Liquidity Risk

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Liquidity Risk
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Liquidity Risk

• Liquidity risk deals with the everyday aspect of
  doing business.
• Interest rate risk, credit risk, off balance
  sheet risk, operational risk all created
  solvency risk for the FI, liquidity risk
  generally does not.
• Liquidity risk represents the risk of the FI not
  having enough short term liquidity to meet daily
  operational needs.

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Causes of Liquidity Risk

• Asset side
• May be forced to liquidate assets too rapidly
  resulting n fire sale prices
• May result from loan commitments
• Traditional approach reserve asset management
• FIs like to reduce cash since cash generally
  pays little or no interest
• Alternative liability management.

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Causes of Liquidity Risk

• Liability side
• Reliance on demand deposits
• Core deposits (provide long term source of funds)
• Need to be able to predict the distribution of
  net deposit drains.
• Managed by
• purchased liquidity management
• stored liquidity management

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Net Deposit Drains

• Deposit withdraws are in part offset by the
  inflow of new funds and income generated by from
  both on and off balance sheet activities.
• The amount by which the cash withdraws exceed the
  new cash inflows is the Net Deposit Drain.
• Positive NDD implies withdraws are greater than
  inflows. Negative NDD implies that inflows are
  greater than withdraws

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Net Deposit Drain

• The decrease in liabilities must be offset with
  an increase in liabilities or a decrease in
  assets if new inflows do not replace the outflow
  of funding sources.

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Net Deposit Drain

• Predictable
• Large commercial transaction accounts (payroll
  etc)
• Maturing Investments
• Unpredictable
• Will customer reinvest maturing CD
• Loan commitments

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Balance Sheet

• Before the NDD
• Assets Liabilities
• Assets 100 Deposits 70
• Borrowed Funds 10
• Other 20
• Total 100 100

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Balance Sheet

• After the NDD
• Assets Liabilities
• Assets 100 Deposits 65
• Borrowed Funds 10
• Other 20
• Total 100 95
• The most likely way to fix the imbalance is for
  borrowed funds to increase by 5.

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Liability Management

• Purchased liquidity
• Federal funds market or repo market.
• 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 fund use
  as investors have increasing investments and
  decreasing deposits.

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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.

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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.

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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.

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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

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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

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Other Borrowings

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

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Liability ManagementBorrowing Funds

• Advantages
• Volume and composition of asset portfolio doesnt
  change
• Can increase rate to attract funds
• Only borrow IF funds are needed
• Disadvantages
• Market determines rate
• Increased uncertainty of costs

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Asset Based Management

• Alternative Stored Liquidity Management
• Liquidate assets.
• 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 noninterest-bearing assets

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Using Cash

• The most obvious asset side management technique
  is to use the cash reserves of the firm.

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Balance Sheet

• Before the NDD
• Assets Liabilities
• Cash 9 Deposits 70
• Other 91 Borrowed Funds 10
• Other 20
• Total 100 100

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Balance Sheet

• Before the NDD
• Assets Liabilities
• Cash 4 Deposits 65
• Other 91 Borrowed Funds 10
• Other 20
• Total 95 95
• The firm meets the increased withdraws by
  decreasing its cash balances

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Cash vs. Liquid Assets

• Cash Assets
• Vault Cash, Demand deposits at Fed Reserve,
  Demand Deposits at private financial
  institutions, cash items in the process of
  collection
• Liquid Assets
• Fed Funds Sold and Reverse Repos, US Treasury and
  Agency Securities with lt 1 yr maturity,
  Corporate obligations and Municipal Securities
  with lt 1yr maturity, Loans that can be readily
  sold or securitized.

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Storing Liquid Assets

• If you attempt to store funds in liquid asset
  they must have
• A ready Market
• A stable price
• Reversible (can recover original investment with
  a high degree of certainty)

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Costs of using liquid assets

• Opportunity cost of foregone earnings if sold
• Opportunity cost of other assets ( liquid assets
  have lower return)
• Transaction costs
• Higher risk of capital loss
• Weakens balance sheet position

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Historical Notes

• Since 1960, ratio of liquid to illiquid assets
  has fallen from about 52 to about 26. But,
  loans themselves have also become more liquid.
• Securitization of DI loans
• In the same period, there has been a shift away
  from sources of funds that have a high risk of
  withdrawal.

