relative to
the interest rate swap level), whereas the bank would pay +150bp
(above matching interest rate swap level); the cost is 175 basis
points. If the bank instead decides to buy, for example, a Spanish
covered bond (with an HLA2 of at least AA) yielding +200bp,
the cost turns into a profit of 50bp17 ). The bank should reflect the
increased (credit) risk of the Spanish covered bond with a higher
internal (credit) risk premium that offsets the advantage in yield. In
theory, the risk-adjusted price of the Spanish covered bond should
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exactly match the price of the risk-free bond, as otherwise arbitrage

would be possible.18
The tenor of the HLA bond (and thus of the match-funding) drives
the spread between the income from the HLA and the expense for
the funding. The credit risk of the issuer of the security drives the
income, whereas the credit risk of the taker of the refinancing (the
bank) drives the expense; the spread between both will normally
widen as tenors lengthen.
If the spread is positive, it is optimal to go for the longest possible
maturity. The risk, however, increases with the tenor so that this
possibility is capped by the banks restricted risk appetite and its
buffer for value risks (capital).
If the spread is negative, it is optimal to go for the shortest possible
maturity. The restriction here is that during the last 30 days of its life
cycle the HLA still improves the LCR but the cashflows of its matur-
ing match-funding offset this positive effect. If the bank refinances
HLAs with, say, a three-month liability, the bonds can be used only
in the first two months and, on average, roughly one-third of them
will be unusable for the LCR.
The bank decreases its current balance sheet. The bank decreases
its current balance sheet by selling non-HLA-assets maturing be-
yond 30 days in order to repay liabilities that mature within 30 days.
Here we have two cost effects:
the income from the assets is normally higher than the expense
for the liabilities because the assets bear credit risk and have a
longer maturity;
the maturity effect should be fully compensated by the banks
transfer pricing.
Selling assets from the balance sheet has serious impacts for the
internal transfer pricing system: if the credit quality of an asset has
deteriorated since its acquisition, the originator has to bear the costs
(assuming it was not sold to an internal credit treasury). If, however,
the credit quality has improved since then, the originator needs to
be compensated for this effect. The above considerations disregard
potential detrimental side effects that may emerge from the 75% rule.
The bank leaves its balance sheet size unchanged. The bank
exchanges non-HLA eligible assets against HLA assets (or level 2
against level 1) or substitutes shorter liabilities with longer ones.
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If the tenors of the assets are the same, we assume that the new
assets will generate less income than the existing assets, which gen-
erates comparative costs. We assume that interest rate and credit
effects from changing tenors are compensated by the transfer-pricing
method.
New longer-term liabilities that are used to pay back existing lia-
bilities that mature within 30 days improve the TNCO. The dif-
ference between the higher cost of the new liabilities and the cost
of the existing generates a comparative loss. Additional costs from
an elongated tenor should be compensated by the transfer-pricing
method.
Strategies that improve the LCR in the future

If the treasury (the steering department) simply started to take coun-
teractive measures only when the LCR has been calculated, it would
run the risk of not being able to heal a bad LCR. A proactive steer-
ing of the LCR requires knowing the forward LCR, (LCRt ), as it
will be in t days from now. Unfortunately, the forward LCR t cannot
be determined unequivocally today because it depends on future,
as-yet unknown transactions of the bank.
Previously (in the section on instantaneous improvements to the
LCR; see page 261) we studied a stationary balance sheet (ie, one
invariant in time); now we need to consider a dynamic balance sheet
(ie, one which changes over time). Maturing transactions disappear
while new transactions arise. We assume that existing transactions
cannot change (but they may cease and emerge renewed). We will
show how the complexity in modelling the forward LCR can be
increased in steps.
Run-off simulation. In the run-off simulation we assume that the

bank does not arrange any new transaction. Assets and liabilities
mature day by day and thus the balance sheet shrinks monotoni-
cally. If during one day the maturing assets fall below (or exceed)
the liabilities, we assume that the bank will square its balance by
acquiring a suitable cash deposit (or loan) until the next day. As
transactions mature and drop out of the 30-day interval or, due to
their shortened residual tenor, materialise in the 30-day interval, the
LCR t will change over time. For the treasury the situation is princi-
pally the same as in the section on instantaneous improvements to
the LCR (see page 261): it will take the balance sheet at t as given and,
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depending on the forward LCR t , carry out the appropriate transac-

tions as described before. If transactions which should enhance a
future LCR t are carried out today, the corresponding P&L effects
will be realised today. It is an interesting intellectual exercise to find
the optimal strategy which minimises the overall steering cost under
certain side constraints like a given risk tolerance.
Business-as-usual simulation. Next, we assume that the origina-

tors execute their business as if there were no restrictions imposed
by the LCR. The transactions from the run-off simulation are the
same (except for the squaring), but the hypothetical transactions
that diverse businesses will engender need to be added. The trea-
sury could, in a thought experiment, replicate all hypothetical trans-
actions according to the banks transfer-pricing procedure (and
thus balance assets and liabilities) and afterwards steer the forward
LCRt as described in the section on instantaneous improvements to
the LCR (see page 261). A business-as-usual simulation starts nor-
mally with the run-off simulation and the maturing transactions are
replaced by hypothetical transactions with similar characteristics.
The problem is that we cannot know with certainty which transac-
tion the businesses will create in the future. Even if the bank tries to
execute a specific business plan, it is unclear whether it will be able
to do so. Therefore, the treasury might be cautious in carrying out
the required steering transaction for the forward LCR t , because cer-
tain assumed hypothetical transactions might not happen in reality
(but instead other unconsidered transactions may happen). Another
issue is that it might be advantageous to avoid carrying out the steer-
ing transaction strictly after the replications, but instead combining
them in order to restrict the banks balance-sheet growth or to reduce
costs.
LCR-adjusted going-concern simulation. It is obviously a subop-

