Chapter 7 Liquidity Risk: Causes and Consequences

1. Chapter 7Liquidity Risk: Causes and Consequences Business 4039

2. Important Terms Liquidity Liquidity risk High power money Fire-sale prices Notice deposits Core deposits Deposit drain Direct clearer Primary reserves Secondary reserves Buffer reserves Financing gap Core funds Financing requirement Bank run

3. Liquidity Risk Occurs if assets cannot be converted into cash quickly without substantial loss. As asset transformers, financial institutions are expected to expose themselves to liquidity risk.

4. Liquidity Risk Arises out of the mismatch between liquid liabilities and less liquid assets. It is exacerbated by insuring, lending or guaranteeing commitments that require use of cash upon notice (example is a customer having and then using a line of credit)

5. Distinguish Between Liquidity and Solvency Solvency is the degree to which assets exceed liabilities, and is therefore a function of the capital base of the FI Liquidity is the ability to meet maturing obligations as they come due.

6. Causes of Liquidity Risk Liability Side of the Balance Sheet Withdrawals of demand and notice deposits Policyholder cancellations Asset Side of the Balance Sheet Unexpected loan commitments Unexpected call on guaranteeds (ie. BAs)

7. Liquidity Crisis Planning Important to have a plan that managers can invoke at the onset of a crisis Planning can lower the cost of funds and minimize the amount of excess reserves a FI needs to hold. Has a number of components: Assigns task to key management personnel.. .areas of managerial responsibility in disclosing information to the public Detailed list of fund provides most likely to withdraw first. Identifies the size of potential runoffs over various time horizons in the future as well as private market funding sources to meet such runoffs. Internal limits on separate subsidiaries and branches, as well as bounds for acceptable risk premiums to pay in each market�and sequence of assets for disposal in anticipation of various degrees or intensities of deposit fund withdrawals.

8. Question 7 - 1 A BANK - Deposit and notice balances that are due upon demand fund less liquid loans. Retail deposits are likely to be stable notwithstanding the fact that legally their maturity is 1 day, because of the CDIC guarantee. Wholesale deposits are typically time deposits that cannot be withdrawn before maturity. Yet because they are not protected they will not be renewed if there are doubts about the soundness of the FI. A faltering FI�s portfolio of wholesale deposits can run off very quickly. A LIFE INSURANCE COMPANY - Any given actuarial liability could become an immediate claim, while the bulk of insurance company assets are long-duration securities. For a large portfolio of correctly priced insurance policies, this is a minor concern. A greater concern for an insurance company whose policy holders fear that the company�s health is questionable is failure to renew and withdrawal of the cash value of whole life policies.

9. Question 7 - 1�. A Pension Fund - Here, the greatest risk concerns employees who are terminated or leave the company prior to retirement and require the cash value of their contributions paid out to them immediately. Since the assets of the pension fund are in long term investments, there may be a lack of liquidity to satisfy this need. A Mutual Fund - If the securities in mutual fund portfolios trade in insufficiently liquid markets, large scale redemptions of mutual fund units (reacting, say, to a stock market fall) may depress the asset values of the securities, causing losses for the redeeming unitholders by lowering the NAV of the units.

10. Question 7 - 2 A Bank - Banks are able to predict liquidity needs fairly accurately. Most deposits form a core stable deposit base. CDIC deposit insurance removes the incentive for a retail depositor run. Bank of Canada as the lender of last resort stands ready to provide unlimited liquidity to solvent FIs. A Life Insurance Company - Actuarial liabilities can be estimated with high accuracy for large portfolios of contracts. CompCorp provides liability insurance for all retail life insurance contracts, removing the incentive for runs. There are significant cost penalties and inconveniences with changing one�s life insurance company, so consumers are likely not to run. A Pension Fund - Payouts from early retirements and dismissals are likely to be small in relation to the entire plan in most instances. Large payouts associated with downsizings are usually anticipated some time in advance, allowing the orderly liquidation of longer term investments.

11. Question 7 - 2... A Mutual Fund - Because the value of a mutual fund�s shares are determined with respect to the market value of the securities in its asset portfolio, liquidity risk does not exist to nearly the same degree for mutual funds as for deposit-taking FI. Since pay-out is not conditional upon sequence of withdrawal, serious liquidity problems of runs are absent.

12. Question 7 - 3 It has increased the complexity of liquidity management because contingencies may require funding. This contingent funding need must be included in the liquidity plan. For credit-substitute off-balance-sheet activities such as guarantees, loan commitments and LCs, one must predict the likelihood and timing of exercise and the cash needs resulting from exercise. Forward contracts have known cash flows. Futures involve unknown daily payments from marking to market. Options sold may be exercised, involving an unexpectedly liquidity need. The rapid increase in the use of derivatives has highlighted these risks.

13. Question 7 - 4 Pros - The peer group method is easy and inexpensive to implement. It gives a picture of current practices in the industry for similar institutions. Cons - The analysis is constrained by the low explanatory power of the simple balance sheet ratios used to proxy for liquidity risk. These ratios are typically calculated using book values rather than market values (since the latter are generally unavailable). Moreover, just because a ratio attains an average value for a peer group does not mean that this is the optimal value. There is a problem with a benchmark that is simply the average of observed practice.

14. Question 7 - 6 A. Both interest rate risk and liquidity risk concern the timing of asset returns relative to liability returns. Both use gapping to measure the risks. Liquidity risk measurement uses the financing gap that is concerned with maturities of assets and liabilities. Interest rate risk measurement uses the interest rate gap that is concerned with the time to repricing of an asset or liability. If an FI exactly match-funds its assets and liabilities in terms of maturity, cash flows and (interest rate) repricing, both interest rate risk and liquidity risk is eliminated. B. The level of prices does not affect FI liquidity. Expectations of changes in price levels may affect liquidity. High inflation expectations relative to interest rates (ie. Negative real interest rates) will cause increased loan demand (and loan drawdowns) and will reduce the demand for deposits. This would decrease FI liquidity.

15. Problem 7 - 1 If the bank purchases liabilities then the new balance sheet is: Balance Sheet (in millions $) Assets Liabilities Cash $10 Core Deposits $ 53 Loans 50 Purchased liabilities 15 Securities 15 Equity 7 If the bank uses reserve asset adjustment, a possible balance sheet: Balance Sheet (in millions $) Assets Liabilities Cash $0 Core Deposits $ 53 Loans 50 Securities 10 Equity 7

16. Problem 7 - 2 A. Net liquidity Position = Sources - Uses = ($1 + $3 + $.5 + .3) - ($1.5 + 0) = $3.3 billion B. Net liquidity Position = ($.55 + $ 1 + $.1) - ($1.5 + .10) = $.05 billion C. Which FI has greater liquidity risk?