FIN 683 Financial Institutions Management Liquidity … • A definitional challenge: you know it when you (do not) see it – theory: the ability to trade arbitrary amounts of an

Professor Robert B.H. HauswaldKogod School of Business, AU

FIN 683Financial Institutions Management

Liquidity Risk

Intermediaries are Special

• Banks are special: intermediaries– reduce informational frictions through

– screening, monitoring, and contracting

• But: acquire information monopoly– reducing one friction, creating another one

– competition is imperfect

– moral hazard in banking: regulation

• Moral hazard and holdup: systemic risk

2/23/2016 Bank Runs and Systemic Risk © Robert B.H. Hauswald 2

Liquidity• A definitional challenge: you know it when you

(do not) see it– theory: the ability to trade arbitrary amounts of an

asset without moving the market

– but how to measure this theoretical yardstick?

• Faced by all FIs: trading short-term claims– deposits, CDs, interbank

• Regulation: how can you control a risk which is– impossible to define

– hard to measure?2/23/2016 3Market Risk © Robert B.H. Hauswald

Liquidity Risk• Definition: asset owner unable to recover full

value of asset when sale desired, or – for borrower, that credit is not rolled over

• Alternative definition – risk of being unable to satisfy claims without impairment of financial or reputational capital

• Defining liquidity mathematically: L1=Pi/P*; L2=∑ i=0…n Pi/P*, L3=E(P)/P* where P* is full value price and Pi is realised price

• Bank liquidity – ability of institution to meet obligations under normal business conditions

2/23/2016 4Bank Runs and Systemic Risk © Robert B.H. Hauswald

Liquidity Risk Leads to


Liquidity Risk and Banking Crises• Bank assets illiquid and long term, liabilities liquid

and short term• Short term liabilities conceptually a means of

disciplining bank managers via threat of runs• But depositors’ monitoring of projects is likely to be

prone to errors, hence – banks vulnerable to “overdiscipline” (runs on solvent

banks) leading to – socially wasteful liquidation of projects.

• Possibility for runs to affect other banks, via – balance sheet similarities under uncertainty or – counterparty exposures


FIs and Liquidity Risk Exposure• High exposure

– Depository institutions

– Loss of confidence in bank-to-bank lending affects liquidity in other markets

• Moderate exposure– Life insurance companies

• Low exposure– Mutual funds, hedge funds, pension funds, and property-

casualty insurance companies.• Typically low, does not mean zero

• Bear Stearns Funds

2/23/2016 7Market Risk © Robert B.H. Hauswald

Causes of Liquidity Risk• Liability-side liquidity risk when depositors or

policyholders cash in claims– With low cash holdings, FI may be forced to liquidate assets

too rapidly

– Faster sale may require much lower price

• Asset-side liquidity risk can result from OBS loan commitments and need to liquidate security positions– liquidity requirements from take down of funds can be met by

– running down cash assets, selling liquid assets, or additional borrowing


Liability-side Liquidity Risk for DIs

• Reliance on demand deposits: core deposits

• Depository institutions need to be able to predict the distribution of net deposit drains– Seasonality effects in net withdrawal patterns

– Early 2000s problem with low rates: Finding suitable investment opportunities for the large inflows

• Managed by:– Purchased liquidity management

– Stored liquidity management2/23/2016 9Market Risk © Robert B.H. Hauswald

Purchase Liquidity

• Federal funds market or repurchase agreement market

• Managing the liability side preserves asset side of balance sheet

• Borrowed funds likely at higher rates than interest paid on deposits

• Deposits are insured but borrowed funds not necessarily protected

• Regulatory concerns: – During financial crisis, wholesale funds were difficult and

sometimes impossible to obtain


Store Liquidity

• Liquidate assets to meet withdrawals– In absence of reserve requirements, banks tend to hold

reserves. (Example: In U.K. reserves ~ 1% or more)

• Downsides: – Opportunity cost of holding excessive cash, or other liquid

assets

– Decreases size of balance sheet

– Requires holding excess low return or zero return assets

• Combine purchased and stored liquidity management– but: leaves you still vulnerable to market forces


Asset Side Liquidity Risk

• Risk from loan commitments and other credit lines

– Met either by borrowing funds and/or by running down reserves

• Current levels of loan commitments: dangerously high– Commercial banks in particular have been increasing

commitments over the past few years, presumably believing commitments will not be used

– In 1994, unused commitments equaled 529%. In 2008, 1,015%. Fell back to 609% during the crisis.


