Liquidity duration OR LRE

[BhatiaI]

Hi All,

Could anyone please explain me the concept behind how to use duration analysis in order to estimate the liquidity risk please?

I am just not able to follow the core reading regarding the same including the meaning of LRE and what should be done if LRE is sharply negative.


Thanks and kind regards
Ishita

 

[Colin McKee]

The idea here is that an institution works out the PV of its assets less liabilities at its current cost of funding - the worth of the institution. It then thinks about the impact of (for example) a reputation issue, which may cause other institutions to stop lending to it. this might, for example, push up its cost of funding by 1%. It then works out the PV of assets less liabilities at this new cost of funding, and sees if the worth of the institution is affected. The change is the LRE as described in the notes. A large LRE suggests that the institution is exposed to a change in the cost of funding - a liquidity risk. This is the duration analysis.

 

[BhatiaI]

Thank you Colin, let me sit down and think and see if I have followed it (little slow my brain is on a Monday morning )

Could we have a numerical example for the same please?

Kind Regards
ishita

 

[Colin McKee]

I am afraid I only know the high level ideas, and don't have a numerical example to hand.

 

[BhatiaI]

Thank you so much for your help. I think I stand at a much better position now.

Kind Regards
ishita

 

[1495_sc]

The idea here is that an institution works out the PV of its assets less liabilities at its current cost of funding - the worth of the institution. It then thinks about the impact of (for example) a reputation issue, which may cause other institutions to stop lending to it. this might, for example, push up its cost of funding by 1%. It then works out the PV of assets less liabilities at this new cost of funding, and sees if the worth of the institution is affected. The change is the LRE as described in the notes. A large LRE suggests that the institution is exposed to a change in the cost of funding - a liquidity risk. This is the duration analysis.

This is very helpful. Just one clarification- how does this difference in cost of funding lead to a liquidity risk? Is it because of the risk of not being able to borrow funds at a reasonable cost at all times?

Whereas, gap analysis satisfies the first definition of liquidity risk i.e insufficient cashflows to meet liabilities. Is my understanding correct?

 

[Gresham Arnold]

Hi, Colin's not working at present, but I think you are on the right lines here. Gap analysis looks at the difference between the level of liquid assets and volatile liabilities. The larger the volatile liabilities relative to the liquid assets, the greater the risk of having insufficient cashflows to meet liabilities. Hence the greater the risk of needing to borrow funds to meet the liabilities. The liquidity gap approach doesn't necessarily consider what might happen to an institution's assets and liabilities if the institution becomes more financially stressed.

LRE can be used to consider this situation. In Colin's example above, an institution has suffered reputational damage which has pushed up its cost of funding. If the institution has a large negative LRE, it will find that as its cost of funding rises, it's assets fall relative to its liabilities. So, it is now more likely to need to borrow money. And the cost of doing so has now risen.

This is covered in a bit more detail in Chapter 18 of Subject SP5 but hope that helps

Gresham

 

[1495_sc]

Hello Gresham. Thank you. This was very helpful!