CAIA Level II: Risk and Risk Management — Liquidity and Funding Risks

CAIA Level II: Risk and Risk Management — Liquidity and Funding Risks

What Is It?

1. Liquidity risk is the inability to meet cash obligations without incurring excessive costs. Funding risk is the inability to secure financing when needed.
2. Tested via scenario analysis, stress testing, regulatory compliance (e.g., Basel III), and real-world portfolio liquidity management.

Why Does the Exam Ask This?

Measures ability to: - Assess liquidity gaps in portfolios (e.g., hedge funds, private equity). - Apply regulatory liquidity ratios (LCR, NSFR). - Design stress tests for funding stability. - Judge operational resilience under market shocks.

What Do I Need to Know First?

1. Market vs. funding liquidity (asset saleability vs. financing availability).
2. Liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) (Basel III).
3. Cash flow mismatch (asset-liability duration gaps).
4. Stress testing (historical vs. hypothetical scenarios).
5. Haircuts and collateral valuation (impact on funding costs).

Topic Snapshot

CAIA Level II embeds liquidity/funding risk in Alternative Investments Risk Management. It bridges portfolio construction (illiquid assets) and regulatory compliance (Basel, SEC). Critical for hedge funds, private credit, and distressed debt strategies.

Exam / Job / Audit Weighting

• Frequency: High (appears in 10–15% of Level II questions).
• Difficulty Rating: Intermediate.
• Question Type: Scenario-based MCQs, calculations (LCR/NSFR), case studies (funding gaps).

Difficulty Level

Intermediate

Must-Know Rules, Formulas, Standards

1. Liquidity Coverage Ratio (LCR):
   [
   \text{LCR} = \frac{\text{High-Quality Liquid Assets (HQLA)}}{\text{Net Cash Outflows (30-day stress)}} \geq 100\%
   ]
2. Net Stable Funding Ratio (NSFR):
   [
   \text{NSFR} = \frac{\text{Available Stable Funding (ASF)}}{\text{Required Stable Funding (RSF)}} \geq 100\%
   ]
3. Liquidity Mismatch Rule:
4. Short-term liabilities should not fund long-term illiquid assets (e.g., repo funding for private equity).

Misconceptions

1. "Liquidity risk = market risk." → Liquidity risk is about funding availability, not price volatility.
2. "HQLA = cash only." → HQLA includes Level 1 (cash, Treasuries), Level 2A (corporate bonds), Level 2B (equities).
3. "NSFR is just LCR’s long-term version." → NSFR focuses on structural funding stability (1-year horizon), not 30-day stress.
4. "Stress tests are only for banks." → Hedge funds and private equity must model redemption shocks and margin calls.

Common Mistakes

1. Ignoring haircuts in collateral valuation (e.g., assuming 100% funding against illiquid assets).
2. Overestimating HQLA (e.g., counting unencumbered corporate bonds as Level 1).
3. Misclassifying liabilities (e.g., treating repo as stable funding vs. short-term wholesale).
4. Static liquidity analysis (not adjusting for rollover risk or counterparty concentration).
5. Confusing liquidity risk with solvency risk (illiquidity ≠ insolvency, but illiquidity can trigger insolvency).

The Common Trap

Assuming liquidity is binary (either "liquid" or "illiquid"). In reality: - Liquidity is a spectrum (e.g., small-cap stocks vs. micro-cap stocks). - Funding costs rise non-linearly under stress (e.g., 10% haircut → 30% funding gap). - Contagion effects (e.g., one fund’s fire sale triggers margin calls for others).

Terms to Remember

1. HQLA (High-Quality Liquid Assets): Assets easily convertible to cash (e.g., Treasuries, cash).
2. LCR (Liquidity Coverage Ratio): 30-day stress liquidity buffer (Basel III).
3. NSFR (Net Stable Funding Ratio): 1-year structural funding stability (Basel III).
4. Rollover Risk: Inability to refinance short-term debt (e.g., commercial paper).
5. Fire Sale: Forced asset sales at deep discounts due to liquidity crunch.

Step-by-Step Process

1. Identify Liquidity Exposures

• Assets: Classify by liquidity (Level 1–3 under Basel).
• Liabilities: Separate stable funding (retail deposits) from volatile funding (wholesale, repo).

2. Calculate Liquidity Ratios

• LCR: HQLA / 30-day net outflows (must ≥ 100%).
• NSFR: ASF / RSF (must ≥ 100%).

3. Stress Test

• Historical: 2008 crisis, 2020 COVID shock.
• Hypothetical: 30% redemption requests, 50% haircut on collateral.

4. Mitigate Gaps

• Assets: Increase HQLA, reduce illiquid holdings.
• Liabilities: Diversify funding sources, extend maturity profiles.

5. Document & Report

• Regulatory: LCR/NSFR filings (Basel III).
• Internal: Liquidity risk appetite statement, contingency funding plan.

