Chapter 12: Liquidity Risk Flashcards
How does the degree of liquidity risk differ for different types of FIs?
Deposit-taking institutions are the FIs most exposed to liquidity risk. Mutual funds, pension funds, and P&C insurance companies are the least exposed. In the middle are life insurance companies.
What are the two reasons liquidity risk arises?
Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI.
What is meant by fire-sale prices?
A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress.
What are core deposits?
Core deposits are those deposits that will stay with the bank over an extended period of time. These deposits are relatively stable sources of funds and consist mainly of demand, savings, and retail term deposits.
Define each of the following four measures of liquidity risk. Explain how each measure would be implemented and utilized by a DTI.
a. Sources and uses of liquidity.
This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds it can borrow in the money/purchased funds market, and any cash reserves. The statement also identifies the amount of each category the bank has utilized. The difference is the amount of liquidity available for the bank. This amount can be tracked on a day-to-day basis.
b. Peer group ratio comparisons
Banks can easily compare their liquidity with peer group banks by looking at several easy to calculate ratios. High levels of the loan to deposit and borrowed funds to total asset ratios will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future.
c. Liquidity index.
The liquidity index measures the amount of potential losses suffered by a DTI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower is the index, the less liquidity the DTI has on its balance sheet. The index should always be a value between 0 and 1.
d. Financing gap and financing requirement
The financing gap can be defined as average loans minus average deposits, or alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds.
How can the financing gap be used in the day-to-day liquidity management of the bank?
A rising financing gap on a daily basis over a period of time may indicate future liquidity problems due to increased deposit withdrawals and/or increased exercise of loan commitments. Sophisticated lenders in the money markets may be concerned about these trends and they may react be imposing higher risk premiums for borrowed funds or stricter credit limits on the amount of funds lent.
What is a bank run?
A bank run is an unexpected increase in deposit withdrawals from a bank.
Bank runs can be triggered by several economic events including (a) concerns about solvency relative to other banks, (b) failure of related banks or other FIs, and (c) sudden changes in investor preferences regarding the holding of nonbank financial assets.
What government safeguards are in place to reduce liquidity risk for DTIs?
Deposit insurance and borrowing from the Bank of Canada both help in the event of a liquidity drain and both help to prevent liquidity drains from occurring.
