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Chapter 13. Liquidity Risk and Liability Management

Chapter 13. Liquidity Risk and Liability Management. Learning Objectives: 1. To understand the importance of liquidity to banks and to the economy 2. To distinguish between core deposits and managed (volatile) liabilities 3. To understand the tradeoff between liquidity and profitability

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Chapter 13. Liquidity Risk and Liability Management

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  1. Chapter 13. Liquidity Risk and Liability Management • Learning Objectives: • 1. To understand the importance of liquidity to banks and to the economy • 2. To distinguish between core deposits and managed (volatile) liabilities • 3. To understand the tradeoff between liquidity and profitability • 4. To understand how to measure bank liquidity Chapter 13

  2. Learning Objectives(cont.) and Chapter Theme • 5. To understand securitization as a tool of liquidity and risk management • Chapter Theme • Banks need liquidity to meet deposit withdrawals and to satisfy customer loan demand. This liquidity can be stored in banks’ balance sheets or purchased in the marketplace. Being too liquid, however, is costly and not having enough liquidity is risky. As a tool of risk management, securitization permits banks to remove risk from their balances sheets and generate liquidity. Chapter 13

  3. The Importance of Liquidity • Consider these headlines from the American Banker • Viewpoint: Too Many Banks Aren’t Ready for Looming Liquidity Crisis • Spare Change: Liquidity Steering Group Going in Circles • In Focus: Liquidity Rivaling Credit Quality as Crisis du Jour Chapter 13

  4. LEMAC: The Inverted CAMEL • L = Liquidity • E = Earnings • M = Management • A = Asset Quality • C = Capital Adequacy Chapter 13

  5. Recent Liquidity Episodes • The aftermath of the “Attack on America” • The bailout of LTCM • The stock market of 1987 • Contrast these events with what the Fed did after the stock-market crash of 1929 Chapter 13

  6. Discussion Topic: Quote from John Reed (1987) • We were providing as much liquidity as we could. Quite a few of the firms went right up to their loan limits. We didn't take physical possession of securities, but we were damn close to our customers. You have a tremendous conflict there. On one hand, there's a need for liquidity in the system. On the other hand, when you're dealing in $100 million lot sizes, you can't afford to be wrong. We can't take a $100 million write-off to save a broker. The stockholders would lynch me and with good reason. Chapter 13

  7. The Role of Confidence • A confidence function: • Net worth (+) • Stability of earnings (+) • Quality of information (+) • Government guarantees (+) • Liquidity (+) Chapter 13

  8. The Evolution of Liquidity Management • Commercial-loan theory or real-bills doctrine (1920s and earlier) • Asset-conversion or shiftability approach (post World War II through 1940s) • Anticipated-income theory (1950s) • Liability management (late 1960s and early 1970s) • Asset-liability management and securitization (mid-1970s to mid-1990s) • Risk management (mid-1990s to present) Chapter 13

  9. The Instruments of Liability Management (LM, see Box 13-1) • Federal funds • Repurchase agreements (RPs, repos) • Negotiable CDs • Consumer CDs • Brokered deposits • Eurodollar CDs • Global CDs Chapter 13

  10. LM Instruments (continued) • MMDAs • IRAs • Commercial paper • Notes and debentures • Volatile liabilities Chapter 13

  11. Chrysler Financial Corporation:Case Study of a Liquidity Crisis • Year-end 1989 financial profile: • CP outstanding = $10.1 billion • Equity capital (E) = $2.8 billion • Total assets (A) = $30.1 billion • CP/A = 33.5% • E/A = 9.3% or EM = 10.75 • Note: CP = commercial paper Chapter 13

  12. The Credit Event • In 1990, Chrysler’s commercial paper (CP) was downgraded from P-2 to P-3 and subsequently to N.P. ( Not Prime) and its long-term bond rating was lowered from Baa to Ba • Under these conditions, Chrysler’s CP was not attractive to the money market at rates that Chrysler was willing to pay, that is, it would have to pay a premium to obtain refinancing Chapter 13

  13. CP Background:Orderly Exit and Asset Sales • Bank back-up lines of credit, standby letters of credit, and medium-term note facilities • Asset sales Chapter 13

  14. Lines of Credit vs. Standby Letters of Credit • Since bank line-of-credit (LOC) contracts typically contain material-adverse-change (MAC) clauses, they are not guarantees and they have annual clean-up and rate resets. Strength of customer relation is important. • In contrast, a standby letter of credit virtually guarantees payment, i.e., the bank will pay off the issue if the borrower cannot. Chapter 13

  15. Chrysler’s Strategy • An aggressive program of asset sales and securitization Chapter 13

  16. “The rest of the story ...” • Immediate cash shortfall is met by borrowing $1.3 billion under its parent company’s banks’ lines of credit • By year-end 1990, CP outstanding is $1.1B, a decrease of $9B • Sales of receivables in 1990 generates $18.3B • Year-end 1990 assets total $24.7B with equity of $2.8B (capital ratio of 11.3%) Chapter 13

