Chapter 5:
Liquidity Risk
Reading materials
• Saunders, chapter 12
Content
• Liquidity risk
• Measure liquidity risk
• BIS measures
• Liquidity planning and Bank run
Liquidity risk
• The risk that a firm is unable to meet its obligation
• Liquidity risk can come from
• Liabilities side
• Assets side
Liquidity risk from liabilities side
• Banks have to repay immediately at customers’ request
• Example: Depositors withdraw cash from their transaction
• But banks do not keep a lot of cash due to low return
Liquidity risk from liabilities side
• In normal condition, only a small proportion of deposit is
withdrawn each day
• A bank can measure the difference between cash
withdrawn and new cash deposit—net deposit drain
Net deposit drain
Manage liquidity risk from liabilities side
• Stored liquidity: use cash or sell assets to have cash
• Purchased liquidity: borrow or issue bonds
Example:
before deposit drain
After deposit drain with
stored liquidity
After deposit drain with purchased liquidity
• How does the balance sheet change?
Liquidity risk from assets side
• Customer exercises a loan commitment contract
• Value of investment portfolio drops
Example: before loan
commitment is exercised
After exercises with
stored liquidity
After exercised, with
purchased liquidity
Example: before drop in
investment value
After drop, with stored
liquidity
After drop, with
purchased liquidity
Measure liquidity risk
Measure with Financing Gap
• Financing gap = Avg. loan balance − Avg. deposit balance
• Financing requirement = Liquid assets + Financing gap
→ Borrow new funds (financing requirement) to bridge the gap
How much funding does the bank need to raise in total?
Banks prefer to fund loans with deposits (cheap, stable)
positive financing gap = funding pressure = loans that are not covered by deposits
Measure with sources and uses of liquidity
• Calculate the bank’s net liquidity position on a daily basis
• Compile a report that lists the bank’s sources and uses of
liquidity, and its net position
• Sources of liquidity: where the bank can obtain liquid funds
• Uses of liquidity: how much the bank has used from the sources
Example
Peer group ratio comparisons
• Compare key liquidity measures with similar banks.
Example:
• Loans to deposits
• Borrowed funds to total assets
• Loan commitment to total assets
• Higher liquidity risk exposure if
• Bank relies more on short-term borrowings to finance loans
• Bank has relatively more loan commitments
Example
Measure with liquidity index
• Measure potential losses if
a bank has to fire-sell
assets for liquidity purpose
• Weighted sum of ratios of
assets’ fire-sale value (FS)
with wi is the value-based weight of asset i in the
to fair market value (MV ) bank’s asset portfolio.
BIS Measures
BIS new measure of liquidity risk
• Bank for International Settlement’s Basel Committee
develops two new standards for liquidity risk supervision.
• Applies to large banks with $250 billion or more in total
consolidated assets
• Liquidity coverage ratio (LCR)
• Net Stable Funding Ratio (NSFR)
Liquidity coverage ratio
• Focus on short-term liquidity capacity
• Banks have to hold sufficient liquid assets to meet 30-day liquidity
needs
Liquidity coverage ratio
• Requirement: LCR ≥ 100%
High-quality liquid assets (HQLA)
• Liquid assets must remain liquid in times of stress
(convertible into cash with little cost and can be used at
the central bank discount window as collateral)
• Two levels: level 1 (highest quality) and level 2
Assets in each level
“Haircut” and Cap
• Haircut rules: asset size reduced by the haircut percentage
• 15% haircut applies to level 2A assets
• 50% haircut applies to level 2B assets
• Cap:
• Level 2 ≤ 40% of HQLA
• Level 2B ≤ 15% of HQLA
Net cash outflows
• Net cash outflows = Cash outflows – Min(inflows; 75% of
outflows)
• Cash outflows
• Eventually, most liabilities have to be repaid
• Every month, a proportion of liabilities will be repaid
• For each liability item, LCR standard imposes a minimum
proportion (run-off factor) that will be repaid
Net cash outflows
• Cash inflows
• Only include inflows for sources where no default is expected in
next 30 days
• The 75% cap means that banks do not rely solely on inflows for
liquidity
Example
Net stable funding ratio (NSFR)
• NSFR standard encourages banks to finance their long-
term assets with stable funding
→ measures long-term liquidity capacity
• Requires a minimum amount of stable funding be held over
a one-year time horizon
• Limits reliance on short-term wholesale funding
Net stable funding ratio
• Requirement: NSFR > 100%
Available amount of stable funding (ASF)
• Include equity and liabilities that are reliable sources of
funds over a one-year time horizon
• Bank capital & preferred stock with a maturity > 1 year
• Liabilities with maturities > 1 year
• Deposits expected to stay with bank during a period of stress
• Calculation: multiply original item’s balance with its
assigned ASF factor
Required amount of stable funding (RSF)
• On- and off-balance sheet assets
• Amount of each item is adjusted to reflected their illiquidity status
• Calculation: multiply original item’s balance with its assigned RSF
factor
Example
Liquidity planning & Bank run
Good liquidity planning
• Allows managers to make borrowing priority decisions
before liquidity problems arise
• Lower the cost of funds
• Minimize excess reserves
Components of liquidity planning
• Clearly defined managerial responsibilities
• Fund suppliers’ pattern of withdrawals
• Size of withdrawals over various time horizons (next week,
next month. . . )
• Internal limits on size and interest rate of borrowings to
meet liquidity
Liquidity risk and bank run
• Large deposit drains may occur due to facts or perceptions
• Public concern about the bank’s solvency
• Bank B’s depositors are worried when bank A fails
• The public prefers a different investment vehicle at the moment
Liquidity risk and bank run
• Bank run: a sudden and unexpected increase in deposit withdrawals from a
bank
• Reasons
• Withdrawals of deposit are first-come, first-serve: depositors receive either full
repayment or nothing
• Depositors who do not need cash may withdraw anyway
• Even good banks may become insolvent in a bank run, after exhausting
borrowings and asset fire-sale
• Nobel prize 2022 awarded for research on banks and financial crises
Mitigate bank runs
• Borrow from the central bank
• Deposit insurance
• Case-by-case protection beyond deposit insurance
Problem sets
• Chapter 12: 4, 5, 8, 9, 12, 13, 14, 15, 17, 18, 19, 20, 22, Minicase