Popular Ways of Risk Measurement - Essay Example

?Finance Table of Contents INTRODUCTION 3 Overview 3 Risk Measurement 5 Popular Way of Risk Measurement 6 ANALYSIS 8 Liquidity Risk Analysis of ANZ and CBA 8 Comparative Analysis between ANZ and CBA 10 CONCLUSION 11 References 13 INTRODUCTION The study aims at analyzing liquidity risk and the different facets of the risk measurement issues involved in this case. The examples of Australia and New Zealand Banking Group Limited (ANZ), and Commonwealth Bank of Australia (CBA), has been utilized here to discuss and compare the international liquidity risks of these financial institutions, and a comparative analysis between these have been done. Overview The term liquidity refers to the ability of the firm to cover its debt obligations through its liquid assets, without incurring a large loss. For example, if a firm wants to repay its outstanding commercial paper obligation of one month, then it might issue new commercial papers instead of selling its assets (The Economist 2001). Thus, liquidity risk involves the inability of the firm to meet its current and its future collateral needs and cash flows, without affecting the overall financial operations of the firm (FRBSF 2010, 1). The financial firms are generally sensitive regarding funding the liquidity risks, as transforming debt maturity such as purchasing assets with the short-term deposits, funding the long-term loans or debt obligations, are the major business areas. As a response to the liquidity risk, the financial firms generally maintain and establish a system for liquidity management. This system helps in assessing the prospective requirements of funds and also ensures that the funds are accessible during the appropriate time. Before moving on to discuss the solutions firms prepare to meet out the liquidity risks, we will discuss the types of liquidity risk that prevails (Nikolaou 2009, 10-11). Figure 1 Source: (Fiedler 2002). There are two types of liquidity risks that would be discussed in this study, namely: a) Market Liquidity Risk, and b) Funding Liquidity Risk. The Market Liquidity Risk means that the assets cannot be sold in the market due to constraints in liquidity in the market. It can be due to widening of the offer spread, expansion of holding period, or making unambiguous liquidity reserves. The Funding Liability Risk means having risk when the liabilities cannot be met, when they are due, can be met when the price is uneconomic, or is systematic. There are different situations or causes due to when liquidity risk can be assessed. The situation when not a single buyer is available in the market to trade for an asset or assets, leads to liquidity risks. Liquidity risk can be denoted as a financial risk which occurs due to uncertain liquidity. Liquidity risks might arise when the credit ratings of the firm falls, or when it experiences a sudden outflow of cash (Drehmann, and Nikolaou 2009, 4-5). The recent disintegration of several huge financial institutions reveals the critical nature of the liquidity risks and also depicts the critical role that it plays for the regulators, globally. The Bank of International Settlements (BIS) was among the first to adopt the comprehensive regime of testing liquidity risk and protecting the institutional stakeholders. The Financial Service Authorities (FSA) has also issued policy statement PS09/16, for strengthening the liquidity standards. Liquidity risk can be regarded as both eccentric as well as systematic. It plays a crucial role for the banking entities and the other industries too. Liquidity risks may vary between assets, liability and time. It includes the institutional stakeholders like the creditors, debtors, owners, etc (Oracle Financial Services 2009, 2-4). Risk Measurement The recent fluctuations in the financial market included the payment system and several banking processes which are directly related to short-term forecasting. The control system should be such so that it can measure the liquidity risks and the performance with relation to the models utilized for market and credit risks. In this part the discussion would be on framework of the banks for the measurement of the liquidity risk, within the developed risk management model of the institution. Based on the types of liquidity risks, the, measurement approaches have been discussed. There are three main approaches for measuring funding liquidity risks, such as cash flow based approach, the stock based approach, and the hybrid approach. The stock based approach is utilized to measure the stock of the financial assets that can be instantly liquidated in case of requirements (Gabbi 2007, 44). The balance sheet of the bank is assessed to check the cashable assets for meeting its short-term liabilities. In case of cash flow based approach, the liquidity gap between cash inflows and outflows are measured. Finally, the hybrid approach as the name suggests is a combination of both the approaches. In case of hybrid approach the results that has been achieved is based on the assumption of amounts and time. In this case both the cashable assets and liquidity gap is considered to measure the liquidity risk. The ways of liquidity risk measurement and the popular models has been discussed below (Vento, and Ganga 2009, 80). Popular Way of Risk Measurement The Value at Risk or VaR model is the most popular framework utilized in banking management. VaR model is utilized to calculate the speculative and liquidity risk. The banking risks require a set measurement that would be helpful in comparing the probable loss that is formed by the financial positions. The nuances of the VaR model has been explained in figure 2. Figure 2 Source: (Jorion 2006). The VaR methodology involves the likely loss that is derived