BFF3651 Week 7 Seminar

BFF3651 WEEK 7 SEMINAR: RISK MANAGEMENT: LIQUIDITY RISK:
Learning Objectives:
1. Liquidity risk management
2. Measure of liquidity risk
3. Bank runs, deposit insurance and discount window
Introduction:
 Liquidity risk is the day to day business activities or business management
activities of any financial institution. E.g. FI’s allow depositors to withdraw
money at short notice, and these deposits are the main source of funding
for the banks or the FI’s.
 FI’s may face liquidity risk when they cannot generate enough cash to pay
creditors as promised
 FI’s can handle this problem, by using their remaining cash to repair short
term creditors, sell some of their assets or borrow additional funds
 As a last resort FI’s may need to sell some of their illiquid assets for fire-
sale prices (lower than market price) for immediate sale
 This can cause liquidity risk for FI’s equity value
 E.g. FI liquidates 10m at 5m loss in order to meet demand for withdrawals
 Reduces equity by 5m
 If another 5m demand for withdrawal, FI incurs at least 5m more in losses
and become insolvent.
TRADE-OFF PROBLEM:
 Too many liquid assets = less profitability for FI = solvency risk
 Less liquidity assets = risks profitability in crisis and regulatory
interventions = solvency risk
 Liability-side risk = FI doesn’t have cash to meet demands for withdrawals
 Asset-side liquidity risk = FI doesn’t have cash to fund investments for
lending
1. Liquidity risk management:

 Demand deposit contracts give holder right to put claims on DI and
demand immediate repayment on FV of deposit claims in cash
 Net deposit drain = deposit withdrawals – deposit additions
 Most demand deposits are consumer core deposits daily, providing a
stable source of funds for DI
 Purchased liquidity management: To purchase liquidity DI’s 1. Borrow
on market for purchase funds, 2. Issuing CDs, notes and bonds
 Benefit: increases size and composition of asset sides
 Costs: expensive for DI’s, higher cost of purchased funds = less attractive
to liquidity management, availability of funds is limited when lenders are
uncertain about solvency of DI
 With borrowing: total balance sheet rebalances
 Stored liquidity management: 1. meet positive net deposit drains, 2.

run down cash assets, 3. sell liquid assets
 Benefit: doesn’t rely on availability of funds on market.
 Cost: decreased asset size, must hold excess low-rate assets and forgo
returns on investing funds in loans and other assets.
 With borrowing: Total balance sheet shrinks
2. Measure of liquidity risk

 Net liquidity statement: lists sources/uses of liquidity providing
measure of DI’s liquidity position
 DI obtains liquidity funds in three ways:
1. Sell liquid assets with little price risk and low transaction cost
2. Borrow funds in money/purchase funds market up to maximum
amount.
3. Uses excess cash held to meet regulatory imposed reserve
requirements.
 Key ratios:
- 1. Borrowed fund to total assets = higher = worse = DI relies on
STMM over core deposits
- 2. Loans to deposits = higher = worse = DI relies on STMM over core
deposits
- 3. Core deposits to total assets = higher = better
- 4. Loan commitments to total assets = higher = worse
 Liquidity index = measure potential losses an FI suffers from fire-sale

disposal of assets compared to amount receive at fair market value
 Wi = weight of asset, Pi = asset’s fair market price
 Higher = more liquid DI’s portfolio of assets
Liquidity Index: Weight of asset1 x T-BILLS + Weight of asset2 x REAL
ESTATE LOANS
Liquidity index for DI’s asset portfolio in one month is:

Question 1: I = 50% x .99 / 1.00 (T-BILLS) + 50% x .85/0.92 (REAL ESTATE
LOANS) = 0.957
Liquidity index for DI’s asset portfolio in one month AFTER

changing market conditions is:
Question 2: I = 50% x 99 / 1.00 (T-BILLS) + 50% 65/0.92 (REAL ESTATE
LOANS) = 0.848
 Key ratios:
- Liquidity coverage ratio
- Net stable funds ratio
 Liquidity coverage ratio: ensure DI maintains adequate HQLA

converted to cash to meet liquidity needs for time horizon.
 Formula: (Stock of HQLA)/(Total NCF over next 30 days) > 100%
 NSFR = (Available amount of stable funding/required amount of stable

funding) > 100%
 Limits short term wholesale funding, takes long term perspective at
liquidity, evaluates liquidity over balance sheet, provides incentives for Dis
to use stable sources of funding (bank capital, preferred stock with
maturity, liabilities with maturity)
Liquidity risk measures used by regulators:

1. Duration mismatch
2. Concentration of funding
3. Available unencumbered assets
4. LCR by significant currency
5. Market-related monitoring tools
Planning ensures borrowing decisions before liquidity problem arises,
reduces costs, minimised amount of excess reserves
1. Delineation of managerial details/responsibilities
2. List fund providers who might withdraw and patterns
3. Size of fund withdrawals in time periods.
4. Sourced of funds, limits on borrowing, pattern of borrowing
3. Bank runs, deposit insurance and discount window
 Bank run: sudden increase in deposit withdrawals from DI

 Reasons:
1. Concerns about DI’s solvency
2. Failure of DI leading to depositor concerns about solvency of other Dis
3. Changes in investor preferences regarding financial assets relative to
deposits
Characteristics of demand deposit contracts and bank runs:
 DI’s assets values < than deposits = a certain proportion of depositors
paid in full, and their place is determined if they can withdraw their
amount from DI as they may not be paid
 Any line outside DI encourages other depositors to join the line
immediately if they don’t need cash today for normal consumption
 Incentives for depositors to run first create instability in the banking
industry, can be pushed into insolvency, larger deposit drains and liquidity
demands
 Regulators have put in place two mechanisms to ease the problem
 1st mechanism: deposit insurance = covers depositor $250,000

maximum per customer = customers will not run due to this guarantee
Moral hazard: deposit holders will not run in a bank insolvency = Dis more
likely to increase liquidity risk on balance sheets
 2nd mechanism: Discount window: central banks lend to financial

institutions that face liquidity problem, they provide temporary liquidity for
an inherently solvent DI
 To borrow from the discount window: DI needs HQLA for collateral. IR
charged on loans = discount rate set by central bank
 Discount rate > federal funds rate
 Three lending programs:

1. Primary credit: sound DI’s on short term basis
2. Secondary credit: Dis not eligible for primary credit, short term at rate
above primary credit
3. Seasons credit program: assists small DIs managing significant
seasonal swings in loans and deposits (e.g. agricultural regions)
Week 7 Quiz:
Liquidity index: 1. One-month liquidity index, 2. liquidity index AFTER
changing conditions
Stored liquidity management: In the balance sheet both deposits and cash
decrease which results in the overall balance sheet shrinking.
Purchased liquidity management: In the balance sheet deposits decrease
and borrowed funds increase by the same amount to offset the balance sheet.
Sources of liquidity:
1. Sell liquid assets with little price risk and low transaction cost ($2
million to Fed funds market)
2. Borrow funds in money/purchase funds market up to maximum
amount. ($15 million, T-bills + borrowed from repo market)
3. Uses excess cash held to meet regulatory imposed reserve
requirements. ($5 cash reservices)
Uses of liquidity: Discount window and deposit insurance
1. Borrowed $1 million from Federal discount window to meet seasonal needs
Net Liquidity Statement: $22 million from sources of liquidity - $1 million from
uses of liquidity = $21 million
Test Bank: Questions and Answers

Potential causes of liquidity risk:
 DI’s most exposed to liquidity risk

 Mutual Funds least exposed to liquidity risk
 Fire sale price: FI’s sell some of their illiquid assets for lower than
market price for immediate sale
 Banks net deposit drain: Positive = withdrawals > deposits,
Negative = deposits > withdrawals

BFF3651 Week 7 Seminar

Uploaded by

Copyright:

Available Formats

BFF3651 Week 7 Seminar

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BFF3651 Week 7 Seminar

Uploaded by

Copyright:

Available Formats

BFF3651 WEEK 7 SEMINAR: RISK MANAGEMENT: LIQUIDITY RISK:

1. Liquidity risk management:

 Stored liquidity management: 1. meet positive net deposit drains, 2.

2. Measure of liquidity risk

 Liquidity index = measure potential losses an FI suffers from fire-sale

Liquidity index for DI’s asset portfolio in one month is:

Liquidity index for DI’s asset portfolio in one month AFTER

 Liquidity coverage ratio: ensure DI maintains adequate HQLA

 NSFR = (Available amount of stable funding/required amount of stable

Liquidity risk measures used by regulators:

3. Bank runs, deposit insurance and discount window

 Bank run: sudden increase in deposit withdrawals from DI

 1st mechanism: deposit insurance = covers depositor $250,000

 2nd mechanism: Discount window: central banks lend to financial

 Three lending programs:

Test Bank: Questions and Answers

 DI’s most exposed to liquidity risk

You might also like