‘LIQUIDITY, LIQUIDITY RISK AND LIQUIDITY CREATION IN FINANCIAL INSTITUTIONS’

Donal McKillopProfessor of Financial Services

Queen’s University Belfastdg.mckillop@qub.ac.uk

30th January 2014

Liquidity Risk and Liquidity Creation

Liquidity trading risk Measurement of liquidity trading risk Cost of liquidation in normal markets

Liquidity funding risk Sources of liquidity Liquidity funding risk Basel III liquidity requirements

Liquidity Creation Definition and measurement of liquidity creation Liquidity creation and the macro economy, competition, bank

failure, financial crises and interaction with capital requirements

Liquidity Trading Risk Liquidity is an important consideration in trading A liquid position is one that can be unwound at short notice. As the market for an asset becomes less liquid, traders are

more likely to take losses because they face larger bid-offer spreads

Market transparency is important for liquidity. If the nature of an asset is uncertain it is not likely to trade in a liquid market for very long. (eg subprime mortgages, ABS and CDOs post 2007)

Price received for an asset depends on The mid market price How much is to be sold How quickly it is to be sold The economic environment

Liquidity Trading Risk A market maker’s bid and offer quotes are good for trades up to a

certain size; above that size the market maker is likely to increase the bid-offer spread The reason for this is that as the size of the trade increases the difficulty for

the market maker of hedging the exposure created by the trade also increases.

The bid offer spread for an asset can vary from 0.05% of the asset's mid-market price to 10% of it mid-market price.

The price that can be realised for an asset often depends on how quickly to can be liquidated and on the economic environment. Following figure describes the market for large deals between financial

institutions. Note the bid-offer spreads for retail clients may well show the opposite

pattern to that depicted in the next slide (as the size of the transaction increases the individual is likely to get a better quote).

Bid-Offer Spread (a Function of Quantity)

Offer Price

Bid Price

Quantity

Bid-Offer Spread

Money bid-offer spread, Offer price Bid price

Offer price Bid priceProportional Bid-offer spread,

Mid-market price

In liquidating a position in an asset a financial institution incurs a cost

2

p

s

p s

2

where is the money (mid-market) value of the position

This reflects the fact that trades are not done at the mid-market price

buy trades are undertaken at offer price; sell trades at the bid price.

Bid-Offer Spread

1

Offer price Bid priceProportional Bid-offer spread,

Mid-market price

Cost of liquidation in normal markets

1

2

is the number of positions,

is the position in the th instrument,

is the

n

i ii

i

i

s

s α

n

i

s

proportional bid-offer spread for the th instrument.i

A Century of Stock Market Liquidity and Trading Costs.

Liquidity Funding Risk

Liquidity funding risk relates to the ability of the financial institution to meet its cash needs as they arise.

Financial institutions that are solvent (have positive equity) can fail due to liquidity problems (eg Northern Rock)

Some cash needs are predictable. For example if a bank has issued a bond it knows when the coupon must be repaid.

Others such as those associated with withdrawals of deposits by retail customers and draw-downs by corporations on lines of credit granted are less predictable.

Liquidity funding risk is related to liquidity trading risk as one way a financial institution can meet its funding requirements is by liquidating part of its trading book.

Liquidity Funding Risk

Sources of liquidity Liquid assets Ability to liquidate trading positions Wholesale and retail deposits Lines of credit and the ability to borrow at short notice Securitization Central bank borrowing

Protecting against bank liquidity funding risk

Hold liquid assets (net defensive position – cost in terms of lower profitability)

Dissipate withdrawal risk by diversifying funding sources (liability management)

Backup: capital adequacy to ensure creditworthiness maintained in face of shocks

Important role of supervision and reserve requirements – and also money market infrastructure ensuring liquidity maintained

Measuring Liquidity Funding Risk

Asset Indicators Loans are the least liquidity type of asset. Banks with

relatively high amounts of loans are illiquid. Net Loans to Assets,

Banks facing a liquidity shortfall sell short-term securities for cash. Firms with lots of such securities are relatively liquid. Short-Term Investments to Assets.

Liabilities Indicators Core Deposits (retail deposits) are the most stable and

least likely to leave unpredictably. Short-term non-core (wholesale deposits) funding is the least stable Core Deposits to Assets S.T. Non Core Funding to Assets

Basel III Liquidity Regulation

Two internationally consistent regulatory standards Liquidity coverage ratio:

Designed to make sure that the bank can survive a 30-day period of acute stress

Banks have to maintain high quality liquid assets that are sufficient to survive a 30-day market crisis on the same scale as the Lehman induced crisis there was a complete freeze in the money markets so that the bank

couldn’t access borrowed cash. Aimed at ensuring that a bank maintains an adequate level of high

quality assets that can be converted into cash to meet its liquidity needs for a 30-day horizon under a liquidity stress scenario

Stock of high quality liquid assets/Net cash outflows over a 30-day time period ≥ 100%

The Liquidity Coverage Ratio is scheduled to be introduced by January 2015.

Basel III Liquidity Regulation

Net stable funding ratio: a longer term measure designed to ensure that stability of funding sources is consistent with the permanence of the assets that have to be funded Aimed at promoting more medium and long-term funding of the assets Minimum acceptable amount of stable funding based on the liquidity of a

bank’s assets over a 1 year horizon Available amount of stable funding/required amount of stable funding > 100% “Stable funding” is defined as those types and amounts of equity and liability

financing expected to be reliable sources of funds over a one-year time horizon under conditions of stress.

This funding ratio seeks to calculate the proportion of long-term assets which are funded by long term, stable funding.

“Stable funding” includes: customer deposits, long-term wholesale funding (from the Interbank lending market), and Equity.

"Stable funding" excludes short-term wholesale funding. Net stable funding rule (NSFR) will commence in 2018

Basel III Liquidity Regulation

Net stable funding ratio: Amount of Stable funding/Required Amount of Stable Funding >

100%

Numerator includes category [weight] retail deposits [0.9]; wholesale deposits [0.5]; Tier 1 capital [1] Tier

2 capital [1]

Denominator includes category [weight] Cash [0] Treasury bonds> 1 year [0.05]; mortgages [0.65]; small

business loans [0.85]; fixed assets [1]

The more illiquid the assets the more stable funding required

Liquidity Creation ‘Liquidity creation’ refers to the fact that banks provide illiquid

loans to borrowers while giving depositors the ability to withdraw funds at par at a moment’s notice

Because of this difference in liquidity between what banks do with their money and the way they finance their activities banks are said to create liquidity

Inherent in the liquidity creation is maturity transformation Banks borrow short and lend long.

Banks also provide borrowers liquidity off the balance sheet through loan commitments and similar claims to liquid funds. Such commitments create liquidity as they provide borrowers

insurance against been rationed in the future in the spot credit market. Liquidity creation is one of the primary functions of banks –

creating liquidity by transforming illiquid assets into liquid liabilities.

Liquidity Creation

Macro economy: Beyond banking, liquidity creation is very important to the macro economy as a whole.

Lending, loan commitments, and liquid deposits are all key to greasing the wheels of commerce, without which we would have very little economic activity.

Boot, Greenbaum and Thakor (1993) show that loan commitments improve ex ante welfare even though they represent only ‘illusory promises’ in that the bank may choose not to honour it commitments when the borrower attempts a takedown. Empirical studies on the use of loan commitments by corporate

customers suggest that over 80% of commercial and industrial lending is in the from of drawdowns under commitments

Liquidity Creation

Measurement of liquidity creation Berger and Bouwman (2009) develop several measures

of liquidity creation. Step 1: classify all bank balance sheet and off-balance sheet

activities as liquid, semiliquid, or illiquid. Step 2: assign weights to the activities classified in step 1. Step 3: combine the activities as classified in step 1 and as

weighted in step 2 in different ways to construct four liquidity creation measures.

These liquidity creation measures are based around categories of assets and liabilities (otherwise known as cat) and maturity of assets and liabilities known as (mat).

Step 1: Classify all bank activities as either liquid, semi-liquid, or illiquid.

Liquid Assetse.g., securities

Semi-liquid Assetse.g., home mortgages

Illiquid Assetse.g., business loans

Liquid Liabilitiese.g., transactions deposits

Semi-liquid Liabilitiese.g., time deposits

Illiquid Liabilities + Equity

ASSETS LIABILITIES + EQUITY

Illiquid Guaranteese.g., loan commitments

OFF-BALANCE SHEET

Liquid Derivatives(gross fair values)

Step 2: Assign weights.

Liquid Assetse.g., securities

Semi-liquid Assetse.g., home mortgages

Illiquid Assetse.g., business loans

Liquid Liabilitiese.g., transactions deposits

Semi-liquid Liabilitiese.g., time deposits

Illiquid Liabilities + Equity

ASSETS LIABILITIES + EQUITY

Illiquid Guaranteese.g., loan commitments

OFF-BALANCE SHEET

Liquid Derivatives(gross fair values)

Weight

- 0.5

0

+ 0.5

+ 0.5

Weight

+ 0.5

0

- 0.5

- 0.5

Step 3: Combine Step 1 and Step 2:

Liquid Assetse.g., securities

Semi-liquid Assetse.g., home mortgages

Illiquid Assetse.g., business loans

Liquid Liabilitiese.g., transactions deposits

Semi-liquid Liabilitiese.g., time deposits

Illiquid Liabilities + Equity

ASSETS LIABILITIES + EQUITY

Illiquid Guaranteese.g., loan commitments

OFF-BALANCE SHEET

Liquid Derivatives(gross fair values)

