liquidity risk and fis’ management

7/28/2019 Liquidity Risk and FIs Management

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risk management, 20080229 1

Liquidity Risk and FIsManagement

Chapter 17 and 18Saunders and Cornett


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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.


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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 ofbanks (FIs) if none of the above works and

depositors run to the FI to get their funds.


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Causes of Liquidity Risk

Reliance on demand deposits: liability side

Core deposits: long term funding source.

Depository Institutions need to be able topredict the distribution ofnet 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 thelarge inflows from selling off mutual funds.

Managed by: purchased liquidity management

stored liquidity management


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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


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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

Combinepurchasedand storedliquidity

management


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Asset Side Liquidity Risk

Risk from loan commitments and othercredit lines:

met either by borrowing funds or

by running down cash reservesCurrent levels of loan commitments

are dangerously high according to

regulators


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Measuring Liquidity Exposure

Net liquidity statement: shows sources anduses 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.


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Other Measures:

Peer group comparisons: usual ratiosinclude borrowed funds/total assets, loancommitments/ total assets etc.

Liquidity index: a measure of the potential

losses an FI could suffer as a result of firesale of assets.

Weighted sum of fire sale price Pto fairmarket price, P*, where the portfolio weightsare the percent of the portfolio value formedby the individual assets.

I = Swi(Pi/Pi*)


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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.


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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


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Liquidity Planning

Bank run: a sudden and unexpectedwithdraw 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.


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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


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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

1. Cash immediacy versus reduced return

2. Constrained optimization Privately optimal reserve holdings

Regulator imposed reserve holdings


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Funding Risk versus Cost

Funding Cost

Funding Risk5 year CD(low funding risk)

Demand deposits

(high funding risk)


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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 minimumbalance requirements to alter attractiveness

of NOW deposits.

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