1. Introduction

2. 1. Introduction • This chapter explores the problem of liquidity risk faced to a greater or lesser extent by all FIs. • Liquidity concerns continue to be a factor affecting recovery from the financial crisis. • Methods of measuring liquidity risk and its consequences are discussed. • The chapter also discusses the regulatory mechanisms put in place to control liquidity risk. • Liquidity risk is a normal aspect of the everyday management of an FI. • Only in extreme cases do liquidity risk problems develop into solvency risk problems.

3. Introduction • All FIs are not exposed to that risk at the same level. • High exposure • Depository institutions • Loss of confidence in bank-to-bank lending affects liquidity in other markets • Moderate exposure • Life insurance companies • Low exposure • Mutual funds, hedge funds, pension funds, and property-casualty insurance companies. • Typically low, does not mean zero

4. 2. Causes of Liquidity Risk • There are liability side reasons and asset side reasons. • Liability-side liquidity risk when depositors or policyholders cashin claims (rights) • FI need to borrow additional funds or sell assets to meet the withdrawal. • With low cash holdings, FI may be forced to liquidate assets too rapidly (or need to borrow) • Faster sale may require much lower price (fire sale price) • Asset-side liquidity risk can result from OBS loan commitments • A borrower uses its loan commitment, then FI must fund the loan immediately, creating a demand for liquidity. • Liquidity requirements from take down of funds can be met by running down cash assets, selling liquid assets, or additional borrowing

5. 3. Liquidity Risk at Depository Institutions • Management and measurement of the Liability and Assets are different. • Liability-side liquidity risk management • Purchased liquidity management • Stored liquidity management • Asset-side liquidity risk management • Sources and Uses of Liquidity • Peer Group Ratio Comparisons • Liquidity Index • Financing Gap and the Financing Requirement • BIS Approach: Maturity Ladder/Scenario Analysis • Liquidity Planning

6. 3.1 Liability-side Liquidity Risk for DIs • Reliance on demand deposits (large amount of short term liabilities) • Cash assets are very little comparing to total deposits.

7. Liability-side Liquidity Risk for DIs • Core deposits is the key (with a long term funding source) • Depository institutions need to be able to predict the distribution of net deposit drains (the difference between deposit withdrawals and deposit additions) on a given day. • Seasonality effects in net withdrawal patterns • Large inflows of funds can be problem sometime: Early 2000s problem with low rates: Finding suitable investment opportunities for the large inflows • Managed by: • Purchased liquidity management • Stored liquidity management (traditionally relied on) • For a DI to be growing, it must have a mean or average deposit drain such that new deposit funds more than offset deposit withdrawals.

8. Purchased Liquidity Management • Federal funds market or repurchase agreement market are the markets to purchase liquidity. • Managing the liability side preservesasset side of balance sheet • Borrowed funds will likely be at higher rates than interest paid on deposits (an expensive solution as you have to pay market rates for low interest bearing deposits, that is unattractive) • Deposits are insured but borrowed funds not necessarily protected(for high risk FI availability might be a problem) • Regulatory concerns: • During financial crisis, wholesale funds were difficult and sometimes impossible to obtain

9. Purchased Liquidity Management • With this approach, FI can keep the size and composition of the assets of the balance sheet without disturbing them. • The higher the cost of purchased funds relative to the rates earned on assets, the less attractive this approach to liquidity management becomes. • Purchased Liquidity Management can insulate the asset side of the balance sheet from normal drains on the liability side of the balance sheet.

10. Stored Liquidity Management • Liquidate assets to meet withdrawals utilizing its stored liquidity. • In absence of reserve requirements, banks tend to hold reserves for that reason. (Example: In U.K. reserves ~ 1% or more) • Downsides: • Opportunity cost of holding excessive cash, or other liquid assets • Decreases size of balance sheet • Requires holding excess low return or zero return assets

11. Stored Liquidity Management • Both sides of the balance sheet will contract. • After 5 m$ deposit drain, the composition: • Combiningpurchased and stored liquidity management is possible.

12. 3.2 Asset Side Liquidity Risk • Risk from loan commitments and other credit linescan cause a DI liquidity problems. • Met either by borrowing funds and/or by running down reserves • Current levels of loan commitments are dangerously high • Commercial banks in particular have been increasing commitments over the past few years, presumably believing commitments will not be used • In 1994, unused commitments equaled 529% of the cash. In 2008, 1,015%. Fell back to 609% during the crisis. • What is the effect of $5 milion exercise of a loan commitment by a borrower? • DI must fund $5 million in additional loans on the balance sheet.

