Chapter 15

Liquidity Risk

Overview
This chapter explores the problems created
by liquidity risk.
Liquidity risk is a normal aspect of the
everyday management of a DI.
Only in limited cases does liquidity risk
threaten the solvency of a DI.
We discuss the causes of liquidity risk,
methods of measuring liquidity risk, and its
consequences.
The chapter also discusses the regulatory
mechanisms put in place to control liquidity
risk.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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Causes of Liquidity Risk

Liquidity risk can arise on both sides of the balance
sheet: the asset side as well as the liability side.
Liability side:
Depositors and other claimholders decide to cash in their
financial claims immediately.
Consequence: the DI has to borrow additional funds or sell
assets.

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Causes of Liquidity Risk

Problems associated with quick asset sales:
High costs for turning illiquid assets into cash.
Low sales price; in worst case, fire-sale price.

Asset side:
Borrowers decide to use the loan commitment facilities
provided by the DI.

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Liquidity Risk at Depository

Institutions

Liability-Side Liquidity Risk:

Large reliance on demand deposits and deposits

raised through other transaction accounts
(mostly at-call deposits).
However, DIs can rely on core deposits.
Need to be able to predict the distribution of net
deposit drains, i.e. the amount by which cash
withdrawals exceed cash additions.
Managed by:
purchased liquidity management,
stored liquidity management.
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Managing Liquidity
Two major ways to manage drains on deposits or
exercise of loan commitments:
Purchased liquidity management, and/or
Stored liquidity management.
Traditionally, DIs have relied on stored liquidity
management.
Today, most DIs rely on purchased liquidity
management.

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Purchased Liquidity Management

Liquidity can be purchased in financial markets, e.g.
borrowed funds from competitor banks and other
institutional investors.
Managing the liability side preserves asset side of
balance sheet.
Borrowed funds are likely to be at higher rates than
interest paid on deposits, i.e. funds to be borrowed at
market rates.
Purchased liquidity management allows DIs to
increase their overall balance sheet size.

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15-7

Stored Liquidity Management

Liquidate assets.
In absence of reserve requirements, banks tend to hold
excess reserve assets, i.e. over 0.6% of total assets are held
in the form of cash.
Downside of excess cash: opportunity cost of reserves.

Decreases size of balance sheet.

Requires holding excess non-interest bearing
assets.

Better to combine purchased and stored

liquidity management.
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15-8

Measuring a DIs Liquidity Exposure

Sources and Uses of Liquidity:
Shown on net liquidity statement
Sources include:
Sale of liquid assets with minimum price risk,
Borrowing funds in the money market,
Using excess cash reserves.

Uses include: borrowed or money market funds

already utilised.

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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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15-9

Measuring a DIs Liquidity Exposure

Peer Group Ratio Comparison:
Comparison of certain key ratios and balance
sheet features of the DI with similar DIs.
Usual ratios include:
Borrowed funds/total assets,
Loan commitments/assets.

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15-10

Measuring a DIs Liquidity Exposure

Liquidity Index:
Developed by James Pierce.
Measures the potential loss a DI could suffer from a sudden
disposal of assets, compared to the amount it would receive under
normal market conditions.

Pi
I Wi *
i 1
Pi
N

Where:
Wi = the per cent of each asset in the DIs portfolio
Pi = the immediate sales price
Pi* = the fair market price.
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15-11

Measuring a DIs Liquidity Exposure

Liquidity Index (cont):
The liquidity index always lies between 0 and 1.
Example:
Assume a DI has two assets: 40% in one-month Treasury
bonds and the remaining 60% in personal loans. If the DI
liquidates the Treasury bonds today, it receives $98 per $100
face value, but it would receive the full face value on maturity
(in one months time). If the DI liquidates its loans today, it
receives $82 per $100 face value, whereas liquidation closer
to maturity, i.e. in one months time, would lead to $93 per
$100 of face value. What is the one-month liquidity index?

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15-12

Measuring a DIs Liquidity Exposure

Liquidity Index (cont):
Solution
We have:
P1 = 0.98

P*1 = 1.00

P2 = 0.82

P*2 = 0.93

W1 = 0.4

W2 = 0.6

0.98
0.82
I 0.4 *
0 .6 *
0.392 0.529 0.921
1.00
0.93
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

15-13

Measuring a DIs Liquidity Exposure

Financing Gap and the Financing Requirement:
Financing gap = average loans average deposits.
A positive gap means that the DI requires funding.
Thus the financing gap can also be defined as:
Liquid assets + borrowed funds.
The financing requirement is defined as the financing
gap plus a DIs liquid assets.
The larger a DIs financing gap and liquid asset
holdings, the greater the exposure.

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15-14

Measuring a DIs Liquidity Exposure

The 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.

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15-15

Web Resources
For further information on the BIS maturity ladder
approach, visit the Bank for International Settlements:
www.bis.org
For information on prudential
standards for liquidity measurement and
management in Australia, visit APRA:
www.apra.gov.au

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15-16

Liquidity Planning
The overall aim of successful liquidity planning is to
ensure that there will be sufficient funds to settle
outflows as they become due.
Liquidity falls into a number of different categories:
Immediate liquidity obligations.
Seasonal short-term liquidity needs.
Trend liquidity needs.

