Chapter TwentyOne Managing Liquidity Risk on the Balance

Liquidity Risk Management • Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs) • At the extreme, liquidity risk can lead to insolvency • Some FIs are more exposed to liquidity risk than others – depository institutions (DIs) are highly exposed – mutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk Mc. Graw-Hill/Irwin 21 -2 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk Management • One type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claims – FIs must meet the withdrawals with stored or borrowed funds – alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices • A second type of liquidity risk arises when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holder – unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes – FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down Mc. Graw-Hill/Irwin 21 -3 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Depository Institutions • DIs’ balance sheets typically have – large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors – large amounts of relatively illiquid long-term assets such as commercial loans and mortgages • DIs know that normally only a small portion of demand deposits will be withdrawn on any given day – most demand deposits act as core deposits—i. e. , they are a stable and long-term funding source • Deposit withdrawals are normally offset by the inflow of new deposits Mc. Graw-Hill/Irwin 21 -4 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Depository Institutions • DI managers monitor net deposit drains—i. e. , the amount by which cash withdrawals exceed additions; a net cash outflow • DIs manage deposit drains with: – stored liquidity • relied on most heavily by community banks – purchased liquidity • relied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds Mc. Graw-Hill/Irwin 21 -5 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Depository Institutions • Purchased liquidity – allows FIs to maintain the overall size of their balance when faced with liquidity demands – purchased liquidity is expensive relative to stored liquidity – purchased liquidity includes: • interbank markets for short-term loans – fed funds – repurchase agreements • fixed-maturity certificates of deposits • notes and bonds Mc. Graw-Hill/Irwin 21 -6 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Depository Institutions • Stored liquidity – may involve the use of existing cash stores or the sale of existing assets – banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements – when managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes • Most DIs utilize a combination of stored and purchased liquidity management Mc. Graw-Hill/Irwin 21 -7 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Depository Institutions • Loan commitments and other credit lines can cause liquidity problems – as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity • If stored liquidity is used, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet • If purchased liquidity is used, the composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet Mc. Graw-Hill/Irwin 21 -8 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Measuring Liquidity Risk Exposure • The liquidity position of banks is measured by managers on a daily basis • A net liquidity statement lists sources and uses of liquidity • Peer group ratio comparisons are used to compare a bank’s liquidity position against its competitors – loans to deposit ratio – borrowed funds to total assets ratio – commitments to lend to assets ratio • Ratios are often compared to those of banks of a similar size and in the same geographic location Mc. Graw-Hill/Irwin 21 -9 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Measuring Liquidity Risk Exposure • The liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions where Mc. Graw-Hill/Irwin wi = the percent of each asset i in the FI’s portfolio Pi = the price it gets if an FI liquidates asset i today Pi* = the price it gets if an FI liquidates asset i under normal market conditions 21 -10 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Measuring Liquidity Risk Exposure • The financing gap is the difference between a bank’s average loans and average (core) assets – if the financing gap is positive, the bank must find liquidity to fund the gap • The financing requirement is the financing gap plus a bank’s liquid assets – a widening financing gap can be an indicator of future liquidity problems Mc. Graw-Hill/Irwin 21 -11 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Measuring Liquidity Risk Exposure • The BIS Approach: Maturity Ladder/Scenario Analysis – liquidity management involves assessing all cash inflows against cash outflows – the maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals – daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder – the BIS also suggests that DIs prepare for abnormal conditions using various “what if” scenarios Mc. Graw-Hill/Irwin 21 -12 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Planning • Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise – lowers the costs of funds by determining an optimal funding mix – minimizes the amount of excess reserves that a bank needs to hold – liquidity plan components • delineation of managerial responsibilities • list of fund providers most likely to withdraw funds and a pattern of fund withdrawals • identification of the size of potential deposit and fund withdrawals over various time horizons • internal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market Mc. Graw-Hill/Irwin 21 -13 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk • Major liquidity problems arise if deposit drains are abnormally large and unexpected • Abnormal deposit drains can occur because – concerns about a bank’s solvency – failure of another bank (i. e. , the contagion effect) – sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank deposits • A bank run is a sudden and unexpected increase in deposit withdrawals from a bank Mc. Graw-Hill/Irwin 21 -14 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk • Demand deposits are first-come, first-served contracts • The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system – a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole • Regulatory mechanisms are in place to ease banks’ liquidity problems and to deter bank runs and panics – deposit insurance – the discount window Mc. Graw-Hill/Irwin 21 -15 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Deposit Insurance • Guarantee programs offer depositors varying degrees of insurance protection to deter bank runs • Deposit insurance was first introduced in the U. S. in 1933 and gave coverage up to $2, 500 • Coverage was increased to $100, 000 by 1980 • Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI) • The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement account from $100, 000 to $250, 000 Mc. Graw-Hill/Irwin 21 -16 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Deposit Insurance • Individuals can achieve many times the $100, 000 ($250, 000) coverage cap on deposits by creatively structuring their deposits and by using multiple banks • The FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiums – the safest institutions now pay 5¢ per $100 of deposits – the riskiest institutions now pay 43¢ per $100 of deposits Mc. Graw-Hill/Irwin 21 -17 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

The Discount Window • The Federal Reserve also provides a “discount window” lending facility • Historically the borrowing rate was below market rates and borrowing was restricted • In 2003 the Fed increased the costs of borrowing but eased the terms – primary credit is available to generally sound DIs on a very short -term basis – secondary credit is available to less sound DIs (at a higher rate than primary credit) on a very short-term basis – seasonal credit assists small DIs in managing seasonal swings in their loans and deposits Mc. Graw-Hill/Irwin 21 -18 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Insurance Companies • Life insurance companies hold cash reserves and other liquid assets – to meet policy payments – to meet cancellation (surrender) payments • the surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early – to fund working capital needs which can be unpredictable • Property-casualty (P&C) insurance companies – the claims against P&C insurers are hard to predict – thus, P&C insurance companies have a greater need for liquidity than life insurance companies Mc. Graw-Hill/Irwin 21 -19 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity Risk and Mutual Funds • Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assets • However, the way MFs are valued reduces the incentive of fund shareholders to engage in banklike runs on any given day – assets are distributed on a pro rate basis (i. e. , rather than a first-come first-served basis) – losses are incurred to shareholders on a proportional basis Mc. Graw-Hill/Irwin 21 -20 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved