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 FI’s 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 = 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, depositor’s 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 Funding Risk

(low funding risk) (high funding risk)
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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 (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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