Chapter 17
Liquidity Risk
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview

17-2
This chapter explores the problem of
liquidity risk faced to a greater or lesser
extent by all FIs. Methods of measuring
liquidity risk, and its consequences are
discussed. The chapter also discusses the
regulatory mechanisms put in place to
control liquidity risk.
Liquidity Versus Solvency
17-3
Remember, a firm is insolvent if the value of
liabilities exceeds the value of assets
 Liquidity is not a solvency issue, but a timing
issue
 The “timing issue” can be become
permanent if a liquidity crisis is severe
enough
 Here is a new formula to remember:

Illiquid assets + leverage = bankruptcy
FIs and Typical Liquidity Risk Exposure

High exposure



DIs
Highly-leveraged hedge funds
Moderate Exposure



17-4
Life Insurance Companies
Leveraged hedge funds
Low exposure

Mutual funds, hedge funds with minimal , pension funds,
property—casualty insurance companies.
Typically low, does not mean zero:
September 2006, Amaranth Advisors, a hedge fund forced to shut
down

Causes of Liquidity Risk

Asset side

May be forced to liquidate assets too rapidly


Faster sale may require much lower price
May result from OBS loan commitments
Traditional approach: cash and reserves
asset management.
 Alternative: liability management.

17-5
Causes of Liquidity Risk for DIs
17-6
Liability side
 Reliance on demand deposits



Core deposits
Depository Institutions need to be able to
predict the distribution of net deposit drains.



Seasonality effects in net withdrawal patterns
Early 2000s problem with low rates: finding suitable
investment opportunities for the large inflows
Managed by:


purchased liquidity management
stored liquidity management
Summary B/S – Commercial Banks
17-7
Borrow to Cover Deposit Outflow
Note that the B/S in the upper right is the “instantaneous effect”.
The B/S must balance.
Also note that equity = 0 in these examples.
17-8
Use Cash to Pay Off Deposit Withdrawal
17-9
Two Ways to Fund Loan Drawdown
17-10
Liquidity Issue Due to Market Risk
17-11
Liquidity Exposure for Two Banks
•What is impact of:
•Variance in reliance on borrowings versus deposits?
•Variance in level of commitments to lend?
17-12
Liability Management

17-13
Purchased liquidity




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.
Deposit insurance allows even distressed
institution to gather deposits


Can be high cost in broker market
Regulatory concerns:

growth of wholesale funds and the potential for
serious problems in credit crunch
Liability Management

Alternative: Stored Liquidity Management

Liquidate assets.




17-14
In absence of reserve requirements, banks tend to
hold reserves. E.g. In U.K. reserves ~ 1% or more.
Downside: opportunity cost of reserves.
Decreases size of balance sheet
Requires holding excess non-interest-bearing
assets
Institutions today typically combine
purchased and stored liquidity management
Asset Side Liquidity Risk

17-15
Risk from loan commitments and other
credit lines:
 met either by borrowing funds or
 by running down reserves
 Current
levels of loan commitments are
dangerously high according to
regulators.
17-16
Investment portfolio & asset side liquidity risk
Interest rate risk and market risk of the
investment portfolio.
 Technological improvements have increased
liquidity in financial markets.


Some argue that “herd” behavior may actually
reduce liquidity.
Measuring Liquidity Exposure

17-17
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


With liquidity improvements gained via securitization
and loan sales, many banks have added loan assets
to statement of sources
Uses include: borrowed or money market funds
already utilized, and any amounts already
borrowed from the Fed.
Other Measures:
17-18
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*)
Liquidity Index Example in Text (p502)
50% T-bills $99 versus $100
50% RE Loans $85 versus $92
Normal RE Market
I= {.50x (99/100)} + {.50x(85/92)} =
.495 + .462 = .957
Slow RE Market
I= {.50x (99/100)} + {.50x(65/92)} =
.495 + .353 = .848
17-19
Measuring Liquidity Risk
17-20
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.
c
Financing Gap = Loans – Deposits = $25 - $20 = $5
Financing requirements = Financing Gap + Liquid Assets =
$5 + $5 = $10
In other words, beyond the $20 in deposits, the institution
must find another $10 in financing somewhere.
17-21
BIS Approach:

17-22
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
BIS Liquidity Ladder
17-23
Note that, despite the “requirement” terminology, positive
numbers in the last line are really the expected liquidity cushion
Liquidity Planning
17-24
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.


