June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 71 of 92 8. LIQUIDITY ADEQUACY 8.1. Introduction Liquidity adequacy is intended to be a separate capital determination from the economic value calculation as described in this white paper. A company may have sufficient capital adequacy for economic capital but may be inadequate in meeting liquidity demands. Capital adequacy implies a balance of both perspectives. A company must have sufficient capital and liquidity because inadequacy in either will affect financial health. This section specifically addresses the measurement of capital adequacy as it relates to liquidity. Recall the Financial Liquidity side of the balance beam of Figure 2.1. This section will focus on the components that make up the Liquidity Adequacy determination. The analysis of Liquidity Adequacy is meant to ensure that a company has sufficient access to cash in order to service its liquidity obligations. The key component in that analysis is the Contingent Liquidity, or Cash Flow at Risk (CFaR), which is the amount of liquid assets that a company should maintain in order to weather potential risks to its cash flow, yet still service its liquidity obligations. We can calculate liquidity adequacy by determining internal funding requirements from all expected internal and external financial resources in meeting cash flow obligations or demands under normal and adverse market conditions taking into account market, credit, and operative contingencies. To the extent possible, the same price propagation or price modeling process used in market and credit risk assessments can be combined with financial relationships used in the construction of forward-looking financial cash flow statements. It is also necessary to account for conditional events such as trigger events, probability of counterparty defaults, material adverse changes, adequate assurances, and debt to equity triggers. Modeling Figure 2.1 Capital Adequacy Economic Value Economic Value Financial Liquidity Financial Liquidity CAPITAL ADEQUACY CAPITAL ADEQUACY Net Assets Debt Economic Capital Capital Shortfall Cash From Ops Fixed Pay- ments Cash On Hand Credit Lines Risk Aggregation Cash Flow - at - Risk Capital Shortfall 0 0.005 0.01 0.015 0.02 0.025 0.03 $0 $9 $18 $27 $36 $45 $54 $63 $72 $81 $90 $99 $108 $117 $126 $135 0 0.05 0.1 0.15 0.2 0.25 0.3 0 1 2 3 4 5 6 7 8 9 10 11 Loss from Credit Defaults ($MM) Probability -40 -35 -30 -25 -20 -15 -10 -5 0 Internal External Physical Market Risk Assessment Credit Risk Assessment Operative Risk Assessment