Liability and Liquidity Management

1
Chapter 18

• Liability and Liquidity Management

2
Overview

• Depository institutions and life insurance
  companies are highly exposed to liquidity risk.
  This chapter discusses how these firms can
  control liquidity risk, the motives for holding
  liquid assets, and specific issues associated
  with liability and liquidity risk management.

3
Liquid Asset Management

• Examples T-bills, T-notes, T-bonds
• Benefits of holding large quantities of liquid
  assets
• Costs of holding liquid assets
• Regulatory requirements for minimum levels of
  liquid assets

4
Liquid Asset Management

• Reasons for regulating minimum holdings of liquid
  assets
• Monetary policy
• Multiplier effect of changes in reserve
  requirements
• Taxation
• Due to absence of interest on reserves requiring
  reserves constitutes transfer of a resource to
  the central bank.
• Note interesting responses such as sweep programs
  and ATM Cash Advantage program

5
Composition

• Composition of liquid asset portfolio
• Liquid assets ratio
• Cash and government securities in countries such
  as U.K.
• Similar case for U.S. life insurance companies
  (regulated at state level)
• U.S. banks cash-based, but banks view government
  securities as secondary, or buffer reserves.

6
Return-Risk Trade-off

• Cash immediacy versus reduced return
• Constrained optimization
• Privately optimal reserve holdings
• Regulator imposed reserve holdings

7
U.S. Cash Reserve Requirements

• Incremental reserve requirements for transaction
  accounts
• Less than 6.0 million 0.0
• 6.0 million to 42.1 million 3.0
• Over 42.1 million 10.0

8
Web Resources

• For information on reserve requirements, visit
• Federal Reserve www.federalreserve.gov

9
Reserve Management Problem

• Computation period runs from a Tuesday to a
  Monday, 14 days later. Average daily reserves are
  computed as a fraction of the average daily
  deposits over the period. This means that Friday
  deposit figures count 3 times in the average.
• In the past, Weekend Game
• Sweep accounts

10
Reserve Management

• The reserve maintenance period, begins 17 days
  after the end of the computation period (or 30
  days after the start of the computation period)
• Lagged reserve accounting as of July 1998.
• Previously, contemporaneous (2-day lag).
• Benefits of lagged reserve accounting

11
Undershooting/Overshooting

• Allowance for up to a 4 error in average daily
  reserves without penalty.
• Surplus reserves required for next 2-week period
• Undershooting by more than 4 penalized by a 2
  markup on rate charged against shortfall.
• Frequent undershooting likely to attract scrutiny
  by regulators

12
Undershooting

• DI has two options near the end of the
  maintenance period
• Liquidate assets
• Borrow reserves
• fed funds
• repurchase agreements

13
Discount Window

• Reserve shortfalls in the past
• Discount window borrowing
• Primary credit

14
Overshooting

• First 4 percent can be carried forward to next
  period
• Excess reserves typically low due to opportunity
  costs
• Knife-Edge management problem

15
Funding Risk versus Cost

• Funding Cost

Funding Risk
16
Liability Management

• Note the tradeoff between funding risk and
  funding cost.
• Demand deposits are a source of cheap funds but
  there is high risk of withdrawal.
• NOW accounts manager can adjust the explicit
  interest rate, implicit rate and minimum balance
  requirements to alter attractiveness of NOW
  deposits.

17
Deposit Accounts

• Passbook Savings Accounts Not checkable. Bank
  also has power to delay withdrawals for as long
  as a month.
• Money market deposit accounts Somewhat less
  liquid than demand deposits and NOW accounts.
  Impose minimum balance requirements and limit the
  number and denomination of checks each month.

18
Time Deposits and CDs

• Retail CDs Face values under 100,000 and
  maturities from 2 weeks to 8 years. Penalties
  for early withdrawal. Unlike T-bills, interest
  earned on CDs is taxable.
• Wholesale CDs Minimum denominations of 100,000.
  Wholesale CDs are negotiable.

