ch17 1

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BUFN 722

• ch-17
• Liquidity Risk

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Overview

• This chapter explores the problem of liquidity
  risk faced to a greater or lesser extent by all
  FIs. Methods of measuring liquidity risk, and its
  consequences are discussed. The chapter also
  discusses the regulatory mechanisms put in place
  to control liquidity risk.

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Causes of Liquidity Risk

• Asset side
• May result from loan commitments- when OBS
  commitments are exercised
• Traditional approach reserve asset management.
• Alternative liability management.

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Causes of Liquidity Risk

• Liability side
• when depositors or insurance policyholders seek
  to cash in or withdraw their financial claims
• Reliance on demand deposits
• Core deposits
• deposits that provide a relatively stable,
  long-term funding source to a bank
• Need to be able to predict the distribution of
  net deposit drains.
• the amount by which cash withdrawals exceed
  additions a net cash outflow

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Liability Management

• Managed by
• purchased liquidity management
• stored liquidity management
• Purchased liquidity
• Federal funds market or repo market.
• Issue additional fixed-maturity CDs, notes,
  and/or bonds
• Managing the liability side preserves asset side
  of balance sheet.
• Borrowed funds likely at higher rates than
  interest paid on deposits.
• Deposits are insured
• Regulatory concerns growth of wholesale funds

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Liability Management

• Alternative Stored Liquidity Management
• Liquidate assets.
• can use or sell off some of its assets (such as
  T-bills)
• May be forced to liquidate assets too rapidly
• Fire-sale price
• the price received for an asset that has to be
  liquidated (sold) immediately
• utilize its stored liquidity (i.e., cash in
  vault)
• In absence of reserve requirements, banks tend to
  hold reserves. E.g. In U.K. reserves 1 or
  more. Downside opportunity cost of reserves.
• Decreases size of balance sheet
• Requires holding excess non-interest-bearing
  assets
• Combine purchased and stored liquidity management

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Asset Side Liquidity Risk

• Risk from loan commitments and other credit
  lines
• met either by borrowing funds or
• by running down reserves
• Current levels of loan commitments are
  dangerously high according to regulators

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Measuring Liquidity Exposure

• Net liquidity statement shows sources and uses
  of liquidity.
• Sources (i) Cash type assets, (ii) maximum
  amount of borrowed funds available, (iii) excess
  cash reserves
• Uses include borrowed or money market funds
  already utilized, and any amounts already
  borrowed from the Fed.

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Other Measures

• Peer group comparisons usual ratios include
  borrowed funds/total assets, loan
  commitments/assets etc.
• a comparison of its key ratios and balance sheet
  features with those for banks of a similar size
  and geographic location
• Liquidity index weighted sum of fire sale
  price P to fair market price, P, where the
  portfolio weights are the percent of the
  portfolio value formed by the individual assets.
  I S wi(Pi /Pi) measures the potential losses
  an FI could suffer from a sudden or fire-sale
  disposal of assets compared to the amount it
  would receive at a fair market value established
  under normal market conditions

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Calculation of the Liquidity Index
N

I ? (wi)(Pi / Pi)
i 1 where wi Percentage of each
asset in the FIs portfolio ? wi 1
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Measuring Liquidity Risk

• Financing gap and the financing requirement
• Financing gap Average loans - Average deposits
  or,
• financing gap liquid assets financing
  requirement.
• The gap can be used in peer group comparisons or
  examined for trends within an individual FI.
• Example of excessive financing requirement
  Continental Illinois, 1984.

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Financing Gap and the Financing Requirement

• Financing gap
• the difference between a banks average loans and
  average (core) deposits
• if the financing gap is positive, the bank must
  fund it by using its cash and liquid assets
  and/or borrowing funds in the money market
• Financing requirement
• the financing gap plus a banks liquid assets
• the larger a banks financing gap and liquid
  asset holdings, the higher the amount of funds it
  needs to borrow on the money markets and the
  greater is its exposure to liquidity problems

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BIS Approach

• Maturity ladder/Scenario Analysis
• For each maturity, assess all cash inflows versus
  outflows
• Daily and cumulative net funding requirements can
  be determined in this manner
• Must also evaluate what if scenarios in this
  framework

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Liquidity Planning

• Allows managers to make important borrowing
  priority decisions
• Components of a liquidity plan
• delineation of managerial details and
  responsibilities
• detailed list of fund providers most likely to
  withdraw and the pattern of fund withdrawals
• identification of the size of potential deposit
  and fund withdrawals over various time horizons
  in the future
• sets internal limits on separate subsidiaries and
  branches borrowing and bounds for acceptable risk
  premiums to pay
• details a sequencing of assets for disposal

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Liquidity Planning

• Important to know which types of depositors are
  likely to withdraw first in a crisis.
• Composition of the depositor base will affect
  the severity of funding shortfalls.
• Allow for seasonal effects.
• Delineate managerial responsibilities clearly.

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Deposit Drains and Bank Run Liquidity Risk

• Deposit drains may occur for a variety of reasons
• concerns about a banks solvency
• failure of a related bank
• sudden changes in investor preferences
• Bank run
• a sudden and unexpected increase in deposit
  withdrawals from a bank
• Bank panic
• a systemic or contagious run on the deposits of
  the banking industry as a whole

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Bank Runs

• Can arise due to concern about banks solvency.
• Failure of a related FI.
• Sudden changes in investor preferences.
• Demand deposits are first come first served.
  Depositors place in line matters.
• Bank panic systemic or contagious bank run.

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Alleviating Bank Runs

• Regulatory measures to reduce likelihood of bank
  runs
• FDIC
• Discount window
• Not without economic costs.

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Deposit Insurance and Discount Window

• Deposits insured for 100,000
• Federal Reserve provides a discount window
  facility to meet banks short-term nonpermanent
  liquidity needs
• loans made by discounting short-term high-quality
  securities such as T-bills and bankers
  acceptances with central bank
• leads to increased monitoring from the Federal
  Reserve which acts as a disincentive for banks to
  use for cheap funding

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Liquidity Risk for Other FIs

• Life Cos. Hold reserves to offset policy
  cancellations. The pattern is normally
  predictable.
• An example First Capital in California, 1991.
• CA regulators placed limits on ability to
  surrender policies.
• Problem is less severe for PC insurers since
  assets tend to be shorter term and more liquid.

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Liquidity Risk and Insurance Companies

• Early cancellation of a life insurance policy
  results in the insurer having to pay the
  surrender value
• the amount that an insurance policyholder
  receives when cashing in a policy early
• when premium income is insufficient to meet
  surrenders, the insurer can sell liquid assets
  such as government bonds
• Property-Casualty
• PC insurers have greater need for liquidity due
  to uncertainty so tend to hold shorter term
  assets
• Guarantee Programs for Life and PC Insurance Co.

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Mutual Funds

• Open-end mutual funds must stand ready to buy
  back issued shares from investors at their
  current market price or net asset value
• Net asset value (NAV) of the fund is market
  value.
• The incentive for runs is not like the situation
  faced by banks.
• If a mutual fund is closed and liquidated, the
  assets would be distributed on a pro rata basis
• Asset losses will be shared on a pro rata basis
  so there is no advantage to being first in line.

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Pertinent Websites

• For further information on the BIS maturity
  ladder approach, visit
• Bank for International Settlements www.bis.org
  
• For information about the Federal Reserve Bank,
  visit
• Federal Reserve Bank www.federalreserve.gov
• FDIC www.fdic.gov
• Thrift Supervision www.ots.treas.gov