Liquidity Risk and FIs Management Chapter 17 and 18

Saunders and Cornett

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How come?
Liquidity

risk arises when a unexpected deposit withdraw or a loan demand occurs. Financial intermediaries facilitate short term funds to longer term investment are vulnerable to liquidity risks on both sides of balance sheets.

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Method s to deal with withdrawal of funds

Assets

fire-sale; Running down the FIs cash assets, drain the liquidity, or By borrowing additional funds.
Liquidity

risk can result in insolvency of banks (FIs) if none of the above works and depositors run to the FI to get their funds.
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Causes of Liquidity Risk

Reliance

on demand deposits: liability side

Core deposits: long term funding source. Depository Institutions need to be able to predict the distribution of net deposit drains (net outflow of deposits).
Seasonality effects in net withdrawal patterns Ex: problem with low rates in the early 2000s: finding suitable investment opportunities for the large inflows from selling off mutual funds.

Managed by:
purchased liquidity management stored liquidity management
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Liability Management
Purchased

liquidity management: adjustment to a deposit drain on the liability side of the balance sheet.
Federal funds market or repo market. Borrowed funds likely at higher rates than interest paid on deposits. Regulatory concerns:

increase of wholesale funds and the potential for serious problems in credit crunch, the contagion effect
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Liability Management

Alternative: Stored Liquidity Management: adjustment to a deposit drain occurs on the asset side of the BS.

Liquidate assets.
In absence of cash reserve requirements, banks tend to hold cash reserves by themselves. In U.K. banks hold cash reserves ca. 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 cash 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
With liquidity improvements gained via securitization and loan sales, many banks have added loan assets to statement of sources

Uses: borrowed or money market funds already utilized, etc.

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Other Measures:
Peer

group comparisons: usual ratios include borrowed funds/total assets, loan commitments/ total assets etc. Liquidity index: a measure of the potential losses an FI could suffer as a result of fire sale of assets.
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 (core) deposits.

Financing gap = borrowed fund - liquid assets. The gap can be used in 1) peer group comparisons. 2)Trend analysis.

Example of excessive financing requirement: Continental Illinois, 1984.

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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
Bank

run: a sudden and unexpected withdraw of deposits on a bank. Triggered by a panic of market beliefs that the bank has a shortage of funds. Diamond and Dybvig (1983) 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.
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Bank run

Demand deposits are first come first served. Therefore, depositors place in line matters. Bank panic: systemic or contagious bank run.

Regulatory measures to reduce likelihood of bank runs:

FDIC Discount window

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Liquid assets ratio

Composition of liquid asset portfolio

Liquid assets ratio: a minimum ratio of liquid assets to total assets set by the central bank. Secondary or buffer reserves: non-reserve assets that can be quickly turned into cash.

Risk return trade-off 1. Cash immediacy versus reduced return 2. Constrained optimization

Privately optimal reserve holdings Regulator imposed reserve holdings

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Funding Risk versus Cost

Funding Cost

5 year CD Demand deposits (low funding risk) (high funding risk)

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Funding Risk
15

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 (interest bearing checkable accounts): manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.
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