Liquidity Risk
Drake Fin 286
DRAKE UNIVERSITY
Liquidity Risk
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Drake University
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Liquidity risk deals with the everyday aspect
of doing business.
Interest rate risk, credit risk, off balance sheet
risk, operational risk all created solvency risk
for the FI, liquidity risk generally does not.
Liquidity risk represents the risk of the FI not
having enough short term liquidity to meet
daily operational needs.
Causes of Liquidity Risk
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Asset side
May be forced to liquidate assets too rapidly
resulting n “fire sale prices”
May result from loan commitments
Traditional approach: reserve asset
management
FI’s like to reduce cash since cash generally
pays little or no interest
Alternative: liability management.
Causes of Liquidity Risk
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Liability side
Reliance on demand deposits
Core deposits (provide long term source of
funds)
Need to be able to predict the distribution of
net deposit drains.
Managed by:
purchased liquidity management
stored liquidity management
Net Deposit Drains
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Deposit withdraws are in part offset by the
inflow of new funds and income generated by
from both on and off balance sheet activities.
The amount by which the cash withdraws
exceed the new cash inflows is the Net
Deposit Drain.
Positive NDD implies withdraws are greater
than inflows. Negative NDD implies that
inflows are greater than withdraws
Net Deposit Drain
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The decrease in liabilities must be offset with
an increase in liabilities or a decrease in
assets if new inflows do not replace the
outflow of funding sources.
Net Deposit Drain
Predictable
Large commercial transaction accounts
(payroll etc)
Maturing Investments
Unpredictable
Will customer reinvest maturing CD
Loan commitments
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Balance Sheet
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Before the NDD
Assets
Assets
100
Total
100
Liabilities
Deposits
70
Borrowed Funds10
Other
20
100
Balance Sheet
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After the NDD
Assets
Assets
100
Total
100
Liabilities
Deposits
65
Borrowed Funds10
Other
20
95
The most likely way to fix the imbalance is for
borrowed funds to increase by 5.
Liability Management
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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.
Deposits are insured
Regulatory concerns: growth of wholesale
fund use as investors have increasing
investments and decreasing deposits.
Liability Management
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Note the tradeoff between funding risk and
funding cost.
Demand deposits are a source of cheap funds
but there is high risk of withdrawal.
NOW accounts: manager can adjust the
explicit interest rate, implicit rate and
minimum balance requirements to alter
attractiveness of NOW deposits.
Deposit Accounts
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Passbook Savings Accounts: Not checkable.
Bank also has power to delay withdrawals
for as long as a month.
Money market deposit accounts:
Somewhat less liquid than demand
deposits and NOW accounts. Impose
minimum balance requirements and limit
the number and denomination of checks
each month.
Time Deposits and CDs
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Retail CDs: Face values under $100,000 and
maturities from 2 weeks to 8 years. Penalties
for early withdrawal. Unlike T-bills, interest
earned on CDs is taxable.
Wholesale CDs: Minimum denominations of
$100,000. Wholesale CDs are negotiable.
Fed Funds
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Fed funds is the interbank market for excess
reserves. 90% have maturities of 1 day.
Fed funds rate can be highly variable
Prior to July 1998: especially around the
second Tuesday and Wednesday of each
period. (as high as 30% and lows close to
0% on some Wednesdays).
Rollover risk
Repurchase Agreements
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RPs are collateralized fed funds transactions.
Usually backed by government securities.
Can be more difficult to arrange than simple
fed funds loans.
Generally below fed funds rate
Other Borrowings
Bankers acceptances
Commercial paper
Medium-term notes
Discount window loans
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Liability Management
Borrowing Funds
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Advantages:
Volume and composition of asset portfolio
doesn’t change
Can increase rate to attract funds
Only borrow IF funds are needed
Disadvantages
Market determines rate
Increased uncertainty of costs
Fin 286
Asset Based Management
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Alternative: Stored Liquidity Management
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.
Decreases size of balance sheet
Requires holding excess noninterest-bearing
assets
Using Cash
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The most obvious asset side management
technique is to use the cash reserves of the
firm.
Balance Sheet
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Drake University
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Before the NDD
Assets
Cash
9
Other
91
Total
100
Liabilities
Deposits
70
Borrowed Funds10
Other
20
100
Balance Sheet
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Before the NDD
Assets
Cash
4
Other
91
Total
95
Liabilities
Deposits
65
Borrowed Funds10
Other
20
95
The firm meets the increased withdraws by
decreasing its cash balances
Cash vs. Liquid Assets
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Cash Assets
Vault Cash, Demand deposits at Fed Reserve,
Demand Deposits at private financial
institutions, cash items in the process of
collection
Liquid Assets
Fed Funds Sold and Reverse Repos, US
Treasury and Agency Securities with < 1 yr
maturity, Corporate obligations and Municipal
Securities with < 1yr maturity, Loans that can
be readily sold or securitized.