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Historical Notes

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

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Final alternative

• It is also possible and likely that the FI can
  combine purchased and stored liquidity management
  techniques.

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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 incoming deposits, revenue from sale of
  non deposit services, Customer Loan repayments,
  Sale of bank Assets, Borrowing in money market
• Uses include Deposit Withdraws, Volume of
  Acceptable loan requests, repayments of bank
  borrowing, other operating expenses, dividend
  payments

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Other Measures

• Peer group comparisons usual ratios include
• borrowed funds/total assets,
• loan commitments/assets
• Loan Losses / Net loans
• Total Deposits./ Total Assets
• Core Deposits/Total Assets
• Fed Funds Purchased / Total Assets
• Reserve for Loan losses / Net Loans

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• 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)

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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.

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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

• 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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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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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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Mutual Funds

• Net asset value (NAV) of the fund is market
  value.
• The incentive for runs is not like the situation
  faced by banks.
• Asset losses will be shared on a pro rata basis
  so there is no advantage to being first in line.

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Liability and Liquidity Management

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

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Liquid Assets

• Liquid assets are assets that can be turned
  quickly into cash
• Low transaction costs
• Little or no loss in principle value
• Traded in large market (trading does not move the
  market)

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Liquid Asset Management

• Examples T-bills, T-notes, T-bonds
• Benefits of holding large quantities of liquid
  assets
• Low risk (except for inflation risks)
• Flexibility in meeting liability claims
• Costs of holding liquid assets
• Lost interest income

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Liquid Asset Management Reserve Requirements

• Reasons for regulating minimum holdings of liquid
  assets
• Monetary policy
• Enables Monetary policy by forcing Depository
  Institutions to participate in the Central
  Banking System.
• Taxation
• Forcing a reserve requirement places a form of
  Tax on the Depository Institution
• Facilitates Clearinghouse Function

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Liquid Asset Management Reserve Requirements

• Use of Reserve Requirements as a monetary Policy
  tool has decreased.
• Feds new emphasis on the control of short term
  interest rates
• Use of Sweep Accounts
• Sweep Account contractual agreement between
  bank and depositor permitting the bank to switch
  funds from checking account to an interest
  bearing account (decreased reserve requirement)

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Composition

• Composition of liquid asset portfolio
• Breakdown between cash and other securities
• Determined by regulations by government and
  earnings of the firm
• Liquid assets ratioLiquid Assets / Total Assets
• 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 buffer reserves.

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U.S. Cash Reserve Requirementsfor Depository
Institutions

• Incremental reserve requirements for transaction
  accounts (all deposits on which account holders
  can make immediate withdrawals)
• First 5.5 million 0.0
• 5.5 million to 42.8 million 3.0
• 42.8 million 10.0

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Lagged Reserve Accounting

• The system for calculating and maintaining
  reserves is based on a lagged reserve accounting
  system.
• In the system the computation of the reserves and
  the reserve maintenance period do not overlap.

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Reserve Management Problem

• Computation period runs from a Tuesday to a
  Monday, 14 days later.
• First a period for transaction balances, then a
  cash computation period. Reserves based upon the
  balance must be maintained over a Reserve
  Maintenance Period.
• Average daily reserves are computed as a fraction
  of the average daily deposits over the period.

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Lagged Computation PeriodBank Vault Computation
Period
Reserve Maintenance Period
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Reserve Management

• The reserve maintenance period, differs from the
  computation period by 17 days.
• Lagged reserve accounting as of July 1998.
• Previously, contemporaneous (2-day lag).
• Benefits and Costs of lagged reserve accounting
• Provides certainty for banks in terms of holdings
• Easier to manage reserves.
• Slows down monetary policy

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Undershooting/Overshooting

• Allowance for up to a 4 error in average daily
  reserves or 50,000 which ever is greater 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

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Costs of Undershooting

• Explicit Cost
• If undershooting by more than 4 the DI is
  subject to an interest penalty equal to 2 plus
  the discount rate
• Implicit Cost
• Increased scrutiny by regulators
• Increased monitoring, examinations and
  surveillance
• Opportunity Costs
• Benefit of undershooting is avoiding high
  opportunity costs of holding more reserves than
  necessary instead of loans etc..

