Transcript Liquidity Risk - George Mason University

Class 18, Chap 17
Purpose: Introduce the challenges banks face in managing asset
liquidity and present techniques used to measure
liquidity risk.

◦
Types of Liquidity Risk
Liability Side


◦
Asset Side



Bank runs
Net depository drain
OBS commitments
Portfolio loses
Measuring Liquidity Risk
◦
◦
◦
Sources and uses of liquidity
Pear Group Comparison
Liquidity Index
Jim Cramer
4
What happened to Bear Stearns
Gary W. Parr is currently the Deputy Chairman of Lazard Frères
Lazard Ltd is the parent company of Lazard Group LLC, a global, independent investment bank with
approximately 2,300 employees in 42 cities across 27 countries throughout Europe, North America, Asia,
Australia, Central and South America. Formerly known as Lazard Frères & Co. the firm's origins date
back to 1848, the firm provides advice on mergers and acquisitions, restructuring and capital raising, as
well as asset management services to corporations, partnerships, institutions, governments, and individuals
5

Depository Institutions

Life insurance companies

Property Casualty insurance companies

Investment funds
 Two
main types of liquidity risk:
1. Liability side liquidity
2. Asset side liquidity
Liability Side Liquidity Risk
Sources:
1. Bank Runs
2. Net Deposit Drain
1.
Bank Runs

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to
cash-in claims immediately.
Assets (Millions)
Liabilities
Total cash Assets
97.6
Total Deposits
Marketable Securities
52.90
Commercial paper
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
154
Total Assets
1,159.90
Sell Cash Assets = $97.6M
Total Liabilities
983.40
1,159.90

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to cash
in claims immediately.
Assets (Millions)
Total cash Assets
Liabilities
0
Total Deposits
885.80
Marketable Securities
52.90
Commercial paper
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
154
Total Assets
1,062.30
$97.60M
Sell Cash Assets = $97.6M
Total Liabilities
1,062.30

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to
cash-in claims immediately.
Assets (Millions)
Total cash Assets
Liabilities
0
Total Deposits
885.80
Marketable Securities
52.90
Commercial paper
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
154
Total Assets
1,062.30
Total Liabilities
$97.60M
Sell Marketable securities = $50.0M
1,062.30

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to
cash-in claims immediately.
Assets (Millions)
$97.60M
Liabilities
Total cash Assets
0
Total Deposits
Marketable Securities
0
Commercial paper
835.80
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
151.1
Total Assets
1,009.40
Total Liabilities
$50M
Sell Marketable securities = $50.0M
1,009.40

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to
cash-in claims immediately.
Assets (Millions)
$97.60M
Liabilities
Total cash Assets
0
Total Deposits
Marketable Securities
0
Commercial paper
835.80
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
151.1
Total Assets
1,009.40
$50M
Sell Mortgages = $450.0M
Total Liabilities
1,009.40

Occurs when there is a run on the bank
◦ Many liability holders (depositors/insurance policy holders) seek to
cash-in claims immediately.
Assets (Millions)
$97.60M
$50M
Liabilities
Total cash Assets
0
Total Deposits
Marketable Securities
0
Commercial paper
Mortgages
0
Interbank loans
12.2
Other loans
64.10
Equity Capital
-344.2
Total Assets
64.10
Total Liabilities
64.10
$450M
Sell Mortgages = $450.0M
385.80
10.3

Could we solve the problem by requiring banks to hold
enough cash to satisfy all of their liabilities
Sure – what is wrong with this plan?

Banks will not earn any money if they can not lend capital

Liquidating assets in crisis:
a) Cash reserves: They can use reserves in the vault or at the fed
b) Borrow Funds: They could try to borrow or purchase funds
c) Fire Sale: They can sell their long-term assets, but the
price they will get for immediate sale is usually far less
than what they would accept for a longer horizon sale
2.
Net Deposit Drain

Aggregate balance sheet for all national banks 2009

Banks do not have enough cash to payoff all depositors
But depositors will almost never demand their full balance –
Bank runs are very rare!
Banks can almost always count on having some stable level of
deposits – core deposits


Are core deposits easy to predict?
1.
2.
Net Deposit Drain > 0
Net Deposit Drain < 0
Core deposits
are decreasing
WHY?
Core deposits
are increasing
WHY?
Core deposits are predictable
The amount of deposits a DI holds depends on the
net deposit drain = withdrawals – incoming deposits
There are two types of liability side liquidity risk
1. Bank Runs – Very rare unpredictable events with extreme losses


