Chapter 7 Liquidity Risk: Causes and Consequences

1
Chapter 7Liquidity Risk Causes and Consequences

• Business 4039

2
Important Terms

• Liquidity
• Liquidity risk
• High power money
• Fire-sale prices
• Notice deposits
• Core deposits
• Deposit drain
• Direct clearer

• Primary reserves
• Secondary reserves
• Buffer reserves
• Financing gap
• Core funds
• Financing requirement
• Bank run

3
Liquidity Risk

• Occurs if assets cannot be converted into cash
  quickly without substantial loss.
• As asset transformers, financial institutions are
  expected to expose themselves to liquidity risk.

4
Liquidity Risk

• Arises out of the mismatch between liquid
  liabilities and less liquid assets.
• It is exacerbated by insuring, lending or
  guaranteeing commitments that require use of cash
  upon notice (example is a customer having and
  then using a line of credit)

5
Distinguish Between Liquidity and Solvency

• Solvency is the degree to which assets exceed
  liabilities, and is therefore a function of the
  capital base of the FI
• Liquidity is the ability to meet maturing
  obligations as they come due.

6
Causes of Liquidity Risk

• Liability Side of the Balance Sheet
• Withdrawals of demand and notice deposits
• Policyholder cancellations
• Asset Side of the Balance Sheet
• Unexpected loan commitments
• Unexpected call on guaranteeds (ie. BAs)

7
Liquidity Crisis Planning

• Important to have a plan that managers can invoke
  at the onset of a crisis
• Planning can lower the cost of funds and
  minimize the amount of excess reserves a FI needs
  to hold.
• Has a number of components
• Assigns task to key management personnel.. .areas
  of managerial responsibility in disclosing
  information to the public
• Detailed list of fund provides most likely to
  withdraw first.
• Identifies the size of potential runoffs over
  various time horizons in the future as well as
  private market funding sources to meet such
  runoffs.
• Internal limits on separate subsidiaries and
  branches, as well as bounds for acceptable risk
  premiums to pay in each marketand sequence of
  assets for disposal in anticipation of various
  degrees or intensities of deposit fund
  withdrawals.

8
Question 7 - 1

• A BANK - Deposit and notice balances that are
  due upon demand fund less liquid loans. Retail
  deposits are likely to be stable notwithstanding
  the fact that legally their maturity is 1 day,
  because of the CDIC guarantee. Wholesale
  deposits are typically time deposits that cannot
  be withdrawn before maturity. Yet because they
  are not protected they will not be renewed if
  there are doubts about the soundness of the FI.
  A faltering FIs portfolio of wholesale deposits
  can run off very quickly.
• A LIFE INSURANCE COMPANY - Any given actuarial
  liability could become an immediate claim, while
  the bulk of insurance company assets are
  long-duration securities. For a large portfolio
  of correctly priced insurance policies, this is a
  minor concern. A greater concern for an
  insurance company whose policy holders fear that
  the companys health is questionable is failure
  to renew and withdrawal of the cash value of
  whole life policies.

2
9
Question 7 - 1.

• A Pension Fund - Here, the greatest risk
  concerns employees who are terminated or leave
  the company prior to retirement and require the
  cash value of their contributions paid out to
  them immediately. Since the assets of the
  pension fund are in long term investments, there
  may be a lack of liquidity to satisfy this need.
• A Mutual Fund - If the securities in mutual fund
  portfolios trade in insufficiently liquid
  markets, large scale redemptions of mutual fund
  units (reacting, say, to a stock market fall) may
  depress the asset values of the securities,
  causing losses for the redeeming unitholders by
  lowering the NAV of the units.

3
10
Question 7 - 2

• A Bank - Banks are able to predict liquidity
  needs fairly accurately. Most deposits form a
  core stable deposit base. CDIC deposit
  insurance removes the incentive for a retail
  depositor run. Bank of Canada as the lender of
  last resort stands ready to provide unlimited
  liquidity to solvent FIs.
• A Life Insurance Company - Actuarial liabilities
  can be estimated with high accuracy for large
  portfolios of contracts. CompCorp provides
  liability insurance for all retail life insurance
  contracts, removing the incentive for runs.
  There are significant cost penalties and
  inconveniences with changing ones life insurance
  company, so consumers are likely not to run.
• A Pension Fund - Payouts from early retirements
  and dismissals are likely to be small in relation
  to the entire plan in most instances. Large
  payouts associated with downsizings are usually
  anticipated some time in advance, allowing the
  orderly liquidation of longer term investments.

4
11
Question 7 - 2...

• A Mutual Fund - Because the value of a mutual
  funds shares are determined with respect to the
  market value of the securities in its asset
  portfolio, liquidity risk does not exist to
  nearly the same degree for mutual funds as for
  deposit-taking FI. Since pay-out is not
  conditional upon sequence of withdrawal, serious
  liquidity problems of runs are absent.

5
12
Question 7 - 3

• It has increased the complexity of liquidity
  management because contingencies may require
  funding. This contingent funding need must be
  included in the liquidity plan.
• For credit-substitute off-balance-sheet
  activities such as guarantees, loan commitments
  and LCs, one must predict the likelihood and
  timing of exercise and the cash needs resulting
  from exercise.
• Forward contracts have known cash flows.
• Futures involve unknown daily payments from
  marking to market.
• Options sold may be exercised, involving an
  unexpectedly liquidity need.
• The rapid increase in the use of derivatives has
  highlighted these risks.

6
13
Question 7 - 4

• Pros - The peer group method is easy and
  inexpensive to implement. It gives a picture of
  current practices in the industry for similar
  institutions.
• Cons - The analysis is constrained by the low
  explanatory power of the simple balance sheet
  ratios used to proxy for liquidity risk. These
  ratios are typically calculated using book values
  rather than market values (since the latter are
  generally unavailable). Moreover, just because a
  ratio attains an average value for a peer group
  does not mean that this is the optimal value.
  There is a problem with a benchmark that is
  simply the average of observed practice.

7
14
Question 7 - 6

• A. Both interest rate risk and liquidity risk
  concern the timing of asset returns relative to
  liability returns. Both use gapping to measure
  the risks. Liquidity risk measurement uses the
  financing gap that is concerned with maturities
  of assets and liabilities. Interest rate risk
  measurement uses the interest rate gap that is
  concerned with the time to repricing of an asset
  or liability. If an FI exactly match-funds its
  assets and liabilities in terms of maturity, cash
  flows and (interest rate) repricing, both
  interest rate risk and liquidity risk is
  eliminated.
• B. The level of prices does not affect FI
  liquidity. Expectations of changes in price
  levels may affect liquidity. High inflation
  expectations relative to interest rates (ie.
  Negative real interest rates) will cause
  increased loan demand (and loan drawdowns) and
  will reduce the demand for deposits. This would
  decrease FI liquidity.

8
15
Problem 7 - 1

• If the bank purchases liabilities then the new
  balance sheet is
• Balance Sheet
• (in millions )
• Assets Liabilities
• Cash 10 Core Deposits 53
• Loans 50 Purchased liabilities 15
• Securities 15 Equity 7
• If the bank uses reserve asset adjustment, a
  possible balance sheet
• Balance Sheet
• (in millions )
• Assets Liabilities
• Cash 0 Core Deposits 53
• Loans 50
• Securities 10 Equity 7

9
16
Problem 7 - 2

• A. Net liquidity Position Sources - Uses
• (1 3 .5 .3) - (1.5 0)
• 3.3 billion
• B. Net liquidity Position (.55 1 .1) -
  (1.5 .10)
• .05 billion
• C. Which FI has greater liquidity risk?

10