timal process if, as assumed in the business-as-usual simulation,
the originators ignore the consequences of the forthcoming LCR t
and the treasury finally solves the problem and charges them. If
the costs of complying with the LCR rule of Basel III are demon-
strated to the originators of transactions in the bank before these
costs arise, the originators can structure their upcoming business
differently to avoid unnecessary transactions and thus costs. If the
costs are allocated to a business through transfer prices, the business
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will recognise the cost impact from the steering of the LCR before it
arises, and is thus enabled to avoid (or at least modify) transactions
which are detrimental for the LCR. Again, it is important to find the
appropriate transfer price (see the next section).
To simulate the effects described above, the forward LCRt should
be produced on the basis of an LCR-adjusted going-concern simu-
lation, which assumes that the reactions of the business originators
are rational and thus avoids hypothetical transactions that are bad
for the LCR in favour of good transactions (see the next section).
Although this simulation is very complex and it is doubtful
whether all assumptions are realistic (eg, that originators will make
fully rational decisions), it is the only way forward, because any
other simplified forecast of the LCR might be easier to assess but
is highly likely to be less realistic.
Transfer prices for the compliance with the LCR

We need to distinguish between the overall costs of making the
banks LCR comply with the rule and the costs of the individ-
ual internal parties (originators) that are refinanced by the funding
department (the treasury). Assume that the treasury has internally
match-funded an originators transaction. If the treasury match-
funds itself with an external party, it can pass on the charges that
result from making the LCR comply. If the funding department, how-
ever, does not match-fund itself externally, the originator cannot be
held responsible for any additional charges. Consequently, the over-
all costs for the bank need to be split into those that can be allotted
directly to the originator and those that stem from the individual
refinancing process of the treasury.
Asset origination. Let us consider the following thought experi-

ment: an originator starts their business with their first transaction
T (with a face value of 100 and a maturity of one year), which
is internally match-funded with the replication R. During the first
11 months, the cashflows are not relevant for the LCR, but after
11 months the inflows and outflows of (T + R) fall into the one-
month bucket. Although the inflows match the outflows, the 75%
rule equates the TNCO to 100 (100% 75%) = 25. As the
existing transaction cannot be changed, the only way to comply
with the 100% rule is to buy in 11 months (when the cash outflows
reach the 30-days bucket) sufficient19 additional HLAs (33.33) and
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match-fund them. The LCR calculation will then be
HLA = 33. 33, inflows = 133.33, outflows = 133.33

TNCO = 133.33 75% 133.33 = 33.33
HLA 33. 33
LCR = = = 100%
TNCO 33. 33
We continue our thought experiment, and the originator initiates
the next transaction of say 200, with (for the sake of convenience)
the same maturity, and buys accordingly 66.66 of HLAs as above.
In 11 months the LCR calculation will be
HLA = 33.33 + 66.66 = 100
inflows = 133.33 + 266.66 = 400
outflows = 133.33 + 266.66 = 400
TNCO = 400 75% 400 = 100
HLA 100
LCR = = = 100%
TNCO 100
Obviously the HLA cost of the second transaction is independent
from the first transaction and thus both can be added. The underly-
ing reason is that the first transaction, together with its replication,
sets the HLA to 100%; therefore, the second transaction starts from
scratch but leaves, together with is replication, the LCR unchanged:
LCR = 100%. We will call a transaction together with its replication
LCR-neutral if
LCR (transaction + replication) = 100% (10.2)
As a consequence for the transfer pricing, we can assume for an

individual transaction of the originator that it should be replicated
in such a way that Equation 10.2 holds.
If we assume in our thought-experiment example that the return
of the 12-month HLA is 20bp and the cost of the match-funding is
52bp, the cost of complying with Basel III for the first transaction of
100 is then roughly the cost of the additional 33.33 HLAs together
1
with their funding times 12 months. This equates to
33 1 0. 24%
(0. 20% + 0. 52%) = = 0.02%
100 12 12
= 2.0 basis points
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Liability origination. We have found a rather simple way to deter-

mine for an asset the LCR portion of its transfer price. Let us now
consider that the LCR = 100% and the originator acquires a liabil-
ity of 100 for 12 months. The treasury pretends to make a match-
ing investment. As the banks LCR is already in compliance with
Basel III, there is no need to buy an HLA. If the bank is asset
driven, the deposit of 100 is exactly 75% of the 133.33 that is
required as a funding for the first originated asset of 100 in the
above example. Thus, we can argue that the treasury can reimburse
75% 2.0bp = 1.5bp to the originator of the liability.
For a liability-driven bank the calculation is not as straightfor-
ward, because it cannot always be assumed that an additional
liability can be used to replicate upcoming assets.
Deductions. Our above example and its conclusions work on the
presupposition that we can start the calculation of the LCR-related
costs with an LCR = 100% for the originators portfolio of transac-
tions. This assumption holds if the bank has been using a transfer-
pricing system on individual transaction basis with assumed match-
funding by the treasury since the origination of the first existing
transaction, or if this situation has been simulated for the historic
transactions. It cannot, however, be presupposed that the trans-
fer price of an existing transaction reflects the LCR premium. The
straightforward way to solve this problem is to restart the banks
transfer-pricing system. All existing transactions are priced (includ-
ing the LCR premium) as if they were originated today (with their
current outstanding and residual maturity). Once this has been fin-
ished, the new transfer-pricing process can start as outlined above.
Another issue is a possible future change in Basel III or other
regulations. Some banks want to include possible changes because
they account not only for expected risks but also for unexpected
risks. A partial solution would be to include a safety buffer b while
internally complying with the LCR rules; ie, LCR = 100% + b needs
always to be true. If the regulation changes dramatically, the only
sustainable solution is to adapt the rules of the transfer pricing and
reset the transfer-pricing system itself.
THE NET STABLE FUNDING RATIO

