Financial Risk Management Liquidity Risk Management 1 — Questions and Answers
Question 1: What is the Liquidity Coverage Ratio (LCR) under Basel III?
- The ratio of long-term stable funding to long-term assets
- The ratio of high-quality liquid assets to net cash outflows over a 30-day stress period (Correct answer)
- The minimum percentage of deposits that must be held as cash reserves
- The ratio of liquid assets to total liabilities required for FDIC insurance
Correct answer: The ratio of high-quality liquid assets to net cash outflows over a 30-day stress period
The LCR requires banks to hold sufficient HQLA to cover net cash outflows over a 30-day stress scenario, with a minimum ratio of 100%.
Question 2: The Net Stable Funding Ratio (NSFR) is designed to:
- Ensure banks can survive a 30-day acute liquidity stress event
- Promote stable medium- and long-term funding relative to asset liquidity needs (Correct answer)
- Limit the use of short-term wholesale funding for trading book activities
- Set the minimum reserve ratio for commercial bank deposits
Correct answer: Promote stable medium- and long-term funding relative to asset liquidity needs
The NSFR requires banks to maintain sufficient stable funding to support their assets over a one-year horizon, addressing structural liquidity risk.
Question 3: What are High-Quality Liquid Assets (HQLA) in the LCR framework?
- Mortgage-backed securities rated AA or above by credit agencies
- Assets that can be easily converted into cash with little or no loss of value in stress conditions (Correct answer)
- All assets with a remaining maturity of 30 days or less
- Cash and deposits held at the Federal Reserve only
Correct answer: Assets that can be easily converted into cash with little or no loss of value in stress conditions
HQLA must be liquid in markets even during stress, unencumbered, and easily convertible to cash; they include central bank reserves, government bonds, and certain corporate bonds.
Question 4: Funding liquidity risk refers to:
- The risk that a firm cannot sell assets quickly without significant price discount
- The risk that a firm cannot meet its financial obligations as they come due without incurring unacceptable losses (Correct answer)
- The risk that interest rates rise, increasing the cost of new borrowing
- Market-wide dislocation that prevents normal secondary market trading
Correct answer: The risk that a firm cannot meet its financial obligations as they come due without incurring unacceptable losses
Funding liquidity risk is the risk of being unable to fund liabilities or meet cash obligations, which can cause insolvency even for solvent institutions.
Question 5: A liquidity stress test typically evaluates a bank's ability to survive:
- An interest rate increase of 200 basis points over 12 months
- A scenario where deposit outflows and funding markets freeze simultaneously (Correct answer)
- A 20% decline in equity prices over a 5-day trading period
- A credit rating downgrade of its loan portfolio by two notches
Correct answer: A scenario where deposit outflows and funding markets freeze simultaneously
Liquidity stress tests model scenarios where market funding dries up and depositors withdraw funds simultaneously to assess survival time and liquidity buffer adequacy.
Question 6: What is a 'liquidity buffer' maintained by banks?
- Excess capital held above the regulatory minimum to absorb unexpected losses
- A reserve of liquid assets readily available to cover unexpected cash outflows (Correct answer)
- The difference between a bank's bid and ask price for its own debt securities
- The portion of loan commitments not yet drawn by borrowers
Correct answer: A reserve of liquid assets readily available to cover unexpected cash outflows
A liquidity buffer is a pool of unencumbered HQLA that can be monetized quickly to fund unexpected outflows during stress.
Financial Risk Management Liquidity Risk Management 1
What is the Liquidity Coverage Ratio (LCR) under Basel III?