1 Chapter 17 Liquidity Risk Power Point Presentation

1 Chapter 17 Liquidity Risk Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University

I. What is liquidity risk? the uncertainty that an FI will be unable to generate sufficient cash to meet cash outflows. 2

II. What creates liquidity risk? Liquidity risk is derived from the balance sheet. 3

4 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 Liability side reasons involve liability holders (i. e. , depositors) cashing in their financial claims (i. e. deposits).

5 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities 2000 400 2400 Owner’s Equity Total Owners’ Equity $300 Total Liabilities and Owners Equity $2, 700 Deposits went down by $300 because of withdrawals $ $ $

6 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 Deposits Corporate Bonds Total Liabilities 2000 400 2400 100 Owner’s Equity $3, 000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $2, 700 A positive net deposit drain occurs when a FI receives insufficient additional deposits to offset deposit withdrawals. $ $ $

7 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 Deposits Corporate Bonds Total Liabilities 2000 400 2400 100 Owner’s Equity $3, 000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $2, 700 $ $ $ BYOD decides to sell $ 300 of its securities to meet the drain. The cost of deposits is 5% and the return on securities is 6%. What is the cost for BYOD? Cost of drain= (. 06 -. 05)(300)= $3

8 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 Deposits Corporate Bonds Total Liabilities 2300 400 2700 100 Owner’s Equity $3, 000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3, 000 Asset side reasons involve demands from those holding loan commitments.

9 Balance Sheet The Bank of your Dreams Assets $ $ Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2600 100 $3, 300 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 Asset side reasons involve demands from those holding loan commitments.

III. What are the sources for meeting liquidity needs? 10 A. Purchasing liquidity using the markets for purchased funds is a liability management tool.

1. What instruments are involved? 11 va) vb) vc) Federal funds market Repurchase Agreements (Repo) market Wholesale (Negotiable) Certificates of Deposit va) vb) vc) Bankalararası Para Piyasası T. C. Merkez Bankası Kredileri Repo

12 2. What is the effect on the balance sheet? Using purchased funds, there is no reduction in the size of the balance sheet.

13 a) If the need for liquidity is derived from the liability side of the balance sheet (i. e. , deposit withdrawals), Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities 2000 400 2400 Owner’s Equity Total Owners’ Equity Total L and O E $300 $2, 700

……. 14 one type of liability is being replaced with another and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Assets Liabilities Cash Securities $150 450 Net Loans Premises & Fixed Assets Total Assets 2300 100 $3, 000 Deposits Fed Funds Purchase Corporate Bonds Total Liabilities 2000 300 400 2700 Owner’s Equity Total Owners’ Equity Total L and O E $300 $3, 000

BOYD decides to buy $ 300 in Fed Funds to 15 cover the drain. The cost of Fed Funds is 5. 5%, but this allows BOYD to keep securities earning 6%. What is the cost for BOYD? Cost of drain= (. 055 -. 05)(300)= $1. 5 Balance Sheet The Bank of your Dreams Assets Liabilities Cash Securities $150 450 Net Loans Premises & Fixed Assets Total Assets 2300 100 $3, 000 Deposits Fed Funds Purchase Corporate Bonds Total Liabilities 2000 300 400 2700 Owner’s Equity Total Owners’ Equity Total L and O E $300 $3, 000

16 b) If the need for liquidity is derived from the asset side of the balance sheet (i. e. , the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2600 100 $3, 300 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000

…. . the additional assets are funded by additional liabilities and the size of the institution increases. Balance Sheet The Bank of your Dreams Assets Liabilities Cash Securities $150 450 Net Loans Premises & Fixed Assets Total Assets 2600 100 $3, 300 Deposits Repos Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 3000 $3, 300 17

III. What are the sources for meeting liquidity needs? 18 B. Stored liquidity is an asset management tool where assets are reserved to be sold or used when cash is needed.

1. What instruments are involved? va) vb) vc) 19 Vault Cash Reserves at the Federal Reserve Banks Securities such as Treasury Bills

20 2. What is the effect on the balance sheet? Using stored liquidity, there is no growth in the size of the balance sheet.

21 a) If the need for liquidity is derived from the liability side of the balance sheet (i. e. , deposit withdrawals), Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities 2000 400 2400 Owner’s Equity Total Owners’ Equity Total L and O E $300 $2, 700

……. 22 both liabilities and assets are removed and the size of the institution contracts. Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $50 2300 100 $2, 700 Deposits Corporate Bonds Total Liabilities 2000 400 2700 Owner’s Equity Total Owners’ Equity Total L and O E $300 $2, 700

23 b) If the need for liquidity is derived from the asset side of the balance sheet (i. e. , the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2600 100 $3, 300 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000

…. one type of asset (i. e. , loans) replaces 24 another (i. e. , cash and securities ) and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $50 2600 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000

IV. How is a bank’s liquidity exposure measured? The methodologies include: 25

26 A. The net liquidity statement lists the sources and uses of liquidity. A FI manager must be able to measure its liquidity position on a daily basis, if possible. What are the sources of liquidity? a) Cash-type assets (i. e. , T-bills) that can be sold. b) The maximum amount of funds the bank can borrow on the money/purchased funds market. c) Excess cash reserves not needed to meet regulatory reserve requirements

A. The net liquidity statement lists the sources and uses of liquidity. 2. What are the uses of liquidity? A) Deposit withdrawals B) The increase in loans That have already been met by drawing down sources of liquidity (i. e. Borrowing in the fed funds market or from the discount window) 27