Investment Portfolio

• Interest rate risk and market risk of the investment portfolio cause values to fluctuate

• Arguments that technological improvements have increased liquidity in financial markets– Some argue that “herd” behavior may actually

reduce liquidity

• Hard to see in light of recent events– liquidity risk and counterparty risk

– analysis of interbank market: the liquidity spigot2/23/2016 13Market Risk © Robert B.H. Hauswald

Measuring Liquidity Exposure• Net liquidity statement: sources of liquidity

1. Cash type assets,

2. maximum amount of borrowed funds available,

3. excess cash reserves

• Liquidity improvements: – securitization loan sales: many banks have added

loan assets to statement of sources

• Uses of liquidity– Borrowed or money market funds already utilized

– Any amounts already borrowed from the Fed2/23/2016 14Market Risk © Robert B.H. Hauswald

Other Measures

• Peer group comparisons: usual ratios include 1. borrowed funds/total assets,

2. loan commitments/assets, etc.

• Liquidity index: can you see the problem?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 = Σ wi(Pi /Pi*)


Measuring Liquidity Risk• Financing gap and the financing requirement

– yet another B/S management technique

– which liquidity risk is not addressed?

• Financing gap = Average loans - Average deposits, or

financing gap + liquid assets = financing requirement

• The gap can be used in peer group comparisons or examined for trends within an individual FI


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

• Managers can then influence the maturity of transactions to fill gaps – Must also evaluate “what if” scenarios in this

framework, but

– cautions about managing in abnormal conditions


Liquidity Planning

• Make funding decisions before liquidity problems arise

• Lower the cost of funds by planning an optimal funding mix– do not rely on one source of liquidity alone

– 2007: what was the problem?

– which assets are always liquid and why?

• Minimize the need for reserve holdings: why?2/23/2016 18Market Risk © Robert B.H. Hauswald

Liquidity Management

• Delineate managerial responsibilities– Identify who responds to regulatory agencies, who

discloses information to the public, etc.

• Detailed list of funds providers, important to anticipate the expected pattern of withdrawals– mutual funds/pension funds more likely to withdraw

than correspondent banks and small businesses

– Allow for seasonal effects

• What to do in a crisis?2/23/2016 19Market Risk © Robert B.H. Hauswald

Internal Implementation

• Identify size of potential deposit and fund withdrawals over various future time horizons– Identify potential alternative sources to meet the liquidity

needs within these horizons

• Set internal limits on subsidiaries’ and branches’ borrowings – limits on risk premiums for funding sources

• Plan the sequence of asset disposal to meet liquidity needs– econometric models of liquidity/withdrawal patterns


A Run on A Bank


Bank Runs• Can arise due to concern about:

– Bank solvency

– Failure of a related FI

– Sudden changes in investor preferences

• Demand deposits are first come, first served– Depositor’s place in line matters

• Where do bank runs occur these days?– why?

• Bank panic: Systemic or contagious bank run2/23/2016 22Market Risk © Robert B.H. Hauswald

Alleviating Bank Runs

• Measures to reduce likelihood of bank runs:– Discount window

– FDIC

– Direct actions such as TARP (2008-2009)

– Fed lending to investment banks in the crisis

• Not without economic costs– Protections can encourage DIs to increase

liquidity risk

– managerial moral hazard: excessive risk taking2/23/2016 23Market Risk © Robert B.H. Hauswald

Liquidity Risk for Life Cos.

