Liquidity
Students should be able to
• Define liquidity risk and explain why it is
important for banks.
• Describe assets used for liquidity inventory
purposes or debts used for liability management.
• Describe some strategies for calculating liquidity
needs.
• Describe and calculate some ratios for
measuring liquidity risk.
• Explain economy theory of bank runs.
Liquidity is a product of banks
• Banks are profitable as an enterprise through
their access to relatively cheap funding from
core deposits.
• Depositors are willing to lend money to banks at
low interest rates because the banks offer
unique liquidity services that facilitate regular
transactions and protect liquidity position of
depositors wealth.
• But if banks are unreliable in providing liquidity
services, their access to cheap funding and
ultimately their profits will disappear.
Liquidity Services
• Banks provide a number of liquidity
services
– Cash Withdrawal
– Checking
– Electronic Payments
– Electronic Transfers
These require
Interbank transactions:
Payments
between banks
Cash Demand is relatively
predictable, though subject to
seasonal factors.
HK: Monetary Base: Before Discount Window : Certificates of Indebtedness
HKD m n
HK Currency
subject to sharp
annual rises in
demand.
170000
160000
150000
140000
130000
Source: HKMA,
CEIC
120000
110000
100000
90000
80000
21-Mar-1999
2-Aug-2000
15-Dec-2001
29-Apr-2003
10-Sep-2004
23-Jan-2006
Interbank Transactions
• Most payments (by value) are done through
checks, credit cards, debit cards, and electronic
transfers.
• Final settlement of these transactions will be
done through the accounts that banks hold at
the HKMA, called clearing balances.
• Unlike USA, banks face no minimum reserve
requirement on accounts at central bank. Only
requirement is must meet obligations.
Transactions at Hong Kong
Interbank Clearance Ltd.
Jan 2006: HK$12trillion (approx.)
Aggregate Transactions/Aggregate Clearing Balances
35000.00
30000.00
Ratio
25000.00
20000.00
15000.00
10000.00
Electronic
Payment
16%
Checks
5%
5000.00
Ja
n0
M 0
ay
-0
Se 0
p0
Ja 0
nM 01
ay
-0
Se 1
p0
Ja 1
n0
M 2
ay
-0
Se 2
p0
Ja 2
nM 03
ay
-0
Se 3
p0
Ja 3
n0
M 4
ay
-0
Se 4
p0
Ja 4
nM 05
ay
-0
Se 5
p05
0.00
Transfer
79%
Large and Volatile Fluctuations in Transactions
Volume and Available Reserves
Daily Liquidity Management
• Banks are able to borrow intraday liquidity from
the central bank to meet transactions demand
using repo operations with Exchange Fund bills.
– Exchange fund bills are debt securities issued by
central bank.
• Banks may borrow overnight liquidity from:
– Other banks at HIBOR rate
– Central bank discount window at base rate
• Discount Window Rate: 150 points above US rate
Banks and Liquidity
• Liquidity Deficit = Gap between liquid
liabilities and assets
– Banking firms especially likely to face a liquidity
deficit because of mortgage lending (non-liquid
assets) and short-term deposits (liquid
liabilities) [Maturity Mismatch]
– Reliance on Time Deposits which are sensitive
to changes on interest rates relative to other
assets or on risk relative to other assets.
Strategies for Liquidity Management
Asset management
• Asset Conversion Strategy: Maintain an
inventory of liquid assets convertible to
cash.
– Liquid assets must have
– ready market,
– reasonably steady price
– or, reversible so original investment can be
easily obtained.