Exam Answer Builder

1-Mark Question (MCQ)

What it tests: Definition of LCR. Example: "Under Basel III, the Liquidity Coverage Ratio (LCR) requires banks to hold enough HQLA to cover net cash outflows over what period?" Options: A) 7 days B) 30 days C) 90 days D) 1 year Key Tip: Memorize 30-day stress horizon for LCR.

3-Mark Question (Calculation)

What it tests: LCR calculation. Example: "A bank has $500M in HQLA and $400M in net cash outflows over 30 days. What is its LCR, and does it comply with Basel III?" Key Tip: 1. Formula: LCR = HQLA / Net Outflows. 2. Threshold: ≥ 100%. 3. Answer: 125% (compliant).

5-Mark Question (Scenario)

What it tests: Funding risk mitigation. Example: "A hedge fund holds $1B in illiquid private credit and $200M in cash. Its $800M in liabilities are 70% short-term repo. How should it adjust its funding strategy to reduce liquidity risk?" Key Tip: - Reduce short-term funding (e.g., extend repo maturities). - Increase HQLA (e.g., sell private credit, hold Treasuries). - Diversify funding (e.g., add term loans, equity).

Case Study (10-Mark)

What it tests: Integrated liquidity/funding risk analysis. Example: "During a market crash, a bank’s HQLA drops 20% due to margin calls, while its 30-day net outflows rise 30%. Its LCR falls to 90%. What are the immediate and long-term risks, and how should regulators respond?" Key Tip: - Immediate: Breach of LCR → regulatory intervention (e.g., liquidity injection). - Long-term: NSFR review, contingency funding plan, asset sales.

This vs That

Time-Saver Hack

LCR vs. NSFR Cheat: - LCR = "Short-term survival" (30-day stress). - NSFR = "Long-term stability" (1-year funding). - If LCR < 100% → Immediate crisis. - If NSFR < 100% → Structural funding gap.

Mini Scenarios

1. Basic

"A bank’s HQLA is $1B, and its 30-day net outflows are $900M. What is its LCR?" What to notice: LCR = 111% (compliant, but tight buffer).

2. Applied

"A hedge fund’s prime broker demands 20% more collateral due to a market crash. The fund’s cash buffer is 10%. What’s the risk?" What to notice: Margin call → liquidity crunch (fund may need to sell assets at a loss).

3. Tricky

"A bank’s NSFR is 110%, but its LCR is 95%. Why is this possible?" What to notice: NSFR measures 1-year funding, LCR measures 30-day stress → short-term liquidity crisis doesn’t always mean long-term instability.

Diagnostic MCQ Bank

Easy (1/3)

Question: What is the primary purpose of the Liquidity Coverage Ratio (LCR)? Options: A) Ensure banks have enough capital for losses. B) Ensure banks can meet 30-day cash outflows under stress. C) Measure long-term funding stability. D) Regulate leverage ratios. Correct Answer: B Explanation: LCR is a 30-day liquidity buffer under Basel III. Trap Option: A (confuses LCR with capital ratios like CET1).

Medium (2/4)

Question: A bank has $500M in HQLA and $600M in 30-day net outflows. What is the LCR, and is it compliant? Options: A) 83%, non-compliant B) 120%, compliant C) 83%, compliant D) 120%, non-compliant Correct Answer: A Explanation: LCR = 500/600 = 83% < 100% → non-compliant. Trap Option: B (miscalculates ratio).

Hard (3/3)

Question: A hedge fund’s assets are 60% illiquid (private equity) and 40% liquid (Treasuries). Its liabilities are 80% short-term repo. What is the biggest funding risk? Options: A) Rollover risk from repo. B) Market risk from Treasuries. C) Credit risk from private equity. D) Operational risk from prime brokers. Correct Answer: A Explanation: Short-term repo funding illiquid assets → rollover risk (can’t refinance). Trap Option: C (private equity has liquidity risk, not credit risk).

Real-World Patterns

1. Hedge Fund Blowups: LTCM (1998) and Archegos (2021) collapsed due to margin calls + illiquid positions.
2. Bank Runs: Silicon Valley Bank (2023) failed from duration mismatch (long-term bonds funded by short-term deposits).
3. Private Equity: Funds with capital call lines face funding risk if LPs default.

30-Second Cheat Sheet

1. LCR = HQLA / 30-day net outflows ≥ 100% (Basel III).
2. NSFR = ASF / RSF ≥ 100% (1-year funding stability).
3. Short-term liabilities + illiquid assets = funding risk.
4. Haircuts increase under stress (e.g., 10% → 30%).
5. Liquidity ≠ solvency (but illiquidity can trigger insolvency).

Related Concepts

1. Market Risk (VaR, stress testing).
2. Counterparty Credit Risk (CVA, collateral agreements).
3. Operational Risk (contingency funding plans).

Verified Source List

1. Basel Committee on Banking Supervision (BCBS): Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (2013).
2. CAIA Association: Alternative Investments: CAIA Level II (2023).
3. Bank for International Settlements (BIS): Principles for Sound Liquidity Risk Management (2008).
4. SEC: Liquidity Risk Management Programs for Open-End Funds (2016).
5. FRB: Supervisory Liquidity Stress Testing (2020).