Chapter 13. Liquidity Risk and
Liability Management
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Learning Objectives:
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1. To understand the importance of
liquidity to banks and to the economy
2. To distinguish between core deposits
and managed (volatile) liabilities
3. To understand the tradeoff between
liquidity and profitability
4. To understand how to measure bank
liquidity
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Learning Objectives
(cont.) and Chapter Theme
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5. To understand securitization as a tool of
liquidity and risk management
Chapter Theme
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Banks need liquidity to meet deposit withdrawals
and to satisfy customer loan demand. This
liquidity can be stored in banks’ balance sheets or
purchased in the marketplace. Being too liquid,
however, is costly and not having enough liquidity
is risky. As a tool of risk management,
securitization permits banks to remove risk from
their balances sheets and generate liquidity.
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The Importance of Liquidity
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Consider these headlines from the
American Banker
Viewpoint: Too Many Banks Aren’t
Ready for Looming Liquidity Crisis
Spare Change: Liquidity Steering Group
Going in Circles
In Focus: Liquidity Rivaling Credit
Quality as Crisis du Jour
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LEMAC: The Inverted CAMEL
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L = Liquidity
E = Earnings
M = Management
A = Asset Quality
C = Capital Adequacy
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Recent Liquidity Episodes
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The aftermath of the “Attack on
America”
The bailout of LTCM
The stock market of 1987
Contrast these events with what the
Fed did after the stock-market crash of
1929
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Discussion Topic: Quote from
John Reed (1987)
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We were providing as much liquidity as we could.
Quite a few of the firms went right up to their loan
limits. We didn't take physical possession of
securities, but we were damn close to our customers.
You have a tremendous conflict there. On one hand,
there's a need for liquidity in the system. On the
other hand, when you're dealing in $100 million lot
sizes, you can't afford to be wrong. We can't take a
$100 million write-off to save a broker. The
stockholders would lynch me and with good reason.
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The Role of Confidence
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A confidence function:
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Net worth (+)
Stability of earnings (+)
Quality of information (+)
Government guarantees (+)
Liquidity (+)
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The Evolution of Liquidity
Management
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Commercial-loan theory or real-bills doctrine
(1920s and earlier)
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Asset-conversion or shiftability approach (post
World War II through 1940s)
Anticipated-income theory (1950s)
Liability management (late 1960s and early
1970s)
Asset-liability management and securitization
(mid-1970s to mid-1990s)
Risk management (mid-1990s to present)
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The Instruments of Liability
Management (LM, see Box 13-1)
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Federal funds
Repurchase agreements (RPs, repos)
Negotiable CDs
Consumer CDs
Brokered deposits
Eurodollar CDs
Global CDs
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LM Instruments (continued)
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MMDAs
IRAs
Commercial paper
Notes and debentures
Volatile liabilities
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Chrysler Financial Corporation:
Case Study of a Liquidity Crisis
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Year-end 1989 financial profile:
CP outstanding = $10.1 billion
Equity capital (E) = $2.8 billion
Total assets (A) = $30.1 billion
CP/A = 33.5%
E/A = 9.3% or EM = 10.75
Note: CP = commercial paper
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The Credit Event
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In 1990, Chrysler’s commercial paper (CP)
was downgraded from P-2 to P-3 and
subsequently to N.P. ( Not Prime) and its
long-term bond rating was lowered from Baa
to Ba
Under these conditions, Chrysler’s CP was not
attractive to the money market at rates that
Chrysler was willing to pay, that is, it would
have to pay a premium to obtain refinancing
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CP Background:
Orderly Exit and Asset Sales
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Bank back-up lines of credit, standby
letters of credit, and medium-term note
facilities
Asset sales
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Lines of Credit vs. Standby
Letters of Credit
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Since bank line-of-credit (LOC) contracts
typically contain material-adverse-change
(MAC) clauses, they are not guarantees and
they have annual clean-up and rate resets.
Strength of customer relation is important.
In contrast, a standby letter of credit virtually
guarantees payment, i.e., the bank will pay
off the issue if the borrower cannot.
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Chrysler’s Strategy
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An aggressive program of asset sales
and securitization
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“The rest of the story ...”
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Immediate cash shortfall is met by borrowing
$1.3 billion under its parent company’s banks’
lines of credit
By year-end 1990, CP outstanding is $1.1B, a
decrease of $9B
Sales of receivables in 1990 generates $18.3B
Year-end 1990 assets total $24.7B with equity
of $2.8B (capital ratio of 11.3%)
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The story continues ...
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To repay maturing debt of $3.6B in
1991 and $3B in 1992, Chrysler
continued its asset-sales strategy.
