‘LIQUIDITY, LIQUIDITY RISK AND LIQUIDITY
CREATION IN FINANCIAL INSTITUTIONS’
Donal McKillop
Professor of Financial Services
Queen’s University Belfast
dg.mckillop@qub.ac.uk
30th January 2014
Liquidity Risk and Liquidity Creation
 Liquidity trading risk
 Measurement of liquidity trading risk
 Cost of liquidation in normal markets
 Liquidity funding risk
 Sources of liquidity
 Liquidity funding risk
 Basel III liquidity requirements
 Liquidity Creation
 Definition and measurement of liquidity creation
 Liquidity creation and the macro economy, competition, bank
failure, financial crises and interaction with capital requirements
Liquidity Trading Risk
 Liquidity is an important consideration in trading
 A liquid position is one that can be unwound at short notice.
 As the market for an asset becomes less liquid, traders are
more likely to take losses because they face larger bid-offer
spreads
 Market transparency is important for liquidity. If the nature of an
asset is uncertain it is not likely to trade in a liquid market for
very long. (eg subprime mortgages, ABS and CDOs post 2007)
 Price received for an asset depends on
 The mid market price
 How much is to be sold
 How quickly it is to be sold
 The economic environment
Liquidity Trading Risk
 A market maker’s bid and offer quotes are good for trades up to a
certain size; above that size the market maker is likely to increase the
bid-offer spread
 The reason for this is that as the size of the trade increases the difficulty
for the market maker of hedging the exposure created by the trade also
increases.
 The bid offer spread for an asset can vary from 0.05% of the asset's midmarket price to 10% of it mid-market price.
 The price that can be realised for an asset often depends on how
quickly to can be liquidated and on the economic environment.
 Following figure describes the market for large deals between financial
institutions.
 Note the bid-offer spreads for retail clients may well show the opposite
pattern to that depicted in the next slide (as the size of the transaction
increases the individual is likely to get a better quote).
Bid-Offer Spread (a Function of Quantity)
Offer Price
Bid Price
Quantity
Bid-Offer Spread
Money bid-offer spread, p  Offer price  Bid price
Offer price  Bid price
Proportional Bid-offer spread, s 
Mid-market price
In liquidating a position in an asset a financial institution incurs a cost
p s

2 2
where  is the money (mid-market) value of the position
This reflects the fact that trades are not done at the mid-market price
buy trades are undertaken at offer price; sell trades at the bid price.
Bid-Offer Spread
Proportional Bid-offer spread, s 
Offer price  Bid price
Mid-market price
Cost of liquidation in normal markets
n
1
si αi

i 1 2
n is the number of positions,
 i is the position in the ith instrument,
si is the proportional bid-offer spread for the ith instrument.
A Century of Stock Market Liquidity and Trading Costs.
Liquidity Funding Risk
 Liquidity funding risk relates to the ability of the financial
institution to meet its cash needs as they arise.
 Financial institutions that are solvent (have positive equity) can
fail due to liquidity problems (eg Northern Rock)
 Some cash needs are predictable. For example if a bank has
issued a bond it knows when the coupon must be repaid.
 Others such as those associated with withdrawals of deposits
by retail customers and draw-downs by corporations on lines of
credit granted are less predictable.
 Liquidity funding risk is related to liquidity trading risk as one
way a financial institution can meet its funding requirements is
by liquidating part of its trading book.
Liquidity Funding Risk
 Sources of liquidity
 Liquid assets
 Ability to liquidate trading positions
 Wholesale and retail deposits
 Lines of credit and the ability to borrow at short notice
 Securitization
 Central bank borrowing
Protecting against bank liquidity funding risk
 Hold liquid assets (net defensive position – cost in
terms of lower profitability)
 Dissipate withdrawal risk by diversifying funding
sources (liability management)
 Backup: capital adequacy to ensure creditworthiness
maintained in face of shocks
 Important role of supervision and reserve
requirements – and also money market infrastructure
ensuring liquidity maintained
Measuring Liquidity Funding Risk
 Asset Indicators
 Loans are the least liquidity type of asset. Banks with
relatively high amounts of loans are illiquid.
 Net Loans to Assets,
 Banks facing a liquidity shortfall sell short-term securities
for cash. Firms with lots of such securities are relatively
liquid.
 Short-Term Investments to Assets.
 Liabilities Indicators
 Core Deposits (retail deposits) are the most stable and
least likely to leave unpredictably. Short-term non-core
(wholesale deposits) funding is the least stable
 Core Deposits to Assets
 S.T. Non Core Funding to Assets
Basel III Liquidity Regulation
 Two internationally consistent regulatory standards
 Liquidity coverage ratio:
 Designed to make sure that the bank can survive a 30-day period
of acute stress
 Banks have to maintain high quality liquid assets that are sufficient
to survive a 30-day market crisis on the same scale as the Lehman
induced crisis
 there was a complete freeze in the money markets so that the bank
couldn’t access borrowed cash.