Liquid Assets
• Treasury Bills
– Other Government Securities
• Lending to/Deposits at Other Banks
• Purchasing Securities for Resale (Repos)
• Commercial Paper
Cash & Current Balances at Banks and HKMA
Money Placed w/Banks within one month
Treasury Bills
Hang Seng BEA
6021
3655
55907
32251
6270
3970
Exchange Fund Bills
• Exchange Fund Bills and Notes are Hong Kong dollar
debt securities issued by the Hong Kong Monetary
Authority (HKMA). The Exchange Fund Bills and Notes
constitute direct, unsecured, unconditional and general
obligations of the Hong Kong SAR
• The Exchange Fund Bills and Notes Issuance
Programme ensures the supply of a significant amount
of high quality Hong Kong dollar debt paper, which can
be employed as trading, investment and hedging
instruments.
– Authorized Institutions that maintain Hong Kong dollar clearing
accounts with the HKMA can use their holdings of Exchange
Fund papers to borrow overnight Hong Kong dollar from the
Discount Window.
• An active primary and secondary market for the trading
of Exchange Fund Bills and Notes, and the
establishment of a reliable benchmark yield curve for up
to 10 years has facilitated the development of a
sophisticated Hong Kong dollar debt market.
Source: HKMA Website
Strategies for Liquidity Management
Liability management
• Borrowed Liability Strategy: Maintain lines of
credit to make up for temporary cash short-falls.
• Accessing money market requires some prior
planning and potentially lines of credit.
• Sources of funds
– Borrowing in Interbank market
– Issuing large CD’s to money market mutual funds or
large depositors. (Brokered deposits)
– Borrowing from central bank.
Liquidity Ratio:
• All authorized institutions in Hong Kong are required to
meet a minimum monthly average liquidity ratio of 25%.
This is calculated as the ratio of liquefiable assets (e.g.
marketable debt securities and loans repayable within
one month subject to their respective liquidity
conversion factors) to qualifying liabilities (basically all
liabilities due within one month).
-GUIDE TO HONG KONG MONETARY AND BANKING TERMS
Liquidity Ratio
2003
2004
43
43.5
44
44.5
45
Hang Seng
45.5
BEA
46
46.5
47
47.5
Estimating Liquidity Needs
Sources and Uses of Funds Approach
• Estimate net liquidity needs for a time
period based on economic factors
E[Liquidity Surplus] = E[ΔTotal Deposits]- E[ΔTotal Loans]
Use economic data to forecast these outcomes.
E[ΔTotal Deposits] = f(Money Growth, Income Growth,
Inflation, Interest Rates) or time series forecast
E[ΔTotal Loans] = f(GDP growth, corporate profits growth,
inflation, interest rates) or time series forecast .
• Construct best and worst case scenarios and
strategies for dealing with expected liquidity surplus
and deficits.
Estimating Liquidity Needs
Structure of Funds Approach
• Calculate a rule of thumb for liquidity holdings
applied to deposits of different types.
Volatile Deposits
Vulnerable Funds
Core Deposits
Liquidity Reserves
0.95
0.3
0.15
• Customer Relationship model for loan
expansion. Don’t turn good borrowers away for
want of liquidity.
Example:
• A bank has the following liability positions
Volatile Deposits
Vulnerable Funds
Core Deposits
Liquidity Reserves
25
24
100
• Currently has $135 million in loans. Has had as
much as $140 million viewed as potential.
Anticipates 10% loan growth.
How much liquidity should we keep?
(.95*25)+(.3*24)+(.15*100)+(154-135)=64.95
Liquidity Indicators
• Bank managers, regulators and analysts may
watch a number of indicators
Cash & Bank Deposits Government Securities
Total Assets
Total Assets
Core Deposits
Total Assets
Net Advances to Customers
Total Assets
Bank Depositors Game
• Banks have very illiquid assets (loans) and
obligations to repay their depositors in full at any
time.
• If all of the depositors at a bank withdraw their
funds at the same time, the bank will have to sell
their loans at a discount, and they will not have
enough funds to pay all of their depositors.
• If all of their depositors keep their money in the
bank, most banks will be able to repay all of their
depositors with interest.
• Thus, the payoff to any individual depositor
depends on what other depositors decide to do.