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Undershooting

• DI has two options near the end of the
  maintenance period to increase reserves
• Liquidate less liquid assets or buffer reserves
• Borrow reserves
• Fed Funds
• Discount window
• repurchase agreements

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Discount Window

• Designed to cover surprise shortfalls
• Discount window borrowing
• Discount rate usually lower than market rates
• Meant to be used on a when needed basis and not
  used for profit.
• Risks of gaming the system
• Gaming claiming that short reserves are the
  result of sudden liquidity crunches then using
  the difference in the discount rate and market
  rates to profit.
• If caught charter can be revoked.

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Overshooting

• First 4 percent can be carried forward to next
  period
• Excess reserves typically low due to opportunity
  costs
• Knife-Edge problem
• Either under or over shooting can be costly to
  the institution and to the career of the manager
  of the liquidity position.

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Managing Liquidity

• When calculating reserves, Friday deposit figures
  count 3 times in the average. (used for Friday,
  Saturday and Sunday)
• Weekend Game
• Transferring foreign deposits to foreign
  subsidiaries for the weekend effectively lowers
  the total reserves required.

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Sweep Accounts

• Weekend Program
• Sweeping transaction deposits to money market or
  savings accounts at the close of business on
  Friday and returning the balance Monday.
• Eliminates need for reserves on that amount for
  Friday, Saturday and Sunday

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Seep Accounts

• Threshold Accounts
• Funds are swept to a different account when the
  account exceeds a minimum level.
• Regulation D limits the number of withdraws or
  transfers to 6 a month.
• If more than 6 withdraws or transfers the account
  is classified as as an ATS (automatic transfer to
  savings) and is subject to Reserve Requirements

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Business Sweep Accounts

• Regulation Q prohibits paying explicit interest
  on business demand deposits
• Commercial sweeps moves money overnight (not
  counted as reserves at end of business day) into
  non interest earning assets (repos for example).
  Funds loose FDIC insurance.

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Return-Risk Trade-off

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

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Liquidity Management

• Liquidity can be managed from either the asset
  side of the balance sheet or the liability side.
• Asset based management
• Main goal is storing liquidity in the form of
  liquid assets.
• Less risky and often used by smaller institutions
• Costs
• Opportunity cost of foregone earnings if sold
• Opportunity cost of liquid assets
• Transaction Costs
• Weakened Balance Sheet

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Liquidity Management

• Raising funds via borrowing if needed
• Advantages
• Only borrow if funds are needed
• Volume and composition of asset portfolio is
  unchanged
• Can always attract funds (by increasing rate)
• Disadvantages
• Dependent upon market rate
• Withdrawal risk (funding risk)

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Funding Risk versus Cost

• Funding Cost

Funding Risk
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Choice of Liability Structure

• Demand Deposits
• High Withdrawal risk
• Low costs interest costs are low, but service
  costs can be high
• Interest Bearing NOW Accounts
• Negotiable order of withdrawal accounts. Pay
  interest on checkable deposits, but require
  minimum balance
• High withdrawal risk
• Higher costs due to interest expenses. Can be
  managed by changing the minimum balance

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Choice of Liability Structure

• Passbook Savings
• Noncheckable and usually require physical
  presence for withdrawal
• Lower withdrawal risk. Institution has the right
  to delay withdrawal requests for up to one month.
• Pay a higher interest rate than NOW accounts
• Money Market Deposit Accounts
• Retail savings accounts with limited check
  writing
• DI do not hold reserves against MMDAs
• Compete with MMMF for funds

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Choice of Liability Structure

• Retail Time Deposits and CDs (lt100,000)
• Structured to reduce withdrawal risk
• Wholesale CDs (gt100,000)
• Depositors can sell their positions in the
  secondary market instead of withdrawing funds.

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Choice of Liability Structure

• Federal Funds and Repos
• Since they are borrowed funds there are no
  reserve requirements
• Subject to settlement risk
• Other borrowings
• Commercial paper issued by holding companies,
  no the DI
• Medium term Notes
• Discount Window Loans

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Liability Structure
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Balanced Liquidity Management

• Combination of Asset and Liability Management
• Borrow only for unanticipated (usually short term
  needs)
• Plan for long term liquidity needs via asset
  management.

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Liquidity Risk in Other FIs

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