Liquidity Risk and FIs Management Chapter 17 and 18

1. risk management, 20080229 1 Liquidity Risk and FIs’ ManagementChapter 17 and 18 Saunders and Cornett

2. risk management, 20080229 2 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.

3. risk management, 20080229 3 Method s to deal with withdrawal of funds Assets fire-sale; Running down the FI’s cash assets, drain the liquidity, or By borrowing additional funds. Liquidity risk can result in insolvency of banks (FIs) if none of the above works and depositors run to the FI to get their funds.

4. risk management, 20080229 4 Causes of Liquidity Risk Reliance on demand deposits: liability side Core deposits: long term funding source. Depository Institutions need to be able to predict the distribution of net 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 the large inflows from selling off mutual funds. Managed by: purchased liquidity management stored liquidity management

5. risk management, 20080229 5 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

6. risk management, 20080229 6 Liability Management 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 Combine purchased and stored liquidity management

7. risk management, 20080229 7 Asset Side Liquidity Risk Risk from loan commitments and other credit lines: met either by borrowing funds or by running down cash reserves Current levels of loan commitments are dangerously high according to regulators

8. risk management, 20080229 8 Measuring Liquidity Exposure Net liquidity statement: shows sources and uses 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.

9. risk management, 20080229 9 Other Measures: Peer group comparisons: usual ratios include borrowed funds/total assets, loan commitments/ total assets etc. Liquidity index: a measure of the potential losses an FI could suffer as a result of fire sale of assets. 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*)

10. risk management, 20080229 10 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.

11. risk management, 20080229 11 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

12. risk management, 20080229 12 Liquidity Planning Bank run: a sudden and unexpected withdraw 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.

13. risk management, 20080229 13 Bank run Demand deposits are first come first served. Therefore, depositor’s place in line matters. Bank panic: systemic or contagious bank run. Regulatory measures to reduce likelihood of bank runs: FDIC Discount window

14. risk management, 20080229 14 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 Cash immediacy versus reduced return Constrained optimization Privately optimal reserve holdings Regulator imposed reserve holdings

15. risk management, 20080229 15 Funding Risk versus Cost Funding Cost

16. risk management, 20080229 16 Liability Management 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 minimum balance requirements to alter attractiveness of NOW deposits.