Topics covered in Liquidity and Treasury Risk Measurement and Management in FRM Part 2

Liquidity and Treasury Risk Measurement and Management is one of the six broad topics that GARP tests in its FRM Part 2 exam. This broad topic has a 15% weight in the exam. This means out of 80 questions asked, you may expect 12 questions from this section. This area focuses on methods to measure and manage liquidity and treasury risk. The broad knowledge points covered in the Liquidity and Treasury Risk Management section include the following:

• Liquidity risk principles and metrics
• Liquidity portfolio management
• Cash-flow modeling, liquidity stress testing, and reporting
• Contingency funding plan
• Funding models
• Funds transfer pricing
• Cross-currency funding
• Balance sheet management
• Asset liquidity

There are nineteen chapters or readings in this section. If you go through the GARP specified learning objectives (LOs) for this section, you will find a good mix of computational and non-computational LOs. As GARP generally asks tricky questions from the non-computational LOs, non-computational LOs are to be equally emphasized to score well in this section.

Let’s go through the essence of each of the nineteen chapters or readings and identify the concepts that GARP might test on exam day.

Chapter 1: Liquidity Risk

Liquidity is enormously vital for a financial institution, as it must be able to meet its cash needs as they fall due. For the exam, focus on the following:

• Concept of liquidity, the costs of liquidation, and the risks (including value at risk) associated with trading in normal and stressed markets
• Liquidity funding risk, the primary sources of liquidity for a financial institution, and how real firms have been undone by a lack of appropriate liquidity management practices
• Basel III’s key liquidity risk equations and the Bank for International Settlements’ 17 principles associated with liquidity risk management
• Liquidity black holes and how trading strategies, leverage, and regulations can heavily impact liquidity needs

Chapter 2: Liquidity and Leverage

This chapter analyzes the impacts of liquidity and leverage on firm risk. For the exam, focus on the following:

• The distinction between transactions liquidity and funding liquidity and the role banks play in providing liquidity
• Calculation of a firm’s leverage ratio and the leverage effect
• How to construct the economic balance sheet given trades such as buying stock on margin, selling stock short, and taking positions in derivatives
• Concept of tightness, depth, and resiliency as they relate to liquidity risk

Chapter 3: Early Warning Indicators

Early warning indicators (EWIs) are important in liquidity risk management (LRM). This reading talks about the desirable qualities of EWIs and how EWIs can be applied in an LRM context. For the exam, focus on the following:

• Characteristics of sound EWIs
• Applications and guidelines related to EWIs

Chapter 4: The Investment Function in Financial-Services Management

This chapter starts by looking at the various types of investments, including the money market and capital market assets, and more recently introduced investments. These instruments are different not only in terms of maturity but also in terms of liquidity, return cash flows, and use as collateral. For the exam, focus on the following:

• Why each financial instrument is desirable to investors and what their key disadvantages are
• Factors that affect a bank’s choice of investment securities, include yield to maturity, tax exposure, and various risks (i.e., interest rate, credit, liquidity, etc.)
• Key investment maturity strategies for consideration by investment firms and managers and the two main maturity management tools (yield curve and duration)

Chapter 5: Liquidity and Reserves Management: Strategies and Policies

Liquidity refers to an institution’s ability to meet its cash requirements via access to low-cost, immediately spendable funds. The net liquidity position of an institution is an important calculation, as it strikes a balance between the demand for, and supply of, liquidity. For the exam, focus on the following:

• Different strategies that a bank can use to meet liquidity demands, including assets, liability, and balanced strategies
• Different approaches used to estimate liquidity needs
• How to calculate the amount of legal reserves needed
• Factors that influence legal reserves
• Factors that weigh into choosing between the different sources available to meet reserve needs

Chapter 6: Intraday Liquidity Risk Management

This chapter examines intraday liquidity and starts with the basics of the uses and sources of intraday liquidity. It then discusses the governance structure of intraday liquidity risk management. It concludes with a discussion on the differences between the methods for tracking intraday flows and monitoring risk levels. For the exam, focus on the following:

