Planning for Optimal Liquidity Execution
International Review of Applied Financial Issues and Economics, Vol. 4(1) (2012)
Posted: 28 Mar 2013
Date Written: March 25, 2012
Lately liquidity risk has received attention from regulators and banks - having witnessed how a credit crisis evolved into a major liquidity funding problem for many banks. Following the crisis regulators has put forward a new regulation, headed under Basel III, for liquidity risk focusing on testing the short- and long-term solvency of banks. One of the most challenging aspects of the new regulation is that banks now need to continuously manage a dedicated liquidity portfolio and that the adequacy of this portfolio in hedging liquidity outflows needs to be frequently tested. Given a sufficient liquidity hedging portfolio banks also need to consider strategizing its response to liquidity crisis in advance. Most notably, this includes having a strategy for liquidity execution. In this paper we propose a multi-stage linear program optimization for resource allocation to optimize the liquidity execution across stages. The optimization not only provides a solution at the time of liquidity execution i.e., in a distress period but also helps build an a priori practical liquidity plan consistent with Basel III required contingency funding plans. The model scenario of non-sufficient counterbalancing capacity allows banks to get prepared by acquiring further liquid funds. In our analysis we find that highly liquid sources, which remain liquid with low execution cost and haircut even in further distress, are optimal to hold until further distress stages and then execute at a still low cost. This is because their values do not diminish as stress increase across stages. Liquidity raising assets with an execution cost and haircut that is significantly worsening across stages are optimal to execute in the beginning of distress. This is because their liquidity values are higher in the initial phases of the distress when execution costs and haircuts are not as severe.
Keywords: Liquidity risk, optimal liquidity execution, counterbalancing capacity
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