VOL. 10, NO.

6 MAY 2015

DALLASFED

Economic
Letter
Liquidity Mismatch Helps Predict
Bank Failure and Distress
by J.B. Cooke, Christoffer Koch and Anthony Murphy

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ABSTRACT: Liquidity mismatch
the risk of a bank being unable
to fund increases in assets or
meet its obligations as they
come dueincreased in the
U.S. banking sector during
the run-up to the financial
crisis, especially at the largest
institutions, contributing to bank
failure and distress.

ommercial bank failures

increased dramatically in
recent years, while numerous
other banks became distressed,
as measured by high ratios of nonperforming assets to equity and loan loss
reserves (Chart 1).1 The quarterly failure
rate of banks peaked at 0.6 percent in
second quarter 2009. The combined failure and distress rate reached 2.5 percent
in fourth quarter 2010the highest level
since the 1980s.
Bank failures are costly, so regulators
want to understand the reasons for them
and how they may be prevented.2 One
possible reason for the heightened failure and distress rate is the largepossibly excessiverise in liquidity mismatch
in the mid-2000s.
The higher risk that banks would
be unable to fund increases in assets
or meet their obligations as they came
due was an important warning sign to
which regulators may have paid insufficient attention. Controlling for the usual
factors that regulators look at (equity
capital, loan quality, etc.), we find that
liquidity mismatch helps predict bank
failure and distress one year ahead.

What Is Liquidity?
A banks liquidity refers to its ability
to fund increases in assets (mostly loans)

and meet its obligations. For example,

when depositors demand access to
funds, they expect to be able to withdraw
their nonterm deposits, such as those in
checking accounts, at any time without
delay. If a bank needs to secure liquidity quickly to fulfill its obligations, it
may have to sell assets hastily, often at
low prices. In the extreme, a bank may
become insolvent. If a bank is rumored
to have financial difficulties, uninsured
depositors may rush to withdraw their
funds, and wholesale sources of funding such as those obtained from foreign
sources may dry up.3
Liquidity problems played a prominent role in many high-profile bank
failures in the U.S. and abroad. Two
examples are Washington Mutual in
the U.S. and Northern Rock in the U.K.
As a result, an international oversight
panel, the Basel Committee on Banking
Supervision, proposed, and the Fed
introduced, new rules designed to reduce
the incidence of very-short-run (one
month) liquidity mismatches at large
bank holding companies.4 New rules to
reduce 12-month liquidity mismatches
will take effect in the next few years.
Versions of these liquidity rules are
likely to trickle down to smaller banks.
However, the contribution of liquidity
mismatch to bank failure or distress, along

Economic Letter
Chart

Bank Failure and Distress Rates Shoot Up During Crisis

Failure or distress (percent)

In a crisis, banks may

2.5

experience a variety of
liquidity shocks.

Failure and distress

2
1.5
1
.5
0

Failure
2001

2003

2005

2007

2009

2011

2013

NOTES: A bank is distressed when the ratio of nonperforming assets to the sum of equity and loan loss provisions (Texas
ratio) exceeds 2. Shaded areas indicate recessions.
SOURCES: Call reports of insured domestic commercial banks; Federal Deposit Insurance Corp.; authors calculations.

with the effectiveness of liquidity rules,

has not been demonstrated. Liquidity
mismatch may already be picked up by the
measures that regulators have relied upon
for many yearsthe so-called CAMELS, an
acronym for capital adequacy, assets, management, earnings, liquidity and sensitivity
to market risk.5

sures may be used to assess the capacity of

banks to withstand such adverse events.

Financial Intermediation

Liquidity mismatch =

Banks channel savings from depositors to borrowers, an activity known

as financial intermediation. They also
create loans from the deposits, a process known as asset transformation.
Inevitably, these activities result in a
maturity mismatch between banks
assets and liabilities. Assets tend to be
more long term than liabilitiesmortgages versus customer deposits. If
depositors suddenly demand their funds,
as often occurs during a financial crisis,
banks may be unable to provide the
funds because of illiquidity.
In a crisis, banks may experience a variety of liquidity shocks. They include a high
rate of withdrawal of retail deposits; loss
of unsecured, wholesale funding; a partial
loss of secured funding due to declines in
the value of underlying collateral; forced
sales of loan portfolios at a discount; and
unscheduled draws on unused credit and
liquidity lines. Liquidity mismatch mea-

Measuring Mismatch
Our measure of liquidity mismatch
looks at the difference in the liquidity of
a banks assets and liabilities:
Liquidity-weighted liabilities
Liquidity-weighted assets
Total assets

