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Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University

Chapter 17

Liquidity Risk

2I. What is liquidity risk?I. What is liquidity risk?

the uncertainty that an FI will be unable to generate sufficient cash to meet cash outflows.

3II. What creates liquidity risk? II. What creates liquidity risk?

Liquidity risk is derived from the balance sheet .

4Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Liability side reasons involve liability holders (i.e., depositors) cashing in their financial claims (i.e. deposits).

5Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2400Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $2,700

Assets Liabilities

Deposits went down by $300 because of withdrawals

$

$

$

6Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2400Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $2,700

Assets Liabilities

A positive net deposit drain occurs when a FI receives insufficient additional deposits to offset deposit withdrawals.

$

$

$

7Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2400Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $2,700

Assets Liabilities

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

8Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Asset side reasons involve demands from those holding loan commitments.

9Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2600 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Asset side reasons involve demands from those holding loan commitments.

$

$

10III. What are the sources for meeting liquidity needs?

III. What are the sources for meeting liquidity needs?

A. Purchasing liquidity using the markets for purchased funds is a liability management tool.

111. What instruments are involved?1. What instruments are involved?

a) Federal funds marketb) Repurchase Agreements (Repo)

marketc) Wholesale (Negotiable) Certificates of

Deposit

a) Bankalararası Para Piyasasıb) T.C. Merkez Bankası Kredileric) Repo

122.What is the effect on the balance sheet?

2.What is the effect on the balance sheet?

Using purchased funds, there is no reduction in the size of the balance sheet.

13a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals),

a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals),

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2400Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total L and O E $2,700

Assets Liabilities

14……. one type of liability is being replaced with another and the size of the institution remains the same.

……. one type of liability is being replaced with another and the size of the institution remains the same.

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Fed Funds Purchase 300

Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total L and O E $3,000

Assets Liabilities

15

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Fed Funds Purchase 300

Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total L and O E $3,000

Assets Liabilities

BOYD decides to buy $ 300 in Fed Funds to 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

16b) If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ),

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 SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2600 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

17…..the additional assets are funded by additional liabilities and the size of the institution increases.

…..the additional assets are funded by additional liabilities and the size of the institution increases.

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Repos 300

Corporate Bonds 400Net Loans 2600 Total Liabilities 3000Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,300

Assets Liabilities

18III. What are the sources for meeting liquidity needs?

III. What are the sources for meeting liquidity needs?

B. Stored liquidity is an asset management tool where assets are reserved to be sold or used when cash is needed.

191. What instruments are involved?1. What instruments are involved?

a) Vault Cash b) Reserves at the Federal Reserve

Banksc) Securities such as Treasury Bills

202.What is the effect on the balance sheet?

2.What is the effect on the balance sheet?

Using stored liquidity, there is no growth in the size of the balance sheet.

21a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals),

a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals),

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2000Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2400Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total L and O E $2,700

Assets Liabilities

22…….both liabilities and assets are removed and the size of the institution contracts.

…….both liabilities and assets are removed and the size of the institution contracts.

Balance SheetThe Bank of your Dreams

Cash $50 Deposits 2000Securities 250 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $2,700 Total Owners’ Equity $300

Total L and O E $2,700

Assets Liabilities

23b) If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ),

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 SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2600 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

24…. one type of asset (i.e., loans) replaces another (i.e., cash and securities ) and the size of the institution remains the same.

…. one type of asset (i.e., loans) replaces another (i.e., cash and securities ) and the size of the institution remains the same.

Balance SheetThe Bank of your Dreams

Cash $50 Deposits 2300Securities 250 Corporate Bonds 400Net Loans 2600 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

25IV. How is a bank’s liquidity exposure measured?

IV. How is a bank’s liquidity exposure measured?

The methodologies include:

26A. 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.

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

27A. The net liquidity statement lists the sources and uses of liquidity.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)

28Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

BOYD has $50m in cash, $50 m in cash reserves at the Fed not needed to meet reserve requirements, $300m in Treasury bills, and, a $5m 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

29Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

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

30B. Peer group comparisons where ratio analysis is used.B. Peer group comparisons where ratio analysis is used.