Weight

- 0.5

0

+ 0.5

+ 0.5

Weight

+ 0.5

0

- 0.5

- 0.5

£ liquidity creation = Σ (weight * $ activity)

Liquidity creation ($billion) in U.S. (1984-2008)

On-balance sheet

Off-balance sheet

Total Bank Liquidity creation

Liquidity Creation

Who creates liquidity? Berger and Bouwman (2009) find that in the US, large banks

(greater than $3 billion) are responsible for 81% of industry liquidity creation, while comprising only 2% of all banks

All size classes generate substantial portions of their liquidity off balance sheet, but the fraction is much higher for large banks.

Berger and Bouwman (2009) find that liquidity creation is positively associated with bank value.

Liquidity Creation Financial Crises: Bank liquidity creation may help keep financial crises from

getting out of control. When financial markets freeze up during a crisis, participants often draw

down their loan commitments, which keeps illiquid firms from becoming insolvent.

In the recent crisis, all of the big investment banks faced liquidity problems and either failed, were merged with banks, or became bank holding companies to gain access to liquidity.

Berger and Bouwman (2009) argue there has been a significant build-up or drop-off of “abnormal” liquidity creation before each crisis Banking crises were preceded by positive abnormal liquidity creation by banks. Market-related crises were generally preceded by negative abnormal liquidity

creation. Berger and Bouwman (2009) suggest that liquidity creation has both

decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation has both exacerbated and ameliorated the effects of crises.

Liquidity Creation

Capital - liquidity creation impediment? ‘the financial fragility-crowding out hypothesis’

Diamond and Rajan (2000; 2001) suggest that bank capital may impede liquidity creation by making the bank’s capital structure less fragile.

A fragile capital structure encourages the bank to commit to monitoring its borrowers, and hence allows it to extend loans. Additional equity capital makes it harder for the less-fragile bank to commit to monitoring, which in turn hampers the bank’s ability to create liquidity.

Capital may also reduce liquidity creation because it crowds out deposits (e.g., Gorton and Winton (2000).

Liquidity Creation Capital - liquidity creation enhancer? ‘the risk absorption

hypothesis’ An alternative view, related to banks’ role as risk transformers,

is that higher capital improves banks’ ability to absorb risk and hence their ability to create liquidity. (e.g., Bhattacharya and Thakor 1993; Repullo 2004; Von Thadden

2004; Coval and Thakor 2005), Liquidity creation exposes banks to risk—the greater the

liquidity created, the greater are the likelihood and severity of losses associated with having to dispose of illiquid assets to meet customers’ liquidity demands

Capital absorbs risk and expands banks’ risk-bearing capacity so higher capital ratios may allow banks to create more liquidity.

Liquidity Creation

Capital - liquidity creation empirical evidence Berger and Bouwman (2009) find empirical support for both

the ‘risk absorption hypothesis’ and the ‘financial fragility-crowding out hypothesis’

The relationship between capital and liquidity creation is positive and significant for large banks, insignificant for medium banks, and negative and significant for small banks.

The finding that the relationship between bank capital and bank liquidity creation differs by bank size raises interesting policy issues. The findings suggest that while regulators may be able to make

banks safer by imposing higher capital requirements, this benefit may have associated with it reduced liquidity creation by small banks, but enhanced liquidity creation by large banks.

Liquidity Creation

Competition and liquidity creation Horvath et al. (2013) consider how bank competition influences

liquidity creation. Two opposing hypotheses are suggested. The first (fragility channel view) is that increased competition

increases the fragility of banks by reducing bank profits, which normally act as a buffer against adverse shocks. Thus banks are incentivized to reduce liquidity creation by limiting the volume of loans granted and the volume of deposits accepted to reduce the threat of bank runs.

The second hypothesis (price channel view) regarding the effect of bank competition on liquidity creation is that increased competition influences banking pricing policies, leading to diminished loan rates and increased deposit rates. As a consequence, demand for both loans and deposits rises. This suggests a positive link between competition and liquidity creation.

Liquidity Creation

Competition and liquidity creation – empirical evidence Horvath et al. (2013) find that increased bank competition

reduces liquidity creation. They interpret this result in terms of the effect of competition in increasing ‘bank fragility’, which reduces banks’ incentives to create liquidity.

They argue that their findings have policy implications: First, bank competition can have detrimental economic effects. In other

words, there is a trade-off between the positive effects of competition on consumer welfare, stemming from lower margins, and the negative effects of competition on liquidity creation.

Second, regulation of bank competition cannot be considered independently of monetary policy. In particular, if bank competition plays a role in liquidity creation, authorities in charge of policies that influence the financing of the economy cannot ignore the impact of market structure on banking activities.