Trying to manage this risk at the bank level is extremely difficult and inefficient
DIs could be required to hold large amounts of excess capital to protect against
losses in a bank run but this reduces the amount they can lend which reduces profits
 This is why the risk is managed at the aggregate level through the FDIC and Fed
2. Net Depository Drain – the day-to-day changes in core deposits
NDD = -2%
NDD = 5%
Banks core deposits will grow on average over time
 Gives the bank access to a stable and inexpensive source of financing
 The bank should become a larger more profitable and more stable firm
Banks core deposits will decrease on average over time
 Must replace deposits with alternative and more costly sources of financing
 Banks cost of capital increases which decreases profits. The bank may
eventually become financially distressed and file for bankruptcy
There are two types of liability side liquidity risk
1. Bank Runs – Very rare unpredictable events with extreme losses
• Trying to manage this risk at the bank level is extremely difficult and inefficient
To be healthy
andamounts
profitable
banks
musttobe
• DIs could be required
to hold large
of excess
capital
protect against a
able
to
manage
their
net
depository
drain
losses in a bank run but this reduces the amount they can lend and reduces profits
• This is why the risk is managed at the aggregate level through the FDIC and Fed
2. Net Depository Drain – the day-to-day changes in core deposits
NDD = -2%
NDD = 5%
Banks core deposits will grow on average over time
 Gives the bank access to a stable and inexpensive source of financing
 The bank should become a larger more profitable and more stable firm
Banks core deposits will decrease on average over time
 Must replace deposits with alternative and more costly sources of financing
 Banks cost of capital increases which decreases profits. The bank may
eventually become financially distressed and file for bankruptcy
Option #1 - Purchased Liquidity Management
◦ A DI manager can borrow funds to satisfy short-term liquidity shortfalls
◦ DIs borrow in the markets for purchased funds
 Federal funds market: Over-night bank-to-bank lending at LIBOR or Fed
funds rate
 Repurchase Agreements: DI sells assets under an agreement to repurchase
them at a slightly higher price – the difference between the purchase and sale
price is the repo rate
 Deposits: The DI could try to increase deposits – issue wholesale
certificates of deposits
◦ Typically larger banks use purchased funds
◦ Purchased funds replace low cost deposits with higher cost financing the
higher the rate for purchased funds the less demand for this option
Option #2 - Used Stored Liquidity:
◦ Exactly what it sounds like: DIs store liquidity in the form of cash
reserves and assets
◦ Cash reserves are held at the Federal Reserve and in their vault
 Fed requires 3% of the first 44.4 million in deposits
10% of remaining deposits
◦ The bank can sell assets to satisfy their net deposit drain
Remember Net Depository Drain is:
Liability Side Liquidity Risk
Purchased liquidity
$5M deposit
drain
Assets and liabilities
do not match we
need to adjust
Notice that with purchased
liquidity the total size of the
firm does not change
With purchased
liquidity we borrow
$5M to satisfy the net
deposit drain
Main Take Away:
Purchasing liquidity basically swaps one liability for another. This insulates the
asset side of the balance sheet and preserves the size of the firm
Stored liquidity:
With stored liquidity
we use cash to pay
the net deposit drain
$5M deposit drain
reduces deposits from
$70M to $65M
Using stored liquidity causes
both the asset and liability side
of the balance sheet to shrink
Main Take Away:
Stored liquidity uses assets to compensate for the loss of liabilities. This
contracts the balance sheet and reduces the size of the firm
The simple balance sheet of Pomona Bank is shown below. Rewrite their balance sheet after the
bank experiences a $10M depository drain if:
Assets
Liabilities
Cash
52.5 Deposits
352
a) The bank wants to maintain the same size
Mortgages
367 Commercial paper
56
C&I Loans
215 Long-term debt
153
b) The bank decides to shrink its balance sheet
Consumer loans
Credit lines (drawn)
Total Assets
65
28
727.5
Repo agreements
Equity
Total liabitlities
127
39.5
727.5
Asset Side Liquidity Risk

Asset side liquidity risk results from unexpected
demand for funds from the FI’s assets

How would that occur?
◦
◦
◦
◦

Loan commitments
When these off balance sheet items are “exercised” the
FI is required to provide liquidity (loan) to the company.
Letters of credit
This represent a cash out flow – Example AIG
Lines of credit
Losses in asset value (loan portfolio)
The FI has 2 options to manage asset side liquidity risk
◦ Purchase liquidity
◦ Stored liquidity
Purchased liquidity – loan commitment $5M
After the loan commitment is taken down the
FI adds a $5M loan to its assets
Assets and Liabilities
do not match so we
need to adjust the B/S
To finance the loan the FI
purchases $5M in funds
For asset side liquidity, using purchased funds
increases both assets and liabilities – the firm grows
Main Take Away:
Purchasing liquidity creates new liabilities to finance the new assets. In
this case the balance sheet and the size of the firm grow
Stored liquidity – loan commitment $5M
After the loan commitment is taken down the
FI adds a $5M loan to its assets
It will fund the new
loan with cash reserves
For asset side liquidity, using stored liquidity keeps the size of the firm
constant – the value of both assets and liabilities remain the same
Main Take Away:
Stored liquidity swaps one asset for another. This preserves the size of the
balance sheet and the size of the firm
The simple balance sheet of Unica Bank is shown below. Suppose Ford Motor Co., one of their
preferred customers, draws down $20 Million on an existing credit line. Rewrite the balance
sheet if:
Assets
Liabilities
Cash
72.5 Deposits
392
a) Unica purchase liquidity to satisfy the draw.
Mortgages
567 Commercial paper
156
b) Unica uses stored liquidity to satisfy the draw.
C&I Loans
215 Long-term debt
253
Credit lines(drawn)
36 Equity
89.5
c) Which method grows the balance sheet?
Total Assets
890.5 Total liabilities
890.5
Measuring Liquidity
1.
2.
3.
Sources and uses of liquidity
Pear Group Comparison
Liquidity Index
DIs obtain liquidity from 3 sources

1.
2.
3.

◦
◦
◦

Selling liquid assets
Borrowing funds
Excess cash reserves
Observing how FIs obtain liquidity gives us an idea of their
liquidity risk exposure:
A FI that relies mainly on purchased liquidity suffers when liquidity in
external markets dries up or borrowing costs increase (Bear Stearns)
FIs that rely on deposits are exposed to net deposit drain and bank runs
FIs that rely on external markets are more exposed to market frictions
All FIs report historical sources of liquidity in their annual report
Page 50 & 106
Page 119/121
Page 87/89 (VaR)

Borrowed Funds
Total Assest

Core Deposits
Total Assest

Loans
Deposits
Larger values means that the bank relies more on
borrowed funds for liquidity
Larger values means that the bank relies more on core
deposits for liquidity
Portion of loans financed using deposits (LTD ratio) –
•
•

Commitment s
Total Assets
Large values mean the bank may not have liquidity to
cover unforeseen funding requirements
2008 values ranged from 56% - 170% over states
Larger value – bank is more exposed to liquidity risk from
future loan take downs
BoA relies more on borrowed funds
and less on deposits than NTB
NTB is not as exposed to future
shortfalls in funding requirements
BoA is more exposed to liquidity risk
from future loan commitment take downs
Use the following in formation to calculate the peer comparison ratios and assess the liquidity
risk of the two banks.
Bank A
Assets
Cash
Loans
Mortgages
Total Assets
Bank B
Liabilities
52.5
167
228
447.5
Core Deposits = 300M
Commitments = 136
Deposits
Total debt
Equity
Total liabilities
Assets
352
56
39.5
447.5
Cash
Loans
Mortgages
total Assets
100.5
67
145
312.5
Core Deposits = 290M
Commitments = 16
Liabilities
Deposits
Total debt
Equity
Total liabilities
295
5
12.5
312.5

Measures the average percent of total assets that could be
recovered in a fire sale
◦ Calculate the percent of fundamental value that could be recovered in a fire sale
◦ Multiply by the fraction of the firms asset value invested in asset “i”
◦ Sum over all assets
Fraction of asset value
invested in asset “i”
  Pi 
I   i 
* 
P
i 

i 1 
N
Pi  fire sale priceof asset i
Pi*  normalmarketpriceasset i
i  proportionof asset value (weight)
0  I 1
Percent of assets i’s value that
could be recovered in a fire sale

Larger value of I = less liquidity risk exposure – a larger
percent of total assets can be recovered in a fire sale
Example: Suppose a DI holds real estate mortgages and T-bills with face values shown below. Calculate the
liquidity index given the following fire sale and normal market prices.
Asset
Face Value
Fundamental
Immediate sale
T-Bill
$100M
$99M
$97M
Mortgage
$98M
$75M
$45M
Government Prevention

Under normal market conditions, banks can borrow funds or use excess cash
reserves to manage net deposit drain

Insolvency becomes a problem when there is abnormal or unexpected deposit
drain which arises because of:
1.
2.
3.

