1. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-1 Chapter Twenty-two Managing Risk on the Balance Sheet II: Liquidity Risk

2. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-2 Causes of Liquidity Risk Two types of liquidity risk: –when depositors or insurance policyholders seek to cash in or withdraw their financial claims –when OBS commitments are exercised Fire-sale price –the price received for an asset that must be liquidated (sold) immediately Two types of liquidity risk: –when depositors or insurance policyholders seek to cash in or withdraw their financial claims –when OBS commitments are exercised Fire-sale price –the price received for an asset that must be liquidated (sold) immediately

3. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-3 Liability Side Liquidity Risk Core deposits –deposits that provide a relatively stable, long-term funding source for a depository institution Net deposit drains –the amount by which cash withdrawals exceed additions; a net cash outflow –can be managed two ways: purchased liquidity management stored liquidity management Core deposits –deposits that provide a relatively stable, long-term funding source for a depository institution Net deposit drains –the amount by which cash withdrawals exceed additions; a net cash outflow –can be managed two ways: purchased liquidity management stored liquidity management (continued)

4. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-4 Liability Side Liquidity Risk Purchased liquidity –federal funds market –repurchased (repo) agreement market –issue additional fixed-maturity CD’s, notes, and/or bonds Stored liquidity –can use or sell off some of it’s assets (such as T-bills) –utilize its stored liquidity (i.e., cash in vault) Purchased liquidity –federal funds market –repurchased (repo) agreement market –issue additional fixed-maturity CD’s, notes, and/or bonds Stored liquidity –can use or sell off some of it’s assets (such as T-bills) –utilize its stored liquidity (i.e., cash in vault)

5. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-5 Loan requests that cannot be funded immediately because of exercise, by borrowers, of their loan commitments and other credit lines Asset Side Liquidity Risk

6. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-6 Measuring a Bank’s Liquidity Exposure Net liquidity statement –measures liquidity position by listing sources and uses of liquidity Peer group ratio comparisons –a comparison of its key ratios and balance sheet features with those for banks of a similar size and geographic location Liquidity index –measures the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to the amount it would receive at a fair market value established under normal market conditions Net liquidity statement –measures liquidity position by listing sources and uses of liquidity Peer group ratio comparisons –a comparison of its key ratios and balance sheet features with those for banks of a similar size and geographic location Liquidity index –measures the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to the amount it would receive at a fair market value established under normal market conditions

7. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-7 Calculation of the Liquidity Index N I =  [(w i )(P i / P i *)] i = 1 where w i = Percentage of each asset in the FI’s portfolio  w i = 1 P i = The price it gets if an FI liquidates asset i today P i * = The price it gets if an FI liquidates asset i at the end of the month N I =  [(w i )(P i / P i *)] i = 1 where w i = Percentage of each asset in the FI’s portfolio  w i = 1 P i = The price it gets if an FI liquidates asset i today P i * = The price it gets if an FI liquidates asset i at the end of the month

8. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-8 Financing Gap and the Financing Requirement Financing gap –the difference between a bank’s average loans and average (core) deposits –if the financing gap is positive, the bank must fund it by using its cash and liquid assets and/or borrowing funds in the money market Financing requirement –the financing gap plus a bank’s liquid assets –the larger a bank’s financing gap and liquid asset holdings, the higher the amount of funds it needs to borrow on the money markets and the greater is its exposure to liquidity problems Financing gap –the difference between a bank’s average loans and average (core) deposits –if the financing gap is positive, the bank must fund it by using its cash and liquid assets and/or borrowing funds in the money market Financing requirement –the financing gap plus a bank’s liquid assets –the larger a bank’s financing gap and liquid asset holdings, the higher the amount of funds it needs to borrow on the money markets and the greater is its exposure to liquidity problems

9. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-9 Liquidity Planning Allows managers to make important borrowing priority decisions Components of a liquidity plan –delineation of managerial details and responsibilities –detailed list of fund providers most likely to withdraw and the pattern of fund withdrawals –identification of the size of potential deposit and fund withdrawals over various time horizons in the future –setting internal limits on separate subsidiaries and branches borrowing and bounds for acceptable risk premiums to pay –details a sequencing of assets for disposal Allows managers to make important borrowing priority decisions Components of a liquidity plan –delineation of managerial details and responsibilities –detailed list of fund providers most likely to withdraw and the pattern of fund withdrawals –identification of the size of potential deposit and fund withdrawals over various time horizons in the future –setting internal limits on separate subsidiaries and branches borrowing and bounds for acceptable risk premiums to pay –details a sequencing of assets for disposal

10. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-10 Deposit Drains and Bank Run Liquidity Risk Deposit drains may occur for a variety of reasons –concerns about a bank’s solvency –failure of a related bank –sudden changes in investor preferences Bank run –a sudden and unexpected increase in deposit withdrawals from a bank Bank panic –a systemic or contagious run on the deposits of the banking industry as a whole Deposit drains may occur for a variety of reasons –concerns about a bank’s solvency –failure of a related bank –sudden changes in investor preferences Bank run –a sudden and unexpected increase in deposit withdrawals from a bank Bank panic –a systemic or contagious run on the deposits of the banking industry as a whole

11. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-11 Deposit Insurance and Discount Window Deposits insured for $100,000 Federal Reserve provides a discount window facility to meet banks’ short-term nonpermanent liquidity needs –loans made by discounting short-term high-quality securities such as T-bills and banker’s acceptances with central bank –leads to increased monitoring from the Federal Reserve which acts as a disincentive for banks to use for ‘cheap’ funding Deposits insured for $100,000 Federal Reserve provides a discount window facility to meet banks’ short-term nonpermanent liquidity needs –loans made by discounting short-term high-quality securities such as T-bills and banker’s acceptances with central bank –leads to increased monitoring from the Federal Reserve which acts as a disincentive for banks to use for ‘cheap’ funding

12. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-12 Liquidity Risk and Insurance Companies Early cancellation of a life insurance policy results in the insurer having to pay the surrender value –the amount that an insurance policyholder receives when cashing in a policy early –when premium income is insufficient to meet surrenders, the insurer can sell liquid assets such as government bonds Property-Casualty –PC insurers have greater need for liquidity due to uncertainty so ten to hold shorter term assets Guarantee Programs for Life and PC Insurance Co. Early cancellation of a life insurance policy results in the insurer having to pay the surrender value –the amount that an insurance policyholder receives when cashing in a policy early –when premium income is insufficient to meet surrenders, the insurer can sell liquid assets such as government bonds Property-Casualty –PC insurers have greater need for liquidity due to uncertainty so ten to hold shorter term assets Guarantee Programs for Life and PC Insurance Co.

13. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 22-13 Liquidity Risk and Mutual Funds Open-end mutual funds must stand ready to buy back issued shares from investors at their current market price or net asset value If a mutual fund is closed and liquidated, the assets would be distributed on a pro rata basis Open-end mutual funds must stand ready to buy back issued shares from investors at their current market price or net asset value If a mutual fund is closed and liquidated, the assets would be distributed on a pro rata basis