The Basel III regulation requires in the NSFR that a bank makes
assumptions about its required amount of stable funding (RSF) and
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Figure 10.5 Available stable funding categories
Figure 10.6 Required stable funding categories
the available amount of stable funding (ASF) in a one-year time

horizon.
The inequality to be met by the bank is expressed in the form of a
ratio
available amount of stable funding
> 100%
required amount of stable funding
As all numbers are positive, we can rewrite this equation as
available amount of stable funding

> required amount of stable funding
Available stable funding

The ASF comprises the banks current liabilities. These are cate-
gorised by their assumed availability for the bank in one year. The
categories are set by the regulator as described in Figure 10.5.
The bank needs to assign its equity and liabilities to one of these
categories, determine the current total amount for each category and
multiply this by the corresponding ASF factor.
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Required stable funding

The RSF comprises the banks current assets and off-balance-sheet
(OBS) exposures. They are categorised by their assumed ability to
fund themselves. The categories are set by the regulator as described
in Figure 10.6.
The bank needs to assign its assets and OBS items to one of these
categories, determine the current total amount for each category and
multiply this by the corresponding RSF-factor.
The NSFR: idea and realisation

The NSFR makes assumptions about a banks liabilities (ASF) and
required funding (RSF) in a years time and compares them in the
form of a ratio. The underlying idea is to diminish the banks reliance
on borrowings of less certain availability in the future, as well as to
restrict the portion of less liquid assets which cannot be used as
collateral for repos and thus to finance themselves.
In the numerator (ASF), liabilities are grouped according to their
assumed availability within the time horizon of one year. Capital
and term liabilities which mature after the end of the one-year time
horizon are credited fully (ASF factor of 100%). Liabilities with no
fixed maturity are assumed only to be available with less certainty in
a year but are still credited with ASF factors of 90% or 80%. Capital
market funding that disappears within one year receives 0% ASF.
The regulation presumes further that term deposits with less than
one-year residual maturity will be party rolled over so that after one
year 50% are still available for the bank.
In the denominator (RSF), loans to financial institutions that cease
to exist within a year are not considered (RSF factor of 0%). Loans
to corporates with a residual maturity of less than one year receive
50%; retail loans even receive 85%.
The other assets are categorised according to their expected liquifi-
ability assuming that they can be either sold or used for collateral-
ising part of their funding (self-financing) with the RSF factor as a
haircut.
The NSFR is a consistent concept. The critical parameters in the
ASF are the roll-over behaviour of the non-maturing and shorter-
term liabilities as well as the self-financing assumptions in the RSF.
The fact that the NSFR calculation is done under a single scenario
has the caveat that this scenario is on the one hand too rigid for
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going concern scenarios and on the other hand not rigid enough
for real stress scenarios. It is like arguing that a fair coin flip with
a 1 coin has the expected outcome of 0.5 although every indi-
vidual experiment ends up with 1 or 0. The assumption that, for
example, only 10% of the savings deposits flowing out of the bank
is hardly compatible with a bank run; whereas on the RSF side the
assumption that residential mortgages will refinance themselves by
35% may not be realistic in a crisis situation. Conversely to the LCR,
however, a banks non-compliance with the NSFR rules does not
immediately affect its ability to stay liquid, but only gives a sign
that its longer-term funding structure is inappropriate.
A certain weakness of the NSFR is that it disregards the creation
of hypothetical new assets and thus assumes that the bank can stop
the production of new assets immediately. For asset-driven banks in
particular, this assumption is difficult to maintain.
HOW CAN A BANK STEER ITS NSFR?

If the bank has an undesirably low NSFR, the average maturity of
its liabilities might be too short. There is not, however, too much
headroom to improve this. Capital is only a very small portion of a
banks balance sheet,20 so a potential increase of capital would not
be material for the NSFR. Savings deposits already count up to 90%
of the face value and thus almost match-fund assets.
On the asset side, the bank might have too many longer-term
assets which may not be sufficiently saleable or are not adequate
as collateral for secured borrowing. Every possible enhancement
endangers the banks business model. The time to maturity of loans
can only be gradually shortened, as it depends on the loan takers
business needs. Purchasing additional assets with a low RSF factor
is perhaps an option for a liability-driven bank (which would have
otherwise bought assets with less liquidity but higher return). Banks
that give loans to small businesses can hardly switch to residential
mortgages (the RSF factor would improve from 85% to 65%) if it is
not active in this market.
From a technical point of view, the situation is similar to what we
have described for the LCR but with a remarkable difference: the
LCR is constructed in such a way that any compliance transaction
needs to be replicated to keep the balance equilibrium intact (eg, an
HLA asset needs to be funded), whereas for the NSFR the bank has
275
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LIQUIDITY MODELLING
the possibility to gradually adjust its balance sheet within a year to

