Chapter 8: Liquidity Risk Flashcards

1
Q

Causes of Liquidity Risk

A
  • 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
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2
Q
A
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3
Q

is a financial institution whose main source of funds is deposits from customers.

A

Depository Institution

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4
Q

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.

A

Demand Deposit Account

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5
Q

Deposits that provide a relatively stable, long-term funding source to a depository institution.

A

Core Deposit

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6
Q

The amount by which cash withdrawals exceed additions; a net cash outflow.

A

Net Deposit Drains

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7
Q

2 major ways for the FI to manage Deposit on Drains

A
  1. Purchased liquidity management
  2. Stored liquidity management
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8
Q

An adjustment to a deposit drain that occurs on the liability side of the balance sheet.

A

Purchased liquidity management

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9
Q

An adjustment to a deposit drain that occurs on the asset side of the balance sheet.

A

Stored liquidity management

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10
Q

True or False

Traditionally, DI managers relied on stored liquidity as the primary mechanism of liquidity management

A

True

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11
Q

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.

A

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.

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12
Q

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.

A

purchases liquidity

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13
Q

These methods take into account the DI’s excess cash reserves and its ability to raise additional purchased funds.

A

Measuring a Bank’s Liquidity Exposure

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14
Q

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.

A

Peer Group Ratio Comparisons

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15
Q

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.

A

True

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16
Q

which lists sources and uses of liquidity and, thus, provides a measure of a DI’s net liquidity position.

A

net liquidity statement

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17
Q

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.

A

Asset Side Liquidity Risk

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18
Q

A measure of the potential losses a DI could suffer as the result of a sudden (or fire-sale) disposal of assets.

A

Liquidity index

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19
Q

The difference between a DI’s average loans and average (core) deposits.

A

Financing Gap

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20
Q

The financing gap plus a DI’s liquid assets.

A

Financing requirement

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21
Q

Formula of Financing Gap

A

FG = Liquid Assets + Borrowed Funds

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22
Q

Fourmula of Financing gap

A

FG = Average loans - Average deposits

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23
Q

Formula of Financing req.

A

Financing req. = Financing gap + liquid assets

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24
Q

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.

A

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.

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25
Q

BIS stands for

A

Bank for International Settlements

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26
Q

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.

A

Liquidity Planning

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27
Q

Liquidity Plan Components:

A
  • 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
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28
Q

is the risk that a depository institution (DI) may not have enough liquid assets to meet short-term obligations

A

Liquidity Risk

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29
Q

Factors Contributing to Abnormal Deposit Drains:

A
  • 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
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30
Q

is a sudden and unexpected increase in deposit withdrawals from a DI

A

Bank Run

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31
Q

operates on a first-come, first- served basis

A

Demand Deposit Contracts

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32
Q

True or False

Quick withdrawals when problems arise make banks less stable

A

True

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33
Q

a systemic or contagious run on the deposits of the banking industry as a whole.

A

Bank Panic

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34
Q

Regulatory mechanisms are in place to ease DIs’ liquidity problems and to prevent bank runs and panics

A

-deposit insurance
- liquidity window

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35
Q

a Philippine government-run deposit insurance fund

A

Philippine Deposit Insurance Corporation (PDIC)

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36
Q

The window shall meet the liquidity needs of the financial system under normal conditions and shall be distinct from overdrafts and emergency advances.

A

liquidity window

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37
Q

Liquidity Window

a. Interest rate - ?
b. Security - ?
c. Loan Values - ?
d. Repayment Period - ?

A

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

38
Q

The amount that an insurance policyholder receives when cashing in a policy early.

A

Surrender Value

39
Q

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.

A

Life Insurance

40
Q

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.

A

True

41
Q

insurers sell policies that protect against specific risks for real property or individuals, like damage to homes or cars.

A

Property and casualty (P&C)

42
Q

These risks are often short-term and unpredictable compared to life insurance.

A

Property and casualty (P&C)

43
Q

P&C insurers need more readily available cash because their claims, such as those from natural disasters, are hard to predict.

A

Property and casualty (P&C)

44
Q

They typically hold shorter-term, easily sellable assets and have shorter policy terms.

A

Property and casualty (P&C)

45
Q

Their main liquidity risk comes from policy cancellations or non-renewals due to various reasons, which can lead to insufficient cash to cover claims.

A

Property and casualty (P&C)

46
Q

sell shares to investors and invest the proceeds in assets such as bonds and equities.

A

Investment funds

47
Q

shares at a price known as the net asset value (NAV) and must be ready to buy back shares from investors at this NAV.

A

Open-end investment funds

48
Q

oncerns the potential impact of interest rate fluctuations on a company’s assets and liabilities.

A

Interest rate risk

49
Q

focuses on a company’s financial stability and its ability to meet its financial obligations.

A

Insolvency risk

50
Q

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

A

Repricing model

51
Q

Concentrates on the impact of interest rate changes on a financial institution’s Net Interest Income (NII)

A

Repricing model

52
Q

refers to a specific time period or range in which financial assets or liabilities will mature or come due.

A

Maturity Bucket

53
Q

Maturity Bucket

A
  1. One day
  2. More than 1 day to 3 months
  3. More than 3 months to 6 months
    1. More than 6 months to 12 months
    1. More than 1 year to 5 years
  4. More than 5 years
54
Q

Strengths of Maturity Bucket

A
  • Simplicity
  • Low data input requirements
55
Q

Weaknesses of Maturity Bucket

A
  • 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
56
Q

is a financial management tool used to measure and
manage interest rate risk.

A

Duration Model

57
Q

It provides a framework for assessing the sensitivity of fixed-income investments to changes in interest rates.

A

Duration Model

58
Q

is a measure of the weighted average time it takes to receive the cash flows from a fixed-income investment.

A

Duration

59
Q

helps investors understand how sensitive the price of a bond or a portfolio of bonds is to changes in interest rates.

A

Duration

60
Q

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

A

duration formula

61
Q

Factors that affect the duration

A
  1. Bond rates
  2. coupon rates
62
Q

Applications of the Duration Model

A
  • Assessing interest rate risk
  • Portfolio management
  • Comparing bond investments
63
Q

Difficulties in applying the Duration Model

A
  • Simplified Assumptions
  • Limited Applicability
  • Duration-Convexity Mismatch
64
Q

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.

A

Insolvency Risk

65
Q

It is also known as “bankruptcy risk.”

A

Insolvency Risk

66
Q

source of funds and is a necessary requirement for growth under the existing minimum capital-to-assets ratios set by regulators.

A

Capital

67
Q

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%.
A

Found in documents

68
Q

Applications of the Duration Model

A
  • Assessing interest rate risk
  • Portfolio management
  • Comparing bond investments
69
Q

Difficulties in applying the Duration Model

A
  • Simplified Assumptions
  • Limited Applicability
  • Duration-Convexity Mismatch
70
Q

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.

A

Troubled Asset Relief Program (TARP) of 2008–2009

71
Q

Financial institutions had to meet certain standards:

A

(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.

72
Q

True or False

FI managers may often prefer high levels of capital.

A

False

FI managers may often prefer low levels of capital.

73
Q

is net worth which is the difference between the market value of its assets and liabilities.

A

Capital

74
Q

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.

A

economic capital or net worth

75
Q

The capital that a company gets from selling shares rather than borrowing money.

A

Equity Capital

76
Q

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.

A

Market Value of Capital

77
Q

is the probability of a financial loss resulting from a borrower’s failure to repay a loan

A

Credit Risk

78
Q

refers to the potential for changes in interest rates to negatively impact the value of investments, particularly fixed-income securities such as bonds.

A

Interest Rate Risk

79
Q

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.

A

True

80
Q

is the difference between the book value of an FI’s assets and its liabilities.

A

BV of Capital

81
Q

In book value of capial, it usually comprises of:

A
  • Par Value of Shares
  • Surplus Value of Shares
  • Retained Earnings
82
Q

Formula of book value of capital

A

Book value of capital = Par value + Surplus + Retained Earnings

83
Q

True or False

book value of equity is always equal the market value of equity

A

False

book value of equity does not always equal the market value of equity

84
Q

the higher the interest rate volatility, the greater the discrepancy.

A

Interest Rate Volatility

85
Q

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.

A

Examination and Enforcement

86
Q

the more loans that are traded, the easier it is to assess the true market value of the loan portfolio.

A

Loan Trading

87
Q

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

A

Market-to-book ratio

88
Q

Formula of market value of equity per share (MV)

A

MV = Market value of equity ownership in shares outstanding / number of shares

89
Q

Formula of Book Value of capital

A

BV = (Par value + Surplus Value + Retained Earnings) / Number of shares

90
Q

The senior preferred shares qualify as ____________ and rank senior to ______________.

A

Tier 1 capital; common stock

91
Q

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.

A

True

92
Q

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.

A

True