Chapter Twenty-One
Managing Liquidity Risk on the
Balance Sheet
Liquidity Risk Management
Liquidity risk arises when an FI’s liability holders, such
as depositors or insurance policyholders, demand
immediate cash for the financial claims they hold with an
FI.
The risk that a sudden surge in liability withdrawals may
require an FI to liquidate assets in a very short period of
time and at less than fair market prices.
Liquidity Risk Management
Unlike other risks, liquidity risk is a normal aspect of
the everyday management of financial institutions
(FIs)
At the extreme, liquidity risk can lead to insolvency
Some FIs are more exposed to liquidity risk than
others
Depository Institutions (DIs) are highly exposed
Mutual Funds, Pension Funds, and property-casualty
insurers have relatively low liquidity risk
Causes of Liquidity Risk
Liquidity Risk arises for two reasons;
Liability-Side reason
Asset-Side reason
Liability-Side Reason
The liability-side reason occurs when an FI’s liability holders,
such as depositors or insurance policyholders, seek to cash in
their financial claims immediately.
Asset-Side Reason
Asset-Side liquidity risk arises when a borrower draws on its
loan commitment, the FI must fund the loan on the balance
sheet immediately; this creates a demand for liquidity.
Liability Side Liquidity Risk
DIs’ balance sheets typically have
Large amounts of short-term liabilities such as deposits and other
transaction accounts that must be paid out immediately if demanded
by depositors
Large amounts of relatively illiquid long-term assets such as
commercial loans and mortgages
DIs know that normally only a small portion of demand
deposits will be withdrawn on any given day
Most demand deposits act as core deposits—i.e., they are a stable and
long-term funding source
Deposit withdrawals are normally offset by the inflow of new
deposits
The Effect of Deposit Drains on the
Balance Sheet
DI managers monitor net deposit drains—i.e.,
the amount by which cash withdrawals exceed
additions; a net cash outflow
How an Financial Institution can Manage their
Deposit Drains
An FI can manage a drain on deposits in two major ways:
1. Purchased Liquidity Management
2. Stored Liquidity Management
Traditionally, DI managers relied on stored liquidity as
the primary mechanism of liquidity management.
Today, many DIs—especially the largest banks with
access to the money market and other non deposit
markets for funds—rely on purchased liquidity.
Purchased Liquidity Management
Purchased Liquidity allows FIs to maintain the overall size of
their balance when faced with liquidity demands.
Purchased liquidity is expensive relative to stored liquidity
Purchased liquidity includes:
Interbank Markets for short-term loans
Fed Funds
Repurchase Agreements
Fixed-Maturity Certificates of Deposits
Notes and Bonds
Adjusting to Deposit Drains by
Purchasing Funds
Stored Liquidity Management
Stored Liquidity may involve the use of existing cash stores or
the sale of existing assets.
Banks hold cash reserves in their vaults and at the Federal
Reserve in excess of minimum requirements
When managers utilize stored liquidity to fund deposit drains,
the size of the balance sheet is reduced and its composition
changes
Most DIs utilize a combination of stored and purchased
liquidity management
Adjusting to Deposit Drain by
Reserve Funds
Asset Side Liquidity Risk
Loan commitments and other credit lines can cause
liquidity problems
as with liability side liquidity risk, asset side liquidity risk
can be managed with stored or purchased liquidity
If stored liquidity is used, the composition of the asset
side of the balance sheet changes, but not the size of
the balance sheet
If purchased liquidity is used, the composition of both
the asset and liability sides of the balance sheet
changes, and increases the size of the balance sheet
The Effects of Loan Commitment
Exercise
Measuring Liquidity Risk Exposure
The liquidity position of banks is measured by
managers on a daily basis
A net liquidity statement lists sources and uses of
liquidity
Peer Group Ratio Comparisons
Peer group ratio comparisons are used to compare
a bank’s liquidity position against its competitors
loans to deposit ratio
borrowed funds to total assets ratio
commitments to lend to assets ratio
Ratios are often compared to those of banks of a
similar size and in the same geographic location
Liquidity Index
The liquidity index measures the potential losses a
bank could suffer from a sudden or fire-sale