suit the NSFR.
The simplest but possibly most expensive measure would be to
match-fund every asset until the end of its tenor. The NSFR can be
fixed for now with a funding that is just longer than one year
but its positive effect will diminish when its maturity drops below
one year and will preserve this negative effect until it matures.21 If
the bank increases its balance sheet and purchases an asset with a
low RSF factor to improve the NSFR, the positive effect will only
fully function if the ASF factor of the corresponding funding is high
enough. If the bank buys short-term corporate bills (an RSF factor
of 0) and simultaneously acquire less stable demand deposits, the
effect will be +80%; whereas, in the case of unsecured wholesale
funding, the advantage drops to 50%.
The specific impact depends of course on every banks individual
balance sheet. In general, it can be said that the NSFR is enhanced if
less stable funding is substituted by more stable funding and assets
that require more stable funding are replaced with assets that require
less stable funding.
CONCLUSIONS
Basel III sets out the regulatory minimum requirements for the mea-
surement and management of liquidity risk. It is a big step forward
for the inclusion of liquidity risk in the overall risk management
process. Basel III allows and entails from each bank the implemen-
tation of individual liquidity methods that are adapted to the con-
crete situation and business model of the bank but correspondingly
defines the framework and parameters to be applied. The measures
of Basel III relate primarily to illiquidity risk and not to liquidity-
induced value risks. The term structure is very raw: the LCR relates
to the period of one month, while the NSFR covers a period of one
year; however, the main parts of the illiquidity risk methods, FLE
and CBC, are integrated into the concept.
The regulatory constraints come as traditional ratios, which
makes the conceptions a little technically cumbersome: cash out-
flows are positive and, instead of the worst liquidity situation within
the 30 days of the LCR, the end of the time interval is regarded. In
particular, the LCR comes in the form HLA / TNCO > 100%, which
can be expressed as HLA > TNCO or, in our notation CBC > FLE.
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The HLA is a simplified version of the CBC: the liquifiability classes

are rigidly restricted to HLA1 , HLA2 and not eligible. The liquifi-
cation process is likewise extremely simplified: the value of an asset
in the HLA is multiplied by a haircut and thus represents a hypo-
thetical cash inflow with indefinite time of occurrence. On the one
hand, the banks will improve the liquifiability of their asset hold-
ings, which is strongly correlated to the quality of these assets; on
the other hand, the HLAs will generate additional costs for the banks,
which have entered into the funding incongruities in order to gen-
erate additional income and thus improve their poor profitability.
As an overall economic effect, it is likely that in a future crisis the
markets will regard all assets that are not HLA-eligible as illiquid.
In the TNCO, cash outflows and inflows are opposed, although
cashflows in the sense of the LCR are not cashflows in the under-
standing of this book but are rather adjusted outstandings of assets
or liabilities with plus and minus signs.
The regulation uses a scenario which is implicitly given by its
parameters; there are, however, no other scenarios. The uncertainties
of the future liquidity situation are aggregated into a single condition
that caps the offsetting inflows at 75% of the outflows, thus reflecting
generically that inflows are not under the control of the bank and
are therefore less certain than outflows.
The potential effect of the LCR and the NSFR on a banks balance
sheet is immense: banks have in the past tried to generate additional
income by skewing longer assets with shorter liabilities. Basel III
forces them to cover these mismatches with asset holdings that can
be easily liquified. This process will reduce funding incongruities
and thus illiquidity risk; but even if a bank were to decide to match-
fund all assets, the 75% rule would require the bank to hold a certain
amount of HLAs which will produce costs.
The NSFR supports resilience over a longer time horizon by forc-
ing banks to use more stable sources of funding on an on-going basis.
The crux of the matter is the parameterisation: in the ASF, stable
non-maturing or term deposits are assumed to roll over with 90%;
which means that less than 1% are assumed to irrevocably flow out
within a month: this seems to be highly optimistic in a crisis scenario.
Therefore, the costs of these deposits might increase sharply because
of the competition among banks, and thus reduce the income from
these instruments which has been a pillar of profit for banks with the
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LIQUIDITY MODELLING
corresponding business model. During the 2008 crisis the owners of

savings deposits and similar instruments believed the affirmations
of the governments that their funds would be secure in the troubled
banks. In a future liquidity crisis, the ability of the governments to
protect depositors might be cast into doubt and thus can lead to
bank runs. On the RSF side, several asset categories are assumed to
be self-financing, which either means that a liquidity crisis will not
last for a full year or the NSFR contradicts the assumption in the
LCR that only HLAs can be used for liquification purposes.
Finally, the liabilities in the ASF are assumed to be rolled over
at least to a certain degree, but the assets are not expected to be
renewed. Either the bank is assumed to cease dealing in credits or
the roll-over assumption in the NSFR is inconsistent.
In summary, Basel III is in line with the liquidity measurement
methods used by the more sophisticated banks but, due to its restric-
tion in complexity, it is only a basic standard and not a fully fledged
liquidity management methodology, which will it make difficult to
integrate into more refined approaches. The parameterisation is crit-
ical: many banks perceive it as too restraining, whereas from an
academic point of view it is possibly not preventive enough.
1 All HLAs should ideally be central bank eligible, but not every central-bank-eligible asset is
automatically an HLA.
2 RWA denotes risk weight asset under the Basel II standardised approach.
3 The HLAs are naturally positive numbers; the cash outflows in this context, however, need
to include also a + sign, because otherwise the left-hand side of the inequality, which has
to be greater than 1, would be negative.
4 The eligibility criteria in Basel III are not identical to the ECB eligibility criteria.
5 The LCR only regards maturities within the 30-day horizon. However, it is not the real
maturity that counts, but the modelled tenors of assets and liabilities which have no specific
maturity date.
6 Even match-funded transactions can cause affect the LCR: different roll-off factors for the
asset (respectively, the liability) can result in significant cliff-effects, when match-funded
pairs of cashflows are running down (eg, covered bonds).
7 If the standing of the bank weakens in a potential counterpartys view, the credit risk of
making a deposit with the bank is far higher than entering into an interest rate swap with it.
Consequently, interest rate hedging will still be possible for the bank (though costly) when
the possibility to fund with longer term deposits has already ceased.
8 In practice it is not so clear how this can be done, as, for example, the tenor of a loan with an
embedded extension option for the loan taker is not unequivocally determined and can thus
not be match-funded in a straightforward way.
9 Financial bonds and equities in particular do not qualify as HLAs.