A rising measure indicates a worsening liquidity mismatch. The measure is

constructed using call reports, regulatory
filings and the latest Basel Committee
tables of proposed one-year asset and
liability liquidity weights.
In the case of the banks liabilities
and equity, the liquidity weights reflect
funding instability over the next year,
the extent to which deposits could run
off or wholesale funding could dry up
in a crisis. For example, equity and borrowings or term deposits with a maturity
of one year or more are considered very
stable, so their liquidity weight is 0. Other
things being equal, liquidity mismatch
rises if banks have lower retail deposits
and higher wholesale deposits, which are
more short term and less stable.
On the asset side of the balance sheet,
the liquidity weights reflect the degree to
which the asset can be sold in the market

Economic Letter Federal Reserve Bank of Dallas May 2015

Economic Letter
without affecting the assets price. For
example, cash has a liquidity weight of 1
because it is perfectly liquid; most residential mortgages have a weight of 0.35,
and construction and land development
loans have a weight of zero because such
loans are very illiquid in a crisis. As a
result, liquidity mismatch rises if banks
hold fewer mortgage loans and more construction and land development loans.6

mismatch from the effects of changes in

equity capital and the other predictors of
bank failure and distress between 2006 and
2011.9 This period was chosen because it
followed a time when there were very few
failures or cases of distress, the early 2000s.
Failure or distress up to two years
ahead was considered. For example, fourth
quarter 2007 data were used to predict failure or distress any time in 2008.10
The results suggest that recent failure and distress rates are explained or

bank failure or distress. Higher levels of

liquidity mismatch may be correlated with
lower levels of equity capital and higher
proportions of brokered deposits and
construction and land development loans
as well as with nonperforming assets or
lower returns on assetsall well-known
predictors of failure or distress.8

Modeling Failure and Distress

Statistical models were used to disentangle the effects of changes in liquidity

Precrisis Rise in Mismatch

Liquidity mismatch rose significantly
between 2002 and 2007. The median level
of mismatch climbed about 6 percentage points.7 Most of this rise was driven
by changes in liquidity-weighted assets
rather than liquidity-weighted liabilities.
Banks pursued higher returns on riskier,
less-liquid assets. To a lesser extent, banks
relied less on stable core deposits and
more on unstable wholesale funding.
The rise in liquidity mismatch before the
financial crisis is noteworthy because
equity capital (as a percentage of assets)
the ultimate buffer against losses
changed little.
The rise in mismatch was faster and
more persistent at the largest banks, representing the top 25 percent of institutions
(Chart 2). Among those banks, the median
mismatch rose about 8.5 percentage points
between 2002 and 2007, while at the 25
percent representing the smallest banks,
the increase was only 3 percentage points.

Early-Warning Sign?
Bank regulators look for early-warning
signs of distress. Is liquidity mismatch
one? Comparing the fourth quarter 2007
mismatch levels of commercial banks that
failed or became distressed in 2008 or 2009
with those that did not may provide an
indication. The average levels of liquidity
mismatch for the two groups were significantly different. Failed or distressed banks
generally had much higher levels of liquidity mismatch, as shown by the final entry
in the liquidity mismatch row of Table 1.
While the timing of the changes in
liquidity mismatch (as seen in Chart 2)
and the difference in levels of mismatch
at any one time (as seen in Table 1) suggest that liquidity mismatch is important,
they do not necessarily imply that a rise
in liquidity mismatch helps predict future

Chart

Rise in Liquidity Mismatch Is Greater at Large Banks

Liquidity mismatch (percent)

15

Greater
mismatch

20
25
30
35

Quartile 4 (largest banks)

Quartile 3
Quartile 2
Quartile 1 (smallest banks)

40
45

2002

2004

2006

2008

2010

2012

2014

NOTES: The lines show the median liquidity mismatch by bank size quartile. The size quartiles are determined each
quarter. Shaded area indicates recession. Less-negative readings indicate greater mismatch.
SOURCES: Call reports of insured domestic commercial banks; authors calculations.

Table

Failed or Distressed Banks Differ from Other Banks in 08 and 09

2008 and 2009

Fourth quarter 2007 warning signs

Liquidity mismatch/assets
Construction and land development loans/assets

Failed or
distressed
banks

Other banks

Difference

11.5%

25.2%

13.7%

27.5%

7.6%

19.8%

Equity capital/assets

10.3%

13.3%

3.0%

Brokered deposits/assets

12.4%

2.9%

9.5%

Nonperforming assets/assets

5.2%

1.8%

3.4%

Net income/assets (return on assets)

0.13%

Size (median assets, millions of dollars)

Number of banks

0.99%

0.86%

$233

$119

$114

324

6,985

NOTES: Except for the difference in median size, data reflect differences in means. All of the differences are statistically
significant at the 1 percent level.
SOURCES: Call reports of insured, domestic commercial banks; authors calculations.