• Life cos. hold reserves such as government bonds as a buffer to offset policy cancellations– cashing out and borrowing against policies

– life settlement bonds

• The pattern is normally predictable

• Solvency concerns can still generate runs on the life insurance company.

• Led to limits on ability to surrender policies2/23/2016 24Market Risk © Robert B.H. Hauswald

Liquidity Risk for P&C Insurers

• Problem is less severe for P&C insurers since assets tend to be shorter term and more liquid

• However, spikes in claims can be problematic– Hurricanes Andrew and Katrina precipitated

severe liquidity crises for many insurers

• Near failure of giant insurer, AIG (2008)– Credit default swaps

– Restructuring and government bailout 2/23/2016 25Market Risk © Robert B.H. Hauswald

Investment Funds

• Mutual funds, hedge funds– Net asset value (NAV) of the fund is market value:

incentive for runs is not like the situation of banks

– Asset losses will be shared on a pro rata basis, so position in line does not matter

– But, MMFs faced liquidity risk at beginning of the crisis

• Hedge funds implicated in some severe liquidity crises– Bear Stearns (2008), LT Capital Man’ment (1998)


Case Study: Iceland

• In Nov. 2007, unemployment was less than 1%, inflation was a problem.

• Icelandic banks were making loads of money borrowing and lending abroad.

• They also had a housing bubble.

• The Crown (Icelandic currency) was depreciating.

• They raised the interest rate to 13.75% to restrain inflation and slow the depreciation.


The Price of Success

• “The nation's celebrated rags-to-riches story began in the Nineties when free market reforms, fish quota cash and a stock market based on stable pension funds allowed Icelandic entrepreneurs to go out and sweep up international credit.”

• “But, as a result of the international banking crisis, the billionaires who own everything from West Ham United football club to the Somerfield supermarket chain, Hamleys toy shops and the House of Fraser, are in trouble and the country is drowning in debt.”

Source: Huffington Post, Oct 6, 2008, not a serious reference


The Price of Hubris

• Icland’s banking system collapsed in October 2008. – Three of four banks in the country were nationalized.

– But no-one would buy Icelandic bonds.

• They sought aid from the IMF. – Interest rates went up to 18% in October, and would have

been higher had they not gotten an IMF loan.

– They are now 17%.

• Unemployment more than tripled as production declined by about 10% (projected)

• Icelanders owe $44,000 per capita for the bailout!2/23/2016 Bank Runs and Systemic Risk © Robert B.H. Hauswald 29

Exception?• Iceland is a small country, and its experience has

been extreme. McKinsey writes: “ In Iceland, an extraordinary credit boom took place after

the country's banks were privatized in 2003 and were inadequately regulated … Total debt to GDP rose by more than 900% between 2000 and 2008 to reach an astounding 1,189% of GDP. Iceland's financial sector debt alone hit 580% of GDP.”

• Concern that Britain and Italy could face a similar collapses of demand for their government bonds, – while the United States is not close to that situation

– “It can’t happen here” are dangerous words!2/23/2016 30Bank Runs and Systemic Risk © Robert B.H. Hauswald

2/23/2016 Bank Runs and Systemic Risk © Robert B.H. Hauswald 31

Bank Runs only Occur in Developing Countries

Northern Rock

• First bank run in UK since 1866 Overend Gurney– theory or practice at fault?

• How could it happen? Strategy and risk well-known, Northern Rock thought solvent– UK had Lender of Last Resort/Emergency Liquidity

Arrangements (home of Bagehot)

– UK had extensive deposit insurance: experienced central bank, unified supervisor, tripartite arrangements

• Crises usually caused by something new– In this case, drying up of wholesale markets with US

sub-prime problems2/23/2016 32Bank Runs and Systemic Risk © Robert B.H. Hauswald

What should governments do?

Documents

FIN 683 Financial Institutions Management Liquidity … • A definitional challenge: you know it when you (do not) see it – theory: the ability to trade arbitrary amounts of an