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15-17

Liquidity Planning
Immediate liquidity obligations:
Occur in contractual and relationship form.

Seasonal short-term liquidity needs:

Can be predictable (e.g. Christmas period) or
unpredictable (disproportionate influence of large
borrowers and large depositors).
Seasonal factors may affect deposit flows and loan
demand.

Trend liquidity needs:

Can be predicted over a longer time horizon.
Likely to be associated with a DIs particular
customer base.
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15-18

Trend Liquidity Planning

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15-19

Determining Seasonal and Trend

Liquidity Needs

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15-20

Other Types of Liquidity Needs

Cyclical liquidity needs:
Liquidity needs that vary with the business cycle.
Difficult to predict.
Out of the control of a single DI.

Contingent liquidity needs:

Liquidity needs necessary to meet an unforeseen
event.
Basically impossible to predict.
APRA requires DIs to hold sufficient liquid assets
to meet a specific institution or name crisis
situation.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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15-21

Liquidity Risk, Unexpected

Deposit Drains, and Bank Runs
Reasons for abnormal deposit drains (shocks) :
Concerns about a DIs solvency relative to other DIs.
Failure of a related DI, leading to heightened depositor
concerns about the solvency of other DIs (contagion).
Sudden changes in investor preferences regarding
holding non-bank financial assets relative to deposits.

Copyright 2007 McGraw-Hill Australia Pty Ltd

PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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15-22

Liquidity Risk, Unexpected

Deposit Drains and Bank Runs
Abnormal deposit drains can cause a bank run:
That is, a sudden and unexpected increase in deposit
withdrawals from a DI.
A bank run, justified or not, can force a DI into
insolvency.
Bank runs can have contagious effects, i.e. because of
the failure of one bank, investors lose faith in DIs
overall and start running on their banks.

Copyright 2007 McGraw-Hill Australia Pty Ltd

PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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15-23

Liquidity Risk, Unexpected

Deposit Drains and Bank Runs
Underlying cause of bank runs: demand deposit
contract.
Demand deposit contract implies a first come, first served
principle.
Depositors are paid their full claims until the DI has no funds
left.
Depositors who come late will not receive the full amount of
their financial claims or, in the worst case, will receive
nothing at all.

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15-24

Dealing with Bank Runs

Deposit insurance:
Guarantee programs offering deposit holders varying
degrees of insurance-type protection.
Deters bank runs and contagion as deposit holders
place in line no longer affects ability to recover their
financial claims.
Mainly used in the USA.
Not offered in Australia.

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15-25

Dealing with Bank Runs

Discount window:
Discount window facility to meet DIs short-term nonpermanent liquidity needs.
Offered by the RBA in the form of rediscount facilities
and repurchase agreements.

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Financial System Stability

and Liquidity

Responsibility of RBA.
Defined as the absence of financial crises that are
sufficiently severe to threaten the health of the
economy.
Financial crises are costly, e.g. Asian financial crisis
in 1997/1998.
RBAs responsibility to implement policies that
prevent financial instability.

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15-27

RBA Role in Maintaining

Financial System Stability

RBA is able to use its balance sheet to provide

liquidity to the financial system.
Open market operations, i.e. intervention in the shortterm money markets to affect the cash interest rate.
RBA affects liquidity by buying or selling
Commonwealth Government securities.

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15-28

Financial Institution
Instability: Australia the 1990s

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15-29

Financial Institution
Instability: Australia the 2000s

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15-30

Australian DI Liquidity Regulations

ADIs are required to have sufficient liquidity to
meet obligations as they fall due.
The responsibility for liquidity management
and strategy lies within an ADIs board of
directors and management (APS 210).
ADI needs to show APRA how it manages
liquidity under normal market conditions and
in worst case scenarios.

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15-31

Australian DI Liquidity Regulations

ADIs must provide APRA with quarterly
liquidity reports.
Liquidity reports need to contain scenario
analysis for:
Going concern, and
Name crisis.

Small ADIs are exempt from these regulations

and need to hold a minimum of 9% of their
liabilities in specified high-quality liquid
assets.
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15-32

Liquidity Risk and Life

Insurance
Companies
Life insurers are affected by early cancellation of an
insurance policy.
Life insurance company needs to pay the surrender
value, i.e. the amount received by an insurance policy
holder when cashing in a policy early.

Recent events that have affected general

insurers:
Hurricane Katrina, USA, 2005.
Bushfires and floods in Australia.
Newcastle earthquake, 1989.
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15-33

Managed Funds
Closed-end funds:
Sell a fixed number of shares in the fund to outside
investors.

Open-end funds:
Sell an elastic (non-fixed) number of shares in the fund to
outside investors.
Must stand ready to buy back issued shares at current
market prices.

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15-34

Managed Funds and Liquidity

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.

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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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