from the market risk. It includes the degree to which a portfolio or assets is going to endure over a time interval and the extent of certainty by the decision-maker. There are five factors that need to be considered in order to estimate the minimum capital required for covering the maximum loss. The five factors are stated below: The volatility of exchange rates, interest and price Correlation among the different positions Time horizon Probable distribution of returns Confidence interval (Basel Committee on Banking Supervision 2000, 1-2). It is a well known fact that the VaR concept is utilized to measure both credit as well as market risk for the tradable securities that lacks the accurate evaluation of liquidity risk. The theoretical approaches of VaR evaluation includes considering the liquidity constraints as the treasury issues that the interbank markets are allowed to resolve. This means that no capital adequacy is required. The Basel Committee for banking supervision has updated their previous paper on the liquidity risk. Liquidity risk was defined as the ability of the fund generated through the assets can meet the obligations due. When the liquidity penetrates into the VaR model, there is no junction on the objective of instability to measure. The selling lag and price elasticity of the portfolio is what the owner liquidates in market (Burucs 2008, 23). ANALYSIS A detailed discussion on the concepts of liquidity risk and its various types, the most popular method of liquidity risk measurement has been discussed in the initial part of this study. The causes and the effects of liquidity risk have being analyzed. Now in the analysis part, the liquidity risks of ANZ and CBA will be discussed to understand the liquidity risks associated with banks and financial institutions. Liquidity Risk Analysis of ANZ and CBA In this section a comparative study of the various risks associated with ANZ and CBA has been discussed here. ANZ considers that the institute is exposed to the different kinds of funding and liquidity. It is obvious that these liquidity risks would affect adversely to the operations and financial condition of the business. The liquidity risk that ANZ is associated with is that it is unable to meet the payment obligations, which includes repaying to the depositors or paying off the wholesale debt. Risk such as insufficiency in funding the increasing assets also prevails in ANZ. This is due to the liquidity gap or mismatch in the cash inflows and cash outflows (Australia and New Zealand Banking Group Limited 2011, 78). CBA group is also another major bank in Australia, who also have their own funding and liquidity risk policies designed especially to meet the obligations of short-term debts. The obligations that are probably included in the liquidity risk assessment of the bank are related to borrowed funds on unsecured basis or insufficiency of superior liquid asset for raising immediate funds. Though the group has the policy of maintaining sufficient balance of cash, but seeing the present financial condition, the risk of liquidity is the major issue (Commonwealth Bank of Australia 2011, 206) During the period of systematic liquidity risk or during the event of the financial crisis the ANZ group was exposed to the liquidity risk as well. They were compelled to seek out alternative funding, but there are various factors on which the alternative was ascertained, along with the credit ratings of the company. As it can be seen in table 1, the consolidated total liquid asset of ANZ on 2011 was $24,899 million, which was $18,945 in 2010. The total liquid assets of the bank excluding the subsidiaries are $20,555 million in 2011, which was $16,047 million in 2010. So the statement reveals an increase in the liquid assets of the company, which can be considered to be a positive aspect. While in table 2, the current liabilities are have also increased in 2011, than 2010, so ANZ develops several policies by utilizing the various risk management approaches, so that the sufficiency of cash balance can be maintained. Table 1 Comparative Analysis of Liquid Assets of ANZ and CBA Liquid Assets of ANZ 2011 2010 Liquid Assets of CBA 2011 2010             Cash at Bank 958 1,082 Interest earning lending assets 67,737 63,559 Bills Receivable 11,539 3,825 Bank acceptance of customers 9,808 9,149 Bank Certificates of Deposits 2,149 3,613 Other assets 690 235 Securities Purchased 5,909 7,527       Total Liquid Assets 20,555 16,047 Total Liquid Assets 78,235 72,943 Table 2 Comparative Analysis of Liquid Liabilities of ANZ and CBA Liquid Liabilities of ANZ 2011 2010 Liquid Liabilities of CBA 2011 2010             Due to financial institutions 23,012 21,610 Public Borrowings & deposits 406,460 379,593 Customer deposit 296,754 256,875 Dues to other financial institutes 15,930 12,633 Other borrowings and deposits 71,975 53,508 Liabilities at fair value through financial statement 10,597 16,055       Derivative Liabilities 52,577 32,601       Bank Acceptance 10,734 11,569       Insurance policy liabilities 13,652 14,592       Loan capital and debt issues 155,670 166,616       Managed funds 1,048 880       Monetary liabilities 7,364 7,074 Total Liquid Liability 391,741 331,993 Total Liquid Liability 674,032 641,613 Source: (Australia and New Zealand Banking Group Limited 2011; Commonwealth Bank of Australia 2011) In table 2 we can see the monetary liabilities of CBA for the year 2011 and 2010 is displayed. The total amount of monetary liabilities of CBA should minute fluctuations, which reveal that the current or short-term debts or obligations of the institution have not fluctuated considerably. However, those balance sheet assets which cannot be liquidated quickly are generally funded with the help of the term borrowings and the