Week 6, Liquidity Risk and the Protection of deposits Flashcards
Explain what Liquidity risk is and how it can arise from both sides of the balance sheet
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.
Explain the costs to the FI if there is a liquidity crisis
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.
What are the consequences of failure to meet liquidity to the FI
If payment can not be made
- threatens confidence in ADI
- may cause a Bank Run
- disrupt to financial system (contagion effect)
How does an ADI estimate the need of its funds?
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
How can ADI meet liquidity
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
How does a liquidity affect the banks risk and return (3 points)
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.
What are the Risks to Central Banks if there is a liquidity problem in one of its FIs
Central Banks are worried about systemic risk because
they are also responsible for financial system stability
Define 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.
If bank failure occurs in a multilateral net settlement system, what are the 3 main ways to ensure that settlement can proceed
- “defaulter pays” system: liquidate the assets of the default FI to pay others
- “survivor pays” system: those who didn’t fail need to make-up difference by failed FIs
- The Central Bank provides the funds
In handling systemic risk, what does the Central bank need 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
What are APRA responsibility for Liquidity Management (3 points)
- 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.
- Shall adhere to its liquidity management strategy at all times and review it regularly (at least annually) to take account of changing operating circumstances.
- Shall inform APRA immediately of any concerns it has about its current or future liquidity, as well as its plans to address these concerns
How does RBA help ADI manage their liquidity requirements and therefore achieve financial system stability
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
Explain the function of the Exchange Settlement Accounts and how they operate
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
What is the RITS of the rba
How are high value payments settled
How are the outstanding balance pf payments settled
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)
What is the difference between RTGS and DNS
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
In the ESA what is the use and function of RTGS.
How does this reduce the payment system risk
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
Explain how the ‘System Queue” and an “Auto-offset” Facility works
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
In the ESA expalin the function of DNS and how it operates
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
Explain how Payment system risk arises
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
Is there a link between the business cycle and liquidity, if so expalin
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
What factors do FI consider when estimating their dynamic liquidity needs
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
Explain Trends in Liquidity Needs
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
Explain the Contingent Liquidity Needs, how has APRA tried to regulate this
Contingent liquidity needs are caused by unusual events that are difficult to predict
APRA regulation: withstand outflows for a minimum of five business days
What are the traditional Sources of 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). 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
What are the other sources of liquidity
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.
What are methods in the two ways to measure liquidity
- Static measures of liquidity
- Liquidity ratio
- Non-core funds dependence ratio
- Liquidity gap - Dynamic liquidity measure
- Dynamic gap and ratio
What is the function for liquidity ratio and the problems with this ratio
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
What is the function for non-core funds dependence ratio and the problems with this ratio
Define what core and non core liabilities are.
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
What is the function for Liquidity Gap and the problems associated with liquidity Gap
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.
What is the function of the Dynamic Liquidity Gap.
What are the liability liquidity and liability needs.
Gap = ( Liquid Assets + Estimated Liability Liquidity ) - ( Estimated Liquidity Needs )
Liabilities Liquidity = Inflows
Liabilities Needs = Outflows
What is the function of Dynamic Liquidity Ratio
Ratio = ( Liquid Assets + Estimated Liability 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
What is Systemic Risk
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
How does the goverment try and manage Systemic Risk
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
According to the IMF what is the best Practice for systemic risk
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
What is the moral Hazard Problem
if insurance is available, FIs are likely to take-up more risky investments => high risk, higher chance of failure
