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Chapter Twenty-One

Managing Liquidity Risk


on the Balance Sheet

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Liquidity Risk Management


Unlike
Unlikeother
otherrisks,
risks,liquidity
liquidityrisk
riskisisaanormal
normalaspect
aspect
of
ofthe
theeveryday
everyday management
managementof
offinancial
financialinstitutions
institutions
(FIs)
(FIs)
At
Atthe
theextreme,
extreme,liquidity
liquidityrisk
riskcan
canlead
leadto
toinsolvency
insolvency
Some
SomeFIs
FIsare
aremore
moreexposed
exposedto
toliquidity
liquidityrisk
riskthan
than
others
others
depository
depositoryinstitutions
institutions(DIs)
(DIs)are
arehighly
highlyexposed
exposed
mutual
mutualfunds,
funds,pension
pensionfunds,
funds,and
andproperty-casualty
property-casualtyinsurers
insurers
have
haverelatively
relativelylow
lowliquidity
liquidityrisk
risk

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Liquidity Risk Management


One
Onetype
typeof
ofliquidity
liquidityrisk
riskarises
ariseswhen
whenan
anFIs
FIsliability
liability
holders
holdersseek
seekto
towithdraw
withdrawtheir
theirfinancial
financialclaims
claims

FIs
FIsmust
mustmeet
meetthe
thewithdrawals
withdrawalswith
withstored
storedor
orborrowed
borrowedfunds
funds
alternately,
alternately,FIs
FIsmay
mayhave
havetotosell
sellassets
assetstotogenerate
generatecash,
cash,which
whichcan
can
be
becostly
costlyififassets
assetscan
canonly
onlybe
besold
soldatatfire-sale
fire-saleprices
prices

AAsecond
secondtype
typeof
ofliquidity
liquidityrisk
riskarises
ariseswhen
whencommitments
commitments
made
madeby
bythe
theFI
FIand
andrecorded
recordedoff-the-balance-sheet
off-the-balance-sheetare
are
exercised
exercisedby
bythe
thecommitment
commitmentholder
holder
unexpected
unexpectedloan
loandemand
demandcan
canoccur
occurwhen
whenoff-balance-sheet
off-balance-sheetloan
loan
commitments
commitmentsare
aredrawn
drawndown
downsuddenly
suddenlyand
andininlarge
largevolumes
volumes
FIs
FIsare
arecontractually
contractuallyobliged
obligedtotosupply
supplyfunds
fundsthrough
throughloan
loan
commitments
commitmentsimmediately
immediatelyshould
shouldthey
theybe
bedrawn
drawndown
down

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Liquidity Risk and Depository Institutions


DIs
DIsbalance
balancesheets
sheetstypically
typicallyhave
have

large
largeamounts
amountsof
ofshort-term
short-termliabilities
liabilitiessuch
suchas
asdeposits
depositsand
andother
other
transaction
transactionaccounts
accountsthat
thatmust
mustbe
bepaid
paidout
outimmediately
immediatelyifif
demanded
demandedby
bydepositors
depositors
large
largeamounts
amountsof
ofrelatively
relativelyilliquid
illiquidlong-term
long-termassets
assetssuch
suchas
as
commercial
commercialloans
loansand
andmortgages
mortgages

DIs
DIsknow
knowthat
thatnormally
normallyonly
onlyaasmall
smallportion
portionof
ofdemand
demand
deposits
depositswill
willbe
bewithdrawn
withdrawnon
onany
anygiven
givenday
day

most
mostdemand
demanddeposits
depositsact
actas
ascore
coredepositsi.e.,
depositsi.e.,they
theyare
areaastable
stable
and
andlong-term
long-termfunding
fundingsource
source

Deposit
Depositwithdrawals
withdrawalsare
arenormally
normallyoffset
offsetby
bythe
theinflow
inflowof
of
new
newdeposits
deposits
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Liquidity Risk and Depository Institutions