19
Fed Funds

• Fed funds is the interbank market for excess
  reserves. 90 have maturities of 1 day.
• Fed funds rate can be highly variable
• Prior to July 1998 especially around the second
  Tuesday and Wednesday of each period. (as high as
  30 and lows close to 0 on some Wednesdays).
• Rollover risk

20
Repurchase Agreements

• RPs are collateralized fed funds transactions.
• Usually backed by government securities.
• Can be more difficult to arrange than simple fed
  funds loans.
• Generally below fed funds rate

21
Other Borrowings

• Bankers acceptances
• Commercial paper
• Medium-term notes
• Discount window loans

22
Historical Notes

• Since 1960, ratio of liquid to illiquid assets
  has fallen from about 52 to about 32.7. But,
  loans themselves have also become more liquid.
• Securitization and sales of DI loans
• In the same period, there has been a shift away
  from sources of funds that have a high risk of
  withdrawal.

23
Historical Notes

• During the period since 1960
• Noticeable differences between large and small
  banks with respect to use of low withdrawal risk
  funds.
• Differences in access to purchased funds and
  capital markets
• Reliance on borrowed funds does have its own
  risks as with Continental Illinois.

24
Liquidity Risk in Other FIs

• Insurance companies
• Diversify across contracts
• Hold marketable assets
• Securities firms
• Example Drexel Burnham Lambert

25
Pertinent Website

• Federal Reserve Bank www.federalreserve.gov

26
Chapter 19

• Deposit Insurance and other liabilities guarantees

27
Overview

• The focus of this chapter is the mechanisms
  designed to protect FIs from liquidity crises.
• Federal Deposit Insurance Corporation
• Securities Investors Protection Corporation
• Pension Benefit Guaranty Corporation
• Deposit Insurance schemes in other countries

28
Background issues and History

• Bank runs can serve a useful purpose
• Contagion has more serious consequences
• FDIC created 1933
• Securities Investors Protection Corporation
  (SIPC) 1970.
• Pension Benefit Guaranty Corporation (PBGC)
  created 1974.

29
FDIC

• FDIC created in wake of banking panics.
• 10,000 failed commercial banks.
• Original coverage 2,500. Now 100,000.
• Between 1945-1980 FDIC worked. Failures
  accelerated in 1980.

30
FDIC (continued)

• In 1991 Borrowed 30 billion from Treasury and
  still generated a 7 billion deficit.
• FDIC Improvement Act 1991.
• The funds reserves now stand at a record high
  with reserves exceeding 1.3 of insured deposits.
• Caveat Superior Bank of Illinois

31
FSLIC

• FSLIC covered SLs. Other thrifts often chose
  FDIC coverage.
• High levels of failed thrifts between 1980-88
  generated losses of 42.3 billion. From 1989-92
  additional 734 failures . Cost 78 billion.
• Result FSLIC estimated net worth negative 40 to
  80 billion.
• Policy of capital forbearance.

32
Demise of FSLIC

• Forbearance consequences
• Accumulation of greater losses.
• Financial Institutions Reform, Recovery and
  Enforcement Act, (FIRREA) 1989.
• Management transferred to FDIC.
• Savings bank insurance fund became Savings
  Association Insurance Fund (SAIF). Managed
  separately from Bank Insurance Fund (BIF).

33
Causes of depository fund insolvency

• Financial Environment
• Rise in interest rates.
• Collapse in oil, real estate and commodity
  prices.
• Increased competition.

34
Depository Fund Insolvency (continued)

• Moral Hazard
• Deposit insurance encouraged underpricing of risk
  and reduced depositor discipline.
• Premiums not linked to risk.
• Role of implicit premiums
• Inadequate monitoring.
• Prompt Corrective Action (1992).

35
Trade-off Moral hazard bank run risk

• Insurance was not actuarially fairly priced.
• Reduced incentive for runs.
• Increased moral hazard.

36
Controlling DI Risk Taking

• Stockholder discipline
• Practical problems in applying option pricing to
  insurance premiums
• FDIC adopted risk-based premiums 1993

37
Risk-Based Deposit Insurance

• Based on
• Categories and concentrations of assets
• Categories and concentrations of liabilities
• insured, uninsured, contingent, noncontingent
• Other factors that affect probability of loss
• Deposit insurers revenue needs.