Liquidity Risk and FIs Management Chapter 17 and 1

1
Liquidity Risk and FIs ManagementChapter 17 and
18

• Saunders and Cornett

2
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.

3
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.

4
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

5
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

6
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

7
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

8
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.

9
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)

10
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.

11
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

12
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.

13
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

14
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
• Cash immediacy versus reduced return
• Constrained optimization
• Privately optimal reserve holdings
• Regulator imposed reserve holdings

15
Funding Risk versus Cost

• Funding Cost

Funding Risk
5 year CD (low funding risk)
Demand deposits (high 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 (interest bearing checkable
  accounts) manager can adjust the explicit
  interest rate, implicit rate and minimum balance
  requirements to alter attractiveness of NOW
  deposits.