DI
DI managers
managers monitor
monitor net
net deposit
deposit drainsi.e.,
drainsi.e.,
the
the amount
amount by
by which
which cash
cash withdrawals
withdrawals exceed
exceed
additions;
additions; aa net
net cash
cash outflow
outflow
DIs
DIs manage
manage deposit
deposit drains
drains with:
with:
stored
storedliquidity
liquidity

relied
reliedon
onmost
mostheavily
heavilyby
bycommunity
communitybanks
banks

purchased
purchasedliquidity
liquidity

relied
reliedon
onmost
mostheavily
heavilyby
bythe
thelargest
largestbanks
bankswith
withaccess
accesstotothe
the
money
moneymarket
marketand
andother
othernondeposit
nondepositsources
sourcesof
offunds
funds

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Liquidity Risk and Depository Institutions


Purchased
Purchased liquidity
liquidity

allows
allowsFIs
FIsto
tomaintain
maintainthe
theoverall
overallsize
sizeof
oftheir
theirbalance
balance
when
whenfaced
facedwith
withliquidity
liquiditydemands
demands
purchased
purchasedliquidity
liquidityisisexpensive
expensiverelative
relativeto
tostored
stored
liquidity
liquidity
purchased
purchasedliquidity
liquidityincludes:
includes:
interbank
interbankmarkets
marketsfor
forshort-term
short-termloans
loans
fed
fedfunds
funds
repurchase
repurchaseagreements
agreements
fixed-maturity
fixed-maturitycertificates
certificatesof
ofdeposits
deposits
notes
notesand
andbonds
bonds

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Liquidity Risk and Depository Institutions


Stored
Stored liquidity
liquidity

may
mayinvolve
involvethe
theuse
useof
ofexisting
existingcash
cashstores
storesor
orthe
thesale
sale
of
ofexisting
existingassets
assets
banks
bankshold
holdcash
cashreserves
reservesin
intheir
theirvaults
vaultsand
andatatthe
the
Federal
FederalReserve
Reservein
inexcess
excessof
ofminimum
minimumrequirements
requirements
when
whenmanagers
managersutilize
utilizestored
storedliquidity
liquidityto
tofund
funddeposit
deposit
drains,
drains,the
thesize
sizeof
ofthe
thebalance
balancesheet
sheetisisreduced
reducedand
andits
its
composition
compositionchanges
changes

Most
Most DIs
DIs utilize
utilize aa combination
combination of
ofstored
stored and
and
purchased
purchased liquidity
liquidity management
management
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Liquidity Risk and Depository Institutions


Loan
Loancommitments
commitmentsand
andother
othercredit
creditlines
linescan
cancause
cause
liquidity
liquidityproblems
problems

as
aswith
withliability
liabilityside
sideliquidity
liquidityrisk,
risk,asset
assetside
sideliquidity
liquidityrisk
riskcan
canbe
be
managed
managedwith
withstored
storedor
orpurchased
purchasedliquidity
liquidity

IfIfstored
storedliquidity
liquidityisisused,
used,the
thecomposition
compositionof
ofthe
theasset
asset
side
sideof
ofthe
thebalance
balancesheet
sheetchanges,
changes,but
butnot
notthe
thesize
sizeof
ofthe
the
balance
balancesheet
sheet
IfIfpurchased
purchasedliquidity
liquidityisisused,
used,the
thecomposition
compositionof
ofboth
boththe
the
asset
assetand
andliability
liabilitysides
sidesof
ofthe
thebalance
balancesheet
sheetchanges,
changes,and
and
increases
increasesthe
thesize
sizeof
ofthe
thebalance
balancesheet
sheet
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Measuring Liquidity Risk Exposure


The
Theliquidity
liquidityposition
positionof
ofbanks
banksisismeasured
measuredby
bymanagers
managers
on
onaadaily
dailybasis
basis
AAnet
netliquidity
liquiditystatement
statementlists
listssources
sourcesand
anduses
usesof
of
liquidity
liquidity
Peer
Peergroup
groupratio
ratiocomparisons
comparisonsare
areused
usedto
tocompare
compareaa
banks
banksliquidity
liquidityposition
positionagainst
againstits
itscompetitors
competitors

loans
loanstotodeposit
depositratio
ratio
borrowed
borrowedfunds
fundstotototal
totalassets
assetsratio
ratio
commitments
commitmentstotolend
lendtotoassets
assetsratio
ratio