disposal of assets versus the sale of the same assets
at fair market value under normal market conditions
N
I [(wi )( Pi / Pi * )]
i 1
where wi = the percent of each asset i in the FI’s portfolio
Pi = the price it gets if an FI liquidates asset i today
Pi* = the price it gets if an FI liquidates asset i under normal market
conditions
Financing Gap and Requirement
The financing gap is the difference between a bank’s
average loans and average (core) Deposits
If the financing gap is positive, the bank must find liquidity
to fund the gap
The financing requirement is the financing gap plus
a bank’s liquid assets
a widening financing gap can be an indicator of future
liquidity problems
Liquidity Planning
Liquidity planning allows managers to make important
borrowing priority decisions before liquidity problems
arise
lowers the costs of funds by determining an optimal funding
mix
minimizes the amount of excess reserves that a bank needs to
hold
liquidity plan components
Delineation of managerial responsibilities
List of fund providers most likely to withdraw funds and a pattern of
fund withdrawals
Identification of the size of potential deposit and fund withdrawals
over various time horizons
Liquidity Risk
Major liquidity problems arise if deposit drains are
abnormally large and unexpected
Abnormal deposit drains can occur because
concerns about a bank’s solvency
failure of another bank (i.e., the contagion effect)
sudden changes in investors’ preferences regarding holding
nonbank financial assets relative to bank deposits
A bank run is a sudden and unexpected increase in
deposit withdrawals from a bank
Liquidity Risk
Demand deposits are first-come, first-served contracts
The incentives for depositors to withdraw their funds
at the first sign of trouble creates a fundamental
instability in the banking system
a bank panic is a systemic or contagious run on the
deposits of the banking industry as a whole
Regulatory mechanisms are in place to ease banks’
liquidity problems and to deter bank runs and panics
deposit insurance
the discount window
Deposit Insurance
Guarantee programs offer depositors varying degrees of
insurance protection to deter bank runs
Deposit insurance was first introduced in the U.S. in
1933 and gave coverage up to $2,500
Coverage was increased to $100,000 by 1980
Beginning in 2011 the Federal Deposit Insurance
Corporation (FDIC) will increase coverage every year
based on the Consumer Price Index (CPI)
The Federal Deposit Insurance Reform Act of 2005
increased deposit insurance for retirement account from
$100,000 to $250,000
Deposit Insurance
Individuals can achieve many times the $100,000
($250,000) coverage cap on deposits by creatively
structuring their deposits and by using multiple banks
The FDIC now uses a risk-based deposit insurance
program to evaluate and assign deposit insurance
premiums
the safest institutions now pay 5¢ per $100 of deposits
the riskiest institutions now pay 43¢ per $100 of deposits
The Discount Window
The Federal Reserve also provides a “discount window”
lending facility
Historically the borrowing rate was below market rates
and borrowing was restricted
In 2003 the Fed increased the costs of borrowing but
eased the terms
Primary credit is available to generally sound DIs on a very
short-term basis
Secondary credit is available to less sound DIs (at a higher
rate than primary credit) on a very short-term basis
Seasonal credit assists small DIs in managing seasonal
swings in their loans and deposits
Liquidity Risk and Insurance Companies
Life insurance companies hold cash reserves and other
liquid assets
To meet policy payments
To meet cancellation (surrender) payments
Thesurrender value of a life insurance policy is the amount that an
insurance policyholder receives when cashing in a policy early
To fund working capital needs which can be unpredictable
Property-casualty (P&C) insurance companies
The claims against P&C insurers are hard to predict
Thus, P&C insurance companies have a greater need for
liquidity than life insurance companies
Liquidity Risk and Mutual Funds
Mutual funds (MFs) can be subject to dramatic
liquidity needs if investors become nervous about the
true value of the funds’ assets
However, the way MFs are valued reduces the
incentive of fund shareholders to engage in bank-like
runs on any given day
assets are distributed on a pro rate basis (i.e., rather than a
first-come first-served basis)
losses are incurred to shareholders on a proportional basis
Thank You