Week 6, Liquidity Risk and the Protection of deposits

Question 1

Explain what Liquidity risk is and how it can arise from both sides of the balance sheet

Answer 1

Liquidity risk is the risk where an ADI has a shortage
of liquidity, it will not be able to access funds to make
payments as they become due.

Liquidity risk can arise on both sides of the balance
sheet: the asset side as well as the liability side.

Liability side: Depositors and other claim holders decide to cash in their financial claims immediately.

Asset side: Borrowers decide to use the loan commitment facilities provided by the ADI.

Question 2

Explain the costs to the FI if there is a liquidity crisis

Answer 2

Shortage of liquidity exposes the ADI to additional costs.

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.

Question 3

What are the consequences of failure to meet liquidity to the FI

Answer 3

If payment can not be made

1. threatens confidence in ADI
2. may cause a Bank Run
3. disrupt to financial system (contagion effect)

Question 4

How does an ADI estimate the need of its funds?

Answer 4

ADIs must estimate funds needs, which is based on deposit inflows and outflows and varying levels of loan
commitment.

Inflows – Settlements, Holding of Liquid assets, access
to borrowed funds

Outflows – withdrawals from saving, drawings on loans

Question 5

How can ADI meet liquidity

Answer 5

ADIs can meet liquidity needs via either asset liquidity
and/or liability liquidity

Asset management – meeting liquidity needs by using
near-cash assets, securitisation.

Liability management – meeting liquidity needs by using
outside sources of discretionary funds

Question 6

How does a liquidity affect the banks risk and return (3 points)

Answer 6

From a policy standpoint, an ADI should develop a liquidity plan or strategy that balances risks and returns.

Excessive liquidity (or liquidity buffer) offers safety but can decrease bank profits.

Aggressive liability management can increase bank profits but can also increase the risk of illiquidity problems.

Question 7

What are the Risks to Central Banks if there is a liquidity problem in one of its FIs

Answer 7

Central Banks are worried about systemic risk because

they are also responsible for financial system stability

Question 8

Define systemic risk

Answer 8

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.

Question 9

If bank failure occurs in a multilateral net settlement system, what are the 3 main ways to ensure that settlement can proceed

Answer 9

1. “defaulter pays” system: liquidate the assets of the default FI to pay others
2. “survivor pays” system: those who didn’t fail need to make-up difference by failed FIs
3. The Central Bank provides the funds

Question 10

In handling systemic risk, what does the Central bank need to consider

Answer 10

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

Question 11

What are APRA responsibility for Liquidity Management (3 points)

Answer 11

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

Question 12

How does RBA help ADI manage their liquidity requirements and therefore achieve financial system stability

Answer 12

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.

When payments are cleared between institutions, they
accrue obligations which must be settled.

In Australia, final settlement of obligations between
payments providers is by entries to their Exchange
Settlement (ES) accounts at the Reserve Bank

Question 13

Explain the function of the Exchange Settlement Accounts and how they operate

Answer 13

In Australia, Exchange settlement accounts are provided
by and held at RBA for settlement of inter-bank
transactions.

FIs make use of ESAs to make payments on behalf of
customers.

Settlements take place by debiting and crediting the ESAs
Balances are deposits of undisputed quality; and They provide a convenient central mechanism for effecting settlement

Question 14

What is the RITS of the rba

How are high value payments settled

How are the outstanding balance pf payments settled

Answer 14

RBA Information and Transfer System (RITS)

RITS is the means by which ESAs are accessed and it
facilitates banks’ credit and liquidity management by providing tools with which they can exercise control over the settlement of payments.

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 is settled under
a deferred net settlement (DNS)

Question 15

What is the difference between RTGS and DNS

Answer 15

RTGS: banks settle all high-value payments in real
time across their ES accounts (90% payments
settled through the RTGS systems in Australia)

DNS: is used for high volume low value transactions

Question 16

In the ESA what is the use and function of RTGS.

How does this reduce the payment system risk

Answer 16

provides continuous processing and settlement of transactions irrevocable in real-time, out of the credit funds in banks’ ESAs with the RBA

Instituted to eliminate settlement risk associated with
domestic interbank high-value payments and to promote
the overall efficiency of Australia’s financial system

Under RTGS, each separate payment instruction is settled immediately as it is received and processed by the system
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 and those of their customers are
able to proceed throughout the day

Question 17

Explain how the ‘System Queue” and an “Auto-offset” Facility works

Answer 17

Transactions recorded in a queue

f they can be settled immediately, they are

If not, then system moves to next transaction

Use of off-setting transactions

Question 18

In the ESA expalin the function of DNS and how it operates

Answer 18

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.