Ratios
Ratiosare
areoften
oftencompared
comparedto
tothose
thoseof
ofbanks
banksof
ofaasimilar
similar
size
sizeand
andin
inthe
thesame
samegeographic
geographiclocation
location
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Measuring Liquidity Risk Exposure


The
Theliquidity
liquidityindex
indexmeasures
measuresthe
thepotential
potentiallosses
lossesaabank
bank
could
couldsuffer
sufferfrom
fromaasudden
suddenor
orfire-sale
fire-saledisposal
disposalof
ofassets
assets
versus
versusthe
thesale
saleof
ofthe
thesame
sameassets
assetsatatfair
fairmarket
marketvalue
value
under
undernormal
normalmarket
marketconditions
conditions
N

I [( wi )( Pi / Pi * )]
i 1

where
where wwi i==the
thepercent
percentof
ofeach
eachasset
assetiiininthe
theFIs
FIsportfolio
portfolio
Pi
Pi==the
theprice
priceititgets
getsififan
anFI
FIliquidates
liquidatesasset
assetiitoday
today
PPi*i*==the
theprice
priceititgets
getsififan
anFI
FIliquidates
liquidatesasset
assetiiunder
under
normal
normalmarket
marketconditions
conditions

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Measuring Liquidity Risk Exposure


The
The financing
financing gap
gap isis the
the difference
difference between
between aa
banks
banksaverage
average loans
loans and
and average
average (core)
(core) assets
assets
ififthe
thefinancing
financinggap
gapisispositive,
positive,the
thebank
bankmust
mustfind
find
liquidity
liquidityto
tofund
fundthe
thegap
gap

The
The financing
financing requirement
requirement isis the
the financing
financing gap
gap
plus
plus aa banks
banksliquid
liquid assets
assets
aawidening
wideningfinancing
financinggap
gapcan
canbe
bean
anindicator
indicatorof
offuture
future
liquidity
liquidityproblems
problems

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Measuring Liquidity Risk Exposure


The
TheBIS
BISApproach:
Approach:Maturity
MaturityLadder/Scenario
Ladder/Scenario
Analysis
Analysis

liquidity
liquiditymanagement
managementinvolves
involvesassessing
assessingall
allcash
cashinflows
inflowsagainst
against
cash
cashoutflows
outflows
the
thematurity
maturityladder
ladderallows
allowsaacomparison
comparisonof
ofcash
cashinflows
inflowsversus
versus
outflows
outflowson
onaaday-to-day
day-to-daybasis
basisand
andover
overaaseries
seriesof
ofspecified
specifiedtime
time
intervals
intervals
daily,
daily,maturity
maturitysegment,
segment,and
andcumulative
cumulativenet
netfunding
fundingrequirements
requirements
are
aredetermined
determinedfrom
fromthe
thematurity
maturityladder
ladder
the
theBIS
BISalso
alsosuggests
suggeststhat
thatDIs
DIsprepare
preparefor
forabnormal
abnormalconditions
conditions
using
usingvarious
variouswhat
whatif
ifscenarios
scenarios

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Liquidity Planning
Liquidity
Liquidityplanning
planningallows
allowsmanagers
managersto
tomake
makeimportant
important
borrowing
borrowingpriority
prioritydecisions
decisionsbefore
beforeliquidity
liquidityproblems
problems
arise
arise

lowers
lowersthe
thecosts
costsof
offunds
fundsby
bydetermining
determiningan
anoptimal
optimalfunding
fundingmix
mix
minimizes
minimizesthe
theamount
amountof
ofexcess
excessreserves
reservesthat
thataabank
bankneeds
needstotohold
hold
liquidity
liquidityplan
plancomponents
components

