Chapter 8: Liquidity Risk Flashcards
Causes of Liquidity Risk
- FI’s liability holders seek to withdraw their financial claims
- when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holder
is a financial institution whose main source of funds is deposits from customers.
Depository Institution
are contracts that give the holders the right to put their financial claims back to the DI on any given day and demand immediate repayment of the face value in cash.
Demand Deposit Account
Deposits that provide a relatively stable, long-term funding source to a depository institution.
Core Deposit
The amount by which cash withdrawals exceed additions; a net cash outflow.
Net Deposit Drains
2 major ways for the FI to manage Deposit on Drains
- Purchased liquidity management
- Stored liquidity management
An adjustment to a deposit drain that occurs on the liability side of the balance sheet.
Purchased liquidity management
An adjustment to a deposit drain that occurs on the asset side of the balance sheet.
Stored liquidity management
True or False
Traditionally, DI managers relied on stored liquidity as the primary mechanism of liquidity management
True
True or False
Today, many DIs—especially the largest banks with access to the money market and other nondeposit markets for funds—rely on stored liquidity, whereas smaller DIs—such as community banks—more often look to purchased liquidity.
False
Today, many DIs—especially the largest banks with access to the money market and other nondeposit markets for funds—rely on purchased liquidity, whereas smaller DIs—such as community banks—more often look to stored liquidity.
A DI manager who __________________ to offset a deposit drain turns to the markets for purchased funds, such as the federal funds market and/or the repurchase (repo) agreement markets, which are interbank markets for short-term loans. Alternatively, a DI manager could issue additional fixed- maturity certificates of deposit or additional notes and bonds.
purchases liquidity
These methods take into account the DI’s excess cash reserves and its ability to raise additional purchased funds.
Measuring a Bank’s Liquidity Exposure
is to compare certain of its key ratios and balance sheet features, such as loans to deposits, core deposits to total assets, borrowed funds to total assets, and commitments to lend to assets ratios.
Peer Group Ratio Comparisons
True or False
A high ratio of loans to deposits and borrowed funds to total assets and/or a low ratio of core deposits to total assets means that the DI relies heavily on the short-term money market rather than on core deposits to fund loans.
True
which lists sources and uses of liquidity and, thus, provides a measure of a DI’s net liquidity position.
net liquidity statement
Just as deposit drains can cause a DI liquidity problems, so can loan requests, resulting from the exercise, by borrowers, of loan commitments and other credit lines.
Asset Side Liquidity Risk
A measure of the potential losses a DI could suffer as the result of a sudden (or fire-sale) disposal of assets.
Liquidity index
The difference between a DI’s average loans and average (core) deposits.
Financing Gap
The financing gap plus a DI’s liquid assets.
Financing requirement
Formula of Financing Gap
FG = Liquid Assets + Borrowed Funds
Fourmula of Financing gap
FG = Average loans - Average deposits
Formula of Financing req.
Financing req. = Financing gap + liquid assets
True or False
If the financing gap is negative, the DI must find liquidity to fund the gap. This funding can come either purchased or stored liquidity management.
False
If the financing gap is positive, the DI must find liquidity to fund the gap. This funding can come either purchased or stored liquidity management.
BIS stands for
Bank for International Settlements
It is essential for managing liquidity risk and costs, as it allows managers to make borrowing decisions before problems arise, lowering fund costs and minimizing excess reserves.
Liquidity Planning
Liquidity Plan Components:
- delineation of managerial responsibilities
- a detailed list of fund providers most likely to withdraw as well as the pattern of fund withdrawals
- the identification of the size of potential deposit and fund withdrawals over various time horizons
- internal limits on separate subsidiaries’ and branches’ borrowings as well as bounds for acceptable risk premiums to pay in each market
is the risk that a depository institution (DI) may not have enough liquid assets to meet short-term obligations
Liquidity Risk
Factors Contributing to Abnormal Deposit Drains:
- Concerns about a DI’s solvency
- Failure of a related DI
- Sudden changes in investor preferences regarding holding nonbank financial assets relative to another DI
is a sudden and unexpected increase in deposit withdrawals from a DI
Bank Run
operates on a first-come, first- served basis
Demand Deposit Contracts
True or False
Quick withdrawals when problems arise make banks less stable
True
a systemic or contagious run on the deposits of the banking industry as a whole.
