Liquidity Risk

Liquidity risk management has been instrumental in maintaining a healthy funding profile during a year characterized by geopolitical tensions (e.g., the Iraq crisis) and by some market participants’ perceived view of a German banking crisis, the latter a particular concern to us.

Funding Matrix
We have mapped all funding relevant assets and liabilities into time buckets corresponding to their maturities to create what we call the “Funding Matrix.” Given that trading assets are typically more liquid than their contractual maturities suggest, we have divided them into liquids (assigned to the time bucket one year and under) and illiquids (assigned in equal installments to time buckets two to five years). We have modeled assets and liabilities from the retail bank that show a behavior of being renewed or prolonged regardless of capital market conditions (mortgage loans and retail deposits) and assigned them to time buckets accordingly. Wholesale banking products are bucketed based on their contractual maturities. We use the expected holding period to assign corporate investments to the Funding Matrix.

The Funding Matrix shows the excess or shortfall of assets over liabilities in each time bucket and thus allows us to identify and manage open liquidity exposures. We have also developed a cumulative mismatch vector, which enables us to predict whether any excess or shortfall will grow, decline or switch over time. The Funding Matrix forms the basis for our annual capital market issuance plan, which upon approval of our Group Asset and Liability Committee establishes issuing targets for securities by tenor, volume and instrument. Funding Matrix and issuance plan form the basis to determine the liquidity spread which is one component of the internal transfer price.

The funding matrix indicates that we are structurally long funded.

Short-term Liquidity
During 2003, we have extended the system that tracks net cash outflows from a horizon of eight weeks to 18 months. This system allows management to assess our short-term liquidity position in any location, region and globally on a by-currency, by-product, and by-division basis. The system captures all of our cash flows, thereby including liquidity risks resulting from off-balance sheet transactions as well as from transactions on our balance sheet. We model products that have no specific contractual maturities using statistical analysis to capture the actual behavior of their cash flows. Our Board of Managing Directors, upon the recommendations of our Group Asset and Liability Committee, has set global and regional cash outflow limits for the liquidity exposures of the first eight weeks, which we monitor on a daily basis. During February 2003, these limits were reduced by up to 20% in light of potential disruptions in the cash markets as a result of geopolitical tensions and the perceived German banking crisis. Subsequently in September, after such concerns faded, limits were marginally increased again. These limit changes come after substantial reductions of between 15% and 25% in the summer of 2002, which were reflecting changes in supply and demand assumptions in light of credit rating reviews and backtesting results, and display the active use of our liquidity risk management framework.

Unsecured Funding
Unsecured wholesale funding is a finite resource. Our Group Asset and Liability Committee has set limits to restrict utilization of unsecured wholesale funding. As with the cash outflow limits, the unsecured funding limits were adjusted during 2003 according to availability and business divisional demand.

Funding Diversification and Asset Liquidity
Diversification of our funding profile in terms of investor types, regions, products and instruments is an important part of our liquidity policy. Our core funding resources, such as retail, small/mid-cap and fiduciary deposits as well as long-term capital markets funding, form the cornerstone of our liability profile. Customer deposits, funds from institutional investors and interbank funding are additional sources of funding. We use interbank deposits primarily to fund liquid assets. The external unsecured funding numbers for 2002 have changed from last year’s report because funds under ‘Institutional Clearing Balances’ had been previously netted against overdrafts and are now reported on a gross basis. Furthermore, the category ‘Capital Markets’ has been extended by structured equity products, which had previously been reported on a net basis. Additionally, we now show Commercial Papers and Certificates of Deposits with an original maturity of more than one year, as well as structured deposits, which were previously included under “Bank Deposits” and “Other Non-Bank Deposits”, under “Capital Markets”.

The above chart shows the composition of our external unsecured liabilities as of December 31, 2003 both in Euro billion and as a percentage of our total unsecured liabilities. Our total external unsecured liabilities amounted to € 360 billion on that date. The liability diversification report is a management information tool we use to actively manage our liability composition and it contains all relevant external unsecured liabilities.

We track the volume and location within our consolidated inventory of unencumbered, liquid assets which we can use immediately to raise funds either in the repurchase agreement markets or by selling the assets. The securities inventory consists of a wide variety of liquid securities, which we can convert into cash even in times of market stress.

The liquidity of these assets is an important element in protecting us against short-term liquidity squeezes. By holding these liquid assets, we also protect ourselves against unexpected liquidity squeezes resulting from customers drawing large amounts under committed credit facilities. In addition, we maintained a € 32.8 billion portfolio of highly liquid securities in major currencies around the world to supply collateral for cash needs associated with clearing activities in euro, U.S. dollar and other major currencies.

Stress Testing and Scenario Analysis
We employ stress testing and scenario analysis to evaluate the impact of sudden, unforeseen events with an unfavorable impact on the bank's liquidity. The scenarios are either based on historic events (such as the stock market crash of 1987, the U.S. liquidity crunch of 1990 and the terrorist attacks of September 11, 2001) or modeled using hypothetical events. They include internal scenarios such as operational risk, merger or acquisition, credit rating downgrade by 1 and 3 notches as well as external scenarios such as market risk, Emerging Markets, systemic shock and prolonged global recession. Additionally, we evaluate the liquidity impact of a crisis in the German banking sector. Under each of these scenarios we assume that all maturing assets will need to be rolled over and require funding whereas rollover of liabilities will be partially impaired (funding gap). We then model the steps we would take to counterbalance the resulting net shortfall in funding needs such as selling assets, switching from unsecured to secured funding and adjusting the price we would pay for liabilities (gap closure). This analysis is fully integrated within the existing liquidity framework. We take our contractual cash flows as a starting point, which enables us to track the cash flows per currency and product over an eight-week horizon (the most critical time span in a liquidity crisis) and apply the relevant stress case to each product. Asset salability as described in the paragraph above complements the analysis. Our stress testing analysis provides guidance as to our ability to survive critical scenarios and would, if deficiencies were detected, cause us to make changes to our asset and liability structure. The analysis is performed monthly. The following report is illustrative for our stress testing results as of December 31, 2003. For each scenario, the table shows what our maximum funding gap would be over an eight-week horizon after occurrence of the triggering event, whether the risk to our liquidity would be immediate and whether it would improve or worsen over time and how much liquidity we believe we would have been able to generate at the time to close the gap.

With the increasing importance of liquidity management in the financial industry, we consider it important to contribute to financial stability by regularly addressing central banks, supervisors, rating agencies, and market participants on liquidity risk-related topics. We participate in a number of working groups regarding liquidity and will strive to assist in creating an industry standard that is appropriate to evaluate and manage liquidity risk.

In addition to our internal liquidity management systems, the liquidity exposure of German banks is regulated by the German Banking Act and regulations issued by the German Federal Financial Supervisory Authority. We are in compliance with all applicable liquidity regulations.