Banks must also make sure that they have sufficient funds in their ESAs for the settlement

Question 19

Explain how Payment system risk arises

Answer 19

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

Question 20

Is there a link between the business cycle and liquidity, if so expalin

Answer 20

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

Question 21

What factors do FI consider when estimating their dynamic liquidity needs

Answer 21

FIs need to estimate their dynamic liquidity needs including

Immediate liquidity obligations (ie contractual and
relationship form)

Seasonal short term Liquidity Needs

Cyclical Liquidity Needs

Trends in Liquidity Needs

Question 22

Explain Trends in Liquidity Needs

Answer 22

Trend liquidity needs include loans expansion in markets
that an ADI serves. In relation to the community the banks serve

In rapidly expanding areas, loans often grow faster than
deposits. The ADI needs more sources of liquidity to provide funds for loan expansion

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

Question 23

Explain the Contingent Liquidity Needs, how has APRA tried to regulate this

Answer 23

Contingent liquidity needs are caused by unusual events that are difficult to predict

APRA regulation: withstand outflows for a minimum of five business days

Question 24

What are the traditional Sources of Liquidity

Answer 24

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). For example cash and cash at bankers, treasury notes and loans to short term 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

Question 25

What are the other sources of liquidity

Answer 25

Securitisation : methods to securitise standardised
loans, particularly housing loans.

A process whereby interests in illiquid incomeproducing
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.

Question 26

What are methods in the two ways to measure liquidity

Answer 26

1. Static measures of liquidity
   - Liquidity ratio
   - Non-core funds dependence ratio
   - Liquidity gap
2. Dynamic liquidity measure
   - Dynamic gap and ratio

Question 27

What is the function for liquidity ratio and the problems with this ratio

Answer 27

Liquidity ratio: Liquid assets as a proportion of total assets

The higher the ratio, the better

Liquidity Ratio = Liquid assets / total assets

Problem with the ratio: Measure of available liquidity but
doesn’t include access to borrowed liquidity / or reflect need for liquidity

Question 28

What is the function for non-core funds dependence ratio and the problems with this ratio

Define what core and non core liabilities are.

Answer 28

Non-core funds dependence ratio

Vulnerable to unexpected withdrawals (non-core)
Stable withdrawals (Core)

NCFD= ( Non Core Liabilities - Liquid Assets NCFD ) / (Long term Earning Assets )

Problems with the 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

Question 29

What is the function for Liquidity Gap and the problems associated with liquidity Gap

Answer 29

Liquidity gap reflects liquidity needs from volatile liabilities

Liquidity Gap = Liquid Assets - Non core Liabilities

Positive gap = able to meet liquidity needs
Negative gap = unable to meet liquidity needs

Problems with the ratio: While related to the availability of assets liquidity,no prediction of actual liquidity needs is made and sources of liability liquidity are not included.

Question 30

What is the function of the Dynamic Liquidity Gap.

What are the liability liquidity and liability needs.

Answer 30

Gap = ( Liquid Assets + Estimated Liability Liquidity ) - ( Estimated Liquidity Needs )

Liabilities Liquidity = Inflows
Liabilities Needs = Outflows

Question 31

What is the function of Dynamic Liquidity Ratio

Answer 31

Ratio = ( Liquid Assets + Estimated Liability Liquidity ) / ( Estimated Liquidity Needs )

Ratio Value > 1 indicates available liquidity will be more than expected liquidity needs

Question 32

Why are Governments Reluctant to let banks fail or depositors lose their savings

Answer 32

Political backlash

Financial system failure

People lose faith in financial systems

Question 33

What is Systemic Risk

Answer 33

Risk that some financial shock causes a set of markets or institutions to simultaneously fail;

Risk that failure of one or a small number of institutions will be transmitted to others due to explicit financial linkages across institutions

Question 34

How does the goverment try and manage Systemic Risk

Answer 34

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
• A1 full explicit guarantee

Question 35

According to the IMF what is the best Practice for systemic risk

Answer 35

Providing legal and regulatory authority for the system;

Giving the national banking supervisor the power to take
prompt remedial actions against failing depository institutions;

Resolving failed banks quickly;

Keeping the size of deposits covered by deposit insurance
small;

Making bank membership in the system compulsory to
avoid adverse selection;

Paying out insured deposits quickly;

Charging risk-adjusted insurance premiums; &

Ensuring the independence of the deposit insurance
agency

Question 36

What is the moral Hazard Problem

Answer 36

if insurance is available, FIs are likely to take-up more risky investments => high risk, higher chance of failure