UNSW Business School

FINS3630
Lecture 06

Liquidity Risk & Liability Management

(Chapter 12,18,19)
 Topics for discussion
We will discuss
Liquidity risk management.
Measure of liquidity risk.
Bank runs, deposit insurance and discount window.
Liquidity and Liability management

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Liquidity Risk
Liquidity risk is a normal aspect of the everyday management of the FIs. For example,
DIs must manage liquidity to meet demands for daily withdrawals. Only in extreme
cases do liquidity risk problems develop into insolvency risk problems.

The FI can usually meet the liquidity demand by

Run down cash assets.
Sell off other liquid assets.
Borrow additional funds.
When all the above measures fail, an FI has to liquidate illiquid assets at usually fire-
sale prices for immediate sale. From this point on, the liquidity risk begins to threaten
the solvency of the FI.

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 Liquidity Risk Arises for Two Reasons
Liability-side liquidity risk:
The FI may not have enough cash to meet the requests for withdrawals.
Asset-side liquidity risk:
The FI may not have enough cash to fund the exercise of loan commitment or
other commitments for lending.
The value of a FIs investment portfolio may fall unexpectedly, although the loss
can be absorbed by equity, the FI still need to fund the loss such that it has enough
liquid assets to meet loan requests and unexpected deposit withdrawals.
Like maturity mismatch, liquidity risk is inherent in an FIs asset transformation
function.
A DI use a large amount of short-term liabilities to finance long-term assets.

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Liability-Side Liquidity Risk
A DI knows that only a small proportion of its deposits will be withdrawn on a
given day and part of these withdrawals are also offset by the inflow of new
deposits. The difference between deposit withdrawals and deposit additions
is called the Net Deposit Drain.
Over time, a DI manager can normally predict the probability distribution of
net deposit drain with a good degree of accuracy.
Most demand deposits act as consumer core deposits on a day-by-day basis,
providing a relatively stable or long-term source of funds for the DI.

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 Managing Deposit Drains using Purchased Liquidity Management
A DI can purchase liquidity by
Borrowing on the market for purchased funds
The Federal Funds Market or Repurchase Agreement Market
Issuing wholesale CDs or even issuing some notes and bonds.
The benefit is that it insulates the size and composition of asset side of the balance
sheet from normal deposit drains.
The cost is that
It can be expensive for the DI since it has to pay the usually higher market rates
for funds in the wholesale money market to offset net drains on low-interest-
bearing deposits.
Furthermore, the availability of these funds can be limited when the lenders are
concerned about the solvency of the DI.

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Managing Deposit Drains using Purchased Liquidity Management (cont.)
Example: the DI purchased (borrowed) $5 million to meet the deposit drain.

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Managing Deposit Drains using Stored Liquidity Management
A DI can utilize its stored liquidity to meet positive net deposit drains.
Run down cash assets.
Sell liquid assets.
The benefit is that it does not rely on the availability of funds on the market.
The cost to the DI is that, apart from decreased asset size, it must hold
excess low-rate assets on the balance sheet and thus forgo the returns that it
could otherwise earn by investing these funds in loans and other higher-
income-earning assets.
The Federal Reserve sets minimum reserve requirements for the cash
reserve the DIs must hold. DIs tend to hold cash in excess of the minimum
requirement to meet liquidity drains.

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Managing Deposit Drains using Stored Liquidity Management
Example: The DI run down $5 million cash to meet the withdrawal demand. The
balance sheet shrinks by $5 million.

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Managing Asset-Side Liquidity Risk
Can use both purchased and stored liquidity management methods.
Example: An exercise of $5 million loan commitment

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 Measure of Liquidity Risk:
Net Liquidity Statement:
It is important that a DI manager can measure its liquidity position on a daily basis.
A useful tool today is a net liquidity statement which lists the sources and uses of
liquidity and thus provides a measure of the DIs liquidity position.
The DI can obtain liquid funds in three ways.
First, It can sell its liquid assets with little price risk and low transaction cost.
Second, it can borrow funds in the money/purchased funds market up to a
maximum amount. The market would impose such a limit based on the DIs debt
capacity.
Third, it can use any excess cash reserve over and above the amount held to
meet regulatory imposed reserve requirements.

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Net Liquidity Statement
An example Net Liquidity Statement.

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Peer Group Ratio Comparisons
Compare certain key ratios and balance sheet feature of the DI with those of
DIs of a similar size and geographic location.
loan to deposit ratio
Borrowed funds to total assets
Commitment to lend to total assets.
Funding from short-term money market is less reliable than core deposits.
For example, during the financial crisis of 2008-2009, banks stopped
lending to each other at anything but high overnight rates. The commercial
paper market also froze.
A high ratio of loans to deposits and borrowed funds to total assets means
that the DI relies heavily on the short-term money market rather than core
deposits to fund loans.

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Liquidity Index
This index measures the potential losses an FI could suffer from a sudden or
fire-sale disposal of assets compared with the amount it would receive at a
fair market value established under normal market (sale) conditions which
might take a lengthy period of time as a result of a careful search and bidding
process.

= )( /

where is the weight of asset i in total asset, is asset is fire-sale price

and * is asset is fair market price.
0< 1 and the higher the the more liquid the DIs portfolio of assets.

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 Calculation of Liquidity Index
Suppose a DI has two assets: 50 percent in one-month T-bills and 50 percent in real estate
loans. If DI must liquidate its T-bills today, it receives $99 per $100 of face value. If it can wait
to liquidate them on maturity (in one months time), it will receive $100 per $100 face value. If
the DI has to liquidate its real estate loans today, it receives $85 per $100 face value.
Liquidation at the end of the month (closer to maturity) will produce $92 per $100 face value.
The one-month liquidity index for this DIs asset portfolio is:
1 .99 1 .85
= + = 0.957
2 1.00 2 0.92

Suppose, alternatively, that a slow or thin real estate market caused the DI to be able to
liquidate the real estate at only $65 per $100 face value. The one-month liquidity index for the
DIs asset portfolio is:
1 .99 1 .65
= + = 0.848
2 1.00 2 0.92

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Financing Gap and the Financing Requirement
Although demand deposits can be withdrawn anytime, most depositors do not
do so in normal conditions. As a result, most demand deposits stay at DIs for
quite long periods often two years or more. Thus, they are considered to be
a core source of funding.
! "=#$%& % '( ) #$%& % *%"() +)
A positive financing gap must be funded by either running down cash and
liquid assets or borrowing on the market
! "=, -. * ))%+)+/(&&(0%* 1. *)
"+, -. * ))%+)= &%-. &%2% +
The larger a DIs financing gap and liquid asset holdings, the larger the
amount of funds it needs to borrow in the money markets and the greater is
the exposure to liquidity problems from such an reliance.

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Financing Gap and the Financing Requirement

This balance sheet illustrate the following relation

" $5 2 '' ( +, -. * ))%+) $5 2 '' ( = 3%-. &%2% + ($10 2 '' ( )
A widening financing gap can warn of future liquidity problems for a DI since it may
indicate increased deposit withdrawals and increasing loans due to increased exercise
of loan commitment.
If the DI does not reduce its liquid assets, the manager must resort to more money
market borrowings.

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Financing Gap and the Financing Requirement
As these borrowings rise, sophisticated lenders in the money market may be
concerned about the DIs creditworthiness.
They may react by imposing higher risk premiums on borrowed funds or
establishing stricter credit limits by not rolling over funds lent to the DI.
If the DIs financing requirements exceed such limits, it may become
insolvent.

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 Liquidity Risk measure implemented by BIS:
Liquidity coverage Ratio (LCR):
Ensures that DI maintains an adequate level of High-Quality Liquid Assets (HQLA) that can
be converted into cash to meet liquidity needs for a 30-day time horizon under an acute
liquidity stress scenario
7+( 8 (1 9:,#
, -. * +4 6($%& % 3 + ( ,63 = > 100%
;(+ ' <%+ )= (.+1'(0) ($%& +=% %>+ 30 '% * & * 4)

The numerator of LCR:

Liquid asset must remain liquid in times of stress and must be unencumbered.
Can include:
Cash, central bank reserves and sovereign debt Level 1,
Government sponsored MBS, higher rated corporate bonds (at least AA-) Level 2A
RMBS not guaranteed by government + lower-rated corporate bonds + Blue chip
equities level 2B

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Liquidity Coverage Ratio:
A minimum 15 % haircut has to be applied to the value of each level 2 assets
Level 2B may not account for more than 15% of banks stock of high-quality liquid
assets.
Level 2 assets may not, in aggregate, account for more than 40%of a banks stock of
HQLA.
Denominator of LCR:

Timeline for implementing LCR

For details (for interest only), please see http://www.bis.org/publ/bcbs238.pdf

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 Net stable Funding Ratio (NSFR):
Takes a long-term perspective at liquidity on DIs Balance Sheet and evaluates liquidity over
entire balance sheet.
Provides incentives for DIs to use stable sources of financing.
#$ ' B'% 2(. + (1 )+ B'% 1. * (#7 )
<7 3 = > 100%
3%-. &%* 2(. + (1 )+ B'% 1. * (37 )
ASF includes:
Bank capital, Preferred stock with maturity greater than year, Liability with maturities
greater than 1 year, portion of retail and wholesale deposits expected to stay with bank
during periods of idiosyncratic stress.
RSF: Measured using supervisory assumptions on the characteristics of liquidity risk profile
of a DIs asset
Sum of both on and off-balance sheet activities adjusted for RSF factor.
http://www.bis.org/bcbs/publ/d295.pdf

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Committed Liquidity Facility (CLF) in Australia
Since January 2015, those ADIs to which APRA applies the Basel III liquidity standards
have been required to hold high-quality liquid assets (HQLA) sufficient to withstand a
30-day period of stress under the liquidity coverage ratio (LCR).
In the domestic securities market, only Australian Government Securities (AGS) and
securities issued by the borrowing authorities of the states and territories (semis) meet
the Basel criteria for HQLA.
While ADIs have significantly increased their holdings of government debt in recent
years, a large proportion of the current stock on issue is held by non-residents, and
ADIs' holdings are well below the amount that would be needed if all ADIs were to meet
their LCR requirement through this means.
The Committed Liquidity Facility is the Reserve Bank and APRA's alternative treatment
for holding the stock of HQLA and under this arrangement, certain ADIs are able to use
a contractual liquidity commitment from the Reserve Bank towards meeting their LCR.

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Bank Runs, Deposit Insurance and Discount Window
Bank run is a sudden and unexpected increase in deposit withdrawals from a
DI.
Abnormal deposit drains can occur for a number of reasons, including
Concerns about a DIs solvency relative to those of other DIs.
Failure of a related DI leading to heightened depositor concerns about the
solvency of other DIs.
Sudden changes in investor preferences regarding holding nonbank financial
assets (such as mutual funds) relative to deposits.
https://www.youtube.com/watch?v=2EnaU7D80oM
https://www.youtube.com/watch?v=IVRgZ9LizZQ

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Characteristics of Demand Deposit Contracts and Bank Runs
Demand deposit contracts are first-come, first-served contracts.
A depositor either gets paid in full or nothing.
When a DIs assets are valued at less than its deposits, only certain proportion of the
depositors will be paid in full and a depositors place in line determines the amount he or
she will be able to withdraw from the DI.
Knowing this, any line outside a DI encourages other depositors to join the line immediately
even if they do not need cash today for normal consumption purposes.
The incentives for depositors to run first and ask questions later creates a fundamental
instability in the banking system in that an otherwise sound DI can be pushed into
insolvency and failure by unexpected large depositor drains and liquidity demands
Regulator have recognized this inherent instability of the banking system and put in place
two mechanisms to ease the problem.

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 Deposit Insurance
FDIC deposit insurance covers the depositors of a failed FDIC-insured depository institution
dollar-for-dollar, principal plus any interest accrued or due to the depositor, through the date
of default, up to at least $250,000 per depositor, per FDIC-insured bank, per ownership
category.
In Australia, the Financial Claims Scheme provides a guarantee on bank deposits of up to
$250,000 per customer per institution.
If a deposit holder believes a claim is totally secure, even if the DI is in trouble, the holder
has no incentive to run.
The undesirable effect of deposit insurance:
Knowing that deposit holders are less likely to run even if there is perceived bank
solvency problem, deposit insurance creates a situation that DIs are more likely to
increase the liquidity risk on their balance sheets.

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 Discount Window
Discount window loans are meant to provide temporary liquidity for inherently solvent DIs, not
permanent, long-term support for otherwise insolvent DIs.
To borrow from the discount window, a DI generally needs high-quality liquid assets to pledge
as collateral. The interest rate charged on the loans is called the discount rate and is set by
the central bank.
In the U.S., the Fed had historically set the discount rate below market rates and required
borrowers to prove they could not get funds from the private sector. The latter put a stigma on
discount window borrowing.
In January 2003, the Fed implemented changes to its discount window lending. With the
changes, the Fed lends to all banks, but the subsidy is gone.