Bank Panic
Regulatory mechanisms are in place to ease DIs’ liquidity problems and to prevent bank runs and panics
-deposit insurance
- liquidity window
a Philippine government-run deposit insurance fund
Philippine Deposit Insurance Corporation (PDIC)
The window shall meet the liquidity needs of the financial system under normal conditions and shall be distinct from overdrafts and emergency advances.
liquidity window
Liquidity Window
a. Interest rate - ?
b. Security - ?
c. Loan Values - ?
d. Repayment Period - ?
a. Interest rate - (90) days
b. Security - eligible under Section 82 of R.A. No. 7653.
c. Loan Values - (80%) of the amount still due outstanding on the paper offered as collateral
d. Repayment Period - shall not exceed (7) days
The amount that an insurance policyholder receives when cashing in a policy early.
Surrender Value
hold cash reserves and other liquid assets in order to meet policy payments and cancellations (surrenders) and other working capital needs that arise in the course of writing insurance.
Life Insurance
True or False
premium income and returns on an insurer’s asset portfolio are sufficient to meet the cash outflows required when policyholders surrender their policies early. When premium income is insufficient to meet surrenders, however, a life insurer can sell some of its relatively liquid assets, such as government bonds.
True
insurers sell policies that protect against specific risks for real property or individuals, like damage to homes or cars.
Property and casualty (P&C)
These risks are often short-term and unpredictable compared to life insurance.
Property and casualty (P&C)
P&C insurers need more readily available cash because their claims, such as those from natural disasters, are hard to predict.
Property and casualty (P&C)
They typically hold shorter-term, easily sellable assets and have shorter policy terms.
Property and casualty (P&C)
Their main liquidity risk comes from policy cancellations or non-renewals due to various reasons, which can lead to insufficient cash to cover claims.
Property and casualty (P&C)
sell shares to investors and invest the proceeds in assets such as bonds and equities.
Investment funds
shares at a price known as the net asset value (NAV) and must be ready to buy back shares from investors at this NAV.
Open-end investment funds
oncerns the potential impact of interest rate fluctuations on a company’s assets and liabilities.
Interest rate risk
focuses on a company’s financial stability and its ability to meet its financial obligations.
Insolvency risk
A book value accounting cash flow analysis of the interest income earned on a financial institution’s assets and the interest expense paid on its liabilities
Repricing model
Concentrates on the impact of interest rate changes on a financial institution’s Net Interest Income (NII)
Repricing model
refers to a specific time period or range in which financial assets or liabilities will mature or come due.
Maturity Bucket
Maturity Bucket
- One day
- More than 1 day to 3 months
- More than 3 months to 6 months
- More than 6 months to 12 months
- More than 1 year to 5 years
- More than 5 years
Strengths of Maturity Bucket
- Simplicity
- Low data input requirements
Weaknesses of Maturity Bucket
- The RPM ignores cash flows generated from off-balance-sheet activities
- The repricing model (RPM) measures only short-term profit changes, not shareholder wealth changes
is a financial management tool used to measure and
manage interest rate risk.
Duration Model
It provides a framework for assessing the sensitivity of fixed-income investments to changes in interest rates.
Duration Model
is a measure of the weighted average time it takes to receive the cash flows from a fixed-income investment.
Duration
helps investors understand how sensitive the price of a bond or a portfolio of bonds is to changes in interest rates.
Duration
is a measure of a bond’s sensitivity to changes in the interest rate, and it is calculated by dividing the sum product of discounted future cash inflow of the bond and a corresponding number of years by a sum of the discounted future cash inflow
duration formula
Factors that affect the duration
- Bond rates
- coupon rates
Applications of the Duration Model
- Assessing interest rate risk
- Portfolio management
- Comparing bond investments
Difficulties in applying the Duration Model
- Simplified Assumptions
- Limited Applicability
- Duration-Convexity Mismatch
Refers to the real possibility that a company may be unable to meet its payment obligations in a defined period of time – generally within a one-year horizon.