 Aimed at ensuring that a bank maintains an adequate level of high
quality assets that can be converted into cash to meet its liquidity
needs for a 30-day horizon under a liquidity stress scenario
 Stock of high quality liquid assets/Net cash outflows over a 30-day
time period ≥ 100%
 The Liquidity Coverage Ratio is scheduled to be introduced by
January 2015.
Basel III Liquidity Regulation
 Net stable funding ratio: a longer term measure
designed to ensure that stability of funding sources is
consistent with the permanence of the assets that have to
be funded
 Aimed at promoting more medium and long-term funding of the assets
 Minimum acceptable amount of stable funding based on the liquidity of a






bank’s assets over a 1 year horizon
Available amount of stable funding/required amount of stable funding > 100%
“Stable funding” is defined as those types and amounts of equity and liability
financing expected to be reliable sources of funds over a one-year time horizon
under conditions of stress.
This funding ratio seeks to calculate the proportion of long-term assets which
are funded by long term, stable funding.
“Stable funding” includes: customer deposits, long-term wholesale funding
(from the Interbank lending market), and Equity.
"Stable funding" excludes short-term wholesale funding.
Net stable funding rule (NSFR) will commence in 2018
Basel III Liquidity Regulation
 Net stable funding ratio:
 Amount of Stable funding/Required Amount of Stable Funding >
100%
 Numerator includes category [weight]
 retail deposits [0.9]; wholesale deposits [0.5]; Tier 1 capital [1] Tier
2 capital [1]
 Denominator includes category [weight]
 Cash [0] Treasury bonds> 1 year [0.05]; mortgages [0.65]; small
business loans [0.85]; fixed assets [1]
 The more illiquid the assets the more stable funding
required
Liquidity Creation
 ‘Liquidity creation’ refers to the fact that banks provide illiquid
loans to borrowers while giving depositors the ability to
withdraw funds at par at a moment’s notice
 Because of this difference in liquidity between what banks do
with their money and the way they finance their activities banks
are said to create liquidity
 Inherent in the liquidity creation is maturity transformation
 Banks borrow short and lend long.
 Banks also provide borrowers liquidity off the balance sheet
through loan commitments and similar claims to liquid funds.
 Such commitments create liquidity as they provide borrowers
insurance against been rationed in the future in the spot credit market.
 Liquidity creation is one of the primary functions of banks –
creating liquidity by transforming illiquid assets into liquid
liabilities.
Liquidity Creation
 Macro economy: Beyond banking, liquidity creation is
very important to the macro economy as a whole.
 Lending, loan commitments, and liquid deposits are all
key to greasing the wheels of commerce, without which
we would have very little economic activity.
 Boot, Greenbaum and Thakor (1993) show that loan
commitments improve ex ante welfare even though they
represent only ‘illusory promises’ in that the bank may
choose not to honour it commitments when the borrower
attempts a takedown.
 Empirical studies on the use of loan commitments by corporate
customers suggest that over 80% of commercial and industrial
lending is in the from of drawdowns under commitments
Liquidity Creation
 Measurement of liquidity creation
 Berger and Bouwman (2009) develop several measures
of liquidity creation.
 Step 1: classify all bank balance sheet and off-balance sheet
activities as liquid, semiliquid, or illiquid.
 Step 2: assign weights to the activities classified in step 1.
 Step 3: combine the activities as classified in step 1 and as
weighted in step 2 in different ways to construct four liquidity
creation measures.
 These liquidity creation measures are based around
categories of assets and liabilities (otherwise known as
cat) and maturity of assets and liabilities known as (mat).
Step 1: Classify all bank activities as either liquid, semi-liquid, or illiquid.
ASSETS
LIABILITIES + EQUITY
Liquid Assets
e.g., securities
Liquid Liabilities
e.g., transactions deposits
Semi-liquid Assets
e.g., home mortgages
Semi-liquid Liabilities
e.g., time deposits
Illiquid Assets
e.g., business loans
Illiquid Liabilities + Equity
OFF-BALANCE SHEET
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
Step 2: Assign weights.
Weight
ASSETS
LIABILITIES + EQUITY Weight
- 0.5
Liquid Assets
e.g., securities
0
Semi-liquid Assets
e.g., home mortgages
Semi-liquid Liabilities
e.g., time deposits
Illiquid Assets
e.g., business loans
Illiquid Liabilities + Equity
+ 0.5
Liquid Liabilities
e.g., transactions deposits + 0.5
0
- 0.5
OFF-BALANCE SHEET
+ 0.5
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
- 0.5
Step 3: Combine Step 1 and Step 2:
£ liquidity creation = Σ (weight * $ activity)
Weight
ASSETS
LIABILITIES + EQUITY Weight
- 0.5
Liquid Assets
e.g., securities
0
Semi-liquid Assets
e.g., home mortgages
Semi-liquid Liabilities
e.g., time deposits
Illiquid Assets
e.g., business loans
Illiquid Liabilities + Equity
+ 0.5
Liquid Liabilities
e.g., transactions deposits + 0.5
0
- 0.5
OFF-BALANCE SHEET
+ 0.5
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
- 0.5
Liquidity creation ($billion) in U.S. (1984-2008)
6,000
5,000
4,000
Off-balance
sheet
Total Bank
Liquidity
creation
3,000
2,000
On-balance
sheet
1,000
2008:Q1
2006:Q1
2004:Q1
2002:Q1
2000:Q1
1998:Q1
1996:Q1
1994:Q1
1992:Q1
1990:Q1
1988:Q1
1986:Q1
1984:Q1
0
Liquidity Creation
 Who creates liquidity?
