Ch5. FRM Financial Risk Manager — Liquidity Risk & Basel III
What Is Liquidity Risk?
Liquidity risk is the risk of being unable to convert assets into cash at a fair price when needed, or being unable to meet maturing obligations. The 2008 financial crisis taught us that even well-capitalized institutions can fail due to a liquidity shortfall — a lesson that drove the Basel III liquidity framework.
Two Types of Liquidity Risk
1. Market Liquidity Risk
- Risk of being unable to exit a position without moving the market
- Indicators: bid-ask spreads, market depth, price resilience
2. Funding Liquidity Risk
- Risk of being unable to meet debt obligations as they come due
- Indicators: credit line utilization, reliance on wholesale funding, deposit run rates
Basel III Liquidity Standards
LCR (Liquidity Coverage Ratio)
LCR = High-Quality Liquid Assets (HQLA) / Net Cash Outflows over 30 days ≥ 100%
Purpose: Ensure 30-day self-sufficiency under a stress scenario.
HQLA Classification:
| Level | Asset Type | Haircut |
|---|---|---|
| Level 1 | Government bonds, central bank reserves | 0% |
| Level 2A | High-quality sovereign, covered bonds | 15% |
| Level 2B | Investment-grade corporate bonds, RMBS | 25–50% |
Assumed Cash Outflows (30-day stress):
- Retail deposits: 3–5% (stable), 10% (less stable)
- Unsecured wholesale funding: 25–100% (varies by counterparty type)
NSFR (Net Stable Funding Ratio)
NSFR = Available Stable Funding (ASF) / Required Stable Funding (RSF) ≥ 100%
Purpose: Ensure structural funding stability over a 1-year horizon.
| Item | ASF/RSF Factor |
|---|---|
| Equity capital | ASF 100% |
| Long-term debt (≥1 year) | ASF 100% |
| Retail deposits | ASF 90–95% |
| Wholesale funding (<3 months) | ASF 0–50% |
| Liquid assets | RSF 0–15% |
| Loans (≥1 year) | RSF 65–100% |
Basel III Capital Framework
Capital Hierarchy
| Capital Tier | Composition | Minimum Ratio |
|---|---|---|
| CET1 (Common Equity Tier 1) | Common stock + retained earnings | 4.5% |
| Tier 1 | CET1 + AT1 (Additional Tier 1) | 6.0% |
| Total Capital | Tier 1 + Tier 2 (subordinated debt) | 8.0% |
| Capital Conservation Buffer | CET1 add-on | +2.5% |
| Countercyclical Capital Buffer | Regulatory discretion | 0–2.5% |
Effective minimum CET1 = 4.5% + 2.5% (conservation buffer) = 7.0%
D-SIBs (Domestic Systemically Important Banks) carry additional surcharges of 1–3.5%.
Leverage Ratio
Leverage Ratio = Tier 1 Capital / Total Exposure ≥ 3%
- Backstop measure that does not rely on risk-weighted assets
- G-SIBs: 3% + additional surcharge
Risk-Weighted Assets (RWA)
Credit Risk RWA = Exposure × Risk Weight
| Asset Type | Risk Weight |
|---|---|
| OECD government bonds | 0% |
| Interbank (short-term) | 20% |
| Residential mortgages | 35% |
| Corporate loans | 100% |
| Equities | 100–150% |
Liquidity Stress Testing
Survival Horizon Analysis
Calculate the number of days until cash is exhausted under a stress outflow scenario.
Sample Scenario:
- 10% daily retail deposit runoff
- 100% immediate recall of wholesale funding
- 15% haircut on HQLA collateral
Funding Concentration Analysis
Assess over-reliance on single counterparties or markets:
- Top-5 funding provider concentration
- Short-term wholesale funding ratio
- Currency mismatch in funding
FRM Exam Key Points
| Topic | High-Yield Content |
|---|---|
| LCR | HQLA level haircuts; 30-day outflow assumptions |
| NSFR | 1-year structural stability; ASF/RSF factors |
| Capital tiers | CET1 4.5%, Tier 1 6%, Total Capital 8% |
| Leverage ratio | Tier 1 / Total exposure ≥ 3% |
| Liquidity risk types | Market liquidity vs. funding liquidity |
Chapter 6 covers Basel IV and FRTB — the most current and frequently tested regulatory developments.
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