Week 9: Liquidity risk

Question 1

What causes the liability side liquidity risk?

Answer 1

– Depositors and other claimholders decide to cash in their financial claims immediately.

– DIs largely rely on demand deposits and other transaction accounts.

Question 2

Solutions to the liability side liquidity risk?

Answer 2

• Solution 1: predict the distribution of net deposit
  drains (the difference between deposit withdrawals
  and deposit additions on any specific normal banking
  day).
• Solution 2: rely on core deposits

Question 3

What causes the asset side liquidity risk?

Answer 3

– The exercise of loan commitments and other credit
lines by borrowers.

– Unexpected loss in the value of investment securities
portfolios.

Question 4

What is Purchased liquidity management?

Answer 4

• A liability-side adjustment to the balance sheet to cover a deposit drain.
• Liquidity can be purchased in financial markets, e.g. borrowed funds from competitor banks and other institutional investors

Question 5

What are the costs of purchased liquidity management?

Answer 5

• Costs: Borrowed funds are likely to be at higher rates (i.e. at market rate) than interest paid on deposits.
• borrowing from money market is way more expensive than borrowing from depositors

Question 6

What does purchased liquidity management allow DIs to do?

Answer 6

• Managing the liability side preserves asset side of balance sheet; purchased liquidity management allows DIs to maintain their overall balance sheet size.

Question 7

What is stored liquidity management (SLM)?

Answer 7

• An asset-side adjustment to the balance
sheet to cover a deposit drain.

• FI could liquidate some of its assets.

• Some central banks (e.g. Federal Reserve of
the U.S.) sets minimum reserve requirements
for cash reserve.

Question 8

What are the costs of stored liquidity management?

Answer 8

Costs:
– Requires holding excess non-interest bearing assets.
Credit creation example

– High costs for turning illiquid assets into cash.

– Liquidating assets may occur only at fire-sale prices.

– Loss of relationship if not renewing loans

• Can hold liquid assets but the cost is that liquid assets like cash usually do not generate income.

Question 9

What does SLM do to the balance sheet?

Answer 9

• Decreases size of balance sheet.

• so its better to combine purchased and stored liquidity
management.

Question 10

In relation to Net Liquidity Statement what are the sources of liquidity?

Answer 10

– Maximum amount of borrowing funds in the
money market.
– Sale of liquid assets with minimum price risk.
– Excess cash reserves.

Question 11

In relation to Net Liquidity Statement what are the uses of liquidity?

Answer 11

– Borrowed or money market funds already utilised.

Question 12

What is the Peer Group Ratio Comparison

Answer 12

• Comparison of certain key ratios and balance sheet features of the DI with similar DIs.

• Usual ratios include:
– Loans/deposits
– Borrowed funds/total assets
– Loan commitments/assets

Question 13

Explain the loans/deposits ratio

Answer 13

• A high ratio means DI relies heavily on the short‐term money market to fund loans (rather than on core deposits)
• Which indicates higher liquidity risk

Question 14

Explain the Borrowed funds/total assets ratio

Answer 14

• A high ratio indicates that DI relies heavily on borrowed funds

Question 15

Explain the Loan commitments/assets ratio

Answer 15

• A high ratio indicates the need for a high degree of liquidity to fund any unexpected takedowns of the loans.

Question 16

What is the liquidity index?

Answer 16

• Measures the potential loss a DI could suffer from a
sudden disposal of assets, compared to the amount it
would receive under normal market conditions.

Question 17

What is Financing Gap?

Answer 17

• Financing gap = average loans – average deposits.

• A positive gap means that the DI requires funding by using liquid assets and/or
borrowing funds from money market

Question 18

What is the Financing Requirement?

Answer 18

• Financing requirement (borrowed funds) = financing gap + liquid assets
– It implies the level of core deposits, loans, and amount of liquid assets determines the DI’s borrowing (i.e. purchased) fund needs.
– The larger a DI’s financing gap and liquid asset holdings, the greater the exposure.

Question 19

What is liquidity planning?

Answer 19

• Liquidity planning allows DI managers to make important borrowing priority decisions before liquidity problems arise.

– It can determine the optimal funding mix and optimal amount of excess reserves.
 – The overall aim is to ensure that there will be sufficient funds to settle outflows as they become due.

Question 20

What are the components of a liquidity plan?

Answer 20

1. Delineation of managerial details and responsibilities.
2. List of fund providers who are more likely to
   withdraw, and the pattern of fund withdrawals.
3. Identification of the size of potential deposit and fund
   withdrawals over various future time horizons.
4. Setting of internal limits on borrowings.
5. A sequencing of asset for disposal

Question 21

Explain immediate liquidity obligations

Answer 21

Contractual:
- the bank must have sufficient funds to repay any liabilities that are due.

Relationship:
- Satisfying the liquidity requirement from customers e.g. when good customer asks for loans

Question 22

Explain Seasonal short-term liquidity needs

Answer 22

– Liquidity need that fluctuates with seasonal factors.

– Can be predictable (e.g. holiday period and farming seasons?

or unpredictable (e.g. influence of large borrowers and large depositors)

Question 23

Explain Trend liquidity needs

Answer 23

– Determined over a longer time span; likely to be
associated with a DI’s particular customer base. (e.g. pensioners)

– Can be predicted over a longer time horizon

Question 24

Explain Cyclical liquidity needs

Answer 24

– Liquidity needs that vary with the business cycle. (e.g. high liquidity needs
in boom economy)

– Difficult to predict; out of the control of a single DI.

Question 25

Explain Contingent liquidity needs

Answer 25

– Liquidity needs necessary to meet an unforeseen
event. (e.g. unexpected deposit
outflow due to
a loss of
confidence in the DI)

– Basically impossible to predict

Question 26

What are the Reasons for abnormal deposit drains?

Answer 26

– Concerns about a DI’s solvency relative to other
DIs.

– Failure of a related DI can lead to heightened
depositor concerns about the solvency of other
DIs.

– Sudden changes in investor preferences
regarding holding non-bank financial assets
relative to deposits.

Question 27

discuss a bank run

Answer 27

– A bank run, justified or not, can force a DI into
insolvency.
– Bank runs can have contagious effects as the
investors lose faith in DIs overall and start running on
their banks.

Question 28

What is the mismatch ratio?

Answer 28

• All registered banks are subject to minimum one-week
and one-month mismatch ratios.

• Defined as mismatch dollar amount (expected cash
inflows against expected outflows) divided by total
funding.

• It means a bank needs to hold a sufficient stock of liquid assets.
• Aim: reduce the risk that an individual bank is brought down by a short-term loss of confidence.

Question 29

What is the core funding ratio?

Answer 29

• Defined as core funding amount relative to total loans
and advances.

• Core funding (stable and to stay in place for at least
one year) vs. core lending business (which needs to
be funded on a continuing basis).

• Minimum requirement: Initially set at 65% in April
2010, increased to 70% at 1 July 2011, then to 75% at
1 January 2013.

• Aim: to reduce the vulnerability of the banking sector
in a period of general market disruption.