Financial Risk Management Liquidity Risk Management 2 — Questions and Answers
Question 1: What is 'asset-liability management' (ALM) in the context of bank liquidity risk?
- The process of selling non-performing loans to reduce balance sheet risk
- Managing the maturity and cash flow mismatches between a bank's assets and liabilities (Correct answer)
- Allocating capital between credit, market, and operational risk
- The daily reconciliation of trading book positions with settlement accounts
Correct answer: Managing the maturity and cash flow mismatches between a bank's assets and liabilities
ALM focuses on managing interest rate risk and liquidity risk arising from differences in the timing of cash inflows from assets and outflows on liabilities.
Question 2: A 'run on the bank' represents which type of liquidity risk?
- Market liquidity risk from inability to sell assets at fair value
- Funding liquidity risk from sudden mass withdrawal of deposits (Correct answer)
- Intraday liquidity risk from payment system disruptions
- Contingent liquidity risk from drawdown of off-balance-sheet commitments
Correct answer: Funding liquidity risk from sudden mass withdrawal of deposits
A bank run occurs when depositors simultaneously withdraw funds due to loss of confidence, creating a severe funding liquidity crisis.
Question 3: What does 'encumbered' mean when describing collateral in liquidity management?
- Collateral that has declined in credit rating below investment grade
- Assets that are pledged or otherwise unavailable for use in meeting liquidity needs (Correct answer)
- Securities that are subject to lock-up periods preventing immediate sale
- Repos that have not yet been included in the LCR calculation
Correct answer: Assets that are pledged or otherwise unavailable for use in meeting liquidity needs
Encumbered assets are pledged as collateral or otherwise legally committed, making them unavailable for the bank to use as a liquidity buffer.
Question 4: Intraday liquidity risk refers to:
- The risk of running out of liquidity within a single business day due to payment timing mismatches (Correct answer)
- Daily fluctuations in the LCR ratio caused by market price movements
- Risk from overnight repo markets refusing to roll over funding each morning
- The risk that intraday trading losses exceed the firm's daily VaR limit
Correct answer: The risk of running out of liquidity within a single business day due to payment timing mismatches
Intraday liquidity risk arises when payment outflows occur before incoming payments are received, creating short-term funding gaps that can disrupt settlement.
Question 5: Which of the following is a primary source of contingent liquidity risk for banks?
- Rising interest rates increasing the duration of the bond portfolio
- Undrawn credit lines and letters of credit that clients may draw upon in stress (Correct answer)
- Short selling activity by hedge fund clients
- Regulatory requirements to hold more capital
Correct answer: Undrawn credit lines and letters of credit that clients may draw upon in stress
Undrawn commitments represent contingent off-balance-sheet obligations that could create sudden large cash outflows if borrowers draw them during market stress.
Question 6: What is a 'Contingency Funding Plan' (CFP) in liquidity risk management?
- A plan to raise additional regulatory capital during periods of financial stress
- A documented plan identifying alternative funding sources and escalation procedures for liquidity stress events (Correct answer)
- The bank's annual strategy for diversifying its wholesale funding mix
- A federal requirement for banks to maintain FDIC-insured deposits above $250,000
Correct answer: A documented plan identifying alternative funding sources and escalation procedures for liquidity stress events
A CFP outlines specific actions, funding sources, and decision-making authority to be activated when normal funding access is impaired.
Financial Risk Management Liquidity Risk Management 2
What is 'asset-liability management' (ALM) in the context of bank liquidity risk?