Funding

The use of the liquidity portfolio as a liquidity reserve is based on the assumption
that the cash equivalent for that portfolio can be funded by the normal credit line
based upon a good credit standing. As a result existing inventory will be free for
funding purposes. Based on a normal yield curve the inventory will be funded for
shorter periods producing a return on the spread difference. The funding period will
be rolled every 3–6 months.
If additional funding is needed the inventory can be used as collateral to acquire
additional liquidity from other counterparties. Normally funds are received at a lower
interest rate because the credit risk is reduced to that of the issuer, which is in most
cases better than the FI’s own credit risk. In the best case one will receive the mark
to market value without a haircut (sell-buy-back trade). In the case of repo trades
there will be a haircut (trades with the central bank).
The worst case would occur if funds are borrowed in one transaction and upon the
rollover date a ‘temporary illiquidity’ occurs. In the meantime the credit rating of the
FI may have deteriorated. For all future fundings with this FI, counterparties will
demand both collateral and a haircut. This means that if 10 units of cash are
required for clearing and 100 units for the liquidity funding the FI will receive 90
units against every 100 units of collateral. The result is that due to the increased
funding of the liquidity portfolio, the original liquidity gap of 10 units increased by
an additional 10 units to 20. As such, the liquidity portfolio failed to fulfil its purpose
of supplying additional necessary reserves. In the case of a rise in interest rates, the
price of the liquidity portfolio will also fall and may, for example, result in the FI
receiving only 80 units; the total additional funding gap for the portfolio would now
be 20 units and total difference 30 (see Figure 15.9).
If the funding of the liquidity portfolio is carried out incorrectly it can lead to an
increase of the liquidity gap. Therefore, it would be beneficial to structure the funding
into several parts. These would be funded in different periods and with different
counterparts. One part should be covered by ‘own capital’ and the market risk should
be hedged.