Bank Run Game: Withdraw or
Don’t Withdraw
•
•
•
1.
Depositors each deposit $1000 at 10%
interest.
They can choose to withdraw their funds
before collecting interest or keep their
funds with the bank.
The right hand table shows pay-offs for
each decision under two possible
situations.
2.
All other depositors keep their funds in the bank
and the bank survives.
All other depositors withdraw funds and the bank
•
must liquidate.
Payoffs
1.
2.
3.
4.
If an individual keeps their funds with the bank
and everyone else does likewise, everyone gets
their funds with interest.
If an individual doesn’t withdraw, but everyone
else does, the bank will have nothing left to pay
the individual who gets nothing.
If the individual depositor withdraws but no one
else does, the depositor loses only interest.
If an individual depositor withdraws and everyone
else does, they have some chance of getting
some funds (say $500) back.
Individual Depositors Decision
Withdraw
Don’t
Withdraw
Withdraw
Payoff:
$500
Payoff:
$0
Don’t
Withdraw
Payoff:
Payoff:
1100
All
Other
Depositors
Decision
$1000
Bank Deposit Game has Multiple
Equilibria
• If no one else withdraws their funds, the best
strategy of any individual is not to withdraw their
funds.
• Thus, a situation in which no-one withdraws their
funds and the bank pays interest to all is a Nash
Equilibria.
• If everyone withdraws their funds, an individuals
best strategy is to withdraw before everyone
else does.
• Thus, a bank run, a situation in which everyone
withdraws their funds and a bank is forced to
liquidate its assets is also a Nash equilibrium.
Bank Runs
• The phenomenon in which all depositors compete to
withdraw their funds at the same time is called a bank
run or a bank panic.
• Depositors lack complete information about the value
of banks assets.
• If depositors believe that there is a significant fraction
of loans which will not be repaid, depositors may
have an incentive to immediately withdraw funds.
• Bank deposits are first come, first serve. If you
withdraw your funds before the bank declares losses
you may not suffer at all.
• Further, even if you believe that banks assets are
sound you may have an incentive to immediately
withdraw, if you believe that other depositors will also
withdraw their funds.
Costs of Bank Panics
• Bank runs can destroy the value of the illiquid
assets of otherwise healthy banks or worsen the
problems at banks suffering minor or major loan
losses.
• Panic is contagious. Since banks lend money to
each other, a bank run at one bank may lead to
beliefs that the resulting bankruptcy will affect
the loan quality of other assets.
• Banks play a large role in the financial
intermediation system. A collapse in the banking
system will disrupt lending.
Remedial Responses to Banking
Panics
• The damage from a banking panic are so
severe that central banks often step in during
a crisis and provide almost unlimited liquidity.
• An emergency source of liquidity is the
“lender of last resort.” Central banks are the
natural lender of last resort as they can
create infinite liquidity through their control of
the money supply.
• Before 1993, there was no central bank in
Hong Kong. Role of lender of last resort was
taken by note issuing banks.
Effects of Lender of Last Resort
• The confidence brought by the knowledge that
the central bank will provide liquidity in the case
of a bank run, can actually reduce the chance
that a bank run will occur.
• Conversely, the fears of depositors of
bankruptcies are an important source of
discipline in the economy. A lender of last resort
may encourage depositors to ignore the
excessive risk taking of their banks, encouraging
banks to take excessive risks.
• Lenders of last resort encourages moral hazard.
HK Lenders of Last Resort
• For most of HK’s history, the note-issuing banks (HSBC
and Chartered) acted as the lender of last resort.
• During banking crisis of 1965 sparked by collapse of a
real estate bubble, HSBC and SC fully backed many
local banks. Eventually HSBC took over Hang Seng.
• During DTC crisis of 1981, sparked by collapse of a real
estate bubble, HSBC and SC pledge vague support for
DTC’s.
• During bank crises of 1984-1986, the government took
over various bankrupt banks, backing deposits with the
Exchange fund.