Comments on: “Thoughts” by Jean-Pierre Landau

By: Bruce

Bruce — Wed, 14 Nov 2007 15:28:05 +0000

I agree that the recent situation with NR should not have consumed capital as the liquidity strategy should have prepared for a lack of wholesale/ securitised funding and the additional costs should have consumed profit not capital.

However, in terms of normal business practise, the risk management process (ie. pillar 2) would consider an event where a number of significant shocks occur. When a combination of debt losses, operation risks, interest rate shocks and liquidity issues occur in parallel. Therefore all profit will be destroyed and capital is required to prevent bankruptcy. In that sence, capital allocation has to include liquidity risks.

To my mind, a part of the risk with NR and other banks, is the business need to commit to lending prior to funds being needed. With the level of business NR were writing, the constant pipeline of mortgages where they had entered a contract to lend was sizable (£billions). As soon as the wholesale funding dried up, they were really stuck as they had no significant short term alternative in place and combined with no functioning securisitation market, the ‘gravy’ train ran out of track.

By: Andrew

Andrew — Mon, 12 Nov 2007 22:59:41 +0000

Bruce,
In the absence of a system-wide event this sort of liquidity issue can be regarded as transient – the trick is to have enough liquidity (and, as you note, from enough sources) to get you through. The Rock failed to diversify its funding sources and paid the price when it was caught between securitisations. It had (and I presume still has) enough capital to comfortably meet the FSA requirements, but this was no help – except that the B of E rode in on their charger, making a lot of noise on the way in.
OTOH, if they had maintained enough liquidity at all times to see them through a drying up of their primary funding source for a month or two there would not have been an issue in the first place. No liquidity problems, no B of E announcement to the LSE, depositors are unaware of any problems (because there aren’t any) business continues.
The extra cost of funding could have been, and should have been, met out of current profits rather than through a call on reserves, with the added margin past on to customers at the next rate reset.
If you look at the Rock incident one way, it was bad luck that the crunch happened just short of their next securitisation (as happened in Oz to a couple of wholesale funded lenders) but really it was bad liquidity management.

By: Bruce

Bruce — Mon, 12 Nov 2007 15:53:30 +0000

I think a slight adjustment of your view, is worth considering:

Liquidity risk mitigation should not be considered purely a capital issue.

Certainly liquidity should be part of a capital assessment (ie ICAAP or similar). In the event of a shift in the money markets, it is reasonable to assume that the cost of funding would increase and capital would be an exceptable method of mitigating this.

However, I do agree that capital cannot fix a liquidity issue where no funds are available at any cost. In the recent environment, those who had a spread of funding sources and had set up emergancy plans such as conduits facilities (paying the ongoing cost as an insurance premium) were in a better position.

Much like any other risk, you don’t go flying a kite next to power lines just because you have good health insurance.