FINS5530 Lecture 4 Liquidity Risk and Liability Management

Lecture 4: Liquidity Risk and Liability

Management

Dr Lixiong Guo

Semester 2 ,2014

1

LIQUIDITY RISK

Part I

2

Liquidity Risk

Liquidity risk is a normal aspect of the everyday management of

the an FI. 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.

3

Liquidity Risk (cont.)

Example 7-3: Impact of liquidity risk on an FIs equity value

The FI is forced to liquidate $10 million illiquid assets at a $5 million loss in order to meet the demand for withdrawals.

This reduces the amount equity in the FI by $5 million.

If there is another $5 million demand for withdrawal, the FI would incur at least another $5 million in losses and become insolvent.

4

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

Liquidity risk is inherent in an DIs asset transformation function because DIs typically use a large amount of short-term liabilities

to finance long-term assets.

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withdrawn on a given day and part of these withdrawals are also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.

6

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 sell 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

Example: the DI purchased (borrowed) $5 million to meet the

deposit drain.

8

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 withdraw

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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MEASURING LIQUIDITY RISK EXPOSURE

Part II

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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

14

An example Net Liquidity Statement.

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.

=

=1

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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Financing Gap

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

= +

+ =

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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BASEL III LIQUIDITY RATIOS

Part III

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The Liquidity Coverage Ratio Under Basel III

The liquidity coverage ratio (LCR) aims to ensure that a DI

maintains its high-quality assets that can be converted into cash

to meet liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors.

=

30 100%

The stock of high quality assets is defined as follows

Liquid asset must remain liquid in times of stress (i.e. convertible into cash at little loss of value and can be used at the central bank

discount window as collateral).

The liquid assets must be unencumbered

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The Liquidity Coverage Ratio Under Basel III

Liquid assets are divided into level 1 and level 2. Level 2 is capped at 40% of total liquid assets

Level 1 = Cash + Central Bank Reserve + Sovereign debt

Level 2A = MBS that are government guaranteed + Corporate bonds rated at lest AA-

Level 2B = RMBS that are not government guaranteed + Lower-rated corporate bonds + Blue chip equities.

Level 2B assets cannot exceed 15% of total liquid assets.

A minimum 15% haircut has to be applied to the value of each level 2 asset.

Total net cash outflows over the next 30 calendar days

= Outflows Min(inflows, 75% of outflows)

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Net Stable Funding Ratio Under Basel III

The net stable funding ratio (NSFR) requires a minimum amount

of stable funding be held over a one-year time horizon based on

the liquidity risk factors assigned to liquidity exposures of on- and

off-balance sheet assets.

=

> 100%

Available stable funding includes

Bank capital

Preferred stock with a maturity > 1 year

Liabilities with maturities > 1 year

The portion of retail deposits and wholesale deposit expected to say with bank during a period of idiosyncratic stress.

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Net Stable Funding Ratio Under Basel III

The available amount of stable funding (ASF) is calculated by

first assigning the value of a DIs equity and liabilities to one of five categories and then multiply the amount by an ASF factor.

The total ASF is the sum of the weighted amounts.

The required stable funding (RSF) is calculated as the sum of the

value of the on-balance-sheet assets held and funded by the DI,

multiplied by a corresponding required stable funding factor, plus

the amount of OBS activities multiplied by the associated RSF

factor.

The RSF factors assigned to various types of assets are

intended to approximate the amount of a particular asset that

could not be sold or used as collateral in a secured borrowing

during a severe liquidity event lasting one year.

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BANK RUNS, DEPOSIT INSURANCE AND

DISCOUNT WINDOW

Part IV

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Bank Runs

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.

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The 2008 Run on Washington Mutual (WaMu)

In early July 2008, hundreds of people lined up outside the headquarters of IndyMac Bank in Pasadena, Calif. On July 11, the FDIC seized

IndyMac. WaMu suffered a $9.4 billion run seven times bigger than IndyMacs. However, no lines were formed outside the block and the run was kept secret.

On Sept. 11, 2008, Moodys downgraded WaMus debt to junk status, rated the companys financial strength at D+ and issued a negative outlook on the company, citing its asset quality and the potential for

future losses. WaMu customers pulled $600 million out of WaMu that

day.

Soon, other rating agencies followed suit. In the next three days,

customers pulled another $2.3 billion out of WaMu.

On Sept 25, 2008, WaMu was seized by OTS. J.P. Morgan agreed to pay $1.9 billion to the government for WaMu's banking operations and

will assume the loan portfolio of the thrift, which has $307 billion in

assets.

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The 2008 Run on Washington Mutual (WaMu)

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Number of Failed U.S. Banks by Year, 1934-2012

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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 insurance covers all deposit accounts. The standard

insurance amount is $250,000 per depositor, per insured bank,

for each account ownership category.

In Australia, the Financial Claims Scheme provides a guarantee

on bank deposits of up to $250,000 per customer and 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

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

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Liquidity Risk in Investment Funds

Most investment funds are open-end funds, which means that

they can issue an unlimited supply of shares to investors and

must also stand ready to buy back previously issued shares from

investors at the current market price for the fund shares.

The price at which an open-end fund stands ready to sell new

shares or redeem existing shares is the net asset value (NAV).

Investment funds are exposed to similar liquidity problems to

banks. Indeed, investment funds can be the subject of dramatic

liquidity runs if investors became nervous about the NAV of the

funds assets.