Example: mutual funds/pension funds more
likely to withdraw than correspondent banks and
small businesses
Allow for seasonal effects.
 Delineate managerial responsibilities clearly.

Sample Analysis of Potential Withdrawals by
Depositor type
17-25
Bank Runs
17-26
Can arise due to concern about bank’s
solvency.
 Failure of a related FI.
 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.

Alleviating Bank Runs:

Regulatory measures to reduce likelihood of
bank runs:



17-27
FDIC
Discount window
Not without economic costs.

FDIC protection can encourage DIs to increase
liquidity risk. (moral hazard)
Mutual Fund with Zero and Max Leverage
No Leverage:
Cash
2
Securities 98
Equity 100
Maximum Leverage (50% net assets):
Cash
3
Securities 147
Borrowings 50
Equity 100
17-28
Investors withdraw $10MM
17-29
No Leverage:
Cash
1
Borrowings 0
Securities
89
Equity
90
Use $1 cash and sell $9 assets to redeem $10, or
Cash
2
Borrowings 10
Securities
98
Equity
90
Borrow $10 to redeem $10
Maximum Leverage (50% net assets):
Cash
Securities
2
133
Borrowings
Equity
45
90
Used up $1 cash and had to sell $14 of securities to pay $10 to redeeming
investors and pay down $5 in borrowings to bring leverage back to 50%
Securities Market Value Falls 10%
17-30
No Leverage:
Cash
Securities
2
88.2
Borrowings
Equity
0
90.2
Note that for the mutual fund with no leverage, there is no
transaction required from a liquidity or leverage limit
standpoint.
The story is quite different with leverage. See the next slide.
Securities Market Value Falls 10%
17-31
Maximum Leverage (50% net assets) Start:
Cash
3
Borrowings 50
Securities
147
Equity
100
First Cut: Securities decline by 14.7 & equity falls the same
Cash
3
Borrowings 50
Securities
132.3
Equity
85.3
But now, the fund is in violation of the SEC leverage limit:
50/85.3 = 58.6% & the limit is 50%
Max borrowings = .5 x 85.3 = 42.65, so need to sell 7.35 of
securities
Cash
3
Borrowings 42.65
Securities
124.95
Equity
85.3
Market Value of Securities Falls 25%
No Leverage:
Cash
Securities
17-32
(note that there is no transaction)
2
73.5
Borrowings
Equity
0
75.5
Maximum Leverage (50% net assets): (start)
Cash
3
Borrowings
50
Securities
147
Equity
100
Loss on securities is 36.75:
Cash
3
Borrowings
50
Securities
110.25
Equity
63.25
But, our equity now only supports borrowings of .5x63.25=31.6
Cash
3
Borrowings
31.6
Securities
91.85
Equity
63.25
Fund must sell $18.4 of securities in a bad market to pay off excess
borrowings.
What About Hedge Funds?

A hedge fund without leverage is in a
similar situation to that of the unlevered
mutual fund

Except that the assets may be less liquid or
more concentrated

Both of these increase liquidity risk
17-33
Hedge Fund With 900% Leverage
17-34
Start:
Cash
50
Borrowings 900
Securities
950
Equity
100
Investors withdraw $30:
Cash
20
Borrowings 630
Securities
680
Equity
70
Manager would use cash to meet the redemption request.
The manager would then very quickly (frantically) try to sell
securities to get the leverage ratio back down. To reach
900% again, would need to sell $270!!! Remember that
unlevered funds would sell none and the mutual fund with
maximum leverage would have to sell only$7.35.
Hedge Fund With 900% Leverage
17-35
Start:
Cash
Securities
50
950
Securities Decline 10%
Cash
50
Securities
855
Borrowings
Equity
900
100
Borrowings
Equity
900
5
Do you think that the lenders might call their loans?
Now, consider that Long Term Capital ran 2000% leverage
routinely and reached 10000% (100:1) at the end.