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7/28/2019 Liquidity Risk and FIs Management
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risk management, 20080229 1
Liquidity Risk and FIsManagement
Chapter 17 and 18Saunders and Cornett
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How come?
Liquidity risk arises when a unexpected
deposit withdraw or a loan demand
occurs.
Financial intermediaries facilitate short
term funds to longer term investment are
vulnerable to liquidity risks on both sides
of balance sheets.
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Method s to deal with withdrawal of
funds
Assets fire-sale;
Running down the FIs cash assets, drain
the liquidity, or
By borrowing additional funds.
Liquidity risk can result in insolvency ofbanks (FIs) if none of the above works and
depositors run to the FI to get their funds.
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Causes of Liquidity Risk
Reliance on demand deposits: liability side
Core deposits: long term funding source.
Depository Institutions need to be able topredict the distribution ofnet deposit drains(net outflow of deposits).
Seasonality effects in net withdrawal patterns
Ex: problem with low rates in the early 2000s:finding suitable investment opportunities for thelarge inflows from selling off mutual funds.
Managed by: purchased liquidity management
stored liquidity management
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Liability Management
Purchased liquidity management:adjustment to a deposit drain on the
liability side of the balance sheet.
Federal funds market or repo market.
Borrowed funds likely at higher rates than
interest paid on deposits.
Regulatory concerns:
increase of wholesale funds and the potential for
serious problems in credit crunch, the contagion
effect
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Liability Management
Alternative: Stored Liquidity Management:
adjustment to a deposit drain occurs on the asset
side of the BS.
Liquidate assets.
In absence of cash reserve requirements, banks tend to hold
cash reserves by themselves. In U.K. banks hold cash reserves
ca. 1% or more. Downside: opportunity cost of reserves.
Decreases size of balance sheet
Requires holding excess non-interest-bearing assets
Combinepurchasedand storedliquidity
management
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Asset Side Liquidity Risk
Risk from loan commitments and othercredit lines:
met either by borrowing funds or
by running down cash reservesCurrent levels of loan commitments
are dangerously high according to
regulators
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Measuring Liquidity Exposure
Net liquidity statement: shows sources anduses of liquidity.
Sources: (i) Cash type assets, (ii) maximum
amount of borrowed funds available, (iii)
excess cash reserves
With liquidity improvements gained via
securitization and loan sales, many banks have
added loan assets to statement of sources
Uses: borrowed or money market funds
already utilized, etc.
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Other Measures:
Peer group comparisons: usual ratiosinclude borrowed funds/total assets, loancommitments/ total assets etc.
Liquidity index: a measure of the potential
losses an FI could suffer as a result of firesale of assets.
Weighted sum of fire sale price Pto fairmarket price, P*, where the portfolio weightsare the percent of the portfolio value formedby the individual assets.
I = Swi(Pi/Pi*)
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Measuring Liquidity Risk
Financing gap and the financing requirement: Financing gap = Average loans - Average (core)
deposits.
Financing gap= borrowed fund - liquid assets.
The gap can be used in 1)peer group
comparisons. 2)Trend analysis. Example of excessive financing requirement:
Continental Illinois, 1984.
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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
Must also evaluate what if scenarios in this
framework
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Liquidity Planning
Bank run: a sudden and unexpectedwithdraw of deposits on a bank. Triggered
by a panic of market beliefs that the bank
has a shortage of funds. Diamond and
Dybvig (1983)
Important to know which types of depositors
are likely to withdraw first in a crisis.
Composition of the depositor base will
affect the severity of funding shortfalls.
Allow for seasonal effects.
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Bank run
Demand deposits are first come first served.
Therefore, depositors place in line matters.
Bank panic: systemic or contagious bank run.
Regulatory measures to reduce likelihood of bank
runs:
FDIC Discount window
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Liquid assets ratio
Composition of liquid asset portfolio Liquid assets ratio: a minimum ratio of liquid assets
to total assets set by the central bank.
Secondary or buffer reserves: non-reserve assets
that can be quickly turned into cash.
Risk return trade-off
1. Cash immediacy versus reduced return
2. Constrained optimization Privately optimal reserve holdings
Regulator imposed reserve holdings
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Funding Risk versus Cost
Funding Cost
Funding Risk5 year CD(low funding risk)
Demand deposits
(high funding risk)
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Liability Management
Note the tradeoff between funding risk and
funding cost.
Demand deposits are a source of cheap funds
but there is high risk of withdrawal.
NOW accounts (interest bearing checkable
accounts): manager can adjust the explicit
interest rate, implicit rate and minimumbalance requirements to alter attractiveness
of NOW deposits.