Planning and management of internal pricing for contingent events Essay Example

transforming below-grade investment assets into investment-grade liabilities. Rating agencies could have played a role in reducing stress in the subprime mortgage market.

The residential sub prime mortgage was downgraded to 17% and 9.8% from investment grade to speculative grade. Additionally, default rates experienced a significant increase. Investors relied on the ratings provided by rating agencies for various products, such as mortgage bonds and asset-backed commercial paper. These ratings were considered stable and timely in forecasting any potential crisis. Institutions responsible for these ratings also imposed regulatory barriers to restrict investment in assets with specific ratings. Rating agencies recommended money market funds to only invest in triple A rated assets, and pension funds were limited to investing in investment grade assets. Credit ratings were used to determine the required amount of regulator capital for each regulated financial institution. The rating process could have potentially prevented the sub prime mortgage crisis by estimating loss distribution and simulating cash flows over a specific timeframe.

The sub prime crisis could have been avoided if liquidity risks were managed effectively. Liquidity risk management involves extending credibility to others to maintain one's own liquidity and minimize the chances of losses.
There are multiple factors that influence the level of contingency liquidity reserves held by individual institutions. These factors include business model, centralization level, geographic dispersion, local market structure, regulatory jurisdiction, and relevant deposit insurance scheme. For example, securities firms may choose to hold more excess liquidity compared to banks due to the absence of a stable funding source like insured retail deposits.
Securities firms utilize various processes and measures to determine the minimum level of liquidity reserves they should maintain. These processes can involve

complex inputs and underlying calculations, as well as spreadsheets that list sources and use of funds. Alternatively, they may employ simple measures and ratios.

To avoid the subprime crisis, organizations needed to consider the following areas: realizing the potential contingent liquidity risk of existing and new products, pricing contingent liquidity to reflect the nature and risk profiles of liabilities, funding certain off-balance sheet obligations in contingency funding plans, monitoring non-contractual obligations to protect the business's reputation, accounting for changes in market clauses and pricing in syndicated lending businesses, and using effective funding managers to monitor and manage funding liquidity positions during the crisis. Additionally, experienced judgment was needed to adequately manage liquidity risk considering the unexpected nature of the crisis.

The text discusses the importance of preparing for increased funding needs by building up liquidity reserves. It suggests using behavioral tools to model liquidity risk and better understand the impact of market conditions on liquidity positions. It also highlights the varying effectiveness of contingency funding plans and emphasizes the need to anticipate the severity and nature of market stresses. The text recommends making improvements to contingency plans based on recent experiences and anticipating impaired asset market liquidity and potential limitations on secured funding during stress events. Additionally, it mentions the likelihood of increased balance sheets during stress events and suggests avoiding prolonged underwriting commitments on balance sheets when unnecessary.

Many firms in Europe encountered difficulties in obtaining dollar funding, particularly in terms of maturities, due to issues in the foreign exchange swap market. This problem arose because participants in the foreign exchange swap market differentiated firms based on perceived exposure, peer groupings, jurisdictions, and specific names of firms.

If these distinctions were not made, it would have improved the cost and availability of liquidity in adverse market conditions. Firms should have taken into account the potential change in market liquidity when creating contingency plans, and planned for a long-lasting funding disruption. It was important for firm contingency funding plans to address recent events and relevant stresses.

Many major banking organizations should have expected that some retail deposits would generally be high or stable recently. However, some firms did not anticipate the need to include stress scenarios in their contingency funding plans. Consequently, their contingent liquidity reserves might not have been as strong as expected, especially when it came to easily monetizing mortgage-backed securities for obtaining liquidity. Despite this, several firms recognized the necessity of holding more liquidity in their holding companies moving forward.
While these firms had incorporated firm-specific or market-wide scenarios in their contingency funding plans, they must consider severe stress events and ensure they can support entities to maintain their reputation and market position. Furthermore, firms should have foreseen the need to support entities that they were not contractually obligated to help, such as money market funds or SVIs. It was crucial for firms to anticipate and address the funding requirements of certain customers in order to protect business relationships.