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Epilogue
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At year-end 1996, CFC was servicing $39.1B
of receivables (94% auto related) up from
$22.5B at year-end 1992. Other data for
1996 are:
CP = $2.6B, Senior term debt = $8.4B, NI =
$0.376B, TA = $17.5B, E = $3.288B
ROE profile: ROE = ROA x EM
0.1144 = 0.0215 x 5.32
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Discussion of other Cases
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First National Bank of Browning,
Montana (1980)
Continental Illinois (Chicago, 1984)
Bank of New England (1991)
REBs and FHLB Advances
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Liquidity Versus Profitability
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Given a positively sloped yield curve,
short-term rates < long-term rates
Short-term assets are safer while
longer-term assets are riskier
When the yield curve is inverted, safer
assets have higher returns but such
rates are expected to decline based on
the expectations theory
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Discussion Questions
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Explain the basic yield-curve shapes
and the embodied tradeoffs
Over the interest-rate/business cycle,
how does the yield curve move? How
do bank loan and deposit flows move?
Distinguish between stored liquidity and
purchased liquidity
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Effective Liquidity
Management
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Confidence
Maintaining relationships
Avoiding “fire sales”
Cost of capital and default-risk
premiums
Avoiding the Fed’s discount window
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Core Deposits Versus Managed
Liabilities
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Core = sum of interest-bearing deposits
in domestic offices minus large time
deposits in domestic offices plus
domestic demand deposits
Core deposits are relatively stable funds
gather in local markets
They vary inversely with bank size
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Managed Liabilities
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Managed liabilities have four
components:
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Interest-bearing deposits in foreign offices
Large time deposits in domestic offices
FF purchased/Repos
Other interest-bearing liabilities
“Hot money” is volatile and use of it
varies directly with bank size
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Types of Interest-Bearing
Liabilities
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Savings accounts
Small time deposits
Large time deposits
Deposits in foreign offices
FF purchases and RPs
Discuss use of these funds by banks of
various sizes
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Noninterest-Bearing Liabilities
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Why do banks hold such funds?
How have these funds varied over time?
What forces have been driving these
trends?
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The Cost of Bank Funds
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Distinguish and discuss the following
pairs of terms with respect to cost:
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Foreign vs. domestic
Core vs. managed liabilties
Explicit vs. implicit interest
Eras of interest-bearing checking accounts:
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Pre-1933
1933-1980
Post 1980
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A Bank’s Weighted Average
Marginal Cost of Funds
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Source of funds (as a % of balance
sheet)
Interest cost
Operating cost
Total cost
Weighted cost
Weighted average
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Example (no operating costs)
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Source
Amt Cost Weighted cost
Deposits
.85 5% 4.25%
Nondep.debt 0.05 7% 0.35%
Equity*
.10 14% 1.40%
Weighted
1.00
6.00%
*Shareholder required return
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Market Discipline and Cost of
Funds
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Since riskier banks will have to pay more for
funds than safer banks, bank should want to
signal/demonstrate to money and capital
markets that they are safe (e.g., have
adequate capital – the K in TRICK)
To the extent that banks engage in cost plus
pricing, they might just ignore this discipline
with respect to the costs of deposits and
nondeposit debt; however, higher shareholder
required returns and lower stock values
should get managers’ attention
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Measures of Bank Liquidity
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Sources and uses of funds
Large-liability dependence
Various ratios (to assets)
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Core deposits
Loans
Temporary investments
Other ratios: Loans to deposits, pledged
securities, brokered deposits, market to book
(of securities)
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The Dynamics of Liquidity
Management
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Role of expectations
Properties of time series data
Forecasting techniques
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The Three Faces of Liability
Management
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Minimize interest expense
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Segment markets
Meeting loan demand to enhance
customer relationships
Desire to reduce regulatory burdens
associated with reserve requirements
and deposit-insurance fees (and Reg Q
when it existed)
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The Risks of Liability
Management
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Maintaining the confidence of the
marketplace is critical
Government guarantees help and may
even thwart market discipline – “hot
money,” however, tends to run and it
does so electronically in today’s world
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Chapter Summary
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The importance and interaction of
liquidity and confidence are captured by
the following statements:
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"Liquidity always comes first; without it a
bank doesn't open its doors; with it, a
bank may have time to solve its basic
problems" (Donald Howard, Chief Financial
Officer, Citicorp).
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Summary (continued)
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"Our whole financial system runs on
confidence and not much else when you
get down to it. What we've learned is
that when confidence erodes, it erodes
very quickly" (L. William Seidman,
former Chairman, FDIC).
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Summary (continued)
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On the topic of liquidity and the
availability of capital, also consider,
this by David Ruder, former chairman of
the SEC, following the stock market
crash of October 1987 :
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"I personally regard that question is
probably the most important one to come
out of the market decline.
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