McGraw-Hill/Irwin

delineation
delineationofofmanagerial
managerialresponsibilities
responsibilities
list
listofoffund
fundproviders
providersmost
mostlikely
likelytotowithdraw
withdrawfunds
fundsand
andaapattern
patternof
of
fund
fundwithdrawals
withdrawals
identification
identificationofofthe
thesize
sizeofofpotential
potentialdeposit
depositand
andfund
fundwithdrawals
withdrawals
over
overvarious
varioustime
timehorizons
horizons
internal
internallimits
limitson
onseparate
separatesubsidiaries
subsidiariesand
andbranches
branchesborrowings
borrowingsas
as
well
as
acceptable
risk
premiums
to
pay
in
each
market
well as acceptable risk premiums to pay in each market

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Liquidity Risk
Major
Major liquidity
liquidity problems
problems arise
arise ifif deposit
deposit drains
drains
are
are abnormally
abnormally large
large and
and unexpected
unexpected
Abnormal
Abnormal deposit
deposit drains
drains can
can occur
occur because
because
concerns
concernsabout
aboutaabanks
bankssolvency
solvency
failure
failureof
ofanother
anotherbank
bank(i.e.,
(i.e.,the
thecontagion
contagioneffect)
effect)
sudden
suddenchanges
changesin
ininvestors
investorspreferences
preferencesregarding
regarding
holding
holdingnonbank
nonbankfinancial
financialassets
assetsrelative
relativeto
tobank
bank
deposits
deposits

A
Abank
bank run
run isis aa sudden
sudden and
and unexpected
unexpected increase
increase
in
in deposit
deposit withdrawals
withdrawals from
from aa bank
bank
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Liquidity Risk

Demand
Demanddeposits
depositsare
arefirst-come,
first-come,first-served
first-servedcontracts
contracts
The
Theincentives
incentivesfor
fordepositors
depositorsto
towithdraw
withdrawtheir
theirfunds
fundsatat
the
thefirst
firstsign
signof
oftrouble
troublecreates
createsaafundamental
fundamentalinstability
instabilityin
in
the
thebanking
bankingsystem
system
aabank
bankpanic
panicisisaasystemic
systemicor
orcontagious
contagiousrun
runon
onthe
thedeposits
depositsof
of
the
thebanking
bankingindustry
industryas
asaawhole
whole

Regulatory
Regulatorymechanisms
mechanismsare
arein
inplace
placeto
toease
easebanks
banks
liquidity
liquidityproblems
problemsand
andto
todeter
deterbank
bankruns
runsand
andpanics
panics

deposit
depositinsurance
insurance
the
thediscount
discountwindow
window

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Deposit Insurance
Guarantee
Guaranteeprograms
programsoffer
offerdepositors
depositorsvarying
varyingdegrees
degreesof
of
insurance
insuranceprotection
protectionto
todeter
deterbank
bankruns
runs
Deposit
Depositinsurance
insurancewas
wasfirst
firstintroduced
introducedin
inthe
theU.S.
U.S.in
in1933
1933
and
andgave
gavecoverage
coverageup
upto
to$2,500
$2,500
Coverage
Coveragewas
wasincreased
increasedto
to$100,000
$100,000by
by1980
1980
Beginning
Beginningin
in2011
2011the
theFederal
FederalDeposit
DepositInsurance
Insurance
Corporation
Corporation(FDIC)
(FDIC)will
willincrease
increasecoverage
coverageevery
everyyear
year
based
basedon
onthe
theConsumer
ConsumerPrice
PriceIndex
Index(CPI)
(CPI)
The
TheFederal
FederalDeposit
DepositInsurance
InsuranceReform
ReformAct
Actof
of2005
2005
increased
increaseddeposit
depositinsurance
insurancefor
forretirement
retirementaccount
accountfrom
from
$100,000
$100,000to
to$250,000
$250,000
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Deposit Insurance
Individuals
Individuals can
can achieve
achieve many
many times
times the
the $100,000
$100,000
($250,000)
($250,000) coverage
coverage cap
cap on
on deposits
deposits by
by creatively
creatively
structuring
structuring their
their deposits
deposits and
and by
by using
using multiple
multiple
banks
banks
The
The FDIC
FDIC now
now uses
uses aa risk-based
risk-based deposit
deposit
insurance
insurance program
programto
to evaluate
evaluate and
and assign
assign deposit
deposit
insurance
insurance premiums
premiums
the
thesafest
safestinstitutions
institutionsnow
nowpay
pay5
5per
per$100
$100of
ofdeposits
deposits
the
theriskiest
riskiestinstitutions
institutionsnow
nowpay
pay43
43per
per$100
$100of
of
deposits
deposits

