Illiquidity Risk: The Foundations of Modelling
Introduction to 'Liquidity Modelling'
Setting the Scene: Why Liquidity Is Important in a Bank
What Is Liquidity Risk?
Illiquidity Risk: The Foundations of Modelling
Capturing Uncertainties
A Template for an Illiquidity Risk Solution
The Counterbalancing Capacity
Intra-Day Liquidity Risk
Liquidity Transfer Pricing and Limits
The Basel III Banking Regulation
After fixing some technical notation we shall describe the bank’s vulnerability to illiquidity in a cashflow model: the forward liquidity exposure (FLE). The bank’s ability to counterbalance a detrimental FLE is then modelled as the counterbalancing capacity (the substitute 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 categorise 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 bank’s balance sheet
Before we model uncertainty we need be able to describe the mechanics of a bank’s 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
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