deposits. CBA maintains a minimum level of asset in liquid form. Those levels of liquid assets comply with the scenario of crisis that prevails in the global market. The institute maintains certain of liquid asset for the liquid risk that the CBA group might confront to, but the obligations which are from undrawn lending are recovered from the customers. Comparative Analysis between ANZ and CBA It was found that ANZ and CBA follow the set guidelines of the ASX and the other regulatory bodies, but ANZ has a defensive approach for liquidity risk, so they maintain an amount of total liquid assets every year based on the amount of their current liabilities, whereas CBA maintains a minimum amount of liquid asset. Their approach is to raise minimum amount of liquid asset for coving maximum debt obligations (Branigan 2009). The current liability position of CBA shows minor fluctuations, while in case of ANZ, considerable fluctuations have been noticed. So we cannot compare and point that one approach is better than the other because any firm or financial institution design their risk management system on the basis of their credit ratings, liquidity risk coverage capabilities and various other factors related to time, market condition, etc. So ANZ’s policy to maintain sufficient cash balance was due to the credit rating which the company considered as a threat or liquidity risk (Ernst & Young 2011). CBA utilizes specific management tools which are similar to cash flow ladder and liquidity gap analysis. This assists the bank to forecast the liquidity needs of the institution on a daily basis. An additional model for assessment of liquidity risk is implemented by CBA to measure the liquidity risks in worst cases. Whereas ANZ has been exposed to the risks associated with the credit. Several reasons such as the natural disaster, geographic regions, slowdown of the Chinese economy, etc adversely affected the liquidity position. Moreover, the US mortgage industry and the liquidity crunch affected ANZ negatively. So the initiative of the bank to maintain and increase its liquid asset balance was very obvious and positive step towards sustainability (Australia and New Zealand Banking Group Limited 2011, 78; Commonwealth Bank of Australia 2011, 206). CONCLUSION The study was designed to cover the various dimensions of liquidity risk. Liquidity risk is referred to as the ability of the company or the organization to meet its short-term liabilities through its current or cashable assets. In case of banks or financial institutions too liquidity risk refers to the capability of the financial institutions to meet its short-term financial obligations or debts. So the minimum cash required to meet the maximum debt is assessed when the liquidity risk assessment models are utilized. Liquidity risk can be of two types namely funded liquidity risk and market liquidity risk. The market liquidity risk can be considered when the buyer for the asset is not available in the market. The funded liquidity risk involves the risk associated with the liquidity gap. There are various risk measurement tools or methodologies that the banks utilize to measure their liquidity risk. However, the selection of procedure depends on the financial stability and capability of the firm. VaR model is the most popular approach of measuring liquidity risk. The example of two major banks of Australia ANZ and CBA has been considered to draw a comparative analysis between the liquidity risk approaches undertaken or followed by these banks. In the first part of the comparative analysis, the total liquid assets and liabilities of ANZ and CBA has been discussed about, along with the probable assumptions of liquidity risks that these institutions project based on their financial status. In the second part of the comparative analysis the similarities and differences has been focused upon to assess the distinguishing factors between ANZ and CBA, if any. References Australia and New Zealand Banking Group Limited. 2011. “Annual Report 2011.” Accessed October 6, http://www.anz.com/resources/3/b/3b9a04804919b3b1a79df7fc8cff90cd/2011_Annual_Report_ANZ.pdf?CACHEID=3b9a04804919b3b1a79df7fc8cff90cd. Basel Committee on Banking Supervision. 2000. “Sound Practices for Managing Liquidity in Banking Organizations.” Accessed October 6, http://www.bis.org/publ/bcbs69.pdf. Branigan, Joanne. 2009. “Liquidity Risk Management: Are You Prepared?” SRC Insights: First Quarter. Accessed October 6, http://www.philadelphiafed.org/bank-resources/publications/src-insights/2009/first-quarter/q1si1_09.cfm. Burucs, Judit. 2008. “How Can a Medium-Sized Bank Develop Its Own Asset/Liability Risk Management System?” Accessed October 6, http://www.ifc.org/ifcext/rbap.nsf/AttachmentsByTitle/ALM_ENG/$FILE/MANUALALRISKMANUAL-new.pdf. Commonwealth Bank of Australia. 2011. “Annual Report 2011.” Accessed October 6, http://www.commbank.com.au/about-us/shareholders/pdfs/annual-reports/2011_Commonwealth_Bank_Annual_Report.pdf. Drehmann, Mathias, and Kleopatra Nikolaou. 2009. Funding Liquidity Risk: Definition and Measurement. Accessed October 6, http://www.hkimr.org/cms/upload/seminar_app/sem_paper_0_347_Kleopatra%20Nikolaou.pdf. Ernst & Young. 2011. “Measuring and Managing Liquidity Risk.” Ernst & Young’s Liquidity Diagnostic Tool for Financial Services Institutions. Accessed October 6, http://www.ey.com/Publication/vwLUAssets/Measuring_and_managing_liquidity_risk/$FILE/Measuring-and-managing-liquidity-risk.pdf. 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Accessed October 6, http://www.economist.com/node/710375. Vento, Gianfranco A., and Pasquale La Ganga. 2009. “Bank Liquidity Risk Management and Supervision: Which Lessons from Recent Market Turmoil?” Journal of Money, Investment and Banking 10: 80-126. Read More