13. Asset Side Liquidity Risk • Below figure shows a $5 million exercise of a loan commitment by a borrower. • Finding 5m$ can be done either by purchased liquidity management (borrowing) or by stored liquidity management (decreasing the excess cash)

14. Asset Side Liquidity Risk • Liquidity risk can be affected from several issues: • Interest rate risk and market risk of the investment portfolio can cause values to fluctuate • Arguments that technological improvements have increased liquidity in financial markets. • Some argue that “herd” behavior may actually reduce liquidity • During the sell off, liquidity dries up and investment securities can be sold only at fire sale prices.

15. Asset Side Liquidity Risk • After a 5m$ decrease in the market value of investment portfolio, FI losses 5 million from the equity in both cases.

16. 3.3 Measuring Liquidity Exposure • 1- Net Liquidity Statement • This statement lists sources and uses of liquidity and provides a measure of a DI’s net position. • Sources of liquidity: (can be obtained in 3 ways) • (i) Cash type assets, (T-bills) • (ii) maximum amount of borrowed funds available, • (iii) excess cash reserves • Uses of liquidity • Borrowed or money market funds already utilized • Any amounts already borrowed from the Fed • This position can be tracked day by daybasis.

17. Measuring Liquidity Exposure • 2-Peer Group Comparisons • Usual ratios include borrowed funds/total assets,loan commitments/assets, etc. • if  have a high ratio that means that DI relies heavily on the short term money market not on core deposit fund loans. This could mean future liquidity problems if the DI is at or near its borrowing limits in the purchased funds market.  

18. Measuring Liquidity Exposure • 3-Liquidity Index • Developed by Jim Pierce at Fed, this index measure 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 under normal market sale conditions. • Weighted sum of “fire sale price” P, to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets • I = S wi(Pi /Pi*) • It will always between 0 and 1. This index can be calculated for a peer group of similar DIs. • The greater the differences between immediate fire sale asset prices (Pi) and fair market Prices (P*i) the less liquid is the DI’s portfolio of assets.

19. Measuring Liquidity Exposure • A DI has the following assets in its portfolioand their fire sale • $20 million in cash reserves with the Fed, %100 • $20 million in T-bills, %99 • $50 million in mortgage loans. %90 • If the assets need to be liquidated at short notice, the DI will receive only 99 percent of the fair market value of the T-bills and 90 percent of the fair market value of the mortgage loans. Estimate the liquidity index using the above information. • I = ($20m/$90m)(1.00) + ($20m/$90m)(0.99) + ($50m/$90m)(0.90) • = 0.942 • Market Price was 1 so, the the discount due to fire sale is 0.058

20. Measuring Liquidity Exposure • 4-Financing Gap and Financing Requirement • Financing gap is the difference between a DI’s average loans and average (core) deposits. • Financing gap = Average loans - Average deposits, • If financing gap is positive that means you need FUND • Financing gap = - Liquid assets + borrowed funds • Rewriting this: • financing gap + liquid assets = financing requirement • The gap can be used in peer group comparisons or examined for trends within an individual FI • In particular, the larger a DI’s financing gap and liquid asset holdings, the larger the amount of funds it needs to borrow in the money markets and the greater is its exposure to liquidity problems from such a reliance.

21. Measuring Liquidity Exposure • Financing gap = Average loans - Average deposits, 5 = 25 - 20 • financing gap + liquid assets = financing requirement • $5 million +$5 million= $ 10 million • A widening gap can warn of future liquidity problems. • Assets are increasing due to increased exercise of loan commitments. A widening financing gap can warn of future liquidty problems.

22. 5-BIS Approach: Maturity Ladder/Scenario Analysis • For each maturity, assess all cash inflows versus outflows • Daily and cumulative net funding requirements can be determined in this manner • Managers can then influence the maturity of transactions to fill gaps • Must also evaluate “what if” scenarios in this framework (cautions about managing in abnormal conditions ) • For further information on the BIS maturity ladder approach, visit: www.bis.org

23. BIS Approach: Maturity Ladder/Scenario Analysis • Excess cash of $4 million is available for 1 day time horizon. But, a cumulative shortfall of $46m. over the next month. • Planning is required to fill this net funding requirement. • Over the 6 months excess cash of $1,104 million must be invested.