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 Discount Window (cont.)
Three lending programs are offered through the Feds discount window.
Primary credit is available to generally sound DIs on a very short-term basis, typically,
overnight, at a rate above the Federal Funds rate. Primary credit may be used for any
purposes.
Secondary credit is available to DIs that are not eligible for primary credit. It is extended on
a very short-term basis at a rate that is above the primary credit rate. Its use should be
consistent with a timely return to a reliance on market sources of funding or the orderly
resolution of a troubles institution.
The Feds Seasonal credit program is designed to assist small DIs in managing significant
seasonal swings in their loans and deposits. Eligible institutions are usually located in
agricultural regions.
https://www.philadelphiafed.org/-
/media/education/teachers/publications/intersections/2004/spring/_images/sb02.gif?la=en

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 Liquid Asset and Liability Management
A DI manager can optimize over both liquid assets and liability structures to insulate the DI
against liquidity risk.
On the one hand, the DI manager needs to build up a prudential level of liquid assets while
minimizing the opportunity costs of funds. A DI manager should try to achieve an optimal mix
of lower-yielding, liquid assets and higher-yielding, less liquid assets. Holding too many liquid
assets penalizes earnings, while holding too few liquid assets exposes the FI to enhanced
liquidity crises.
On the other hand, the DI manager needs to structure the liabilities so that the need for large
amounts of liquid assets is reduced while trading off funding risk and funding costs.

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 Demand Deposits, NOW Accounts
Demand Deposit
It has a high degree of withdrawal risk.
zero explicit interest
However, this does not mean this is a costless source of funds
DIs provide a whole set of associated services which absorb real resources. Hence, DIs pay
implicit interests on these accounts
Interest-Bearing Checking (NOW) Accounts
These are checkable deposits that pay interest and can be withdrawn on demand.
They are called negotiable order of withdrawal (NOW) accounts.
Depositors are required to maintain a minimum balance to earn interest.
The DIs can influence withdrawal risk of NOW accounts by adjusting explicit interest,
minimum balance requirement and implicit interest.

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 Passbook Savings, Money Market Deposit Accounts (MMDAs)
Passbook Savings
These accounts are non-checkable and usually involve physical presence at the DI to
withdrawal. The DI has the legal power to delay payment or withdrawal requests for as long as
a month.
The principal costs to the DI are the explicit interest payments on these accounts.
Money Market Deposit Accounts (MMDAs)
These accounts are used to control the risk of funds disintermediating from DIs and flowing
into money market mutual funds (MMMFs).
Limits on number of checks written on each account per month, minimum denomination of
each check, minimum balance requirement in depositors
The explicit interest paid to depositors is the major cost of MMDAs. The DI managers can
use the spread on MMMF-MMDA accounts to influence the net withdrawal rate on MMDAs.
MMDAs are insured by FDIC but MMMFs are not.

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Retail Time Deposits and CDs
Retail CDs
They are fixed-maturity instruments with face values under $100,000. Regulation
empowers the DIs to impose penalties on early withdrawals of time deposits or CDs.
Although this does not stop withdrawals when the depositors perceive the DI to be
insolvent, under normal conditions, these instruments have relatively low withdrawal
risk compared with transaction accounts.
The major cost of these instruments is the explicit interest payments.
Wholesale CDs
They have a minimum denomination of $100,000 or more.
The unique feature of these instruments is that they are negotiable, i.e. they can be
sold by title assignment on a secondary market to other investors.

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 Wholesale CDs
A depositor can sell a relatively liquid wholesale CD without causing adverse withdrawal risk
exposure for the DI.
The only withdrawal risk is that these CDs are not rolled over and reinvested by the holder of
the deposit claim on maturity.
The rates paid on these instruments are competitive with other wholesale money market rates,
especially those on commercial papers and T-bills. In addition, required yield on CDs reflect
investors perception of the depth of the secondary market for CDs.
Only the first $250,000 (per investor, per institution) invested in these CDs is covered by
deposit insurance.

