Transcript 3-_chap017-edited04.ppt

CHAPTER 17
Liquidity Risk
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
1. Introduction
 This chapter explores the problem of liquidity risk
faced to a greater or lesser extent by all FIs.
 Liquidity concerns continue to be a factor affecting
recovery from the financial crisis.
 Methods of measuring liquidity risk and its
consequences are discussed.
 The chapter also discusses the regulatory
mechanisms put in place to control liquidity risk.
 Liquidity risk is a normal aspect of the everyday
management of an FI.
 Only in extreme cases do liquidity risk problems
develop into solvency risk problems.
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Introduction
 All FIs are not exposed to that risk at the same level.
 High exposure
– Depository institutions
– Loss of confidence in bank-to-bank lending
affects liquidity in other markets
 Moderate exposure
– Life insurance companies
 Low exposure
– Mutual funds, hedge funds, pension funds, and
property-casualty insurance companies.
 Typically low, does not mean zero
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2. Causes of Liquidity Risk
 There are liability side reasons and asset side reasons.
 Liability-side liquidity risk when depositors or policyholders cash
in claims (rights)
– FI need to borrow additional funds or sell assets to meet the
withdrawal.
– With low cash holdings, FI may be forced to liquidate assets too
rapidly (or need to borrow)
 Faster sale may require much lower price (fire sale price)
 Asset-side liquidity risk can result from OBS loan commitments
– A borrower uses its loan commitment, then FI must fund the loan
immediately, creating a demand for liquidity.
– Liquidity requirements from take down of funds can be met by
running down cash assets, selling liquid assets, or additional
borrowing
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3. Liquidity Risk at Depository Institutions
 Management and measurement of the Liability and
Assets are different.
 Liability-side liquidity risk management
 Purchased liquidity management
 Stored liquidity management
 Asset-side liquidity risk management
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Sources and Uses of Liquidity
Peer Group Ratio Comparisons
Liquidity Index
Financing Gap and the Financing Requirement
BIS Approach: Maturity Ladder/Scenario Analysis
Liquidity Planning
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3.1 Liability-side Liquidity Risk for DIs
 Reliance on demand deposits (large amount of
short term liabilities)
 Cash assets are very little comparing to total
deposits.
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Liability-side Liquidity Risk for DIs
– Core deposits is the key (with a long term funding source)
– Depository institutions need to be able to predict the
distribution of net deposit drains (the difference between
deposit withdrawals and deposit additions) on a given
day.
 Seasonality effects in net withdrawal patterns
 Large inflows of funds can be problem sometime: Early
2000s problem with low rates: Finding suitable
investment opportunities for the large inflows
– Managed by:
 Purchased liquidity management
 Stored liquidity management (traditionally relied on)
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Purchased Liquidity Management
– Federal funds market or repurchase agreement market are
the markets to purchase liquidity.
– Managing the liability side preserves asset side of balance
sheet
– Borrowed funds will likely be at higher rates than interest
paid on deposits (an expensive solution as you have to pay
market rates for low interest bearing deposits, that is
unattractive)
– Deposits are insured but borrowed funds not necessarily
protected (for high risk FI availability might be a problem)
– Regulatory concerns:
 During financial crisis, wholesale funds were difficult and
sometimes impossible to obtain
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Purchased Liquidity Management
– With this approach, FI can keep the size and composition of the
assets of the balance sheet without disturbing them.
– The higher the cost of purchased funds relative to the rates
earned on assets, the less attractive this approach to liquidity
management becomes.
– Purchased Liquidity Management can insulate the asset side of
the balance sheet from normal drains on the liability side of the
balance sheet.
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Stored Liquidity Management
 Liquidate assets to meet withdrawals
utilizing its stored liquidity.
– In absence of reserve requirements, banks tend
to hold reserves for that reason. (Example: In U.K.
reserves ~ 1% or more)
– Downsides:
 Opportunity cost of holding excessive cash, or other
liquid assets
 Decreases size of balance sheet
 Requires holding excess low return or zero return assets
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Stored Liquidity Management
 Both sides of the balance sheet will contract.
 After 5 m$ deposit drain, the composition:
 Combining purchased and stored liquidity
management is possible.
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3.2 Asset Side Liquidity Risk
 Risk from loan commitments and other credit lines can cause
a DI liquidity problems.
– Met either by borrowing funds and/or by running down
reserves
 Current levels of loan commitments are dangerously high
– Commercial banks in particular have been increasing
commitments over the past few years, presumably believing
commitments will not be used
– In 1994, unused commitments equaled 529% of the cash. In 2008,
1,015%. Fell back to 609% during the crisis.
– What is the effect of $5 milion exercise of a loan commitment by a
borrower?
– DI must fund $5 million in additional loans on the balance sheet.
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Asset Side Liquidity Risk
 Below figure shows a $5 million exercise of a loan commitment
by a borrower.
 Finding 5m$ can be done either by purchased liquidity
management (borrowing) or by stored liquidity management
(decreasing the excess cash)
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Asset Side Liquidity Risk
 Liquidity risk can be affected from several issues:
 Interest rate risk and market risk of the investment
portfolio can cause values to fluctuate
 Arguments that technological improvements have
increased liquidity in financial markets.
– Some argue that “herd” behavior may actually reduce
liquidity
 During the sell off, liquidity dries up and investment
securities can be sold only at fire sale prices.
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Asset Side Liquidity Risk
 After a 5m$ decrease in the market value of
investment portfolio, FI losses 5 million from the
equity in both cases.
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3.3 Measuring Liquidity Exposure
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1- Net Liquidity Statement
This statement lists sources and uses of liquidity and provides a
measure of a DI’s net position.
Sources of liquidity: (can be obtained in 3 ways)
– (i) Cash type assets, (T-bills)
– (ii) maximum amount of borrowed funds available,
– (iii) excess cash reserves

