Living wills and LVAR could help kill liquidity risk

When used with living wills, a new method may help banks quantify liquidation costs

Having an exit strategy is usually considered to be a good thing, but having an exit strategy and not knowing its implications could be disastrous.

There's no better example of this than the so-called 'London whale' loss suffered by JP Morgan in 2012. Back then, a toxic mix of bad modelling and a strategy designed to reduce risk-weighted assets ended up costing the US bank a whopping $6.2 billion in just five months.

An important factor that drove those losses was the impact of heavy liquidations on market prices – something also witnessed in credit assets during the 2008 financial crisis. In the aftermath of the crisis, regulators recognised the dangers of illiquidity and rapid deleveraging by introducing requirements such as the Basel III liquidity coverage and leverage ratios, respectively. The impact of liquidity has also been reflected in more recent regulatory changes, such as the Fundamental review of the trading book (FRTB), also a product of the Basel Committee on Banking Supervision. The final version of the FRTB, released in January, applies longer liquidity horizons for specific types of asset to reflect the time it could take to hedge or exit the position in a stressed environment.

But despite this increased regulatory focus, many banks' handling of liquidity risk remains simple and ad hoc. "Many do it in a pretty straightforward way – for example, adding some discretionary margin of safety on top of a simple superposition of the value-at-risk numbers, instead of applying a comprehensive, integrated risk measure," says Alexander Passow, a research fellow at the University of Darmstadt and founder of UK-based advisory firm JP Omega.

Rama Cont, chair of mathematical finance at Imperial College London, agrees. "Banks usually have some internal liquidity risk model," he says. "If the size of the position is larger than a threshold, they calculate an ad hoc charge that increases with size. But there is no theoretical underpinning to these charges and banks do not publicise this, because they know it wouldn't stand the scrutiny of any serious methodological examination."

In a paper published recently on Risk.net, entitled Risk management for whales, Cont and co-author Lakshithe Wagalath, an associate professor of finance at France's IÉSEG School of Management, attempt to quantify liquidation risk and incorporate it into the VAR numbers used by risk management. Using the leverage ratio as a constraint, the academics develop a model in which positions are liquidated if losses fall to a level that causes the bank to breach its leverage ratio requirement. They then model the price impact of the liquidation depending on its size: buying raises the price and selling decreases it.

All this leads to what the authors call 'liquidity VAR' (LVAR), which is the result of an adjustment to VAR numbers that reflects this price impact. In theory, it allows risk managers and traders to see what their loss profiles would look like if they accounted for liquidation in a systematic way.

A key requirement for generating a meaningful LVAR number is prior knowledge of what the bank's liquidation strategy is, given a stressed scenario or a regulatory constraint.

"Say, if you liquidate 20% of your portfolio over a given time horizon, this corresponds to a known liquidation rate, which we can then put into the model and compute by how much it might move markets in each asset class," explains Cont.

The liquidation strategy might not always be completely thought-out beforehand, but Cont says banks might have a better idea of what to do in light of the need for large US banks to file 'living wills', or resolution plans, with regulators under the US Dodd-Frank Act.

Looking at LVAR instead of VAR can make a huge difference. As an example, Cont and Wagalath looked at the London whale case. Factoring in JP Morgan's strategy of liquidating investment-grade credit derivatives index positions of $278 billion in notional during a five-month period, their model showed an LVAR of more than $10.5 billion – well above the value of the London whale losses. In contrast, a simple benchmark VAR model with the same confidence level and time horizon showed just $2 billion.

Given that liquidity risk and liquidation costs are still poorly understood areas, having a plan and knowing its implications certainly seems like a step in the right direction. A combination of living wills and LVAR might well offer banks the nudge they need to get their act together.