 Berger and Bouwman (2009) find that in the US, large banks
(greater than $3 billion) are responsible for 81% of industry
liquidity creation, while comprising only 2% of all banks
 All size classes generate substantial portions of their liquidity
off balance sheet, but the fraction is much higher for large
banks.
 Berger and Bouwman (2009) find that liquidity creation is
positively associated with bank value.
Liquidity Creation
 Financial Crises: Bank liquidity creation may help keep financial crises from
getting out of control.
 When financial markets freeze up during a crisis, participants often draw
down their loan commitments, which keeps illiquid firms from becoming
insolvent.
 In the recent crisis, all of the big investment banks faced liquidity problems
and either failed, were merged with banks, or became bank holding
companies to gain access to liquidity.
 Berger and Bouwman (2009) argue there has been a significant build-up or
drop-off of “abnormal” liquidity creation before each crisis
 Banking crises were preceded by positive abnormal liquidity creation by banks.
 Market-related crises were generally preceded by negative abnormal liquidity
creation.
 Berger and Bouwman (2009) suggest that liquidity creation has both
decreased during crises (e.g., the 1990-1992 credit crunch) and increased
during crises (e.g., the 1998 Russian debt crisis / LTCM bailout).
 Thus, liquidity creation has both exacerbated and ameliorated the effects of crises.
Liquidity Creation
 Capital - liquidity creation impediment? ‘the financial
fragility-crowding out hypothesis’
 Diamond and Rajan (2000; 2001) suggest that bank
capital may impede liquidity creation by making the bank’s
capital structure less fragile.
 A fragile capital structure encourages the bank to commit
to monitoring its borrowers, and hence allows it to extend
loans. Additional equity capital makes it harder for the
less-fragile bank to commit to monitoring, which in turn
hampers the bank’s ability to create liquidity.
 Capital may also reduce liquidity creation because it
crowds out deposits (e.g., Gorton and Winton (2000).
Liquidity Creation
 Capital - liquidity creation enhancer? ‘the risk absorption
hypothesis’
 An alternative view, related to banks’ role as risk transformers,
is that higher capital improves banks’ ability to absorb risk and
hence their ability to create liquidity.
 (e.g., Bhattacharya and Thakor 1993; Repullo 2004; Von Thadden
2004; Coval and Thakor 2005),
 Liquidity creation exposes banks to risk—the greater the
liquidity created, the greater are the likelihood and severity of
losses associated with having to dispose of illiquid assets to
meet customers’ liquidity demands
 Capital absorbs risk and expands banks’ risk-bearing capacity
so higher capital ratios may allow banks to create more
liquidity.
Liquidity Creation
 Capital - liquidity creation empirical evidence
 Berger and Bouwman (2009) find empirical support for both
the ‘risk absorption hypothesis’ and the ‘financial fragilitycrowding out hypothesis’
 The relationship between capital and liquidity creation is
positive and significant for large banks, insignificant for medium
banks, and negative and significant for small banks.
 The finding that the relationship between bank capital and bank
liquidity creation differs by bank size raises interesting policy
issues.
 The findings suggest that while regulators may be able to make
banks safer by imposing higher capital requirements, this benefit
may have associated with it reduced liquidity creation by small
banks, but enhanced liquidity creation by large banks.
Liquidity Creation
 Competition and liquidity creation
 Horvath et al. (2013) consider how bank competition influences
liquidity creation. Two opposing hypotheses are suggested.
 The first (fragility channel view) is that increased competition
increases the fragility of banks by reducing bank profits, which
normally act as a buffer against adverse shocks. Thus banks are
incentivized to reduce liquidity creation by limiting the volume of loans
granted and the volume of deposits accepted to reduce the threat of
bank runs.
 The second hypothesis (price channel view) regarding the effect of
bank competition on liquidity creation is that increased competition
influences banking pricing policies, leading to diminished loan rates
and increased deposit rates. As a consequence, demand for both
loans and deposits rises. This suggests a positive link between
competition and liquidity creation.
Liquidity Creation
 Competition and liquidity creation – empirical evidence
 Horvath et al. (2013) find that increased bank competition
reduces liquidity creation. They interpret this result in terms of
the effect of competition in increasing ‘bank fragility’, which
reduces banks’ incentives to create liquidity.
 They argue that their findings have policy implications:
 First, bank competition can have detrimental economic effects. In other
words, there is a trade-off between the positive effects of competition on
consumer welfare, stemming from lower margins, and the negative effects
of competition on liquidity creation.
 Second, regulation of bank competition cannot be considered
independently of monetary policy. In particular, if bank competition plays a
role in liquidity creation, authorities in charge of policies that influence the
financing of the economy cannot ignore the impact of market structure on
banking activities.