Concerns about the DI solvency relative to other DIs
Failure of a related DI leading to contagious runs
Sudden changes in investors’ preference for holding non-bank financial assets
Deposit contracts and runs
◦ Deposits contracts are first come first served – this is the driving force behind a run
◦ Because everyone lines up to be first or as close to first as possible, depositors will
drain all the banks deposits including core deposits


First come first served deposit contracts introduce severe
instability to the banking sector
Regulators introduced 2 mechanisms to enhance stability
1.
2.

Insured deposits – We will talk about this later
Discount window
Discount Window:
◦ A program set up to allow eligible FIs to borrow usually on a short-term basis from the
Fed to meet temporary liquidity shortfalls cause by internal or external disturbances
◦ Primary Credit: Set up to lend to financially sound FI’s with temporary liquidity needs
◦ Secondary Credit: Set up to lend to less financially sound FIs with temporary liquidity
needs
◦ Seasonal Credit: designed to assist small FIs with seasonal fluctuations in the variation of
loan volume and deposits
Liquidity risk for other Financial
Institutions

Life insurance companies are also exposed to liquidity risk from policy
cancelation

When a policy is canceled the holder is paid the surrender – a value less than
100% of face value

Under normal market conditions the difference between surrenders and income
from policies and other activities is relatively predictable

However, concerns about the solvency of a life insurer can cause a run
◦ New contract premiums dries up
◦ Existing contracts are canceled and the surrenders are paid out

To meet the demand for funds the life insurer may have to liquidate assets (TBills, bonds RMBS) at fire sale prices

The proceeds will not likely be enough to save the FI

PC insurers usually insure against large loss low probability events- earth
quakes, hurricanes …

Because claims are much harder to predict, PC insurers usually hold shorterterm and more liquid assets than life insurers

For PC insurers, paying out surrenders from cancelation is not usually a
problem

Liquidity risk comes from fluctuations in premium income from cancelation
or failure to renew (PC contracts are short term 1-3 yrs) – premiums may be
insufficient to cover claims

Natural disasters can also cause liquidity shortfalls



Open-ended Mutual funds & some hedge funds allow investors to redeem
shares for cash at any time.
If investors simultaneously redeem shares the fund may be subject to large
capital outflows which will likely cripple the fund
The difference is that investment fund shares are not first come first serve –
they are redeemed at the NAV which eliminates incentives for runs
Example:


Suppose 100 depositors (share holders) deposit $1 each in a DI (Mutual fund)
Suppose asset values at the DI and mutual fund fell to $90
DI


Mutual Fund
Assets
Liabilities
Assets
Liabilities
$90
$100
$90
$100
At the DI depositors run and the first 90 people get $1 the rest get $0
At the mutual fund each investor gets the NAV
NAV 
value of assets
90

 $0.9
sharesoutstanding 100
Appendix


DI managers will usually consider core deposits a source of long-term
financing
The financing gap is the average loan amount not covered by core deposits
Financing Gap = (Average Loans) – (Average Core Deposits)

Rewrite the equation – Consider a simple balance sheet
Loans =
Total Assets
–
Liquid Assets
– Core Deposits = – ( Total Liabilities – Financing Requirements)
Loans – Core Deposits = – Liquid Assets + Financing Requirements
Financing Gap = – (Liquid Assets) + (Financing Requirements)
Financing Requirements = Financing Gap + (Liquid Assets)


In this form, the larger the financing GAP and the more liquid assets a bank
holds, the more it must rely on borrowed funds to satisfy liquidity shortfalls.
This makes the bank more exposed to liquidity risk


In Feb 2000 BIS introduced the maturity ladder method
The idea is to assess all cash inflows against outflows at different
horizons
The bank is expected to
have a $4 mill cash
surpluses in one day
The bank expects to have a $50
mill cash deficit in 1 month –
cumulative $46 mill deficit
The bank expects to have a 1,150
• The laddering approach allows DI manages to see when they will
have
excess
mill cash
surplus
in 1 month –
cumulative
$46
mill to
deficit
liquidity and when they will need liquidity they can then borrow accordingly
manage their risk
• Note that the laddering method is for use in normal market conditions NOT
DURING CRISIS

Types of Liquidity Risk
◦ Asset side
◦ Liability side

Measuring Liquidity Risk
◦ Sources and uses of liquidity
◦ Pear Group Comparison
◦ Liquidity Index