• Uses and sources of intraday liquidity
• Metrics involved in tracking intraday flows and monitoring risk

Chapter 7: Monitoring Liquidity

Liquidity and cash flow management are of paramount importance to the success and survival of a financial institution. For the exam, focus on the following:

• Two dimensions (time and amount) of cash flows and differences between deterministic and stochastic cash flows
• Liquidity options and the primary impacts these options have on a bank
• Elements of liquidity management–liquidity risks, a bank’s liquidity generation capacity, and sources of liquidity
• Term structures for both expected cash flows and cumulative expected cash flows must be modelled and perpetually managed to ensure solvency
• The bank’s term structure of available assets and the impact various transactions have on this structure

Chapter 8: The Failure Mechanics of Dealer Banks

Understanding the key failure mechanics for dealer banks is important for reducing liquidity and solvency risks. Liquidity risks get augmented when counterparties or prime broker clients doubt the solvency of a large dealer bank and, in turn, restrict their exposure. This increases the liquidity risk and insolvency risk for the bank and systemic liquidity risk for the financial markets in which dealer banks play blended roles. Dealer banks often act as prime brokers, securities underwriters, special purpose entities (SPE), and counterparties in the over-the-counter (OTC) derivatives and repo markets. Diseconomies of scope in risk management and corporate governance came to light during the market crisis of 2007-2008. For the exam, focus on the new policies that were implemented to deal with off-balance-sheet risks, capital requirements, leverage, liquidity risks, clearing banks, and adverse selection effects in “toxic” asset markets.

Chapter 9: Liquidity Stress Testing

This chapter defines various types of liquidity and introduces the liquidity asset buffer to estimate the contingent liability. For the exam, focus on the following:

• Difference between different types of liquidity
• Liquidity stress test design issues, including scope, scenario development, assumptions, outputs, governance, and integration with other models

Chapter 10: Liquidity Risk Reporting and Stress Testing

This chapter focuses on best practices in reporting bank liquidity and conducting stress tests. For the exam, pay attention to the following:

• Specific liquidity reports such as deposit tracker, deposit type and tenor, daily liquidity, mismatch, funding concentration, undrawn commitment, and wholesale pricing and volume
• Reports of daily liquidity and mismatch reports that are related to the survival horizon stress test
  Interpretation of the significance of the survival horizon stress test

Chapter 11: Contingency Funding Planning

Contingency funding plans (CFPs) are intertwined with liquidity stress testing. This chapter is an extension of earlier readings on liquidity risk management, liquidity stress testing, and early warning indicators. For the exam, focus on the following:

• Relationship between a CFP and liquidity stress testing
• Important considerations for a CFP, include governance and oversight, scenarios and liquidity gap analysis, contingent actions, monitoring and escalation, and data and reporting

Chapter 12: Managing and Pricing Deposit Services

This chapter presents deposits as a funding source for financial institutions and talks about the different types of deposits available and the relative benefits and costs of each kind of deposit from the financial institution’s perspective. For the exam, focus on the following:

• Difference between deposit accounts that are used for transactions and deposit accounts that are primarily savings vehicles
• Different approaches to pricing deposit services, including the cost-plus method, the marginal cost approach, and the conditional pricing method
• Calculation of the marginal cost of raising additional funds
• How deposit insurance lowers the bank’s cost of funds
• Social/ethical issues that banks are challenged with

Chapter 13: Managing Non-deposit Liabilities

Financial institutions borrow from money and capital markets to meet funding gaps when deposits are inadequate to cover loan demand and security purchases. This chapter deals with non-deposit funding such as federal (fed) funds, negotiable certificates of deposit (CDs), repurchase agreements, discount window borrowing, commercial paper, Federal Home Loan Bank (FHLB) borrowing, and Eurodollar funding. For the exam, focus on the following:

• Characteristics of each type of funding and the factors that affect the institution’s choice of non-deposit funding
• Calculation of the available fund’s gap and estimation of the cost of total funding using the historical average cost approach and the pooled funds approach

