Lecture 6 Flashcards
What is liquidity risk?
Liquidity risk is the risk where an ADI has a shortage
of liquidity;
that is, will not be able to access funds to make
payments as they become due.
On the balance sheet where does Liquidity risk arise?
Liquidity risk can arise on both sides of the balance
sheet: the asset side as well as the liability side.
Liquidity risk on the balance
sheet liability side;
Depositors and other claimholders decide to cash in
their financial claims immediately.
Liquidity risk on the balance
sheet asset side;
Borrowers decide to use the loan commitment facilities
provided by the ADI.
What are the additional costs shortage of liquidity exposes ADI to?
Higher cost of borrowing (at short notice or ad hoc
borrow)
High costs for turning illiquid assets into cash
Quick asset sales may result in; in worst case, firesale
price.
Failure to meet liquidity means and threatens to….
If payment can not be made
=> threatens confidence in ADI
=> may cause a Bank Run
=> disrupt to financial system (contagion effect
ADIs must estimate funds needs, which is based on…
ADIs must estimate funds needs, which is based on deposit
inflows and outflows and varying levels of loan
commitment.
ADIs inflows of liquidity?
Inflows – Settlements, Holding of Liquid assets, access
to borrowed funds
ADIs outflows of liquidity?
Outflows – withdrawals from saving, drawings on loans
ADIs can meet liquidity needs via either…
ADIs can meet liquidity needs via either asset liquidity
and/or liability liquidity
What is Asset management?
Asset management – meeting liquidity needs by using
near-cash assets, securitisation.
What is Liability management?
Liability management – meeting liquidity needs by using
outside sources of discretionary funds
From a policy standpoint, an ADI should develop a…
From a policy standpoint, an ADI should
develop a liquidity plan or strategy that
balances risks and returns.
Downside of Excessive liquidity?
Excessive liquidity (or liquidity buffer) offers safety but can decrease bank profits
Problems with Aggressive liability management?
Aggressive liability management can increase
bank profits but can also increase the risk of
illiquidity problems.
Why are Central Banks are worried about systemic risk?
Central Banks are worried about systemic risk because
they are also responsible for financial system stability.
Definition of systemic risk?
• Events which may jeopardise financial system stability
and cause harm to the real economy
• They may include the risk that the failure of one
participant in a payments system, or in financial
markets generally, to meet their required obligations
when due, will cause other participants or financial
institutions to be unable to meet their obligations
(including settlement obligations in a transfer system)
when due. Such a failure may cause significant
liquidity or credit problems.
Typical Settlement System for Central Banks?
Multilateral Net Settlement
System
If a bank failure is to occur in a multilateral net
settlement system, there are 3 main ways to ensure
that settlement can proceed:
- “defaulter pays” system
• ie, liquidate the assets of the default FI to pay
others - “survivor pays” system
• ie, those who didn’t fail need to make-up difference
by failed FIs - The Central Bank provides the funds
In handling systemic risk, Central bank needs to
consider:
- The design of the payments clearing system
- The risk that an institution will be unable to meet its
obligations - Enforceable arrangements
- Likely disruption to the financial system
Who is responsible for the ADI liquidity management?
The Board of directors and management of an ADI shall implement and maintain a liquidity
management strategy that is appropriate for the operations of the ADI to ensure that it has
sufficient liquidity to meet its obligations as they fall due” (APS 210 Responsibility for liquidity
management)
An ADI’s liquidity management strategy shall include the following elements:
- A liquidity management policy statement strategy approved by the
board of directors or a board committee. For foreign ADIs, the
policy statement should be approved by an appropriate senior
officer from outside Australia - A system of measuring, assessing and reporting liquidity
- Procedures for managing liquidity
- Clearly defined managerial responsibilities and controls
- A formal contingency plan for dealing with a liquidity crisis
Covers both the local and overseas operations of the ADI, as well as all
related entities which have impact on the ADI’s liquidity.
Address all on and off-balance sheet activities of the ADI
ADI’s Responsibility for Liquidity Management under APS 210
1.Shall implement and maintain a liquidity management strategy
that is appropriate for the operations of the ADI to ensure that it has
sufficient liquidity to meet its obligations as they fall due.
2.Shall adhere to its liquidity management strategy at all times and
review it regularly (at least annually) to take account of changing
operating circumstances.
3. Shall inform APRA immediately of any concerns it has about its
current or future liquidity, as well as its plans to address these
concerns.
Provide liquidity reports to APRA on what basis?
Provide liquidity reports to APRA, normally on a quarterly
basis
ADI have to cater for 2 specific liquidity scenarios, what are they?
“going-concern”: day-to-day liquidity management and
“Name crisis”: bank-specific crisis – for 5 days
minimum
Scenario analysis requirements may vary dependent on
the size and scope of the FI.
Limiting exposure to unanticipated liquidity requires ADIs to do what?
Limiting exposure to unanticipated liquidity needs by
matching maturities of assets with maturities of liabilities
How can APRA limit ADIs from taking on unacceptable risk levels?