However, the fundamental difference in the way investment fund

contracts are valued compared with the valuation of DI deposit

contracts mitigates the incentives for fund shareholders to

engage in runs.

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An Example of Redeeming Shares in A Mutual Fund

At the beginning of the day

Assume a mutual fund has $1 million assets under management, with no liabilities, and 10,000 shares outstanding.

=$1,000,000

10,000= $100

NAV is calculated at the close of market every day.

During the day, suppose the asset value falls to $500,000 and

there is a outflow of 5,000 shares.

=500,000

10,000= $50

The shares are redeemed at $50 per share. After the redemption, the mutual fund has 5,000 shares outstanding and $250,000

assets under management.

Key point: All investments and redemptions during the day are

priced at the closing NAV.

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LIQUIDITY AND LIABILITY MANAGEMENT

Part V

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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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Funding Risk and Cost

A DI must trade off the benefits of attracting liabilities with a low

funding cost with a high chance of withdrawal against liabilities at

a high funding cost and low liquidity.

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Demand Deposits, NOW Accounts

Demand Deposit

It has a high degree of withdrawal risk. In the U.S., demand deposits have paid zero explicit interest since the 1930s by law.

However, this does not mean this is a costless source of funds for

DIs because DIs provide a whole set of associated services which

absorb real resources. Hence, DIs pay implicit interests on these

accounts and they can use the implicit interest they pay to control

the withdrawal risk.

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.

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NOW Accounts, Passbook Savings, MMDAs

The DIs can influence withdrawal risk of NOW accounts by adjusting explicit interest, minimum balance requirement and

implicit interest.

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).

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MMDAs

In the U.S., MMDAs are checkable but subject to restrictions on the number of checks written on each account per month, the

number of preauthorized automatic transfers per month, and the

minimum denomination of the amount of each check. In addition,

the MMDAs impose minimum balance requirements on

depositors. The Fed does not require the DIs to hold reserves

against MMDAs. Accordingly, DIs generally pay a higher rates on

MMDAs than on NOW accounts.

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.

The rate that MMMFs pay on their shares directly reflects the rates earned on the underlying money market assets. However, the rates on

MMDAs are not based directly on any underlying portfolio of money

market assets.

MMDAs are insured by FDIC but MMMFs 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.

45

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.

That is the funds-purchasing DI temporarily exchanges securities

for cash. The next day, this transaction is revered. 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.

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Repurchase Agreement

A major liability management difference between fed funds and

RPs is that 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.

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An Example Repo Transaction

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?

Answer: $10,000,000 1 +1

360 0.03 = $10,000,833

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Bankers Acceptance

A bankers acceptance (BA) is created when a time draft drawn on a bank, usually to finance the shipment or temporary storage

of goods, is stamped accepted by the bank. By accepting the draft, the bank makes an unconditional promise to pay the holder

of the draft a stated amount at a specified date.

If the bank pays foreign exporters bank for the acceptance before the maturity date, the bank can either hold the acceptance

as investment until it matures or sell the bankers acceptance in

the secondary market and are, thus, a source of financing for the

bank.

Thus, BA sales to the secondary market are an additional

funding source.

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Commercial Papers

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.

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Medium-Term Notes and Discount Window Loans

A number of DIs in search of more stable sources of funds with

low withdrawal risk have begun to issue medium-term notes,

often in the five- to seven-year range. These notes are

additionally attractive because 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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Best Strategy of Liability Management

Too heavy a reliance on borrowed funds can be a risky strategy

in itself.

Even though withdrawal risk may be reduced if lenders in the market for borrowed funds have confidence in the borrowing DI,

perceptions that the DI is risky can lead to sudden nonrenewals of

fed funds and RP loans and the nonrollover of wholesale CDs and

other purchased funds as they mature.

Thus, excessive reliance on borrowed funds may be as bad an

overall liability management strategy as excessive reliance on

transaction accounts and passbook savings.

A well-diversified portfolio of liabilities may be the best strategy to

balance withdrawal risk and funding cost considerations.

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IMPLEMENTATION OF MONETARY POLICY

IN THE US AND AUSTRALIA

Supplemental Materials

57

Open Market Operations in the U.S.

The Federal Open Market Committee (FOMC), a committee

within the Federal Reserve, establishes the target for the federal

funds rate and oversee the open market operations (i.e., the

Fed's buying and selling of United States Treasury securities) to

keep the federal funds rate within a narrow band of the target.

The FOMC holds eight regularly scheduled meetings per year.

Open market operations is a main tool of U.S. monetary policy.

Changes in the federal funds rate trigger a chain of events that

affect other short-term interest rates, foreign exchange rates,

long-term interest rates, the amount of money and credit, and,

ultimately, a range of economic variables, including employment,

output, and prices of goods and services.

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Federal Funds Target Rate

59

Domestic Market Operations in Australia

The Reserve Bank Board's operational target for monetary policy

is the cash rate the rate at which banks borrow and lend to each other on an overnight, unsecured basis.

To meet the Board's target, the Reserve Bank operates in

financial markets to maintain an appropriate level of exchange

settlement (ES) balances. ES balances are liabilities of the Bank

and are used by financial institutions to settle their payment

obligations with each other and with the Bank.

The Bank pays interest on ES balances at a rate 25 basis points

below the Board's cash rate target. ES account holders are not

permitted to overdraw their accounts, although the Bank is willing

to advance overnight funds, against appropriate securities, to

account holders at an interest rate 25 basis points above the

cash rate target.

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RBA Cash Rate

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