Liquidity Risk and Crisis - Coursework Example

Liquidity Risk Table of Contents Executive Summary………………………………………………………………………..3 Task A Define liquidity risk. How can liquidity risk be measured?.....................................3 Explain why the regulator would require more liquidity…………………………..4 Task B Illustrate the process of securitization……………………………………………...5 Explain how CDOs may have contributed to the GFC……………………………6 Task C Securitization can affect the liquidity of a bank. Explain how this may be the case…………………………………………………………………………………………..7 Task D Collect time series data on securitization in the Australian banking market. Examine and analyze the data and report. Include which types of ADIs have traditionally securitized assets………………………………………………………8 References………………………………………………………………………………….10 Appendices…………………………………………………………………………………12 Executive summary The recent global crisis of 2007 made the entire financial market topsy-turvy across the globe. However, it also unveiled some of the faulty and non-monitored banking practices prevailing in the financial sector which was actually the budding stage for this fiasco. Australian financial market is being considered as a big market in terms of securities and mortgages. As a result, the economic turmoil had dire repercussions on it and it triggered the need for regulators like Australian Prudential Regulation Authority to put in place structured and legitimate framework and policies for banking practices. In the realm of liquidity crunch being observed and related loopholes, this report is developed with an aim to understand the process of securitization and its impact on liquidity status and reserves maintained by banks and regulators. In addition to it, data is also collected and analyzed on securitization phenomenon taking place in Australian market with focus on ADIs (Authorized Deposit-taking Institutions). A. As part of the reform process from the Global Financial Crisis, APRA is proposing that banks in Australia hold more liquidity in the event of future crises. i. Define Liquidity Risk. How can Liquidity risk be measured? Liquidity, in layman terms, refers to the available cash position. Liquidity risk as such connotes a risk situation where a party holding or about to hold any current asset cannot trade it in the market because of the unavailability of a trading partner or because the asset being considered to be worthless in the market. Thus, in such a situation, the party is not able to trade that asset and extract out its value in monetary terms, which blocks the liquidity position. Liquidity risk can fall in two categories, one where the asset is unable to be traded and secondly when liquid position is not strong enough to pay for the liabilities that have become due. There are two ways by which liquidity risk can be measured: The measure of liquidity gap is used to determine the value of a firm’s liquid assets in excess to its liabilities. This gives an estimate of the firm’s condition to repay its liabilities with available cash position. Another measure of liquidity risk is the liquidity risk elasticity where the change in the value of net assets is measured over funded liabilities using LIBOR rate exchange and other means of paper rates. ii. Explain why the regulator would require more liquidity. The changed landscape of regulation in financial services sector has made regulators more active in their efforts to observe liquidity and risk management more closely. Financial and bank regulators are considered to be last resort for commercial banks (Aspachs, Nier & Tiesset 2005). In normal course of business, banks enjoy a host of funding resources because there are plenty of buyers and sellers in the market. Both cash and credit movement take place which results in good liquidity position for banks. However, in cases of crisis or drastic changes taking place in the macroeconomic scenario, most of the suppliers of liabilities fail to pay their credit and cash obligations, due to which most of the funding sources like government bonds, bank loans and mortgages run dry, making it difficult for individuals to respond to market fluctuations. Here comes the role of the bank and financial services regulator. For APRA, increased ADI liquidity demands call for more structured liquidity framework. Due to fractional-reserve banking model practiced across the globe, it becomes the duty of the regulator to hold enough cash reserves or liquidity reserve because each individual bank is expected to follow a statutory liquidity ratio. When one bank runs dry, the regulator has to sell the assets from other banks or infuse cash into the economy to redeem the deposits so that the chances of a full-scale bank run are eliminated (Deloitte 2009). B. It is suggested that securitization and Collateral Debt Obligations (CDOs) contributed as a cause of the Global Financial Crisis (GFC). i. Illustrate the process of Securitization. Securitization in its very basic sense refers to the marketing of a