Limits on maturity mismatches by stopping ADI to take on
new business which might be profitable but increase
liquidity risk to unacceptable level
Basel III liquidity reforms: Two parts to the new regulatory requirements;
liquidity coverage ratio (LCR) (full compliance required
by 1 January 2015)
o Promotes short-term resilence
o net stable funding ratio (NSFR) (full compliance
required by 1 January 2018)
o Promotes more medium and longer-term resilence
In Australia, final settlement of obligations between
payments providers is by
In Australia, final settlement of obligations between
payments providers is by entries to their Exchange
Settlement (ES) accounts at the Reserve Bank
To achieve financial system stability, RBA operates a
number of liquidity facilities and payments operations,
which allow ADIs to….
to settle payment obligations and
manage their liquidity requirements
why is a safe and efficient payments system essential?
A safe and efficient payments system is essential to
support the day-to-day business of the Australian economy
and to settle transactions in its financial markets.
In Australia how is the final settlement of obligations between payments providers performed?
is by entries to their Exchange
Settlement (ES) accounts at the Reserve Bank
In Australia, Exchange settlement accounts are held by who are what for?
In Australia, Exchange settlement accounts are provided
by and held at RBA for settlement of inter-bank
transactions.
Why would FIs use ESAs?
FIs make use of ESAs to make payments on behalf of
customers.
Applicants for ESAs must be:
An actual or prospective provider of 3rd-party (customer)
payment services;
Able to demonstrate that they have enough liquidity
Institutions with limited payment experience are required to
lodge collateral (ie, A$ securities issued by State & Territory
governments)
Applicants for ESAs must submit a business plan what is in this plan?
Expected gross daily payment flows, both routinely and during
predictable “peak” period;
Expected net settlement obligations, both routinely and during
predictable “peak” period;
Sources of ES liquidity to settle routine and predictable “peak”
payment of obligations; and
Sources of liquidity (and its terms) available to settle payment
obligations in times of unpredictable pressures.
The characteristics of ESAs include:
Not allowed to go into debit, hence must maintain in credit at
all times
The rate on ES balances is set 25 basis points below the
cash rate target to encourage ES account holders to lend
surplus funds into the market rather then leave them with the
RBA (Interest paid at target cash rate less 25 basis points;
100 basis point = 1%)
ESAs, are mandatory for all Australian-licensed banks and….
for other ADIs with RTGS transactions that are 0.25 per
cent or more of the total value of RTGS transactions; and for any
licensed central counterparty (CCP) that the Reserve Bank
deems to be systemically important.
However, eligible banks may apply to the RBA and the
Australian Prudential Regulation Authority (APRA) to use an
agent rather than settle across their own ESA – Must still
maintain an ESA for use in contingency
What exactly is RITS? (TWO MAIN COMPONENTS)
Australia’s high-value payments system across
which settlement of interbank payment obligations
occurs on a real-time gross settlement (RTGS)
basis.
Over 90% of interbank payments by value are
settled on an RTGS basis
The balance of outstanding payments
The balance of outstanding payments is settled under?
deferred net settlement (DNS)
RTGS:
all high-value payments in real
time across their ES accounts (90% payments
settled through the RTGS systems in Australia)
DNS:
high volume low value transactions
RTGS used to eliminate what risk? And to promote?
Instituted to eliminate settlement risk associated with domestic interbank high-value payments and to promote
the overall efficiency of Australia’s financial system
How does RTGS eliminate settlement risk?
This minimises payment system risk as any default by
one bank would simply be reflected in the inability to
settle a single payment and not a number of payments
Banks must have sufficient funds in their ESAs to ensure that their own payments proceed as well as those of…
those of their customers are
able to proceed throughout the day.
2 main sources of liquidity for settlement:
- overnight ESA balances;
- intra-day reciprocal purchase agreements (repos) with the RBA,
called RBA Repos.
RITS has been designed to use available
liquidity efficiently through its….
through the use of a centralised ‘System
Queue’ and an ‘Auto-offset’ facility
What does RITS centralised ‘System
Queue’ and an ‘Auto-offset’ facility do?
- Transactions recorded in a queue
- If they can be settled immediately, they are
- If not, then system moves to next transaction
- Use of off-setting transactions
DNS what is it used for?
Inter-bank obligations arising from cheques, credit and debit cards, and bulk electronic payments are settled on a multilaterally netted basis at around 9am on the business day following exchange.
What risk arises from using DNS?
Payment system risk arises from the use of DNS
What is payment system risk that arises under DNS?
A bank failed to settle, the default and delays in settlement would
create associated losses for other participants in the payments
system due to the requirement to unwind and recalculate the net
payments
In Aug 2004 what ‘failure to settle rules’ where introduced?
-If a member cannot settle, they are taken out of the multilateral
net settlement and obligation between remaining members are
recalculated
- Each survivor subsequently settles obligations with the defaulter
on a bilateral basis
Systems settled through Deferred Net Settlement include:
- APCS – Australian Paper Clearing System (ie, cheques)
- BECS – Bulk Electronic Clearing System (ie, direct entry payment such as credit employees’ accounts with the amount of their salaries
- CECS – Consumer Electronic Clearing System (ie., ATM, EFTPOS, Credit and debit cards)
How are the business cycle and liquidity needs are related?
