FRM Part II · FRM Exam Part II

Liquidity and Reserves Management: Strategies and Policies: formula sheet

Full chapter guide

Key formulas

Liquidity Coverage Ratio (LCR): LCR = Stock of HQLA ÷ Total net cash outflows over the next 30 days ≥ 100%; Short-term resilience under a 30-day stress. HQLA means high-quality liquid assets.
Net Stable Funding Ratio (NSFR): NSFR = Available stable funding ÷ Required stable funding ≥ 100%; One-year structural measure that limits maturity mismatch.
Survival horizon: Survival horizon = number of days the bank can meet outflows under stress using its liquid resources; A common appetite metric. The board sets a minimum number of days.
Liquidity gap: Net gap in a time bucket = Cash inflows − Cash outflows; A cumulative negative gap shows a funding need to be covered by buffers.
Liquidity Coverage Ratio: LCR = Stock of HQLA ÷ Total net cash outflows over the next 30 calendar days ≥ 100%; Net outflows are stressed outflows minus the lesser of stressed inflows and 75% of outflows.
Net cash outflows (LCR): Net outflows = Outflows − min(Inflows, 75% × Outflows); Inflows are capped at 75% of outflows, so net outflows are at least 25% of outflows.
HQLA after haircut: Adjusted value = Market value × (1 − haircut); Level 1 has no haircut. Level 2A has 15%. Level 2B has larger haircuts, such as 25% for qualifying RMBS and 50% for qualifying corporate equities.
Composition caps: Level 2 ≤ 40% of HQLA; Level 2B ≤ 15% of HQLA (after haircuts); Caps are applied after haircuts and adjusted for secured transactions maturing within 30 days.
Survival horizon: Survival days = Buffer ÷ Average daily stressed net outflow; A simple internal measure. It assumes outflows are even, which stress rarely is.
Cumulative net stressed outflow: Net outflow(t) = Σ stressed outflows(1..t) − Σ stressed inflows(1..t); Calculate for each day up to the survival horizon. The peak value drives buffer size.
Required buffer: Required buffer = max over scenarios of (peak cumulative net outflow + contingency needs); Size to the most severe scenario, not the average.
Stressed value of buffer: Stressed value = Market value × (1 − haircut); Use for each asset. Only unencumbered assets count.
Survival horizon test: Survives to day T if buffer stressed value + other counterbalancing capacity ≥ cumulative net outflow(t) for every t ≤ T; The horizon is the last day this holds. It is a path test, not a single-day test.
Liquidity Coverage Ratio (Basel III): LCR = Stock of HQLA ÷ Total net cash outflows over next 30 calendar days ≥ 100%; Net outflows = outflows − min(inflows, 75% of outflows).
Funding concentration ratio: Concentration = Funding from largest counterparties ÷ Total funding; Compare with the policy limit. Define the group (top 5, top 10) exactly as the question does.
Share of funding source: Share = Funding from source ÷ Total funding × 100%; Use to compare wholesale versus retail reliance.
Loan-to-deposit ratio: LTD = Loans ÷ Customer deposits; A higher ratio means more reliance on non-deposit funding. It is a rough indicator, not a regulatory ratio.
Net Stable Funding Ratio (Basel III): NSFR = Available stable funding ÷ Required stable funding ≥ 100%; Encourages stable, longer-term funding for less liquid assets over a one-year horizon.
Maturity ladder rollover gap: Gap in bucket = Assets maturing in bucket − Liabilities maturing in bucket; A negative gap means refinancing is needed. Cumulate gaps across buckets to see the survival period.
Liquidity gap under stress: Stress gap = Stressed cash outflows − Stressed cash inflows; Compute per time bucket. A positive gap must be covered by the buffer and CFP actions.
Survival horizon: Survival horizon = number of days until cumulative net outflows exceed available liquid resources; Include only assets that can be monetised in the stress, after haircuts.
Counterbalancing capacity after haircuts: Available liquidity = Σ (market value of asset × (1 − haircut)); Apply haircuts to each asset class before adding.
Funding shortfall to be covered by CFP: CFP need = Cumulative net outflow − Buffer available; If zero or negative, the buffer alone covers the horizon.
Trigger logic: Indicator ≥ (or ≤) threshold → escalate to the next tier; Direction depends on the metric: higher is worse for outflow rates, lower is worse for buffer ratios.
Encumbrance ratio: Encumbrance ratio = Encumbered assets ÷ Total assets; Some supervisors also include collateral received and re-used in the denominator and numerator. Follow the definition in the question.
Collateral value after haircut: Lending value = Market value × (1 − haircut); Use this to find the funding raised or the collateral still needed.
Required collateral for a loan: Market value required = Loan amount ÷ (1 − haircut); Haircut rises in stress, so required collateral rises.
Unencumbered liquid buffer: Usable buffer = Σ [Unencumbered market value × (1 − haircut)]; Exclude any asset already pledged or legally trapped.
Daily maximum intraday liquidity usage: Max usage = largest net cumulative negative position during the day (net payments sent − received); A Basel monitoring tool. Compare it with available intraday liquidity.
Intraday coverage check: Available intraday liquidity − Peak net cumulative outflow ≥ 0; A negative result means a shortfall; payments may be delayed or extra credit needed.