10 For liability-driven banks this might be different.
11 For example, contingent liquidity risks such as drawings on credit or liquidity facilities.
278
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12 The line items on p. 32ff in the Basel III Liquidity document.
13 The type of customer is another dimension which is very important for the LCR and can be
used as a steering instrument, since different roll-over assumptions are applied to different
types of counterparts. For the current view on tactical improvements we can, however, not
assume that changes of customer types can be immediately be realised.
14 When the residual maturity of the security is less than 30 days The HLA move from the buffer
into the inflows (TNCO) (LCR line item 203).
15 Changes to counterparts with higher roll-over factors would also help, but can only be
executed in a longer perspective.
16 The treasury has internally match-funded the originated transaction for the originator, which
does not necessarily mean that it has externally match-funded its own position.
17 Free limit for investment in HLA2 must be available.
18 In reality, the risk-adjusted return of the risk-free bond can even be higher than that of the
risky bond, as banks that try to generate higher term income (for accounting purposes, not on
a value basis) gauge their risk adjustments in such a way that they can accept the yield of
the risky bond. A non-ambiguous method to determine the expected return of a bond would
be to deduct the costs of a credit insurance (CDS) from its yield (assuming that the CDS price
is quoted in the market and not made up internally). This method also highlights that the
risk-free bonds are not risk-free (their CDSs do not come a zero cost) but are only the best
approximation that can be found in the market.
19 In fact, we need 33.33, as the 25% additional HLA is not sufficient as its funding is also
detrimental for the TNCO. If we purchase a 100%/3 = 33.33% new HLA and match-fund it,
we get LRC = 100%.
20 Deutsche Bank reported end-of-2008 assets of 2,202 billion and a capital of 31.9 billion,
which is less than 1.5%.
21 Unless the borrowing is prolonged.
279
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Index
(page numbers in italic type relate to tables or figures)
A Basel III, 24979

available stable funding 273,
asset flows, cashflows and 273
inventories, 1057 CBC in, 160
asset and option inventories, liquidity coverage ratio
interaction between, 1045 (LCR), 25172
assets and liabilities, yield bad, reasons for, 25760
curves for, 2234 examples of
improvements to 264, 265,
B 266
idea and realisation of,
banking crisis 2008, 39
2527
Basels initial reaction to, 249
improvements to, by bank,
historical risk models fail
25772
during, 3
instantaneous
see also Basel III
improvements to, 26172
banks:
possible strategies to
assets of, capital agglutinated
comply with, 26072
to cashflows of, 33
stock of high-quality
balance sheet of, described,
liquid assets, 2512
3541
strategies for future
cashflows, 367
improvement to, 26872
financial transactions,
tactical improvements to
payments and nostro
260
accounts, 356
forecasts and scenarios, total net cash outflows, 252
3841 liquidity related part of 251
uncertainty and risk, 378 liquidity risk in, 250
critical question for, 12 and net stable funding ratio
and financial transactions (NSFR), 2726
and balance sheets, 1112 idea and realisation of,
liquiditys importance to, 2745
1118 required stable funding,
and income, expense and 274
earnings, 1213 steering of, by bank, 2756
and time value of structure of 250
payments, 1314 bidoffer spread, 245
base case, 39 widening of, increasing
Basel Committee on Banking illiquidity reflected by, 25
Regulation, 209 bilateral interbank clearing, 207
Basel Committee on Banking blocked securities, 1367
Supervision (BCBS), 249 bootstrapping algorithm, 58, 224
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LIQUIDITY MODELLING
breach of contract, 170 central banks, liquidity of

by correspondent bank, 2023 markets for funds of, 268
distorted payments due to, 198 collateral and securities flows
wilful, distortion by, 199 and inventories, 107
breach options, 669 conditional transactions, 62
breach-of-covenant transactions, contingent cashflows, 5960
968 contingent transactions and
contractual options, 714
C contractual liquidity options, 74
contractual options, and
capital:
contingent transactions,
cashflows agglutinated to, 33
714
and liquiditys importance to
contractually contingent
banks, 1517
transactions, 98
as opaque concept, 15
counterbalancing capacity
and value and risk, 1617
(CBC), 11765
as buffer for liquidity risk,
323 in Basel III, 160
cashflow(s): basic, forward cashflows and
agglutinated to capital, 33 inventories establishing
and asset flows and 128
inventories, 1057 basis of, for a single security,
capital agglutinated to, 33 126
of conditional transactions, 89 and building blocks of a
contingent, 56, 5960, 89, technical solution, 12637
11112, 1878, 18990 admissible portfolio of
from contractual transactions, securities, determining,
89 126
deterministic, 55, 82 blocked securities, 1367
discussed, 367 for single security, 12636,
external and internal, 112 131, 132, 133, 134, 135
as forecast of future payment, and classes of securities,
46 solving problem for,
as function of time, 11213 13757
generated by rejectable implementation, 138
liquidity options, 89 liquifiability
non-deterministic, 5660 classes/liquidity units,
at risk, 60 1378
stemming from short selling, stepwise solution, 138
remark on, 158 components of, 1214
taxonometry of, 11013 concept, extension of, 1601
time-correlated, 113 contractual elements of, 1212
timelines of contracts and 177 defining strategy for, 13942
of unenforceable disjunct liquidity units for
transactions, 89 125
variable, 567 and European Central Bank
CBC, see counterbalancing (ECB) open market
capacity (CBC) operations, 1567
282
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INDEX
and forward liquidity dynamic modelling, 613