Insolvency Risk
It is also known as “bankruptcy risk.”
Insolvency Risk
source of funds and is a necessary requirement for growth under the existing minimum capital-to-assets ratios set by regulators.
Capital
Computing duration
- Consider a 2-year, 8% coupon bond, with a face value of $1,000 and yield-to-maturity of 12%. Coupons are paid semi-annually.
- Therefore, each coupon payment is $40 and the per period YTM is (1/2) x 12% = 6%.
Found in documents
Applications of the Duration Model
- Assessing interest rate risk
- Portfolio management
- Comparing bond investments
Difficulties in applying the Duration Model
- Simplified Assumptions
- Limited Applicability
- Duration-Convexity Mismatch
which was designed to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.
Troubled Asset Relief Program (TARP) of 2008–2009
Financial institutions had to meet certain standards:
(1) ensure that incentive compensation for senior executives did not encourage unnecessary and excessive risks that threatened the value of the financial institution;
(2) agree to pay back any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that were later proven to be materially inaccurate;
(3) refrain from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and
(4) agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.
True or False
FI managers may often prefer high levels of capital.
False
FI managers may often prefer low levels of capital.
is net worth which is the difference between the market value of its assets and liabilities.
Capital
Role of ______________________ as a device to protect against two of the major types of risk described in the previous chapters and in this chapter: credit risk and interest rate risk.
economic capital or net worth
The capital that a company gets from selling shares rather than borrowing money.
Equity Capital
Can be thought of as the total amount of money investors believe a company’s equity and debt securities are worth in the financial markets. It determines how the market views the company’s total value based on its assets, liabilities, future earnings, growth opportunities, and general financial situation.
Market Value of Capital
is the probability of a financial loss resulting from a borrower’s failure to repay a loan
Credit Risk
refers to the potential for changes in interest rates to negatively impact the value of investments, particularly fixed-income securities such as bonds.
Interest Rate Risk
True or False
Rising interest rates reduce the market value of the FI’s long-term securities and loans, while floating-rate instruments find their market values largely unaffected if interest rates on such securities are instantaneously reset.
True
is the difference between the book value of an FI’s assets and its liabilities.
BV of Capital
In book value of capial, it usually comprises of:
- Par Value of Shares
- Surplus Value of Shares
- Retained Earnings
Formula of book value of capital
Book value of capital = Par value + Surplus + Retained Earnings
True or False
book value of equity is always equal the market value of equity
False
book value of equity does not always equal the market value of equity
the higher the interest rate volatility, the greater the discrepancy.
Interest Rate Volatility
the more frequent are on-site and off- site examinations and the stiffer the examiner/regulator standards regarding charging off problem loans, the smaller the discrepancy.
Examination and Enforcement
the more loans that are traded, the easier it is to assess the true market value of the loan portfolio.
Loan Trading
shows the degree of discrepancy between the market value of an FI’s equity capital as perceived by investors in the stock market and the book value of capital on its balance sheet
Market-to-book ratio
Formula of market value of equity per share (MV)
MV = Market value of equity ownership in shares outstanding / number of shares
Formula of Book Value of capital
BV = (Par value + Surplus Value + Retained Earnings) / Number of shares
The senior preferred shares qualify as ____________ and rank senior to ______________.
Tier 1 capital; common stock
True or False
AIG faced massive losses from guarantees it made on mortgage derivatives, requiring it to post billions in collateral it didn’t have. AIG sought emergency funding from the Federal Reserve to avoid collapse and underwent a significant bailout and restructuring.
True
True or False
In a book value accounting world, when all assets and liabilities reflect their original cost of purchase, the rise in interest rates does not affect the value of assets, liabilities, or the book value of equity—the balance sheet remains unchanged.
True