Quick revision

Funding liquidity risk is the risk of being unable to meet obligations when due; market liquidity risk is the risk of being unable to sell assets without a large price impact.
Liquidity risk appetite and limits are set by the board and senior management, with independent monitoring.
A buffer should be sized against a stated stress scenario and survival horizon, not an average day.
High-quality liquid assets are only useful if they are unencumbered and can be monetised quickly.
Haircuts rise in stress, so the cash raised from collateral can fall just when you need it.
Diversify funding by source, tenor, currency, counterparty and instrument; heavy reliance on short-term wholesale funding raises rollover risk.
Maturity mismatches matter most when funding is short and assets are illiquid.
A CFP sets out roles, triggers, actions and communication, and it should be tested regularly.
Early warning indicators should be forward-looking and linked to specific CFP actions.
Intraday liquidity needs depend on payment timing, so delays in receipts can force larger intraday borrowing.
Rating downgrades can trigger collateral calls and withdrawal of funding, so consider them in stress design.
Holding more liquidity lowers risk but costs earnings, so policy is a trade-off.

Common mistakes

Treating funding and market liquidity as the same thing. Fix: Funding is about raising cash for liabilities. Market liquidity is about selling an asset at a fair price.
Assuming a solvent bank cannot face a liquidity crisis. Fix: A bank with positive equity can fail if it cannot roll over funding. Liquidity and solvency are linked but different.
Counting encumbered assets in the buffer. Fix: Only unencumbered assets count. Pledged collateral is not available to meet new outflows.
Using full inflows instead of capping at 75% of outflows. Fix: Net outflows = outflows − min(inflows, 75% × outflows). Check the cap every time.
Sizing the buffer to the average or expected scenario. Fix: Size to the most severe plausible scenario. The buffer must cover the peak cumulative need.
Counting encumbered assets or using market value without haircuts. Fix: Exclude pledged assets and apply haircuts. Only the stressed, unencumbered value counts.
Treating all deposits as equally stable. Fix: Separate insured retail from uninsured corporate and financial deposits. Stability depends on the depositor type and relationship.
Assuming diversification removes funding risk in a systemic crisis. Fix: State that sources can fail together in market-wide stress. Diversification reduces, not removes, risk and must be paired with buffers.
Treating the CFP as the same as the liquidity buffer. Fix: The buffer is the stock of liquid assets. The CFP is the plan for governance, triggers and actions, including how to use the buffer and what comes after it.
Listing only internal indicators. Fix: Include market-based signals too, such as CDS spreads, share price, rating actions and repo terms. Good frameworks use both.

Exam tips

Expect scenario stems asking you to classify the risk type, then to name the interaction. Label first, then choose.
Governance questions test who does what. Memorise board, management, independent risk, audit roles.
In LCR questions, check that inflows are netted and that you divide by net outflows, not gross.
Be careful with absolutes such as always or never in options about liquidity and solvency.
Read for encumbrance and currency clues. They are often the hidden reason a buffer fails.
Always check the 75% inflow cap and the haircut before dividing.
Memorise Level 1 (no haircut), Level 2A (15%) and the 40% and 15% caps.
For strategy questions, pick the answer that balances cost against stress resilience, not the one that maximises either alone.