exposure (FLE), 1245, 157 and conditional
further issues regarding, transactions, 62
15762 and endogenous
future cashflow (FCF) of, for transactions, 62
individual securities, 155 and exogenous
and liquidity buffers, transactions, 63
reduction to, 1612 and hypothetical
and liquidity risk transactions, 61
requirements, 11819 and replacement
and liquification, 1423 transactions, 62
null scenario before, 143 and unenforceable
and measuring illiquidity transactions, 623
risk, 456
and mitigation of account E
balances, 212
in narrower sense, 1256 Einstein, Albert, 53
practical considerations of, endogenous transactions, 623
1234 and dynamic modelling, 62
problem of, discussed, 11926 parent and child, 62
rejectable liquidity options in, European Central Bank (ECB),
1223 49
specific transactions, open market operations of,
treatment of, 155 1567
strategy, definition of, 1201
example bond, forward asset
covenants: flows and inventories of
breach of, 968 127
liquidity-option, 75
excess liquidity, 27, 28
option, inventories and flows
exogenous transactions, 63
of, 99107, 100, 101
exposure and strategy scenarios,
as options on options, 69
8891
taxonometry of, 10713
exposure, risks stemming from
credit facility, simplified data
uncertainty about, 38
model of 71
credit risk:
F
of correspondent bank, 2012
distortion of payments by, 198
financial and liquidity options,
currencies, forward liquidity
656
exposure in, 44
financial crisis, 2, 3, 39, 44, 62
D financial instruments and
markets, liquidity risk of,
discount factors, (net) present 225
values and internal rates, forecast-at-risk, 579
2256 forecasting process, risks
disjunct and complete stemming from
hierarchies of liquidity uncertainty about, 38
units, 845, 85 forecasts, and scenarios, 3841
283
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LIQUIDITY MODELLING
forward asset flows and I

inventories of an example
bond 127 IKB, 2
forward liquidity exposure illiquidity:
(FLE), 416, 50 and insolvency, 202
continuous/enhanced, 1758 time dimension lacked by, 20
and counterbalancing illiquidity inequality:
capacity (CBC), 1245 first, 45
and deterministic cashflows, second, 50
55 illiquidity risk, 14, 33, 45
enhanced, intra-day liquidity additional considerations
risks (ILRs) that go concerning, 4750
beyond, 1917 as consequential risk, 1
and payments with very and foundations of
short notice, 1912 modelling, 3552
and uncertainty about measuring, 34, 4150
payments already and counterbalancing
received, 1935 capacity, 456
and uncertainty about forward liquidity
payments not yet exposure, 414, 42, 43
received, 1923 illiquidity risk solution,
enhanced, measurement of template for, 79116
intra-day liquidity risk and inventories and flows,
(ILR) with, 18991 99107, 100, 101
intra-day liquidity risk (ILR) of option covenants,
that can be captured with, 99102
1778 of transactions, 1037
intra-day liquidity risk (ILR) and liquidity (risk) drivers,
that cannot be captured 867
with, 178 and taxonometry, 10713
TNCO versus 255, 256 of covenants, 107
unequivocal determination of transactions, 10810
of, 53 scenarios, 8091
forward rate and forecast at risk, comprehensiveness, 812
579 dependency, 834
and disjunct and complete
G hierarchies of liquidity
units, 845
Group of Ten (G10), 2089
exposure and strategy,
Group of Twenty (G20), 249
8891
H how realistic?, 878
liquidity units, 82
Herstatt risk, 2089 null, 82
high-quality liquid assets and simulations, 801
(HLA), 23, 160 uniqueness and
hypothetical transactions: consistency, 81
and dynamic modelling, 613 and technical
types of, 61 implementation, 919
284
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INDEX
and example of credit measurement of, within an

facility, 98 enhanced FLE or
and hierarchies of bank, 94 separately, 1889
and portfolios, selections, and minimum reserve, role
inventories and flows, 913 of, 20910
and selections and and non-financial
hierarchies, 93 transactions, 1901
and transactions, 949 and nostro, insufficient
incorrectly captured deals, 190 coverage of, 2001
individual securities, and operational risk,
liquification of, 149 distortion by, 198200
initial value, risks stemming other issues concerning,
from uncertainty about, 38 197200
insolvency, and illiquidity, 202 and payment process, 17888
interest-rate effects, in forward and payment process,
liquidity exposure, 44 idiosyncratic risks of,
interest-rate hedging, 2312 20610
and payments to correct
intra-day deals, 190
beneficiary bank, 197
intra-day liquidity risk, 167217, 169
and payments to wrong
and banks incorrect
beneficiary bank, 196
payments, 1957
and real-time gross
and bilateral interbank
settlement systems, 207
clearing, 207
and risk as result of
and breach of contract by uncertainty, 1734
correspondent bank, 2023 and risks related to
and clearing that is effective correspondent banks,
only at end of day, 207 2006
and continuous/enhanced and time splinter risk, 202
FLE, 1758, 177 and time-zone splinter risk
and credit risk of (Herstatt), 2089
correspondent bank, 2012 and timed payments, 208
and credit risk, distortion of and vostro risk, 2036, 204
payments by, 198 and wilful breach of contract,
and direct debit, 208 distortion by, 199
and distorted payments due inventories and flows, 99107,
to breach of contract, 198 100, 101
and distortion by wilful collateral and securities, 107
retention of payments, 199 of transactions, 1037
and financial risk 172, 1723 and asset and cashflows,
going beyond enhanced FLE, 1917 1057
and Herstatt risk, 208 assets and liabilities, 1034
and incorrectly captured and interaction between
deals, 190 asset and option, 1045
and intra-day deals, 190
L
and late deals, 190
measurement of, with late deals, 190
enhanced FLE, 18991 Lehman Brothers, 199
285
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LIQUIDITY MODELLING
liquidity: strategies for future