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 Federal Funds
Besides funding their assets by issuing deposits, DIs also can borrow in various market for
purchased funds.
Since the funds generated from these purchases are borrowed funds, not deposits, they
are subject to neither reserve requirements nor deposit insurance premium payments to the
FDIC.
The largest market available for purchased funds is the federal funds market. This refers to
the interbank market for excess cash reserves where DIs with excess reserves can lend their
surplus balances to DIs in need of those balances to earn interest.
Federal funds are short-term uncollateralized loans made by one DI to another; more than 90
percent of such transactions have maturities of one day.

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 Federal Funds
The cost of fed funds for the purchasing institution is the federal funds rate, which is the
interest rate at which depository institutions lend reserve balances to each other overnight.
However, the Fed establishes target for the federal funds rate and keeps it around that
target through buying and selling U.S. Treasury securities.
Since fed funds are uncollateralized loans, institutions selling fed funds normally impose
maximum bilateral limits or credit caps on borrowing institutions.
For the liability-funding DIs, the main risk of funding by federal funds is that the fed funds
will not be rolled over by the lending bank the next day if rollover is desired by the
borrowing DI.
In reality, this has occurred only in periods of extreme crisis, such as during the 2008-2009
financial crisis.

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 Repurchase Agreement (RPs or Repos)
Repurchase agreement can be viewed as collateralized federal funds transactions where
The funds-selling DI receives government securities as collateral from the funds-purchasing DI
The funds-purchasing DI temporarily exchanges securities for cash The next day, this
transaction is reversed. The funds-purchasing DI sends back the fed funds it borrowed plus
interest It receives in return (or repurchases) its securities used as collateral in the
transaction.
As with the fed funds, the RP market is a highly liquid and flexible source of funds for DIs needing
to increase their liabilities and to offset deposit withdrawals. Because of their collateral nature, RP
rates normally lie below federal fund rates.
Major liability management difference between fed funds and RPs: A fed funds transaction can be
entered into at any time in the business day, while it is difficult to transact a RP borrowing late in
the day since the DI sending the fed funds must be satisfied with the type and quality of the
securities collateral proposed by the borrowing institution.
Negotiations over the collateral package can delay RP transactions and make them more difficult to
arrange than simple uncollateralized fed fund loans.

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 A General Definition of Repurchase Agreement
Repurchase agreements (RPs): a sale of securities coupled with an agreement to
repurchase the same securities at a higher price on a later date.
The difference between the selling and buying price effectively represents the interest
payment on the borrowing.
The maturity date is either fixed or extended on a day-to-day basis.
The interest rate (repo rate) can depend on a number of factors, such as the quality of the
collateral and the identity of the borrower.
The repos are commonly renewed with the same dealer or replaced by new repos with other
dealers.
Economically, repo is a collateralized loan. The cash provider receives the repo rate.

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 A General Definition of Repurchase Agreement
If the collateral provider were to default on its obligation to repay the cash, the cash provider is
entitled to sell the pledged securities.
If the cash provider fails to return the securities, the collateral provider can keep the cash.
A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the
seller's. Hence, the seller executing the transaction would describe it as a "repo", while the
buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo"
are exactly the same kind of transaction, just being described from opposite viewpoints.
Example: Dealer A can borrow $10,000,000 overnight at an repo rate of 3% per annum by
selling Treasury securities to a mutual fund and simultaneously agreeing to repurchase the
securities the following day. How much would dealer A pay to repurchase the securities?
E
Answer: $10,000,000 1 + 0.03 = $10,000,833
FGH

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 Commercial Papers & Medium Term Notes(MTN)
Commercial paper is an unsecured short-term promissory note issued by a corporation to
raise short-term cash.
Commercial paper is one of the largest money market instruments. Companies with strong
credit ratings can generally borrow money at a lower interest rate by issuing commercial
paper than by directly borrowing from other sources such as commercial banks.
Commercial paper generally has a maturity of less than 270 days.
Although a DI subsidiary itself cannot issue commercial paper, its parent holding company
can. This provides DIs owned by holding companies with an additional funding source.
A number of DIs in search of more stable sources of funds with low withdrawal risk have
begun to issue MTN, often in the five- to seven-year range. Attractive since they are subject
to neither reserve requirements nor deposit insurance premiums.
DIs facing temporary liquidity crunches can borrow from the central banks discount window
at the discount rate.

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