pool of illiquid assets through repackaging the cash flows which they are expected to generate. It is a means of distributing risk by issuing new securities that will be backed by the asset pool and so securitization process gives rise to Asset-backed Securities (ABS). A step by step illustration of securitization process is given as below: Creating the pool of asset- the seller of the asset creates an asset pool and initiates its sale to some company or trust which is known as Special Purpose Vehicle (SPV). Issuance of securitized paper- how and when the securitized paper is to be issued is looked after by the SPV and depends on the rate of interest that the investors hold on the paper. Determination of credit risk- since the securities are asset backed, the credit risk is determined in advance by ascertaining the interest, redemption and amortization payments of the pool of assets. A graphical representation of the securitization process is as follows (Fig. 1): Fig. 1: Securitization Process Source: http://www.iief.com/Research/debt_chp21.pdf ii. Explain how CDOs may have contributed to the GFC. CDOs or Collateral Debt Obligations played a major role in the Global Financial Crisis. CDOs are like a pool of asset backed securities where similar loans are bundled together and the investor purchasing a CDO becomes entitled to a part of the interest income and the principal amount contained in the CDO. When housing bubble started in 1997, homeowners considered it easier and preferable to purchase home loans or refinance their homes at lower rates. The banks started issuing large number of mortgage loans and creating a pool of these mortgage loans to sell this pool in the form of a CDO to generate cash payments from investors. However, banks and financial institutions failed to judge the credit rating of the borrowers and when housing bubble reached a limit, the investment-grade ratings of the CDOs started to fall, thereby generating lesser cash flows but greater return on the invested amount by the bank, owing to the reduced home prices. By the year 2008, due to declining home prices, the borrowers could not pay the interest amounts and started to default, leading to most of the CDOs and mortgage based securities turning delinquent or foreclosed by the banks. C. Securitization can affect the liquidity of a bank. Explain how this may be the case. The fact that securitization may affect the liquidity status of a bank is based on a basic premise that asset-backed securities are comparatively less liquid than their counterparts. With sharp growth of residential mortgage-backed securities (RMBS) in Australia, securitization seem to be a better funding option, both domestic and off-shore for banks because of the lower deal costs involved (APRA 2009). When the housing market started to grow, the mortgage backed securities proved lucrative to banks to sell to third parties, instead of sticking them to the balance sheets, in anticipation that it would look after their credit risk and also free up their capital engaged. Even relationships with borrowers can be maintained easily. Securitization was seen as a diversification option in lending process (The Free Library n.d). Mostly the securities are of two types, prime and non-conforming. The prime loans are primarily for borrowers with good credit history but constitute low-doc format where much of documentation is not done. Absence of documentary evidence makes this category riskier than full-doc loans. On the other hand, non-confirming loans are mostly higher risk loans because the credit history of borrowers in not very good. Thus, chances of these loans getting repaid fully are not cent percent. Slowly, the securitization market started getting overloaded and when financial turbulence arrived the market, the prices of these mortgages started to decline because of which investors started declining the purchase of such securities. Being illiquid and that too much capital intensive, the bank could not find buyers to dispose off these mortgage-backed securities (Benjamin & Skully n.d). Loopholes in security valuations and inability to judge the accurate credit history of borrowers added fuel to the fire when the entire onus of mortgages and securities pool fell upon backs (Altunbus, Gambacorta & Marques 2007). D. Collect time series data on securitization in the Australian banking market. Examine and analyze the data and report. Include which types of ADIs have traditionally securitized assets. The Australian banking market has seen a revolution in its funding practices in the last decade, owing to the housing bubble and prices of mortgages seeming lucrative. In the following paragraphs, we try to analyze the progress of securitization in the Australian banking market (Bailey, Davies & Dixon 2004). From Fig.2, it is clear that from the trend of creating pool of illiquid assets in Australian banking market has risen in the last 10 years. From bonds and normal loans, the major chunk of assets of banks in