P2.T7.303. Liquidity and Leverage (Malz)

[Fran]

Questions:

303.1. Your colleague Peter blames the fragility of commercial banks primarily on the fractional-reserve banking system. He argues that fractional-reserve banking exposes a bank to the threat of a general loss of confidence in its ability to pay out depositors. In an extreme scenario, this can result in the notorious "bank run," but problems can manifest short of the extreme scenario. He cites four examples of initiatives or actions that can mitigate this threat caused by fractional-reserve banking. Which of these is the LEAST persuasive?

a. Higher regulatory capital requirements
b. Implementation of the Volker Rule
c. Increase in (shift toward greater mix of) funding via commercial paper
d. Better asset-liability management (ALM) including shorter-duration assets

303.2. Each of the following is true about markets for collateral EXCEPT which is false?

a. Collateral markets enable the ability to establish leveraged positions in securities
b. Collateral markets enhance the ability of firms to borrow money
c. Collateral markets include three economically similarly but different in legal form and market practice: margin loans, repurchase agreements, and securities lending
d. While collateral markets do comprise credit and counterparty risk, they neither comprise market risk nor enable short-selling

303.3. A bank has a simple two-class capital structure, one class each of debt (D) and equity (E) such that Assets (A) = D + E. It's fixed return on assets, ROA, is 5.0% and its fixed cost of debt of 4.0%. The bank's investors have a hurdle rate which is a required rate of return on equity (ROE). Their ROE hurdle rate is 15.0%. If leverage ratio is defined as Assets/Equity per Malz, what is the minimum implied leverage ratio needed by the bank?

a. 6.7
b. 11.0
c. 15.5
d. Need more information; i.e., Asset size

Answers:

• Here in Forum

 

[Roshan Ramdas]

Hi David,
I wasn't able to find any questions on "Liquidity and Leverage (Malz)" under the Operational Risk Management module of the study planner. Just noticed that that this forum thread has a few questions on this chapter. Are there any more questions for this chapter please ?
Thank you

 

[Roshan Ramdas]

Hi David,

Need your help please on one of the AIMS under Liquidity and Leverage (Malz) - "Calculate the LVAR for a position to be liquidated over a number of trading days".

There is a formula in there which I think I understand, but need to just double check with you.

Could you please validate the working under Column E of the attached file,....I've basically reproduced the LVAR calculation from the BT workbook pertaining to chapter "Liquidity and Risk" by Kevin Dowd and tried to scale VAR for a period of 6 days.

Thank you

 

[David Harper CFA FRM]

Hi @Roshan,

Yes, that's excellent! ... and I would like to incorporate your idea into a revision of the learning XLS. Indeed, it looks correct as, for example, given a liquidation time horizon of 6 days (T = 6), I also get an adjustment of sqrt[(1+6)*(1+2*6)/(6*6)] = 1.590.

There is one important caveat: This adjustment, introduced by Malz not Dowd (as you are clearly aware due to your attempt to reconcile them in the first place!), which multiplies the daily VaR by sqrt[(1+T)*(1+2*T)/(6*T)] is an endogenous-price approach. That is, it attempt to quantify the exit trade's impact itself on the asset price, so it is a sort of alternative to Dowd's usage of price elasticity (both have in common the assumption that endogenous liquidity adjustments are only necessary if the position is large enough, relative to the market, such that exiting the position will depress the price and adversely impact the seller).

That's why, in my opinion, you are justified in multiplying by the already-calculated "LVaR-constant spread" because, by doing so, you are effectively estimating a liquidity adjusted VaR that aims to account for both exogenous (where bid-ask spread is an indicator) and endogenous (where "days to orderly exit" or price elasticity [per Dowd]) liquidity risks. As Dowd somewhere fully says, they are not substitutes, in theory it is perfectly sensible to include them both. I hope that helps, thanks!

 

[Roshan Ramdas]

Hi @Roshan,

Yes, that's excellent! ... and I would like to incorporate your idea into a revision of the learning XLS. Indeed, it looks correct as, for example, given a liquidation time horizon of 6 days (T = 6), I also get an adjustment of sqrt[(1+6)*(1+2*6)/(6*6)] = 1.590.

There is one important caveat: This adjustment, introduced by Malz not Dowd (as you are clearly aware due to your attempt to reconcile them in the first place!), which multiplies the daily VaR by sqrt[(1+T)*(1+2*T)/(6*T)] is an endogenous-price approach. That is, it attempt to quantify the exit trade's impact itself on the asset price, so it is a sort of alternative to Dowd's usage of price elasticity (both have in common the assumption that endogenous liquidity adjustments are only necessary if the position is large enough, relative to the market, such that exiting the position will depress the price and adversely impact the seller).

That's why, in my opinion, you are justified in multiplying by the already-calculated "LVaR-constant spread" because, by doing so, you are effectively estimating a liquidity adjusted VaR that aims to account for both exogenous (where bid-ask spread is an indicator) and endogenous (where "days to orderly exit" or price elasticity [per Dowd]) liquidity risks. As Dowd somewhere fully says, they are not substitutes, in theory it is perfectly sensible to include them both. I hope that helps, thanks!

Thank you David !!!

 

[HFlei5545]

Questions:

303.1. Your colleague Peter blames the fragility of commercial banks primarily on the fractional-reserve banking system. He argues that fractional-reserve banking exposes a bank to the threat of a general loss of confidence in its ability to pay out depositors. In an extreme scenario, this can result in the notorious "bank run," but problems can manifest short of the extreme scenario. He cites four examples of initiatives or actions that can mitigate this threat caused by fractional-reserve banking. Which of these is the LEAST persuasive?

a. Higher regulatory capital requirements
b. Implementation of the Volker Rule
c. Increase in (shift toward greater mix of) funding via commercial paper
d. Better asset-liability management (ALM) including shorter-duration assets

303.2. Each of the following is true about markets for collateral EXCEPT which is false?

a. Collateral markets enable the ability to establish leveraged positions in securities
b. Collateral markets enhance the ability of firms to borrow money
c. Collateral markets include three economically similarly but different in legal form and market practice: margin loans, repurchase agreements, and securities lending
d. While collateral markets do comprise credit and counterparty risk, they neither comprise market risk nor enable short-selling

303.3. A bank has a simple two-class capital structure, one class each of debt (D) and equity (E) such that Assets (A) = D + E. It's fixed return on assets, ROA, is 5.0% and its fixed cost of debt of 4.0%. The bank's investors have a hurdle rate which is a required rate of return on equity (ROE). Their ROE hurdle rate is 15.0%. If leverage ratio is defined as Assets/Equity per Malz, what is the minimum implied leverage ratio needed by the bank?

a. 6.7
b. 11.0
c. 15.5
d. Need more information; i.e., Asset size

Answers:

• Here in Forum

hello @David Harper CFA FRM
On fractional reserve banking of this thread, will a full reserve banking (100%) erradicate our typical (FRM) liquidity risk for banks and convert this risk in the normal liquidity risk born by any other company in the non-financial sector?
The maturity transformation characteristic will disappear as all deposits will be matched to their corresponding maturity so as to make a profit e.g. a CD of 1 year will be loaned out to a 1 year term as well, having the profit of the bank spreadwise, asset rate > liability rate.

I will appreciate your insights on this.