Economic Letter Federal Reserve Bank of Dallas May 2015

Economic Letter

predicted by many of the same factors

as in 198592, when large numbers of
commercial banks and savings and loans
failed. These factors include too little
equity capital, a high ratio of nonperforming assets and a high share of construction and land development lending.

Mismatch Has Predictive Power

In addition to these factors, liquidity
mismatch helps predict bank failure and
distress one or two years ahead. Results
of our model suggest that a 5 percentagepoint rise in liquidity mismatch raises
the probability of failure or distress in the
next year about 0.25 percentage points.
By contrast, a 1 percentage-point fall in
equity capital (as a share of assets) raises
the probability about 0.5 percentage
points. These effects may appear small,
but they should be gauged against the
average failure or distress rate of 1.4 percentage points per quarter in 200711.
The importance of the liquidity
mismatch effect may also be judged by
comparing it to the equity capital effect.
Banks that failed or were distressed in
200809 had a liquidity mismatch that
was 13.7 percentage points higher and
equity that was 3 percentage points lower
than other banks in fourth quarter 2007
(seen in Table 1). Leaving aside the roles
played by factors such as construction
and land development loans, the higher
levels of mismatch raised the chances of
failure or distress by about 0.75 percentage points, while lower levels of equity
increased the chances by 1.5 percentage points. Thus, the liquidity mismatch

DALLASFED

effect is about half as important as the

equity capital effect.

Liquidity Mismatch Matters

Liquidity mismatch rose significantly
before the financial crisis, especially at
large banks, our research shows. The
rise in mismatch contributed to the rise
in bank failures and cases of distress.
Liquidity mismatch helps predict bank
failure or distress one year ahead, even
accounting for equity capital and the other indicators at which regulators look.
Cooke is an economic analyst, Koch is
a research economist and Murphy is
an economic policy advisor and senior
economist in the Research Department of
the Federal Reserve Bank of Dallas.

Notes
The Texas ratio, a measure that got its name during
the Texas banking collapse of the late 1980s, is the ratio
of nonperforming assets to the sum of equity capital
and loan loss provisions. A traditional warning sign of
bank failure is a ratio exceeding 1. During the period
under study, a number of institutions recorded Texas
ratios greater than 2. See The So-Called Texas Ratio,
by Thomas F. Siems, Federal Reserve Bank of Dallas
Financial Insights, vol. 1, no. 3, 2012.
2
Between 2008 and 2011, bank failures (including
commercial bank, savings and loan association, and
savings bank failures) cost the Deposit Insurance Fund
an estimated $72.9 billion. The fund, which is run by the
Federal Deposit Insurance Corp. and funded by bank levies, fully insures covered deposits against bank failures.
3
Wholesale funds are an alternative source of funds to
equity capital and core deposits. Sources include federal
funds, Federal Home Loan Bank advances, foreign de1

Economic Letter

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posits, brokered deposits and deposits obtained through

the Internet or certificate of deposit listing services that
post a banks CD notes for a fee.
4
The Basel Committee on Banking Supervision is a
forum for regulatory cooperation between member
countries on matters relating to banking supervision. It
consists of senior representatives of bank supervisory
authorities and central banks from major economies.
5
CAMELS ratings are supervisory ratings of a banks or
credit unions overall condition. A five-point scale1
(strong) to 5 (critical)is used.
6
Because a banks assets are more liquid than its liabilities,
the liquidity mismatch measure is almost always negative.
7
Fifty percent of banks had lower liquidity mismatch values
than the median, and 50 percent had higher values.
8
A brokered deposit is a large deposit typically arranged
through a broker that is subsequently broken into small
pieces and sold to customers. Such deposits pay a higherthan-prevailing rate of interest to attract investor funds.
9
The usual indicators are all CAMELS proxies. They include
net income, brokered deposits, cash, securities, loan loss
provisions, goodwill, one- to four-family residential loans,
multifamily residential loans, commercial real estate loans,
and construction and land development loans, all expressed
as a ratio of total assets. We also took account of receipt
of Troubled Asset Relief Program capital injections and
aggregate financial market stress.
10
We estimated a range of cross-section and panel probit
models, a standard way of modeling binary outcomes such
as bank failure versus bank survival.

Mine Ycel, Senior Vice President and Director of Research

Carlos E.J.M. Zarazaga, Executive Editor
Michael Weiss, Editor
Kathy Thacker, Associate Editor
Ellah Pia, Graphic Designer

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