Liquidity Risk
Chapter 17
Financial Institutions Management, 3/e
By Anthony Saunders
Irwin/McGraw-Hill
1
Causes of Liquidity Risk
• Liability side
• Asset side
» may be forced to liquidate assets too rapidly
» may result from loan commitments
• Need to be able to predict the distribution of net
deposit drains.
• Traditional approach: reserve asset
management. Alternative: liability
management.
Irwin/McGraw-Hill
2
Liability Management
• Federal funds market or repo market.
• Managing the liability side preserves asset side
of balance sheet. Borrowed funds likely at
higher rates than interest paid on deposits.
• Alternative: liquidate assets. In absence of
reserve requirements, banks tend to hold
reserves. E.g. In U.K. reserves ~ 1% or more.
Downside: opportunity cost of reserves.
Irwin/McGraw-Hill
3
Asset Side Liquidity Risk
• Risk from loan commitments and other credit
lines:
» met either by borrowing funds or
» by running down reserves.
Irwin/McGraw-Hill
4
Measuring Liquidity Exposure

Net liquidity statement: shows sources and
uses of liquidity.
• Sources: (i)Cash type assets, (ii) maximum
amount of borrowed funds available,
(iii) excess cash reserves
• Uses include: borrowed or money market funds
already utilized, and any amounts already
borrowed from the Fed.
Irwin/McGraw-Hill
5
Other Measures:
• Peer group comparisons: usual ratios include
borrowed funds/total assets, loan
commitments/assets etc.
• Liquidity index: 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 = S wi(Pi /Pi*)
Irwin/McGraw-Hill
6
Measuring Liquidity Risk
• Financing gap and the financing requirement:
• 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.
» Example of excessive financing requirement:
Continental Illinois, 1984.
Irwin/McGraw-Hill
7
Liquidity Planning
• 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.
• Delineate managerial responsibilities clearly.
Irwin/McGraw-Hill
8
Bank Runs
• Can arise due to concern about bank’s solvency.
• Failure of a related bank.
• Sudden changes in investor preferences.
Demand deposits are first come first served.
Depositor’s place in line matters.
 Bank panic: systemic or contagious bank
run.

Irwin/McGraw-Hill
9
Alleviating Bank Runs:

Regulatory measures to reduce likelihood of
bank runs:
• FDIC
• Discount window

Not without economic costs.
Irwin/McGraw-Hill
10
Liquidity Risk for Other FIs
• Life Cos. Hold reserves to offset policy
cancellations. The pattern is normally
predictable.
• An example: First Capital in California, 1991.
• CA regulators placed limits on ability to
surrender policies.
• Problem is less severe for P&C insurers since
assets tend to be shorter term and more liquid.
Irwin/McGraw-Hill
11
Mutual Funds
• Net asset value (NAV) of the fund is market
value.
• The incentive for runs is not like the situation
faced by banks.
• Asset losses will be shared on a pro rata basis
so there is no advantage to being first in line.
Irwin/McGraw-Hill
12