Liquidity Risk • Liquidity risk deals with the everyday aspect of doing business. • Interest rate risk, credit risk, off balance sheet risk, operational risk all created solvency risk for the FI, liquidity risk generally does not. • Liquidity risk represents the risk of the FI not having enough short term liquidity to meet daily operational needs.
Causes of Liquidity Risk • Asset side • May be forced to liquidate assets too rapidly resulting n “fire sale prices” • May result from loan commitments • Traditional approach: reserve asset management • FI’s like to reduce cash since cash generally pays little or no interest • Alternative: liability management.
Causes of Liquidity Risk • Liability side • Reliance on demand deposits • Core deposits (provide long term source of funds) • Need to be able to predict the distribution of net deposit drains. • Managed by: • purchased liquidity management • stored liquidity management
Net Deposit Drains • Deposit withdraws are in part offset by the inflow of new funds and income generated by from both on and off balance sheet activities. • The amount by which the cash withdraws exceed the new cash inflows is the Net Deposit Drain. • Positive NDD implies withdraws are greater than inflows. Negative NDD implies that inflows are greater than withdraws
Net Deposit Drain • The decrease in liabilities must be offset with an increase in liabilities or a decrease in assets if new inflows do not replace the outflow of funding sources.
Net Deposit Drain • Predictable • Large commercial transaction accounts (payroll etc) • Maturing Investments • Unpredictable • Will customer reinvest maturing CD • Loan commitments
Balance Sheet Before the NDD Assets Liabilities Assets 100 Deposits 70 Borrowed Funds 10 Other 20 Total 100 100
Balance Sheet After the NDD Assets Liabilities Assets 100 Deposits 65 Borrowed Funds 10 Other 20 Total 100 95 The most likely way to fix the imbalance is for borrowed funds to increase by 5.
Liability Management • Purchased liquidity • Federal funds market or repo market. • Managing the liability side preserves asset side of balance sheet. • Borrowed funds likely at higher rates than interest paid on deposits. • Deposits are insured • Regulatory concerns: growth of wholesale fund use as investors have increasing investments and decreasing deposits.
Liability Management • Note the tradeoff between funding risk and funding cost. • Demand deposits are a source of cheap funds but there is high risk of withdrawal. • NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.
Deposit Accounts • Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month. • Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.
Time Deposits and CDs • Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable. • Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.
Fed Funds • Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. • Fed funds rate can be highly variable • Prior to July 1998: especially around the second Tuesday and Wednesday of each period. (as high as 30% and lows close to 0% on some Wednesdays). • Rollover risk
Repurchase Agreements • RPs are collateralized fed funds transactions. • Usually backed by government securities. • Can be more difficult to arrange than simple fed funds loans. • Generally below fed funds rate
Other Borrowings • Bankers acceptances • Commercial paper • Medium-term notes • Discount window loans
Liability ManagementBorrowing Funds • Advantages: • Volume and composition of asset portfolio doesn’t change • Can increase rate to attract funds • Only borrow IF funds are needed • Disadvantages • Market determines rate • Increased uncertainty of costs
Asset Based Management • Alternative: Stored Liquidity Management • Liquidate assets. • In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves. • Decreases size of balance sheet • Requires holding excess noninterest-bearing assets
Using Cash • The most obvious asset side management technique is to use the cash reserves of the firm.
Balance Sheet Before the NDD Assets Liabilities Cash 9 Deposits 70 Other 91 Borrowed Funds 10 Other 20 Total 100 100
Balance Sheet Before the NDD Assets Liabilities Cash 4 Deposits 65 Other 91 Borrowed Funds 10 Other 20 Total 9595 The firm meets the increased withdraws by decreasing its cash balances
Cash vs. Liquid Assets • Cash Assets • Vault Cash, Demand deposits at Fed Reserve, Demand Deposits at private financial institutions, cash items in the process of collection • Liquid Assets • Fed Funds Sold and Reverse Repos, US Treasury and Agency Securities with < 1 yr maturity, Corporate obligations and Municipal Securities with < 1yr maturity, Loans that can be readily sold or securitized.
Storing Liquid Assets • If you attempt to store funds in liquid asset they must have • A ready Market • A stable price • Reversible (can recover original investment with a high degree of certainty)
Costs of using liquid assets • Opportunity cost of foregone earnings if sold • Opportunity cost of other assets ( liquid assets have lower return) • Transaction costs • Higher risk of capital loss • Weakens balance sheet position
Historical Notes • Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid. • Securitization of DI loans • In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.
Historical Notes • During the period since 1960: • Noticeable differences between large and small banks with respect to use of low withdrawal risk funds. • Reliance on borrowed funds does have its own risks as with Continental Illinois.
Final alternative • It is also possible and likely that the FI can combine purchased and stored liquidity management techniques.