28 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 BOYD has $50 m in cash, $50 m in cash reserves at the Fed not needed to meet reserve requirements, $300 m in Treasury bills, and, a $5 m line of credit to borrow in the repo market. What is the $ amount of their sources of funds? Sources of liquidity= 50+50+300+5=$405 million

29 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 BOYD has repos of $3 million. What is their $ uses of liquidity? Uses of Liquidity= $3 million What is their net liquidity position? Net Liquidity= $405 - $3 million = $402 million

B. Peer group comparisons where ratio analysis is used. What ratios are examined to make inferences about liquidity? 30

31 Balance Sheet The Bank of your Dreams Assets Liabilities Cash Securities Net Loans Premises & Fixed Assets Total Assets Loans Deposits $150 450 2300 100 $3, 000 = Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 = 1 2300 400 2700 $3, 000

32 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Borrowed Funds = Total Assets Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 400 3000 = 2300 400 2700 $3, 000 13. 3%

33 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 A high ratio of loans to deposits and borrowed funds to total assets means that the bank relies heavily on the short term money market rather than on deposits to fund loans. Maturity differences on loans and deposits will also be important to judge liquidity position of the bank.

34 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Loan Commitments Total Assets = Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 300 = 10% 3000

35 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Loan Commitments Total Assets Off-Balance Sheet = Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 300 = 10% 3000 Item

36 Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2300 100 $3, 000 Deposits Corporate Bonds Total Liabilities Owner’s Equity Total Owners’ Equity Total Liabilities and Owners Equity 2300 400 2700 $3, 000 A high ratio of loan commitments to assets indicates the need for a high degree of liquidity to fund any unexpected takedowns of these loans by customers.

C. The liquidity index 37 measures the potential losses suffered by an FI from the immediate sale of assets compared to the market value of the assets established under normal market conditions. Where Pi = fire sale prices Pi*= fair market prices wi is the percentage of each asset in the FI’s portfolio xi=1

The liquidity Index 38 The greater the differences between immediate fire-sale asset prices and fair market prices, the less liquid the FI’s portfolio of assets. Example: 50 percent in one month t-bills and 50 percent in real estate loans. If the FI has to liquidate its T-bills today, it will receive $99 per $100 of face value. If the FI had to liquidate its real estate loans today, it would receive $85 per $100 of face value, while liquidation at the end of one month would be expected to produce $92 per $100 of face value. Thus, one month liquidity index value for this FI’s asset portfolio would be; I=(1/2)[(. 99/1. 00)]+1/2[(. 85/. 92)]= 0. 495+0. 462= 0. 957. The liquidity index will always lie between 0 and maximum of 1. This index could also be compared to similar indexes for a peer group of similar Fis.

D. The Financing Gap and the Financing Requirement capture liquidity by examining the following relationships: 39 Financing Gap= Average Loans - Average Deposits Financing Gap= -(liquid Assets) + Borrowed Funds Financing Gap + Liquid Assets=Financing Requirement

Financing Gap= Average Loans - Average Deposits 40 Financing Gap= 2600 - 2300= 300 This must be funded by using liquid assets or borrowing in the money market. Balance Sheet The Bank of your Dreams Assets Cash Securities Net Loans Premises & Fixed Assets Total Assets Liabilities $150 450 2600 Deposits Corporate Bonds Total Liabilities 2300 400 2700 100 Owner’s Equity $3, 300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3, 000

V. What are the causes of unexpected deposit drains and more severe bank runs? 41 We are not talking about the expected drains, for instance banks can have seasonal anticipated needs for liquidity. Major liquidity problem arise if deposit drains are abnormally large and unexpected. Such deposit withdrawal shocks may occur following reasons:

V. What are the causes of unexpected 42 deposit drains and more severe bank runs? A. Explicit triggers include: 1. Public Concerns about a Bank’s Solvency 2. Failure of Similar or Related Banks (Contagion Effects) 3. Changes in Investor Preferences

V. What are the causes of unexpected 43 deposit drains and more severe bank runs? A. Explicit triggers include: 1. Public Concerns about a Bank’s Solvency 2. Failure of Similar or Related Banks (Contagion Effects) 3. Changes in Investor Preferences

V. What are the causes of unexpected 44 deposit drains and more severe bank runs? A. Explicit triggers include: 1. Public Concerns about a Bank’s Solvency 2. Failure of Similar or Related Banks (Contagion Effects) 3. Changes in Investor Preferences

B. The structure of the demand deposit claim is an underlying factor that magnifies reactions. Demand deposits are first come, first served contracts 45

46 VI. What tools have regulators provided to deal with the liquidity-based instabilities of the banking system? Regulatory mechanism A. Deposit Insurance provides protection for the insured depositor that deters runs. B. The discount window (of the Federal Reserve banks) exists to provide funds to institutions having liquidity problems to stabilize the banking system.

V!I. Do financial institutions, other than depository institutions, have liquidity risk problems? 47 A. Life Insurance companies have exhibited liquidity risk problems when concerns about the solvency of the insurer have occurred. B. Property-Casualty insurance companies have liquidity crises relating to disasters (i. e. , Hurricane Andrew) C. Mutual Funds exhibit more stability because mutual fund shares are distributed on a pro rata (proportional) basis at net asset value. (P= Value of assets / shares outstanding) thus eliminating the firstcome, first-served incentives associated with other FIs’ contracts.