Under economic boom conditions, bank encounters high liquidity needs because of rapid loan growth accompanied by a decline in deposits
FIs need to estimate their dynamic liquidity needs including:
- Immediate liquidity obligations (ie contractual and relationship form, overdraft facility)
- Seasonal short term Liquidity Needs
- Cyclical Liquidity Needs
- Trends in Liquidity Needs
Trend liquidity in rapidly expanding areas, loans and deposits often:
Grow faster than deposits:
• The ADI needs more sources of liquidity to provide funds for loan expansion
Trend liquidity in stable communities, loans and deposits often:
- In stable communities, deposits may show a steady rise while loans remain virtually unchanged
- Longer view of liquidity requirements may enable the ADI to invested more
Contingent liquidity needs are caused by?
unusual events that are difficult to predict
How are contingent liquidity needs anticipated?
- Presence of rules of thumb (something happening in US economy and you look at past spill overs so you know you can cover it)
- APRA regulation: withstand outflows for a minimum of five business days
What are Traditional Sources of Liquidity?
- Stored liquidity / asset liquidity
2. Purchased funds / liability liquidity
Stored liquidity / asset liquidity consists of;
holding liquid assets (funds which are temporarily invested with assurance that they either mature and be paid or are readily saleable)
e.g. cash and cash at bankers, treasury notes and loans to shortterm
money market dealers.
Purchased funds / liability liquidity include;
interbank market for exchange settlement funds, interbank market, securities sold under repos, large certificates of deposits, Euro $A deposits and other foreign sources, other liability forms.
Other sources of liquidity?
Securitisation
What is Securitisation?
-Securitisation : methods to securitise standardised loans, particularly housing loans.
-A process whereby interests in illiquid in-come producing assets to be converted into trade-able
capital markets instruments.
-This is achieved by transferring the illiquid
assets to a special purpose vehicle (SPV)
usually a company or a trust.
-The SPV funds its purchase of those assets by issuing trade-able instruments, and secures those instruments by giving a charge or other security interest over the underlying assets.
There are 2 ways to measure liquidity;
A. Static measures of liquidity Liquidity ratio Non-core funds dependence ratio Liquidity gap B. Dynamic liquidity measure Dynamic gap and ratio
What is the Liquidity ratio? (Static measure of liquidity)
-Liquid assets as a proportion of total assets
-The higher the ratio, the better
Liquidity Ratio= Liquid Assets / Total Assets
Problem with the Liquidity ratio?
Measure of available liquidity but doesn’t include access to borrowed liquidity / or reflect need for liquidity
What is Non-core funds dependence ratio? (Static measure of liquidity)
-Vulnerable to unexpected withdrawals (non-core)
-Stable withdrawals (Core)
NCFD=(Non-Core Liabilities-Liquid Assets)/Long Term Earning Assets
Problem with the Non-core funds dependence ratio?
While relates to liquidity needs from volatile
liabilities, it does not actually predict liquidity needs. Neither does it take into account other liquidity needs (such as new lending) or availability of liquidity.
What is Liquidity gap? (Static measure of liquidity)
reflects liquidity needs from volatile
liabilities.
Liquidity Gap= Liquid Assets-Noncore Liabilities
Positive gap = able to meet liquidity needs
Negative gap = unable to meet liquidity needs
Problems with the Liquidity gap:
While related to the availability of assets liquidity, no prediction of actual liquidity needs is made and sources of liability liquidity are not included.
Most stable liquidity ratios are criticized when they only do what?
Criticized when they just focus on one area
Dynamic Liquidity Gap calculation?
Gap=Liquid Assets + Estimated Liab
Liquidity - Estimated Liquidity Needs
Liabilities liquidity = inflows
Liabilities needs = outflows
Dynamic Liquidity Ratio calculation?
(Liquid Assets + Estimated Liab Liquidity) /Estimated Liquidity Needs
Ratio value >1 indicates available liquidity will be more than expected liquidity needs
Why are Governments reluctant to let banks fail or
depositors lose their savings?
- Political backlash
- Financial system failure
- People lose faith in financial systems
To tackle system risk, governments have taken on a series of approaches:
- Lender of last resort (will RBA or APRA interfere?)
- Regulation & supervision (ie, APRA, ASIC)
- Deposit Insurance
- An explicit denial of protection
- Legal priority for the claims of depositors over other claimants during the liquidation of a failed bank
- Ambiguity regarding coverage
- An Implicit guarantee - by central banks
- Explicit limited coverage
- A full explicit guarantee
How does IMF recommend the funding deposit insurance is paid?
through
premiums paid by its member banks even if govt helps at start:
Ensures that the agency in charge of its operations will manage it in a
fiscally responsible manner;
Working capital available quickly
Member banks have an incentive to monitor the system’s operation
Insuring banks causes what problem?
Moral Hazard Problems
If insurance is available, FIs are likely to take-up more risky
investments => high risk, higher chance of failure