Chapter 14: Repurchase Agreements and Financing

Repurchase agreements, or repos, can be treated as short-term financing vehicles that can be used to borrow/lend funds on a secured basis. Mostly, repos are used for overnight lending. This chapter talks about the mechanics of repos, including settlement calculations, the motivations of market participants for entering into repos, and the risks (credit risk and liquidity risk) that stem from their use. It also talks about collateral types used in repos, including general collateral and special collateral. For the exam, focus on the following:

Characteristics of repo transactions and the primary motivations for using repos

• How and why repos are used in the market
• What risks repos hedge
• What risks arise from repo trading
• How changes in the market environment affect repos

Chapter 15: Liquidity Transfer Pricing: A Guide to Better Practice

This chapter focuses on the best practices in liquidity transfer pricing (LTP) that are suggested by regulatory authorities following the global financial crisis. For the exam, focus on the following:

• How a proper LTP process is structured with a centralized treasury overseeing all wholesale funding
• Why the matched-maturity marginal cost approach is the recommended way to allocate costs, benefits, and risks of liquidity at a granular level to all business units
• How stress tests using scenario analysis of idiosyncratic and systemic shocks are applied for providing an adequate liquidity cushion including potential off-balance-sheet cash outflows such as derivatives and collateral calls
• Why better LTP practices are necessary to ensure that banks do not accumulate illiquid long-term assets that are funded with overnight or short-term funding

Chapter 16: The US Dollar Shortage in Global Banking and the International Policy Response

This chapter provides an important insight into some of the susceptibilities that contributed to the global financial crisis starting in 2007, and the institutional responses that helped handle these pressures. This chapter has three parts: an overview of the banks’ balance sheet structures and an explanation and causes of funding risk; the nature of the U.S. dollar crisis caused by an increase of these funding risks; and the international policy response. For the exam, focus on the following:

• How vulnerabilities in the financial system can best be measured by studying banks’ global consolidated balance sheets and by analysing the maturity mismatches between banks’ U.S. dollar assets and their U.S. dollar liabilities
• How the Fed helped banks tide over the liquidity crisis during the financial crisis with the help of swap network and collateralized arrangements

Chapter 17: Covered Interest Parity Lost: Understanding the Cross-Currency Basis

This chapter poses a direct question: why have deviations from covered interest parity (CIP) persisted since the financial crisis of 2007–2009? The typical finance textbook labels violations of CIP as arbitrage opportunities that arbitrageurs can easily exploit. Hence, CIP should work all the time. However, real-world constraints cause these mispricings to occur and persist. For the exam, focus on the following:

• What is CIP?
• What is the cross-currency basis?
• How the pricing of foreign exchange (FX) swaps and cross-currency basis swaps reflects violations of CIP
• Two main causes of persistent violations of CIP since the financial crisis: increased demand for currency hedges and limits to CIP arbitrage

Chapter 18: Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

This chapter primarily discusses the impact of interest rate changes on bank profitability and capital. Banks mainly use two measures, interest-sensitive gap, and duration gap, for managing their interest rate risk. For the exam, focus on the following:

• Calculation of net interest income, net interest margin, and interest-sensitive (IS) gap
• How a bank’s IS gap is related to the effects of interest changes on its net interest income (NII) and net interest margin (NIM)
• How a bank can manage its IS gap
  Calculation of the duration of an asset and a bank’s duration gap, given the duration of portfolio assets and liabilities
• Limitations of the IS gap and duration gap as risk measures and as tools for managing a bank’s net income, net equity, and risk

Chapter 19: Illiquid Assets

This chapter talks about illiquid asset market characteristics and the relationship between illiquidity and market imperfections. Reported return biases and the illiquidity risk premium within and across asset classes are talked about. For the exam, focus on the following:

Why all markets, even highly liquid markets such as commercial paper, can be illiquid at some point in time
Three biases that impact reported returns of illiquid asset classes (survivorship bias, sample selection bias, and infrequent sampling)
Factors that influence the decision to include illiquid asset classes in a portfolio

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