Storing Liquid Assets
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If you attempt to store funds in liquid asset
they must have
A ready Market
A stable price
Reversible (can recover original investment
with a high degree of certainty)
Costs of using liquid assets
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Opportunity cost of foregone earnings if sold
Opportunity cost of other assets ( liquid
assets have lower return)
Transaction costs
Higher risk of capital loss
Weakens balance sheet position
Historical Notes
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Since 1960, ratio of liquid to illiquid assets has
fallen from about 52% to about 26%. But,
loans themselves have also become more
liquid.
Securitization of DI loans
In the same period, there has been a shift
away from sources of funds that have a high
risk of withdrawal.
Historical Notes
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During the period since 1960:
Noticeable differences between large and
small banks with respect to use of low
withdrawal risk funds.
Reliance on borrowed funds does have its own
risks as with Continental Illinois.
Final alternative
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It is also possible and likely that the FI can
combine purchased and stored liquidity
management techniques.
Asset Side Liquidity Risk
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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
Measuring Liquidity Exposure
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Net liquidity statement: shows sources and
uses of liquidity.
Sources: incoming deposits, revenue from sale
of non deposit services, Customer Loan
repayments, Sale of bank Assets, Borrowing in
money market
Uses include: Deposit Withdraws, Volume of
Acceptable loan requests, repayments of bank
borrowing, other operating expenses, dividend
payments
Other Measures:
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Peer group comparisons: usual ratios include:
borrowed funds/total assets,
loan commitments/assets
Loan Losses / Net loans
Total Deposits./ Total Assets
Core Deposits/Total Assets
Fed Funds Purchased / Total Assets
Reserve for Loan losses / Net Loans
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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*)
Measuring Liquidity Risk
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Drake University
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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.
BIS Approach:
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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
Liquidity Planning
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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.
Bank Runs
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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:
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Regulatory measures to reduce likelihood of
bank runs:
FDIC
Discount window
Not without economic costs.
Liquidity Risk for Other FIs
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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.
Mutual Funds
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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.
Liability and Liquidity
Management
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Depository institutions and life insurance
companies are highly exposed to liquidity risk.
The second half of the liquidity risk portion of
class discusses how these firms can control
liquidity risk, the motives for holding liquid
assets, and specific issues associated with
liability and liquidity risk management.
Liquid Assets
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Liquid assets are assets that can be turned
quickly into cash
Low transaction costs
Little or no loss in principle value
Traded in large market (trading does not move
the market)
Liquid Asset Management
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Examples: T-bills, T-notes, T-bonds
Benefits of holding large quantities of liquid
assets
Low risk (except for inflation risks)
Flexibility in meeting liability claims
Costs of holding liquid assets
Lost interest income
Liquid Asset Management:
Reserve Requirements
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Reasons for regulating minimum holdings of
liquid assets:
Monetary policy
Enables Monetary policy by forcing Depository
Institutions to participate in the Central
Banking System.
Taxation
Forcing a reserve requirement places a form of
Tax on the Depository Institution
Facilitates Clearinghouse Function
Liquid Asset Management:
Reserve Requirements
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Use of Reserve Requirements as a monetary
Policy tool has decreased.
Fed’s new emphasis on the control of short
term interest rates
Use of Sweep Accounts
Sweep Account – contractual agreement
between bank and depositor permitting the
bank to switch funds from checking account to
an interest bearing account (decreased
reserve requirement)
Composition
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Composition of liquid asset portfolio
Breakdown between cash and other securities
Determined by regulations by government and
earnings of the firm
Liquid assets ratio=Liquid Assets / Total Assets
Cash and government securities in countries
such as U.K
Similar case for U.S. life insurance companies
(regulated at state level)
U.S. banks: cash-based, but banks view
government securities as buffer reserves.
U.S. Cash Reserve Requirements
for Depository Institutions
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Incremental reserve requirements for
transaction accounts (all deposits on which
account holders can make immediate
withdrawals):
First $5.5 million
$5.5 million to $42.8 million
$42.8 million +
0.0%
3.0%
10.0%
Lagged Reserve Accounting
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The system for calculating and maintaining
reserves is based on a lagged reserve
accounting system.
In the system the computation of the
reserves and the reserve maintenance period
do not overlap.
Reserve Management Problem
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Computation period runs from a Tuesday to a
Monday, 14 days later.
First a period for transaction balances, then a
cash computation period. Reserves based
upon the balance must be maintained over a
Reserve Maintenance Period.
Average daily reserves are computed as a
fraction of the average daily deposits over the
period.
Lagged Computation Period
Bank Vault Computation Period
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Reserve Maintenance Period
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Reserve Management
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The reserve maintenance period, differs from
the computation period by 17 days.
Lagged reserve accounting as of July 1998.
Previously, contemporaneous (2-day lag).
Benefits and Costs of lagged reserve
accounting
Provides certainty for banks in terms of
holdings
Easier to manage reserves.
Slows down monetary policy
Undershooting/Overshooting
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Allowance for up to a 4% error in average
daily reserves or $50,000 which ever is
greater without penalty.
Surplus reserves required for next 2-week
period
Undershooting by more than 4% penalized
by a 2% markup on rate charged against
shortfall.