What ratios are examined to make inferences about liquidity?

31Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

LoansDeposits

2300 2300

= = 1

32Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Borrowed FundsTotal Assets

400 3000

= = 13.3%

33Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

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.

34Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Loan Commitments Total Assets

300 3000

= =10%

35Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Loan Commitments Total Assets

300 3000

= =10%

Off-Balance Sheet Item

36Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2300 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

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.

37C. The liquidity index C. The liquidity index

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.

]*PP)w[(I

N

1i i

i

i

Where Pi = fire sale prices Pi*= fair market prices wi is the percentage of each

asset in the FI’s portfolio xi=1

38The liquidity IndexThe liquidity Index

The greater the differences between immediate fire-sale The greater the differences between immediate fire-sale asset prices and fair market prices, the less liquid the FI’s asset prices and fair market prices, the less liquid the FI’s portfolio of assets. portfolio of assets.

Example: 50 percent in one month t-bills and 50 percent in 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, 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 it will receive $99 per $100 of face value. If the FI had to liquidate its real estate loans today, it would receive $85 liquidate its real estate loans today, it would receive $85 per $100 of face value, while liquidation at the end of one per $100 of face value, while liquidation at the end of one month would be expected to produce $92 per $100 of month would be expected to produce $92 per $100 of face value. Thus, one month liquidity index value for this face value. Thus, one month liquidity index value for this FI’s asset portfolio would be; I=(1/2)[(.99/1.00)]FI’s asset portfolio would be; I=(1/2)[(.99/1.00)]+1/2[(.85/.92)]= 0.495+0.462= 0.957.+1/2[(.85/.92)]= 0.495+0.462= 0.957.

The liquidity index will always lie between 0 and maximum The liquidity index will always lie between 0 and maximum of 1. This index could also be compared to similar of 1. This index could also be compared to similar indexes for a peer group of similar Fis.indexes for a peer group of similar Fis.

39D. The Financing Gap and the Financing Requirement capture liquidity by examining the following relationships:

D. The Financing Gap and the Financing Requirement capture liquidity by examining the following relationships:

Financing Gap= Average Loans - Average Deposits

Financing Gap= -(liquid Assets) + Borrowed Funds

Financing Gap + Liquid Assets=Financing Requirement

40Financing Gap= Average Loans - Average DepositsFinancing Gap= Average Loans - Average Deposits

Balance SheetThe Bank of your Dreams

Cash $150 Deposits 2300Securities 450 Corporate Bonds 400Net Loans 2600 Total Liabilities 2700Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300

Total Liabilities and Owners Equity $3,000

Assets Liabilities

Financing Gap= 2600 - 2300= 300This must be funded by using liquid assets or borrowing

in the money market.

41V. What are the causes of unexpected deposit drains and and more severe bank runs?

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 deposit drains and and more severe bank runs?

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:

42V. What are the causes of unexpected deposit drains and and more severe bank runs?

V. What are the causes of unexpected deposit drains and 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

43V. What are the causes of unexpected deposit drains and and more severe bank runs?

V. What are the causes of unexpected deposit drains and 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

44V. What are the causes of unexpected deposit drains and and more severe bank runs?

V. What are the causes of unexpected deposit drains and 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

45B. The structure of the demand deposit claim is an underlying factor that magnifies reactions.

B. The structure of the demand deposit claim is an underlying factor that magnifies reactions.

Demand deposits are first come, first served contracts

46VI. What tools have regulators provided to deal with the liquidity-based instabilities of the banking system?

Regulatory mechanism

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.

47V!I. Do financial institutions, other than depository institutions, have liquidity risk problems?

V!I. Do financial institutions, other than depository institutions, have liquidity risk problems?

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 first-come, first-served incentives associated with other FIs’ contracts.