Uses of liquidity
– Borrowed or money market funds already utilized
– Any amounts already borrowed from the Fed
– This position can be
tracked day by day
basis.
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Measuring Liquidity Exposure
 2-Peer Group Comparisons
 Usual ratios include borrowed funds/total assets, loan
commitments/assets, etc.
 if  have a high ratio that means that DI relies heavily on the
short term money market not on core deposit fund loans. This
could mean future liquidity problems if the DI is at or near its
borrowing limits in the purchased funds market.


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Measuring Liquidity Exposure
 3-Liquidity Index
 Developed by Jim Pierce at Fed, this index measure the
potential losses an FI could suffer from a sudden or fire sale
disposal of assets compared with the amount it would receive
at a fair market value under normal market sale conditions.
 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*)
 It will always between 0 and 1. This index can be calculated
for a peer group of similar DIs.
 The greater the differences between immediate fire sale asset
prices (Pi) and fair market Prices (P*i) the less liquid is the DI’s
portfolio of assets.
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Measuring Liquidity Exposure
 A DI has the following assets in its portfolio and their fire sale
–
–
–
$20 million in cash reserves with the Fed,
$20 million in T-bills,
$50 million in mortgage loans.
%100
%99
%90
 If the assets need to be liquidated at short notice, the DI will
receive only 99 percent of the fair market value of the T-bills
and 90 percent of the fair market value of the mortgage
loans. Estimate the liquidity index using the above information.
 I = ($20m/$90m)(1.00) +
($20m/$90m)(0.99) +
($50m/$90m)(0.90)
 = 0.942
 Market Price was 1 so, the the discount due to fire sale is 0.058
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Measuring Liquidity Exposure
 4-Financing Gap and Financing Requirement
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Financing gap is the difference between a DI’s average loans and
average (core) deposits.
Financing gap = Average loans - Average deposits,
If financing gap is positive that means you need FUND
Financing gap = - Liquid assets + borrowed funds
Rewriting this:
financing gap + liquid assets = financing requirement
The gap can be used in peer group comparisons or examined for
trends within an individual FI
In particular, the larger a DI’s financing gap and liquid asset holdings,
the larger the amount of funds it needs to borrow in the money
markets and the greater is its exposure to liquidity problems from such
a reliance.
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Measuring Liquidity Exposure
 Financing gap = Average loans - Average deposits,
5=

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- 20
financing gap + liquid assets = financing requirement
 $5 million + $5 million =
$ 10 million
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A widening gap can warn of future liquidity problems.

Assets are increasing due to increased exercise of loan commitments.
A widening financing gap can warn of future liquidty problems.
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5-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
 Managers can then influence the maturity of
transactions to fill gaps
 Must also evaluate “what if” scenarios in this
framework (cautions about managing in abnormal
conditions )
 For further information on the BIS maturity ladder
approach, visit: www.bis.org
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BIS Approach: Maturity Ladder/Scenario Analysis
 Excess cash of $4 million is available for 1 day time horizon.
But, a cumulative shortfall of $46m. over the next month.
 Planning is required to fill this net funding requirement.
 Over the 6 months excess cash of $1,104 million must be
invested.
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BIS Approach: Maturity Ladder/Scenario Analysis
 Cumulative Excess or Shortages of Funds for a High quality DI
under Various Market Conditions
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Liquidity Planning
 Make funding decisions before liquidity problems
arise: Therefore;
– Lower the cost of funds by planning an optimal funding mix
– Minimize the need for reserve holdings
 There are some components of a liquidity plan. They
are:
– Delineate (describe) managerial responsibilities
– Detailed list of funds providers,
– Identify size of potential deposit and fund withdrawals over
various future time horizons
– Set internal limits on subsidiaries’ and branches’ borrowings
and limits on risk premiums for funding sources
– Plan the sequence of asset disposal to meet liquidity needs
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3.4 Liquidity Risk, Unexpected Deposit Drains,
Bank Runs
 Anticipated needs are not unexpected deposit drains.
(summer, christmast, seasonal effects etc.)
 Any sudden and unexpected surges in net deposit
witdrawals risk triggering a bank run that could
eventually force a bank into solvency.
 Major liquidity problems can arise if deposit drains are
abnormally large and unexpected due to concern
about:
– Bank solvency
– Failure of a related FI
– Sudden changes in investor preferences
 Demand deposits are first come, first served
 Bank panic: Systemic or contagious bank run [a sudden
and unexpected increase in deposit withdrawels from a DI]
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Alleviating(Reducing) Bank Runs
 Regulatory mechanisms/measures to reduce
likelihood of bank runs are in effect.
 Discount window
– FDIC (or Deposit Insurance)
– Direct actions such as Troubled Asset Relief Program (TARP)
(2008-2009)
– Fed lending to investment banks in the crisis. First time in its
history. (not only depository FIs but also investment banks)
 Reducing bank risk is okay but not without
economic costs
– Protections can encourage DIs to increase liquidity risk
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4. Liquidity Risk for Life Insurance Cos.
 Concerns about the solvency of an insurer can
result in a run, new premium income dries up and
existing policyholders seek to cancel their policies
by cashing them in early.
 The early cancellation of an insurance policy
results in the insurer’s having to pay the insured
the surrender value of that policy.
 Insurance companies need to cash some assets
if the premium income is not sufficiant.
 Life insurance hold reserves such as government
bonds as a buffer to offset policy cancellations.
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5. Liquidity Risk for Property Casualty Insurers
 PC Insurers sell policies insuring against certain contingencies
impacting either real property or individuals.
 Claims are not predictable so that they should have relatively
short term assets and more than those of life insurers.
 As a result, problem is less severe for PC insurers since assets
tend to be shorter term and more liquid
 However, large unexpected claims can be problematic
 Hurricane Andrew and Hurricane Katrina precipitated severe
liquidity crises for many insurers
 Near failure of giant insurer, AIG (2008)
− Credit default swaps / Restructuring and government bailout
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6. Investment Funds
 Investment funds (mutual funds hedge funds) sell shares as liabilities to
investors and invest the proceeds in assets such as bonds and equities.
 It depends if an investment fund is closed end or open end fund.
 In the case of a liquidity crisis in DIs and insurance firms, there are
incentives for depositors and policyholders to withdraw their money or
cash in their policies as early as possible.
 Latecomers will be penalized because the financial institution may be out
of liquid assets. They will have to wait until the institution sells its assets at
fire-sale prices, resulting in a lower payout.
 In the case of investment funds, the net asset value for all shareholders is
lowered or raised as the market value of assets change, so that
everybody will receive the same price if they decide to withdraw their
funds. Hence, the incentive to engage in a run is minimized.
 Closed-end funds are traded directly on stock exchanges, and therefore
little liquidity risk exists since any fund owner can sell the shares on the
exchange.
 An open-end fund is exposed to more risk since those shares are sold
back to the fund which must provide cash to the seller.
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Investment Funds
 The mutual fund shareholder knows that their loss of asset value on a pro
rata bases. (proportional)
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Summary
– Liquidity risk is a common problem faced by FI
managers.
– Very large withdrawals can cause asset liquidity
problems that can be compounded by
incentives for liability claim holders to engage in
runs.
– Insolvencies have costs to society as well as to
private shareholders.
– Regulators have developed mechanisms such as
deposit insurance and the discount window to
alleviate liquidity problems.
– These will be discussed in another chapter.
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