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Chapter 13. Liquidity Risk and Liability Management. Learning Objectives: 1. To understand the importance of liquidity to banks and to the economy 2. To distinguish between core deposits and managed (volatile) liabilities 3. To understand the tradeoff between liquidity and profitability

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chapter 13 liquidity risk and liability management
Chapter 13. Liquidity Risk and Liability Management
  • Learning Objectives:
    • 1. To understand the importance of liquidity to banks and to the economy
    • 2. To distinguish between core deposits and managed (volatile) liabilities
    • 3. To understand the tradeoff between liquidity and profitability
    • 4. To understand how to measure bank liquidity

Chapter 13

learning objectives cont and chapter theme
Learning Objectives(cont.) and Chapter Theme
  • 5. To understand securitization as a tool of liquidity and risk management
  • Chapter Theme
    • Banks need liquidity to meet deposit withdrawals and to satisfy customer loan demand. This liquidity can be stored in banks’ balance sheets or purchased in the marketplace. Being too liquid, however, is costly and not having enough liquidity is risky. As a tool of risk management, securitization permits banks to remove risk from their balances sheets and generate liquidity.

Chapter 13

the importance of liquidity
The Importance of Liquidity
  • Consider these headlines from the American Banker
  • Viewpoint: Too Many Banks Aren’t Ready for Looming Liquidity Crisis
  • Spare Change: Liquidity Steering Group Going in Circles
  • In Focus: Liquidity Rivaling Credit Quality as Crisis du Jour

Chapter 13

lemac the inverted camel
LEMAC: The Inverted CAMEL
  • L = Liquidity
  • E = Earnings
  • M = Management
  • A = Asset Quality
  • C = Capital Adequacy

Chapter 13

recent liquidity episodes
Recent Liquidity Episodes
  • The aftermath of the “Attack on America”
  • The bailout of LTCM
  • The stock market of 1987
  • Contrast these events with what the Fed did after the stock-market crash of 1929

Chapter 13

discussion topic quote from john reed 1987
Discussion Topic: Quote from John Reed (1987)
  • We were providing as much liquidity as we could. Quite a few of the firms went right up to their loan limits. We didn't take physical possession of securities, but we were damn close to our customers. You have a tremendous conflict there. On one hand, there's a need for liquidity in the system. On the other hand, when you're dealing in $100 million lot sizes, you can't afford to be wrong. We can't take a $100 million write-off to save a broker. The stockholders would lynch me and with good reason.

Chapter 13

the role of confidence
The Role of Confidence
  • A confidence function:
    • Net worth (+)
    • Stability of earnings (+)
    • Quality of information (+)
    • Government guarantees (+)
    • Liquidity (+)

Chapter 13

the evolution of liquidity management
The Evolution of Liquidity Management
  • Commercial-loan theory or real-bills doctrine (1920s and earlier)
    • Asset-conversion or shiftability approach (post World War II through 1940s)
    • Anticipated-income theory (1950s)
  • Liability management (late 1960s and early 1970s)
  • Asset-liability management and securitization (mid-1970s to mid-1990s)
  • Risk management (mid-1990s to present)

Chapter 13

the instruments of liability management lm see box 13 1
The Instruments of Liability Management (LM, see Box 13-1)
  • Federal funds
  • Repurchase agreements (RPs, repos)
  • Negotiable CDs
  • Consumer CDs
  • Brokered deposits
  • Eurodollar CDs
  • Global CDs

Chapter 13

lm instruments continued
LM Instruments (continued)
  • MMDAs
  • IRAs
  • Commercial paper
  • Notes and debentures
  • Volatile liabilities

Chapter 13

chrysler financial corporation case study of a liquidity crisis
Chrysler Financial Corporation:Case Study of a Liquidity Crisis
  • Year-end 1989 financial profile:
  • CP outstanding = $10.1 billion
  • Equity capital (E) = $2.8 billion
  • Total assets (A) = $30.1 billion
  • CP/A = 33.5%
  • E/A = 9.3% or EM = 10.75
  • Note: CP = commercial paper

Chapter 13

the credit event
The Credit Event
  • In 1990, Chrysler’s commercial paper (CP) was downgraded from P-2 to P-3 and subsequently to N.P. ( Not Prime) and its long-term bond rating was lowered from Baa to Ba
  • Under these conditions, Chrysler’s CP was not attractive to the money market at rates that Chrysler was willing to pay, that is, it would have to pay a premium to obtain refinancing

Chapter 13

cp background orderly exit and asset sales
CP Background:Orderly Exit and Asset Sales
  • Bank back-up lines of credit, standby letters of credit, and medium-term note facilities
  • Asset sales

Chapter 13

lines of credit vs standby letters of credit
Lines of Credit vs. Standby Letters of Credit
  • Since bank line-of-credit (LOC) contracts typically contain material-adverse-change (MAC) clauses, they are not guarantees and they have annual clean-up and rate resets. Strength of customer relation is important.
  • In contrast, a standby letter of credit virtually guarantees payment, i.e., the bank will pay off the issue if the borrower cannot.

Chapter 13

chrysler s strategy
Chrysler’s Strategy
  • An aggressive program of asset sales and securitization

Chapter 13

the rest of the story
“The rest of the story ...”
  • Immediate cash shortfall is met by borrowing $1.3 billion under its parent company’s banks’ lines of credit
  • By year-end 1990, CP outstanding is $1.1B, a decrease of $9B
  • Sales of receivables in 1990 generates $18.3B
  • Year-end 1990 assets total $24.7B with equity of $2.8B (capital ratio of 11.3%)

Chapter 13

the story continues
The story continues ...
  • To repay maturing debt of $3.6B in 1991 and $3B in 1992, Chrysler continued its asset-sales strategy.

