08. Liquidity Risk

Question 1

Market Liquidity vs Funding Liquidity

Answer 1

Market L: Risk that an asset owner (i.e., seller of a house) will not be able to sell the
asset at its full value. Sell the asset at a fraction τ<1 of its value.

Funding L: Risk that the creditor/lender may choose not to renew a loan (debt). Risk that depositors may unexpectedly withdraw their deposits and the bank may not be able to replace them without impairing its net worth.

Question 2

• The most extreme manifestation of market liquidity risk is that ….
• During the 2007-2009 crisis, τ was …
• The most extreme manifestation of funding liquidity risk is that …
• Great depression, Northern Rock

Answer 2

the seller of an asset is simply unable to sell the asset at any price

equal to 0 for almost safe assets.

the bank experiences a run.

Question 3

Assets: Cash(m), Loans(y)
Liabilities: Short-term debt (s), Long-term debt(l), Equity(e)

Case 1: Bank has enough cash
* A fraction α of short-term creditors do not rollover.
* αs<m, use cash, no need to liquidate the risky asset.
* Bank has …

Find the value of the assets at t=2 and the condition for which the bank is solvent.

Answer 3

The short term debt not rolling over means that they need to be paid in cash. Thus αs needs to be paid in cash and if the bank has enough cash=> m > αs, no need to liquidate any risky assets.

m-αs units of cash left

Value of assets at t=2 => y*R + (m-αs)rs

Bank is solvent if:
yR + (m-αs)rs >= (1-α)srs + lrl

Question 4

If αs > m, the bank does not have enough cash and thus needs to sell some loans.

value of assets at t=2 :

Bank is solvent if:

Answer 4

(αs-m) / (tow * R)
tow ==> resale fraction

(y- amount of loans sold) * R

If value of assets >= (1-α)srs + l*rl

Question 5

Reducing liquidity risk
…

Lender of Last Resort (LoLR)
– Borrow from the…
– Sound but illiquid banks can be protected
– Moral hazard:…

Answer 5

Deposit insurance
– Deposits are guaranteed by deposit insurance
– Federal Deposit Insurance Corporation (FDIC) in the US

central bank; Incentive to hold cash assets and diversify deposit base is weakened

Question 6

Reducing liquidity risk
Hold …

Reduce withdrawal risk (α): …

Answer 6

liquid assets (m)
– Liquidity improved at the expense of profits

– Diversify sources of funding (i.e., having a diverse depositor base)
– Still some (even small) probability that withdrawals exceed the bank’s capacity to service them

Question 7

Liquidity regulation
* Became part of international bank regulation in Basel III
* Liquidity Coverage Ratio (LCR):
* Bank needs to …
* Net Stable Funding Ratio (NSFR):
* Bank needs to …

Answer 7

hold high quality liquid assets (HQLA) to cover 30 days of withdrawals in a stress scenario.

have stable sources of funding to cover funding needs for a period of 1 year.

Question 8

Credit Risk + Liquidity Risk
* Credit risk: …
* Liquidity risk: …
* They usually happen at the same time with very strong effects
* … resulting in credit risk
* When the news spread, creditors …
* Bank sells …
* Sales depress prices, fire sales lead to further fire sales…

Answer 8

Low R
High α, low τ

Recession, low returns for the bank
do not roll over resulting in funding liquidity risk

assets at a discount, resulting in market liquidity risk