Frequent undershooting likely to attract
scrutiny by regulators
Costs of Undershooting
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Explicit Cost
If undershooting by more than 4% the DI is subject to
an interest penalty equal to 2% plus the discount rate
Implicit Cost
Increased scrutiny by regulators
Increased monitoring, examinations and surveillance
Opportunity Costs
Benefit of undershooting is avoiding high opportunity
costs of holding more reserves than necessary instead
of loans etc..
Undershooting
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DI has two options near the end of the
maintenance period to increase reserves
Liquidate less liquid assets or buffer reserves
Borrow reserves
Fed Funds
Discount window
repurchase agreements
Discount Window
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Designed to cover surprise shortfalls
Discount window borrowing
Discount rate usually lower than market rates
Meant to be used on a when needed basis and not
used for profit.
Risks of gaming the system
“Gaming” claiming that short reserves are the
result of sudden liquidity crunches then using the
difference in the discount rate and market rates to
profit.
If caught charter can be revoked.
Overshooting
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First 4 percent can be carried forward to next
period
Excess reserves typically low due to
opportunity costs
Knife-Edge problem
Either under or over shooting can be costly to
the institution and to the career of the
manager of the liquidity position.
Managing Liquidity
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When calculating reserves, Friday deposit
figures count 3 times in the average. (used
for Friday, Saturday and Sunday)
“Weekend Game”
Transferring foreign deposits to foreign
subsidiaries for the weekend effectively lowers
the total reserves required.
Sweep Accounts
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Weekend Program
Sweeping transaction deposits to money
market or savings accounts at the close of
business on Friday and returning the balance
Monday.
Eliminates need for reserves on that amount
for Friday, Saturday and Sunday
Seep Accounts
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Threshold Accounts
Funds are swept to a different account when
the account exceeds a minimum level.
Regulation D – limits the number of withdraws
or transfers to 6 a month.
If more than 6 withdraws or transfers the
account is classified as as an ATS (automatic
transfer to savings) and is subject to Reserve
Requirements
Business Sweep Accounts
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Regulation Q prohibits paying explicit interest
on business demand deposits
Commercial sweeps – moves money
overnight (not counted as reserves at end of
business day) into non interest earning assets
(repos for example). Funds loose FDIC
insurance.
Return-Risk Trade-off
Cash immediacy versus reduced return
Constrained optimization
Privately optimal reserve holdings
Regulator imposed reserve holdings
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Liquidity Management
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Liquidity can be managed from either the asset
side of the balance sheet or the liability side.
Asset based management
Main goal is storing liquidity in the form of liquid
assets.
Less risky and often used by smaller institutions
Costs
Opportunity cost of foregone earnings if sold
Opportunity cost of liquid assets
Transaction Costs
Weakened Balance Sheet
Liquidity Management
Raising funds via borrowing if needed
Advantages
Only borrow if funds are needed
Volume and composition of asset portfolio is
unchanged
Can always attract funds (by increasing rate)
Disadvantages
Dependent upon market rate
Withdrawal risk (funding risk)
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Funding Risk versus Cost
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Funding Cost
Funding Risk
Choice of Liability Structure
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Demand Deposits
High Withdrawal risk
Low costs – interest costs are low, but service costs
can be high
Interest Bearing NOW Accounts
Negotiable order of withdrawal accounts. Pay interest
on checkable deposits, but require minimum balance
High withdrawal risk
Higher costs due to interest expenses. Can be
managed by changing the minimum balance
Choice of Liability Structure
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Passbook Savings
Noncheckable and usually require physical presence for
withdrawal
Lower withdrawal risk. Institution has the right to delay
withdrawal requests for up to one month.
Pay a higher interest rate than NOW accounts
Money Market Deposit Accounts
Retail savings accounts with limited check writing
DI do not hold reserves against MMDA’s
Compete with MMMF for funds
Choice of Liability Structure
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Retail Time Deposits and CD’s (<100,000)
Structured to reduce withdrawal risk
Wholesale CD’s (>100,000)
Depositors can sell their positions in the
secondary market instead of withdrawing
funds.
Choice of Liability Structure
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Federal Funds and Repos
Since they are borrowed funds there are no
reserve requirements
Subject to settlement risk
Other borrowings
Commercial paper – issued by holding
companies, no the DI
Medium term Notes
Discount Window Loans
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Liability Structure
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Fin 286
1960
2001
2001
2001
Liability
All
banks
All
Banks
Large
Banks
Small
Banks
Transaction Accounts
61%
9.7%
9.8% 11.8%
Retail CD’s and time
Deposits
29%
40%
38.2% 54.6%
Wholesale CD’s
0
15.5%
9.6% 12.5%
Borrowings
2%
28.2% 34.2% 10.1%
Bank Capital
8%
6.6%
8.2%
11%
Balanced Liquidity Management
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Combination of Asset and Liability
Management
Borrow only for unanticipated (usually short
term needs)
Plan for long term liquidity needs via asset
management.
Liquidity Risk in Other FIs
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Insurance companies
Diversify across contracts
Hold marketable assets
Securities firms
Example: Drexel Burnham Lambert and Junk
Bonds