24. BIS Approach: Maturity Ladder/Scenario Analysis • Cumulative Excess or Shortages of Funds for a High quality DI under Various Market Conditions

25. Liquidity Planning • Make funding decisions before liquidity problems arise: Therefore; • Lower the cost of funds by planning an optimal funding mix • Minimize the need for reserve holdings • There are some components of a liquidity plan. They are: • Delineate (describe) managerial responsibilities • Detailed list of funds providers, • Identify size of potential deposit and fund withdrawals over various future time horizons • Set internal limits on subsidiaries’ and branches’ borrowings and limits on risk premiums for funding sources • Plan the sequence of asset disposal to meet liquidity needs

26. 3.4 Liquidity Risk, Unexpected Deposit Drains, Bank Runs • Anticipated needs are not unexpected deposit drains. (summer, christmast, seasonal effects etc.) • Any sudden and unexpected surges in net deposit witdrawals risk triggering a bank run that could eventually force a bank into solvency. • Major liquidity problems can arise if deposit drains are abnormally large and unexpected due to concern about: • Bank solvency • Failure of a related FI • Sudden changes in investor preferences • Demand deposits are first come, first served • Bank panic: Systemic or contagious bank run [a sudden and unexpected increase in deposit withdrawels from a DI]

27. Alleviating(Reducing) Bank Runs • Regulatory mechanisms/measures to reduce likelihood of bank runs are in effect. • Discount window • FDIC (or Deposit Insurance) • Direct actions such as Troubled Asset Relief Program (TARP) (2008-2009) • Fed lending to investment banks in the crisis. First time in its history. (not only depository FIs but also investment banks) • Reducing bank risk is okay but not without economic costs • Protections can encourage DIs to increase liquidity risk

28. 4. Liquidity Risk for Life Insurance Cos. • Concerns about the solvency of an insurer can result in a run, new premium income dries up and existing policyholders seek to cancel their policies by cashing them in early. • The early cancellation of an insurance policy results in the insurer’s having to pay the insured the surrender value of that policy. • Insurance companies need to cash some assets if the premium income is not sufficiant. • Life insurance hold reserves such as government bonds as a buffer to offset policy cancellations.

29. 5. Liquidity Risk for Property Casualty Insurers • PC Insurers sell policies insuring against certain contingencies impacting either real property or individuals. • Claims are not predictable so that they should have relatively short term assets and more than those of life insurers. • As a result, problem is less severe for PC insurers since assets tend to be shorter term and more liquid • However, large unexpected claims can be problematic • Hurricane Andrew and Hurricane Katrina precipitated severe liquidity crises for many insurers • Near failure of giant insurer, AIG (2008) • Credit default swaps / Restructuring and government bailout

30. 6. Investment Funds • Investment funds (mutual funds hedge funds) sell shares as liabilities to investors and invest the proceeds in assets such as bonds and equities. • It depends if an investment fund is closed end or open end fund. • In the case of a liquidity crisis in DIs and insurance firms, there are incentives for depositors and policyholders to withdraw their money or cash in their policies as early as possible. • Latecomers will be penalized because the financial institution may be out of liquid assets. They will have to wait until the institution sells its assets at fire-sale prices, resulting in a lower payout. • In the case of investment funds, the net asset value for all shareholders is lowered or raised as the market value of assets change, so that everybody will receive the same price if they decide to withdraw their funds.Hence, the incentive to engage in a run is minimized. •  Closed-end funds are traded directly on stock exchanges, and therefore little liquidity risk exists since any fund owner can sell the shares on the exchange. • An open-end fund is exposed to more risk since those shares are sold back to the fund which must provide cash to the seller.

31. Investment Funds • The mutual fund shareholder knows that their loss of asset value on a pro rata bases. (proportional)

32. Summary • Liquidity risk is a common problem faced by FI managers. • Very large withdrawals can cause asset liquidity problems that can be compounded by incentives for liability claim holders to engage in runs. • Insolvencies have costs to society as well as to private shareholders. • Regulators have developed mechanisms such as deposit insurance and the discount window to alleviate liquidity problems. • These will be discussed in another chapter.