Use the liquid asset buffer as the basis for estimating a firm's contingent liquidity.
The idea
The liquid asset buffer is the stock of unencumbered, high quality assets a firm can sell or repo quickly to raise cash in stress, and it is the natural starting point for measuring contingent liquidity, meaning the cash the firm can generate if a stress event occurs. The estimate works in steps. Start with the market value of each asset class, remove anything already pledged or otherwise encumbered, apply a stress haircut to reflect price falls and repo margin increases, and then remove assets that cannot be transferred to the entity that needs the cash. Counterbalancing sources such as central bank facilities are added separately and only if eligible collateral remains, because one asset cannot be both sold and pledged. Buffer after haircuts divided by net daily stress outflow gives a survival horizon. Usability in stress must be tested, not assumed: high quality alone does not guarantee cash, so check encumbrance, currency, haircuts that widen in stress, continued eligibility and marketability, and the operational ability to mobilise the assets in time. Common errors are counting encumbered assets, using haircuts that are too small, and double counting collateral.
Formulas
Survival horizon from the liquid asset buffer
Survival horizon = B ÷ (O − I)
- B
- the buffer after stress haircuts, excluding encumbered and non-transferable assets
- O
- daily gross stress outflows
- I
- daily stress inflows
Assumes a constant net outflow. Using the buffer before haircuts, or gross outflows, misstates it.
A practice question
In estimating a firm's contingent liquidity, what is the role of the liquid asset buffer?
- It is the total of all assets on the balance sheet, because in a stress any asset can in principle be sold to raise cashWhy not: A buffer holds only assets that can be sold or repoed quickly with limited loss, not every asset on the balance sheet.
- It is the maximum loss the firm expects at a chosen confidence level over a short horizon, such as a ten-day VaRWhy not: Describes a VaR-type measure of losses; the buffer is a stock of liquid assets that produces cash.
- It is the stock of unencumbered, high quality assets that can quickly be turned into cash in stress - correct
- It is the amount of regulatory capital the firm holds against liquidity risk, which absorbs losses in stressWhy not: Capital absorbs losses; a buffer provides cash. They are not interchangeable.
The buffer is the pool of unencumbered, readily saleable or repoable assets. After haircuts and transfer limits it indicates how much cash the firm can raise under stress.
A harder one
A bank holds USD 800 million of government bonds, of which USD 100 million are pledged, USD 400 million of corporate bonds and USD 200 million of equities. Stress haircuts are 2%, 15% and 40% respectively. Contingent liquidity based on the unencumbered buffer after haircuts, in USD million, is closest to:
- 1,244Why not: Applies the haircut but includes the USD 100 million of pledged government bonds.
- 1,300Why not: Sums unencumbered market values and omits the stress haircuts altogether.
- 154Why not: Adds up the haircut amounts rather than the cash remaining after the haircuts.
- 1,146 - correct
Unencumbered government bonds are 700, so 700 x 0.98 = 686, plus 400 x 0.85 = 340, plus 200 x 0.60 = 120. The total is 1,146.
The hardest tier
A group's parent entity holds USD 1,200 million of buffer assets after haircuts. A subsidiary holds USD 500 million after haircuts, but regulation prevents transfer of it to the parent. The group's stressed net outflows include the subsidiary's own net outflows of USD 380 million. What buffer can the group count against its stressed outflows, in USD million?
- 1,700Why not: Adds the full subsidiary buffer, ignoring that the cash cannot be moved and cannot cover parent needs.
- 1,200Why not: Excludes the subsidiary altogether, although its buffer can still cover its own stressed outflows.
- 1,320Why not: Counts only the subsidiary's USD 120 million surplus, rather than the part that matches its own needs.
- 1,580 - correct
Trapped subsidiary assets can offset only the subsidiary's own outflows, so only min(500, 380) = 380 counts. Group buffer = 1,200 + 380 = 1,580. The extra 120 is restricted liquidity.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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