Australia is comprised by mortgages with further hike in residential mortgages, owing to the housing sector getting lucrative. Not only the range of securities has broadened but also the amount of assets has also increased rapidly from $10 billion in 1995 to almost $160 billion in 1994. As such, liabilities also comprise mostly asset-backed securities both domestic and offshore (Liaw, & Eastwood 2000). In Fig. 2, the issuance of residential mortgage-backed securities by type of issuer is depicted. It is evident that initially, only specialist mortgage originators hold majority of the mortgage and loan advances because banks were little hesitant in investing all their money in illiquid assets and had other options available for funding. Even Fig. 4 shows that in the year 1985, the composition of house lending in Australia was a meager 2-3 percent. However, it took a steep climb and reached to a level high where most of the housing loans in Australia today are securitized. Fig. 5 and Fig. 6 show that the Australian market has expanded both in volume and diversity terms since the middle of the decade of 90s. While the volume of securities has increased manifold over the years, the portion consumed by overseas funding has also increased proportionately. Again, from Fig. 6, almost entire part of securitized assets in banks comprise of mortgages. Thus, from the above mentioned data and analysis, it is pretty much clear that mortgages and that too, residential mortgages remain the dominating category in the Australian banking market. Moreover, private funding has also increased dramatically due to the reduced governmental and regulatory restrictions on private sector banking practices. Low interest rates coupled with reduction in government debt and forces from demand side of housing loans, ADIs or Authorized Deposit-taking Institutions were compelled to enter the market in order to respond to the competitive trends and match the supply with the demand. APRA announced revised prudent guidelines as to the involvement of ADIs in asset-backed securities market and this resulted in ADIs capturing around 40% of the RMBS and 35% of the overall securities market in Australia. (Fig. 7) In securitizing the assets, all types of ADIs have been active. From regional banks to foreign subsidiary banks, Australian owned banks, branches of foreign banks and CUBS (credit unions and Building Societies) have played active role. In the beginning, the majority of the securitization process was undertaken by specialist mortgagers but later on, CUBS and major and regional banks also forayed into the market garnering a good pie of the total share (APRA n.d). References APRA (2009, Sep 11). APRA’s Prudential approach to ADI Liquidity Risk. Retrieved April, 6, 2010 from http://www.apra.gov.au/Policy/upload/ADI_DP_PALR_092009_v5.pdf APRA (n.d). List of Authorized Deposit-taking Institutions. Retrieved April, 6, 2010 from http://www.apra.gov.au/adi/ADIList.cfm Altunbus, Y, Gambacorta, L & Marques, D (2007, Dec). Securitization and the bank lending channel. Retrieved April, 6, 2010 from http://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdf Aspachs, O, Nier, A & Tiesset, M (2005, Feb). Liquidity, Banking Regulation And The Macroeconomy. Retrieved April, 6, 2010 from http://www.bis.org/bcbs/events/rtf05AspachsNierTiesset.pdf Bailey, K., Davies, M., & Dixon Smith, L. (2004, September). Asset securitization in Australia. Financial Stability Review, 48–54. Retrieved April, 6, 2010 from http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-1.pdf Battellino, R. (2004, July 28). Some comments on securitization. Talk to the Third Australian Credit Forum. Reserve Bank of Australia. Retrieved April, 6, 2010 from http://www. rba.gov.au/Speeches/2004/sp_ag_280704.html Benjamin, L & Skully, M. (n.d). The impact of securitization and structural changes of Australian mortgage markets on bank pricing behavior. Retrieved April, 6, 2010 from http://www98.griffith.edu.au/dspace/bitstream/10072/22360/1/50602_1.pdf Deloitte (2009). Liquidity Risk management- finding the right balance. Retrieved April, 6, 2010 from http://www.deloitte.com/assets/Dcom-Australia/Local%20Assets/Documents/Industries/Financial%20services/Regulatory%20Review%20November%202009/040266_04_LiquidityRisk.pdf Liaw, A., & Eastwood, G. (2000, October). The Australian securitization market. APRA Working Paper 6. Retrieved April, 6, 2010 from http://www.apra.gov.au/Policy/upload/The-Australian-Securitisation-Market-Oct-2000.pdf The Free Library (n.d). Set & ready: Australian securitization market back on track: the Australian securitization market screeched to a halt at the height of the global financial crisis, but there have been recent signs of rejuvenation. AB+F looks at the state of the market and gauges optimism levels. Retrieved April, 6, 2010 from http://www.thefreelibrary.com/Set+&+ready:+Australian+securitisation+market+back+on+track:+the...-a0215410658 Appendices Fig.2 Fig. 3 Fig. 4 Fig. 5 Fig. 6 Fig. 7 Read More