Chapter 13

epilogue
Epilogue
  • At year-end 1996, CFC was servicing $39.1B of receivables (94% auto related) up from $22.5B at year-end 1992. Other data for 1996 are:
  • CP = $2.6B, Senior term debt = $8.4B, NI = $0.376B, TA = $17.5B, E = $3.288B
  • ROE profile: ROE = ROA x EM
  • 0.1144 = 0.0215 x 5.32

Chapter 13

discussion of other cases
Discussion of other Cases
  • First National Bank of Browning, Montana (1980)
  • Continental Illinois (Chicago, 1984)
  • Bank of New England (1991)
  • REBs and FHLB Advances

Chapter 13

liquidity versus profitability
Liquidity Versus Profitability
  • Given a positively sloped yield curve, short-term rates < long-term rates
  • Short-term assets are safer while longer-term assets are riskier
  • When the yield curve is inverted, safer assets have higher returns but such rates are expected to decline based on the expectations theory

Chapter 13

discussion questions
Discussion Questions
  • Explain the basic yield-curve shapes and the embodied tradeoffs
  • Over the interest-rate/business cycle, how does the yield curve move? How do bank loan and deposit flows move?
  • Distinguish between stored liquidity and purchased liquidity

Chapter 13

effective liquidity management
Effective Liquidity Management
  • Confidence
  • Maintaining relationships
  • Avoiding “fire sales”
  • Cost of capital and default-risk premiums
  • Avoiding the Fed’s discount window

Chapter 13

core deposits versus managed liabilities
Core Deposits Versus Managed Liabilities
  • Core = sum of interest-bearing deposits in domestic offices minus large time deposits in domestic offices plus domestic demand deposits
  • Core deposits are relatively stable funds gather in local markets
  • They vary inversely with bank size

Chapter 13

managed liabilities
Managed Liabilities
  • Managed liabilities have four components:
    • Interest-bearing deposits in foreign offices
    • Large time deposits in domestic offices
    • FF purchased/Repos
    • Other interest-bearing liabilities
  • “Hot money” is volatile and use of it varies directly with bank size

Chapter 13

types of interest bearing liabilities
Types of Interest-Bearing Liabilities
  • Savings accounts
  • Small time deposits
  • Large time deposits
  • Deposits in foreign offices
  • FF purchases and RPs
  • Discuss use of these funds by banks of various sizes

Chapter 13

noninterest bearing liabilities
Noninterest-Bearing Liabilities
  • Why do banks hold such funds?
  • How have these funds varied over time?
  • What forces have been driving these trends?

Chapter 13

the cost of bank funds
The Cost of Bank Funds
  • Distinguish and discuss the following pairs of terms with respect to cost:
    • Foreign vs. domestic
    • Core vs. managed liabilties
    • Explicit vs. implicit interest
    • Eras of interest-bearing checking accounts:
      • Pre-1933
      • 1933-1980
      • Post 1980

Chapter 13

a bank s weighted average marginal cost of funds
A Bank’s Weighted Average Marginal Cost of Funds
  • Source of funds (as a % of balance sheet)
  • Interest cost
  • Operating cost
  • Total cost
  • Weighted cost
  • Weighted average

Chapter 13

example no operating costs
Example (no operating costs)
  • SourceAmtCostWeighted cost
  • Deposits .85 5% 4.25%
  • Nondep.debt 0.05 7% 0.35%
  • Equity* .1014%1.40%
  • Weighted 1.00 6.00%
  • *Shareholder required return

Chapter 13

market discipline and cost of funds
Market Discipline and Cost of Funds
  • Since riskier banks will have to pay more for funds than safer banks, bank should want to signal/demonstrate to money and capital markets that they are safe (e.g., have adequate capital – the K in TRICK)
  • To the extent that banks engage in cost plus pricing, they might just ignore this discipline with respect to the costs of deposits and nondeposit debt; however, higher shareholder required returns and lower stock values should get managers’ attention

Chapter 13

measures of bank liquidity
Measures of Bank Liquidity
  • Sources and uses of funds
  • Large-liability dependence
  • Various ratios (to assets)
    • Core deposits
    • Loans
    • Temporary investments
  • Other ratios: Loans to deposits, pledged securities, brokered deposits, market to book (of securities)

Chapter 13

the dynamics of liquidity management
The Dynamics of Liquidity Management
  • Role of expectations
  • Properties of time series data
  • Forecasting techniques

Chapter 13

the three faces of liability management
The Three Faces of Liability Management
  • Minimize interest expense
    • Segment markets
  • Meeting loan demand to enhance customer relationships
  • Desire to reduce regulatory burdens associated with reserve requirements and deposit-insurance fees (and Reg Q when it existed)

Chapter 13

the risks of liability management
The Risks of Liability Management
  • Maintaining the confidence of the marketplace is critical
  • Government guarantees help and may even thwart market discipline – “hot money,” however, tends to run and it does so electronically in today’s world

Chapter 13

chapter summary
Chapter Summary
  • The importance and interaction of liquidity and confidence are captured by the following statements:
    • "Liquidity always comes first; without it a bank doesn't open its doors; with it, a bank may have time to solve its basic problems" (Donald Howard, Chief Financial Officer, Citicorp).

Chapter 13

summary continued
Summary (continued)
  • "Our whole financial system runs on confidence and not much else when you get down to it. What we've learned is that when confidence erodes, it erodes very quickly" (L. William Seidman, former Chairman, FDIC).

Chapter 13

summary continued37
Summary (continued)
  • On the topic of liquidity and the availability of capital, also consider, this by David Ruder, former chairman of the SEC, following the stock market crash of October 1987 :
    • "I personally regard that question is probably the most important one to come out of the market decline.

Chapter 13