Asset Side Liquidity Risk • Risk from loan commitments and other credit lines: • met either by borrowing funds or • by running down reserves • Current levels of loan commitments are dangerously high according to regulators
Measuring Liquidity Exposure • Net liquidity statement: shows sources and uses of liquidity. • Sources: incoming deposits, revenue from sale of non deposit services, Customer Loan repayments, Sale of bank Assets, Borrowing in money market • Uses include: Deposit Withdraws, Volume of Acceptable loan requests, repayments of bank borrowing, other operating expenses, dividend payments
Other Measures: • Peer group comparisons: usual ratios include: • borrowed funds/total assets, • loan commitments/assets • Loan Losses / Net loans • Total Deposits./ Total Assets • Core Deposits/Total Assets • Fed Funds Purchased / Total Assets • Reserve for Loan losses / Net Loans
Liquidity index: 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*)
Measuring Liquidity Risk • Financing gap and the financing requirement: • Financing gap = Average loans - Average deposits or, financing gap + liquid assets = financing requirement. • The gap can be used in peer group comparisons or examined for trends within an individual FI.
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 • Must also evaluate “what if” scenarios in this framework
Liquidity Planning • Important to know which types of depositors are likely to withdraw first in a crisis. • Composition of the depositor base will affect the severity of funding shortfalls. • Allow for seasonal effects. • Delineate managerial responsibilities clearly.
Bank Runs • Can arise due to concern about bank’s solvency. • Failure of a related FI. • Sudden changes in investor preferences. • Demand deposits are first come first served. Depositor’s place in line matters. • Bank panic: systemic or contagious bank run.
Alleviating Bank Runs: • Regulatory measures to reduce likelihood of bank runs: • FDIC • Discount window • Not without economic costs.
Liquidity Risk for Other FIs • Life Cos. Hold reserves to offset policy cancellations. The pattern is normally predictable. • An example: First Capital in California, 1991. • CA regulators placed limits on ability to surrender policies. • Problem is less severe for P&C insurers since assets tend to be shorter term and more liquid.
Mutual Funds • Net asset value (NAV) of the fund is market value. • The incentive for runs is not like the situation faced by banks. • Asset losses will be shared on a pro rata basis so there is no advantage to being first in line.
Liability and Liquidity Management • Depository institutions and life insurance companies are highly exposed to liquidity risk. • The second half of the liquidity risk portion of class discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.
Liquid Assets • Liquid assets are assets that can be turned quickly into cash • Low transaction costs • Little or no loss in principle value • Traded in large market (trading does not move the market)
Liquid Asset Management • Examples: T-bills, T-notes, T-bonds • Benefits of holding large quantities of liquid assets • Low risk (except for inflation risks) • Flexibility in meeting liability claims • Costs of holding liquid assets • Lost interest income
Liquid Asset Management: Reserve Requirements • Reasons for regulating minimum holdings of liquid assets: • Monetary policy Enables Monetary policy by forcing Depository Institutions to participate in the Central Banking System. • Taxation Forcing a reserve requirement places a form of Tax on the Depository Institution • Facilitates Clearinghouse Function
Liquid Asset Management: Reserve Requirements • Use of Reserve Requirements as a monetary Policy tool has decreased. • Fed’s new emphasis on the control of short term interest rates • Use of Sweep Accounts Sweep Account – contractual agreement between bank and depositor permitting the bank to switch funds from checking account to an interest bearing account (decreased reserve requirement)
Composition • Composition of liquid asset portfolio • Breakdown between cash and other securities • Determined by regulations by government and earnings of the firm • Liquid assets ratio=Liquid Assets / Total Assets • Cash and government securities in countries such as U.K • Similar case for U.S. life insurance companies (regulated at state level) • U.S. banks: cash-based, but banks view government securities as buffer reserves.
U.S. Cash Reserve Requirementsfor Depository Institutions • Incremental reserve requirements for transaction accounts (all deposits on which account holders can make immediate withdrawals): • First $5.5 million 0.0% • $5.5 million to $42.8 million 3.0% • $42.8 million + 10.0%
Lagged Reserve Accounting • The system for calculating and maintaining reserves is based on a lagged reserve accounting system. • In the system the computation of the reserves and the reserve maintenance period do not overlap.
Reserve Management Problem • Computation period runs from a Tuesday to a Monday, 14 days later. • First a period for transaction balances, then a cash computation period. Reserves based upon the balance must be maintained over a Reserve Maintenance Period. • Average daily reserves are computed as a fraction of the average daily deposits over the period.
Lagged Computation PeriodBank Vault Computation Period Reserve Maintenance Period
Reserve Management • The reserve maintenance period, differs from the computation period by 17 days. • Lagged reserve accounting as of July 1998. • Previously, contemporaneous (2-day lag). • Benefits and Costs of lagged reserve accounting • Provides certainty for banks in terms of holdings • Easier to manage reserves. • Slows down monetary policy
Undershooting/Overshooting • Allowance for up to a 4% error in average daily reserves or $50,000 which ever is greater without penalty. • Surplus reserves required for next 2-week period • Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall. • Frequent undershooting likely to attract scrutiny by regulators