  17. The story continues ... • To repay maturing debt of $3.6B in 1991 and $3B in 1992, Chrysler continued its asset-sales strategy. Chapter 13

  18. Epilogue • At year-end 1996, CFC was servicing $39.1B of receivables (94% auto related) up from $22.5B at year-end 1992. Other data for 1996 are: • CP = $2.6B, Senior term debt = $8.4B, NI = $0.376B, TA = $17.5B, E = $3.288B • ROE profile: ROE = ROA x EM • 0.1144 = 0.0215 x 5.32 Chapter 13

  19. Discussion of other Cases • First National Bank of Browning, Montana (1980) • Continental Illinois (Chicago, 1984) • Bank of New England (1991) • REBs and FHLB Advances Chapter 13

  20. Liquidity Versus Profitability • Given a positively sloped yield curve, short-term rates < long-term rates • Short-term assets are safer while longer-term assets are riskier • When the yield curve is inverted, safer assets have higher returns but such rates are expected to decline based on the expectations theory Chapter 13

  21. Discussion Questions • Explain the basic yield-curve shapes and the embodied tradeoffs • Over the interest-rate/business cycle, how does the yield curve move? How do bank loan and deposit flows move? • Distinguish between stored liquidity and purchased liquidity Chapter 13

  22. Effective Liquidity Management • Confidence • Maintaining relationships • Avoiding “fire sales” • Cost of capital and default-risk premiums • Avoiding the Fed’s discount window Chapter 13

  23. Core Deposits Versus Managed Liabilities • Core = sum of interest-bearing deposits in domestic offices minus large time deposits in domestic offices plus domestic demand deposits • Core deposits are relatively stable funds gather in local markets • They vary inversely with bank size Chapter 13

  24. Managed Liabilities • Managed liabilities have four components: • Interest-bearing deposits in foreign offices • Large time deposits in domestic offices • FF purchased/Repos • Other interest-bearing liabilities • “Hot money” is volatile and use of it varies directly with bank size Chapter 13

  25. Types of Interest-Bearing Liabilities • Savings accounts • Small time deposits • Large time deposits • Deposits in foreign offices • FF purchases and RPs • Discuss use of these funds by banks of various sizes Chapter 13

  26. Noninterest-Bearing Liabilities • Why do banks hold such funds? • How have these funds varied over time? • What forces have been driving these trends? Chapter 13

  27. The Cost of Bank Funds • Distinguish and discuss the following pairs of terms with respect to cost: • Foreign vs. domestic • Core vs. managed liabilties • Explicit vs. implicit interest • Eras of interest-bearing checking accounts: • Pre-1933 • 1933-1980 • Post 1980 Chapter 13

  28. A Bank’s Weighted Average Marginal Cost of Funds • Source of funds (as a % of balance sheet) • Interest cost • Operating cost • Total cost • Weighted cost • Weighted average Chapter 13

  29. Example (no operating costs) • SourceAmtCostWeighted cost • Deposits .85 5% 4.25% • Nondep.debt 0.05 7% 0.35% • Equity* .1014%1.40% • Weighted 1.00 6.00% • *Shareholder required return Chapter 13

  30. Market Discipline and Cost of Funds • Since riskier banks will have to pay more for funds than safer banks, bank should want to signal/demonstrate to money and capital markets that they are safe (e.g., have adequate capital – the K in TRICK) • To the extent that banks engage in cost plus pricing, they might just ignore this discipline with respect to the costs of deposits and nondeposit debt; however, higher shareholder required returns and lower stock values should get managers’ attention Chapter 13

  31. Measures of Bank Liquidity • Sources and uses of funds • Large-liability dependence • Various ratios (to assets) • Core deposits • Loans • Temporary investments • Other ratios: Loans to deposits, pledged securities, brokered deposits, market to book (of securities) Chapter 13

  32. The Dynamics of Liquidity Management • Role of expectations • Properties of time series data • Forecasting techniques Chapter 13

  33. The Three Faces of Liability Management • Minimize interest expense • Segment markets • Meeting loan demand to enhance customer relationships • Desire to reduce regulatory burdens associated with reserve requirements and deposit-insurance fees (and Reg Q when it existed) Chapter 13

  34. The Risks of Liability Management • Maintaining the confidence of the marketplace is critical • Government guarantees help and may even thwart market discipline – “hot money,” however, tends to run and it does so electronically in today’s world Chapter 13

  35. Chapter Summary • The importance and interaction of liquidity and confidence are captured by the following statements: • "Liquidity always comes first; without it a bank doesn't open its doors; with it, a bank may have time to solve its basic problems" (Donald Howard, Chief Financial Officer, Citicorp). Chapter 13

  36. Summary (continued) • "Our whole financial system runs on confidence and not much else when you get down to it. What we've learned is that when confidence erodes, it erodes very quickly" (L. William Seidman, former Chairman, FDIC). Chapter 13

  37. Summary (continued) • On the topic of liquidity and the availability of capital, also consider, this by David Ruder, former chairman of the SEC, following the stock market crash of October 1987 : • "I personally regard that question is probably the most important one to come out of the market decline. Chapter 13

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