Week 9: Liquidity risk Flashcards
What causes the liability side liquidity risk?
– Depositors and other claimholders decide to cash in their financial claims immediately.
– DIs largely rely on demand deposits and other transaction accounts.
Solutions to the liability side liquidity risk?
- 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
What causes the asset side liquidity risk?
– The exercise of loan commitments and other credit
lines by borrowers.
– Unexpected loss in the value of investment securities
portfolios.
What is Purchased liquidity management?
- 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
What are the costs of purchased liquidity management?
- 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
What does purchased liquidity management allow DIs to do?
• Managing the liability side preserves asset side of balance sheet; purchased liquidity management allows DIs to maintain their overall balance sheet size.
What is stored liquidity management (SLM)?
• 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.
What are the costs of stored liquidity management?
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.
What does SLM do to the balance sheet?
• Decreases size of balance sheet.
• so its better to combine purchased and stored liquidity
management.
In relation to Net Liquidity Statement what are the sources of liquidity?
– Maximum amount of borrowing funds in the
money market.
– Sale of liquid assets with minimum price risk.
– Excess cash reserves.
In relation to Net Liquidity Statement what are the uses of liquidity?
– Borrowed or money market funds already utilised.
What is the Peer Group Ratio Comparison
• 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
Explain the loans/deposits ratio
- 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
Explain the Borrowed funds/total assets ratio
- A high ratio indicates that DI relies heavily on borrowed funds
Explain the Loan commitments/assets ratio
- A high ratio indicates the need for a high degree of liquidity to fund any unexpected takedowns of the loans.
What is the liquidity index?
• 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.
What is Financing Gap?
• 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
What is the Financing Requirement?
• 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.
What is liquidity planning?
• 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.
What are the components of a liquidity plan?
- Delineation of managerial details and responsibilities.
- List of fund providers who are more likely to
withdraw, and the pattern of fund withdrawals. - Identification of the size of potential deposit and fund
withdrawals over various future time horizons. - Setting of internal limits on borrowings.
- A sequencing of asset for disposal
Explain immediate liquidity obligations
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
Explain Seasonal short-term liquidity needs
– 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)
Explain Trend liquidity needs
– 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
Explain Cyclical liquidity needs
– 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.
Explain Contingent liquidity needs
– 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
What are the Reasons for abnormal deposit drains?
– 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.
discuss a bank run
– 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.
What is the mismatch ratio?
• 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.
What is the core funding ratio?
• 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.