contractual options, 74 improvement to, 26872
excess, 27, 28 tactical improvements to 260
forward exposure of (FLE), total net cash outflows, 252
416, 50 liquidity option covenants, 75
and deterministic liquidity risk:
cashflows, 55 in Basel III, 250; see also
unequivocal Basel III; regulation
determination of, 53 capital as buffer for, 323
importance of, in a bank, explained and discussed,
1118 1934
and capital, 1516 of financial instruments
of markets, for central and markets, 225
bank funds, 268 and illiquidity, 1922
importance of, to banks, intra-day, 167217, 169
1118
and banks incorrect
and income, expense and
payments, 1957
earnings, 1213
and bilateral interbank
and time value of
clearing, 207
payments, 1314
and breach of contract by
of markets for funds of
correspondent bank, 2023
central banks, 268
and clearing that is
option covenants, 75
effective only at end of
rejectable options, 756
day, 207
units, 82
and continuous/enhanced
disjunct and complete
FLE, 1758, 177
hierarchies of, 845
example of possible and credit risk of
hierarchy, 85 correspondent bank, 2012
value risk induced by, 2832 and credit risk, distortion
liquidity-at-risk (LaR), 3 of payments by, 198
liquidity buffers, reduction to, and direct debit, 208
1612 and distorted payments
liquidity coverage ratio (LCR), due to breach of contract,
25172 198
bad, reasons for, 25760 and distortion by wilful
examples of improvements to retention of payments, 199
264, 265, 266 and financial risk 172,
idea and realisation of, 2527 1723
improvements to, by bank, going beyond enhanced
25772 FLE, 1917
instantaneous improvements and Herstatt risk, 208
to, 26172 and incorrectly captured
costs of, 26372 deals, 190
possible strategies to comply and intra-day deals, 190
with, 26072 and late deals, 190
stock of high-quality liquid measurement of, with
assets, 2512 enhanced FLE, 18991
286
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INDEX
measurement of, within an other risks compared with,

enhanced FLE or 46
separately, 1889 and pricing of risk transfer,
and minimum reserve, 2389
role of, 20910 as result of uncertainty, 174
and non-financial types of, 1745
transactions, 1901 wide field, scarcely covered, 6
and nostro, insufficient liquidity transfer pricing, 21948
coverage of, 2001 basic concepts of, 2203
and operational risk, for assets and liabilities,
distortion by, 198200 2223
other issues concerning, funds pricing: flat, mixed
197200 rate, 221
and payment process, individual, 2212
17888 methods, 220
and payment process, and payments and
idiosyncratic risks of, cashflows of transactions,
20610 223
and payments to correct components, summary of,
beneficiary bank, 197 242, 243
and payments to wrong and liquidity risk limits, 242,
beneficiary bank, 196 2445
and real-time gross regulatory requirements,
settlement systems, 207 2457
and risk as result of and replicating transaction,
uncertainty, 1734 deterministic costs of,
and risks related to 22336, 228, 229, 230
correspondent banks, and assets and liabilities,
2006 yield curves for, 2234
and time splinter risk, 202 and changing nominal
and timed payments, 208 amounts, 228, 229, 230
and time-zone splinter and discount factors, (net)
risk, 2089 present values and
and vostro risk, 2036, 204 internal rates, 2256
and wilful breach of and funding matrix,
contract, distortion by, 199 2324, 233
measurements of, 1718 and funding in other
mitigation of, 21013 currencies, 2345
of account balances and and interest-rate hedging,
the counterbalancing 2312
across time, 211 and liabilities, replication
between multiple of, 231
currencies, 21011 and other deterministic
between multiple nostros costs, 2356
in one currency, 210 and risk-neutral/
capacity, 212 structural yields, 2245
and collateral, double and structural liquidity
counting of, 21213 premium, 22631
287
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LIQUIDITY MODELLING
of risk, 23642 nostro, insufficient coverage of,

and credit, operation and 2001
market risk, 2378 null scenarios, 82, 143, 1525, 153
credit risk, 240
and expected and O
unexpected risk, and
economic capital, 2367 operational risk, distortion by,
and liquidity risk, 2389 198200
and originated optionality:
transaction, price of modelling, 7076
uncertainty of, 23640 and contractual options
and risk mitigation, effects and contingent
of, 2402 transactions, 714
and secondary risk types, role of, 6370
239 options:
and uncertainties from breach, 669
unreplicated relative contractual, and contingent
values, 23940 transactions, 714
liquidity units, 82 contractual liquidity, 74
example of possible financial and liquidity, 656
hierarchy, 85 liquidity (covenants), 75
liquifiability class, synthetic on options (covenants), 6970
security of, 1434 rejectable liquidity, 756
liquifiability classes/liquidity typical life cycle of, 734, 73
units, 1378
liquification algorithm, 1478 P
illustration of 154
payment process and intra-day
M liquidity risk, 17888, 179,
180, 182
markets, liquidity of, for central and bank as payment agent,
bank funds, 268 183
modelling: and cashflows, 1838, 185
dynamic, and hypothetical internal and external, 187
transactions, 613 from deal to cashflow to
foundations of, and payment, 1846
illiquidity risk, 3552 execution in a bank, 1823
indirect, 183
N processing, 18081
settlement, 179
net stable funding ratio (NSFR), uncertainties, 181, 1878
2726 payments, time value of, 1315
idea and realisation of, 2745 and present-value concept,
required stable funding, 274 implicit assumptions in,
steering of, by bank, 2756 1415
non-deterministic cashflows, portfolios, selections, inventories
5660 and flows, 913
288
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INDEX
present-value concept: credit risk, 240

