On September 11, the Australian Prudential Regulation Authority released its discussion paper on liquidity risk regulations for authorized deposit-taking institutions in Australia. This thoughtful paper highlights a key issue in liquidity risk management that has been important in the current 2007-2009 credit crisis. “Core deposits,” demand and savings deposits from individual investors and small businesses, are “not core”—they run off in a crisis. This post combines those insights from the APRA paper with real data from the current credit crisis.
In our blog post on April 23, 2009 “Cash Flow at Risk: Liquidity Risk Lessons from President William Jefferson Clinton,” we highlighted the normal transmission of a liquidity risk crisis:
- Macro-economic factors move
- Assets of the financial institution decline in value, because of factors like increased default risk, credit spreads, changed foreign exchange rates, or increases in interest rates
- The default probability of the financial institution rises
- Suppliers of liabilities to the financial institution sharply reduce their supply of funds to the institution because of its higher default risk
- If assets cannot be liquidated fast enough to pay down these liabilities, the financial institution fails or is rescued
In the case of Countrywide Financial Corporation, for example, the sharp decline in home prices in 2007 led to much higher mortgage defaults and a sharp rise in the perceived credit risk of Countrywide. The chart below shows that Countrywide suffered a 94% decline in commercial paper outstanding once 5 year credit default quotes on the firm exceeded 200 basis points:
By the end of 2007, Countrywide was completely shut out of the commercial paper market as credit default swap quotes topped 800 basis points.
The APRA liquidity risk paper describes three basic environments for analyzing liquidity risk:
- A “going concern” scenario with a time horizon of 12 months or more
- An “idiosyncratic crisis” with a time span of 20 business days
- A “market disruption” with a time horizon of 3 months
In this post, we are focused on the latter two analyses as the only two that would have been helpful to firms trying to survive the 2007-2009 credit crisis. Countrywide’s case doesn’t fall neatly into either the “idiosyncratic” or “market disruption” category because its troubles were triggered by macro factor movements (home prices) that affected a wide array of financial institutions. Countrywide had the misfortune to be one of the first to be affected. The APRA paper correctly requires financial institutions to assume “100 percent run off at maturity” for debts like commercial paper, exactly as Countrywide experienced. The suggestion we would make to institutions analyzing these scenarios is to extend the time horizon beyond 20 business days (idiosyncratic crisis) and 3 months (market disruption) in order to get a more transparent view of how liquid the asset side has to be in order to insure the firm’s survival without a government bailout.
In the case of household or small business call deposits (demand deposits), the APRA paper requires financial institutions to assume a 10 percent runoff where the deposits are fully covered by a government guarantee. For those not fully covered, a 30 percent runoff is to be assumed. For term deposits, the assumed runoff figures are 25 and 75% respectively. The case of Northern Rock in the United Kingdom sheds light on the realism of these figures.
Northern Rock lost 63% of “customer accounts” and interbank deposits between June 30, 2007 and December 31, 2007, forcing intervention by the Bank of England in September 2007 even though Northern Rock had not reported a loss on its June 30, 2007 financial statements. The Northern Rock case shows that, if anything, the runoff of allegedly “core” deposits may not be high enough to be realistic of the kind of crisis faced by institutions like Northern Rock itself, Washington Mutual, IndyMac, and Wachovia.
We think the very best insight among many in the APRA paper is this one:
“There are some modeling aspects where APRA is better placed to develop a suitable assumption than any individual ADI (“authorized deposit-taking institution”). In particular, APRA may have access to data not generally available (e.g. in relation to retail deposit behavior under stress…”
As APRA points out, a financial institution which has not yet been under stress itself has literally zero information on how its own retail depositors and small business depositors will behave if, like Countrywide, its credit risk as measured in the credit default swap market goes from 70 basis points to 200 basis points to 800 plus basis points. The only institutions that have this information are institutions that have failed, and that information is generally not publicly available. It’s the daily movements of deposit balances that are key to managing a crisis, and these are not available for the most part except for occasional press references as institutions have gotten into trouble. Only regulators have this data on failed institutions.
We agree that this is one of those cases where bank regulators have special insights and data that are of great value to risk managers. We applaud APRA’s focus on the key role of consumer and small business deposits in the transmission of a crisis, and we hope APRA and other regulators are sharing these insights. Bank failures around the world are all of interest. By comparing notes on consumer deposit behavior in different crsises, regulators can maximize the realism in the liquidity risk analysis of a future crisis. Good on ya, APRA.
Donald R. van Deventer
Honolulu, September 28, 2009