Managing Liquidity Risk on the Balance Sheet

8-1McGraw-Hill/IrwinChapter Twenty-OneManaging Liquidity Risk on the Balance Sheet21-2McGraw-Hill/IrwinLiquidity Risk ManagementUnlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs)At the extreme, liquidity risk can lead to insolvencySome FIs are more exposed to liquidity risk than othersdepository institutions (DIs) are highly exposedmutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk21-3McGraw-Hill/IrwinLiquidity Risk ManagementOne type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claimsFIs must meet the withdrawals with stored or borrowed fundsalternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale pricesA second type of liquidity risk arises when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holderunexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumesFIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down21-4McGraw-Hill/IrwinLiquidity Risk and Depository InstitutionsDIs’ balance sheets typically havelarge amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositorslarge amounts of relatively illiquid long-term assets such as commercial loans and mortgagesDIs know that normally only a small portion of demand deposits will be withdrawn on any given daymost demand deposits act as core deposits—i.e., they are a stable and long-term funding sourceDeposit withdrawals are normally offset by the inflow of new deposits21-5McGraw-Hill/IrwinLiquidity Risk and Depository InstitutionsDI managers monitor net deposit drains—i.e., the amount by which cash withdrawals exceed additions; a net cash outflowDIs manage deposit drains with:stored liquidityrelied on most heavily by community bankspurchased liquidityrelied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds21-6McGraw-Hill/IrwinLiquidity Risk and Depository InstitutionsPurchased liquidityallows FIs to maintain the overall size of their balance when faced with liquidity demandspurchased liquidity is expensive relative to stored liquiditypurchased liquidity includes:interbank markets for short-term loansfed fundsrepurchase agreementsfixed-maturity certificates of depositsnotes and bonds21-7McGraw-Hill/IrwinLiquidity Risk and Depository InstitutionsStored liquiditymay involve the use of existing cash stores or the sale of existing assetsbanks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirementswhen managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changesMost DIs utilize a combination of stored and purchased liquidity management21-8McGraw-Hill/IrwinLiquidity Risk and Depository InstitutionsLoan commitments and other credit lines can cause liquidity problemsas with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidityIf stored liquidity is used, the composition of the asset side of the balance sheet changes, but not the size of the balance sheetIf purchased liquidity is used, the composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet21-9McGraw-Hill/IrwinMeasuring Liquidity Risk ExposureThe liquidity position of banks is measured by managers on a daily basisA net liquidity statement lists sources and uses of liquidityPeer group ratio comparisons are used to compare a bank’s liquidity position against its competitorsloans to deposit ratioborrowed funds to total assets ratiocommitments to lend to assets ratioRatios are often compared to those of banks of a similar size and in the same geographic location21-10McGraw-Hill/IrwinMeasuring Liquidity Risk ExposureThe liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditionswhere wi = the percent of each asset i in the FI’s portfolio Pi = the price it gets if an FI liquidates asset i today Pi* = the price it gets if an FI liquidates asset i under normal market conditions21-11McGraw-Hill/IrwinMeasuring Liquidity Risk ExposureThe financing gap is the difference between a bank’s average loans and average (core) assetsif the financing gap is positive, the bank must find liquidity to fund the gapThe financing requirement is the financing gap plus a bank’s liquid assetsa widening financing gap can be an indicator of future liquidity problems21-12McGraw-Hill/IrwinMeasuring Liquidity Risk ExposureThe BIS Approach: Maturity Ladder/Scenario Analysisliquidity management involves assessing all cash inflows against cash outflowsthe maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervalsdaily, maturity segment, and cumulative net funding requirements are determined from the maturity ladderthe BIS also suggests that DIs prepare for abnormal conditions using various “what if” scenarios21-13McGraw-Hill/IrwinLiquidity PlanningLiquidity planning allows managers to make important borrowing priority decisions before liquidity problems ariselowers the costs of funds by determining an optimal funding mixminimizes the amount of excess reserves that a bank needs to holdliquidity plan componentsdelineation of managerial responsibilitieslist of fund providers most likely to withdraw funds and a pattern of fund withdrawalsidentification of the size of potential deposit and fund withdrawals over various time horizonsinternal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market21-14McGraw-Hill/IrwinLiquidity RiskMajor liquidity problems arise if deposit drains are abnormally large and unexpectedAbnormal deposit drains can occur becauseconcerns about a bank’s solvencyfailure of another bank (i.e., the contagion effect)sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank depositsA bank run is a sudden and unexpected increase in deposit withdrawals from a bank21-15McGraw-Hill/IrwinLiquidity RiskDemand deposits are first-come, first-served contractsThe incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking systema bank panic is a systemic or contagious run on the deposits of the banking industry as a wholeRegulatory mechanisms are in place to ease banks’ liquidity problems and to deter bank runs and panicsdeposit insurancethe discount window21-16McGraw-Hill/IrwinDeposit InsuranceGuarantee programs offer depositors varying degrees of insurance protection to deter bank runsDeposit insurance was first introduced in the U.S. in 1933 and gave coverage up to $2,500Coverage was increased to $100,000 by 1980Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI)The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement account from $100,000 to $250,00021-17McGraw-Hill/IrwinDeposit InsuranceIndividuals can achieve many times the $100,000 ($250,000) coverage cap on deposits by creatively structuring their deposits and by using multiple banksThe FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiumsthe safest institutions now pay 5¢ per $100 of depositsthe riskiest institutions now pay 43¢ per $100 of deposits 21-18McGraw-Hill/IrwinThe Discount WindowThe Federal Reserve also provides a “discount window” lending facilityHistorically the borrowing rate was below market rates and borrowing was restrictedIn 2003 the Fed increased the costs of borrowing but eased the termsprimary credit is available to generally sound DIs on a very short-term basissecondary credit is available to less sound DIs (at a higher rate than primary credit) on a very short-term basisseasonal credit assists small DIs in managing seasonal swings in their loans and deposits21-19McGraw-Hill/IrwinLiquidity Risk and Insurance CompaniesLife insurance companies hold cash reserves and other liquid assetsto meet policy paymentsto meet cancellation (surrender) paymentsthe surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy earlyto fund working capital needs which can be unpredictableProperty-casualty (P&C) insurance companiesthe claims against P&C insurers are hard to predictthus, P&C insurance companies have a greater need for liquidity than life insurance companies21-20McGraw-Hill/IrwinLiquidity Risk and Mutual FundsMutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assetsHowever, the way MFs are valued reduces the incentive of fund shareholders to engage in bank-like runs on any given dayassets are distributed on a pro rate basis (i.e., rather than a first-come first-served basis)losses are incurred to shareholders on a proportional basis