Chapter 18: Liability and Liquidity Management Flashcards
What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Government of Canada and U.S. Treasury securities considered good examples of liquid assets?
A major benefit of an FI holding a large amount of liquid cash is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand.
Government securities, particularly Government of Canada and U.S. Treasury securities are considered good examples of liquid assets because they can be converted into cash quickly with very little loss of value from current market levels.
How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities?
For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event liabilities began to leave the FI not be reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire sale prices. These prices would tend to deviate farther from the market value as the maturity of the assets increased. Thus, the FI may sustain larger losses.
What concerns motivate regulators to require DTIs to hold minimum amounts of liquid assets?
Regulators prefer DTIs to hold more liquid assets because this ensures that they are able to withstand unexpected and sudden withdrawals of deposits. In addition, regulators are able to conduct monetary policy by influencing the money supply through liquid assets held by DTIs.
Rank these financial assets according to their liquidity: cash, corporate bonds, TSX-traded stocks, and T-bills.
cash, T-bills, TSX-traded stocks, and corporate bonds.
What is the relationship between funding cost and funding or withdrawal risk?
Liabilities that have a low cost often have the highest risk of withdrawal. Thus a DTI that chooses to attract low cost demand deposits may have high withdrawal risk.
How is the withdrawal risk different for interbank funds and repos?
Withdrawal risk is lower for repurchase agreements (repos) because they are collateralized usually by government securities. Since repos are collateralized, they require a lower risk premium but they require time to process because of the need to post collateral. In every other respect, the transaction of a repo is similar to interbank funds.
How does the cash balance, or liquidity, of an FI determine the types of repos into which it will enter?
If the FI has surplus cash, it would buy securities with the understanding that the seller would repurchase them later. In this case the repurchase agreement is an asset for the firm that bought the securities. If an FI is low on cash, it would sell securities for cash with the understanding that it would repurchase the securities later. Here the repo is a liability.
What are the primary methods that insurance companies can use to reduce their exposure to liquidity risk?
First, insurance companies can reduce their exposure by diversifying the distribution of risk in the contracts they write. In addition, insurance companies can meet liquidity needs by holding relatively marketable assets to cover claim payments.