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The Discount Window


The
TheFederal
FederalReserve
Reservealso
alsoprovides
providesaadiscount
discountwindow
window
lending
lendingfacility
facility
Historically
Historicallythe
theborrowing
borrowingrate
ratewas
wasbelow
belowmarket
marketrates
rates
and
andborrowing
borrowingwas
wasrestricted
restricted
In
In2003
2003the
theFed
Fedincreased
increasedthe
thecosts
costsof
ofborrowing
borrowingbut
but
eased
easedthe
theterms
terms

primary
primarycredit
creditisisavailable
availabletotogenerally
generallysound
soundDIs
DIson
onaavery
very
short-term
short-termbasis
basis
secondary
secondarycredit
creditisisavailable
availabletotoless
lesssound
soundDIs
DIs(at
(ataahigher
higherrate
rate
than
thanprimary
primarycredit)
credit)on
onaavery
veryshort-term
short-termbasis
basis
seasonal
seasonalcredit
creditassists
assistssmall
smallDIs
DIsininmanaging
managingseasonal
seasonalswings
swingsinin
their
theirloans
loansand
anddeposits
deposits

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Liquidity Risk and Insurance Companies


Life
Lifeinsurance
insurancecompanies
companieshold
holdcash
cashreserves
reservesand
andother
other
liquid
liquidassets
assets

totomeet
meetpolicy
policypayments
payments
totomeet
meetcancellation
cancellation(surrender)
(surrender)payments
payments

the
thesurrender
surrendervalue
valueofofaalife
lifeinsurance
insurancepolicy
policyisisthe
theamount
amountthat
thatan
an
insurance
insurancepolicyholder
policyholderreceives
receiveswhen
whencashing
cashingininaapolicy
policyearly
early

totofund
fundworking
workingcapital
capitalneeds
needswhich
whichcan
canbe
beunpredictable
unpredictable

Property-casualty
Property-casualty(P&C)
(P&C)insurance
insurancecompanies
companies

the
theclaims
claimsagainst
againstP&C
P&Cinsurers
insurersare
arehard
hardtotopredict
predict
thus,
thus,P&C
P&Cinsurance
insurancecompanies
companieshave
haveaagreater
greaterneed
needfor
forliquidity
liquidity
than
thanlife
lifeinsurance
insurancecompanies
companies

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2009, The McGraw-Hill Companies, All Rights

Liquidity Risk and Mutual Funds


Mutual
Mutual funds
funds (MFs)
(MFs) can
can be
be subject
subject to
to dramatic
dramatic
liquidity
liquidity needs
needs ifif investors
investors become
become nervous
nervous about
about
the
the true
true value
value of
of the
the funds
fundsassets
assets
However,
However,the
the way
way MFs
MFs are
are valued
valued reduces
reduces the
the
incentive
incentive of
of fund
fund shareholders
shareholders to
to engage
engagein
in bankbanklike
like runs
runs on
on any
any given
given day
day
assets
assetsare
aredistributed
distributedon
onaapro
prorate
ratebasis
basis(i.e.,
(i.e.,rather
rather
than
thanaafirst-come
first-comefirst-served
first-servedbasis)
basis)
losses
lossesare
areincurred
incurredto
toshareholders
shareholderson
onaaproportional
proportional
basis
basis

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2009, The McGraw-Hill Companies, All Rights