and credit v. liquidity risk, 15 and expected and unexpected
and time value of payments, risk, and economic capital,
1415 2367
and liquidity risk, 2389,
R 2412
and originated transaction,
reduction to liquidity buffers, price of uncertainty of,
1612 23640
regulation: and risk mitigation, effects of,
and Basel III, 24979 2402
available stable funding, and secondary risk types, 239
273, 273 and uncertainties from
and idea and realisation of unreplicated relative
NSFR, 2745 values, 23940
and liquid assets, risks related to correspondent
high-quality, 2512 banks, 2006
liquidity coverage ratio credit risk, 2012
(LCR), 25172 insufficient coverage of
liquidity related part of, nostro, 2001
251
S
liquidity risk in, 250
and net stable funding Sachsen LB, 2
ratio (NSFR), 2726 saleability, term structure of, 147
and required stable scenario dependency, 834
funding, 274 scenario, risk-management
and steering of NSFR, by use of, 39
bank, 2756 scenarios:
structure of, 250 and forecasts, 3841
counterbalancing capacity passive or active future
(CBC) and Basel III, 160 behaviour modelled by, 40
see also Basel III scenarios for illiquidity risk
rejectable liquidity options, 756 solution, 8091
replacement transactions, and comprehensiveness, 812
dynamic modelling, 62 dependency, 834
repoability, term structure of, liquidity units, 825
147 disjunct and complete
repos in synthetic bonds, 137 hierarchies of, 845
risk exposures, compensation null, 82
of, 45 and simulations, 801
risk mitigation, effects of, 2402 uniqueness and consistency,
credit risk, 240 81
liquidity risk and cost securities lending, expressing
thereof, 2412 blocking with, 137
risk, transfer pricing of, 23642 Sombart, Werner, 16
and credit, operation and structural liquidity premium,
market risk, 2378 22631
289
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LIQUIDITY MODELLING
sub-prime securities, 2, 201 typical life cycle of an option 73,

survival horizons, 15860, 159 73
synthetic bonds, repos in, 137
synthetic security, 142, 145, 146 U
of liquifiability class, 1434 uncertainties, 5378
structural position in, 145 and cashflow at risk, 60
and contingent cashflows,
T 5960
and forward rate and forecast
taxonometry, 10713 at risk, 579
of cashflows, 11013 and payments already
of covenants, 10713 received, 1935
of transactions, 10810 and payments not yet
term structure of saleability, received, 1923
repoability, 147 stationary modelling of,
theoretical price, 235 passim 5460
theory, Einsteins stipulation and deterministic
concerning, 53 cashflows, 55
time-correlated cashflows, 113 and non-deterministic
time splinter risk, 202 cashflows, 5660
time value of payments, 1315 and variable cashflows,
and present-value concept, 567
implicit assumptions in, uncertainty, risk as result of,
1415 1734
time-zone splinter risk unenforceable transactions, 623
(Herstatt), 2089 uniqueness and consistency in
transactions: scenarios, 81
accumulated, across unreplicated relative values,
covenants, 110 uncertainties from, 23940
active, 1089
aggregated, with one V
covenant, 109 value-at-risk (VaR), 3
and forward asset flows and value-liquidity-at-risk (VLaR),
inventories of an example 2832, 30, 31
bond, 127 value, risk and capital, and
pseudo- 108 liquiditys importance to
as result of options, 64 banks, 16
cashflow-generating value risk, liquidity-induced,
function of, 39 2832
taxonometry of, 10713 variable cashflows, 567
see also conditional vostro payments, risks
transactions; endogenous stemming from, 2036, 204
transactions; exogenous
transactions; replacement W
transactions;
unenforceable transactions Weber, Max, 16
290
i i
i i

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Liquidity risk is hard to understand.

It needs Robert Fiedler is one of a handful of

In this comprehensive guide to modelling by Robert Fiedler

Liquidity Modelling is required reading

This book has been

liquidity modellingCS4.indd 1 15/11/2011 10:39

fiedler_reprint 2012/8/10 13:44 page i #1

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Published by Risk Books, a Division of Incisive Media Investments Ltd

2011 Incisive Media

Publisher: Nick Carver

fiedler_reprint 2012/8/10 13:44 page v #5

I dedicate this book to my father, Edvard Fiedler

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2 Setting the Scene: Why Liquidity Is Important in a Bank 11

3 What Is Liquidity Risk? 19

4 Illiquidity Risk: The Foundations of Modelling 35

6 A Template for an Illiquidity Risk Solution 79

7 The Counterbalancing Capacity 117

8 Intra-Day Liquidity Risk 167

9 Liquidity Transfer Pricing and Limits 219

10 The Basel III Banking Regulation 249

fiedler_reprint 2012/8/10 13:44 page viii #8

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About the Author

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This is a second impression of the first edition, which has been

PREFACE TO THE FIRST EDITION

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At that time, value-at-risk (VaR) techniques had been commonly

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fiedler_reprint 2012/8/10 13:44 page 1 #15

WHAT IS THIS BOOK ABOUT?

ILLIQUIDITY RISK: A RISK TYPE OF ITS OWN?

fiedler_reprint 2012/8/10 13:44 page 2 #16

Let us look at banking history: in the summer of 2007 the prices of

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MEASURING ILLIQUIDITY RISK: WHAT IS THE PROBLEM?

fiedler_reprint 2012/8/10 13:44 page 4 #18

To ensure the inclusion of risks which come to the fore as a result

COMPARING THE MEASUREMENT OF LIQUIDITY AND OTHER

the probability of losing more than 1 million is X,

the probability of this client defaulting is Y,

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given an error probability of 0.5%, the maximum loss in this

In illiquidity risk, however, we will not be able to give comparable

providing such a probabilistic answer would require the esti-

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WHAT IS COVERED BY THIS BOOK?

fiedler_reprint 2012/8/10 13:44 page 7 #21

transactions and its cashflows as forecasts for future payments, as

fiedler_reprint 2012/8/10 13:44 page 8 #22

us to describe the mechanics of future balance-sheet progressions

fiedler_reprint 2012/8/10 13:44 page 9 #23

specific to liquidity risk are modelled and integrated, allowing the

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Setting the Scene: Why Liquidity Is