Liquidity Risk Chapter 17 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

17-2 Overview  This chapter explores the problem of liquidity risk faced to a greater or lesser extent by all FIs. Methods of measuring liquidity risk, and its consequences are discussed. The chapter also discusses the regulatory mechanisms put in place to control liquidity risk.

17-3 Liquidity Versus Solvency  Remember, a firm is insolvent if the value of liabilities exceeds the value of assets  Liquidity is not a solvency issue, but a timing issue  The “timing issue” can be become permanent if a liquidity crisis is severe enough  Here is a new formula to remember: Illiquid assets + leverage = bankruptcy

17-4 FIs and Typical Liquidity Risk Exposure  High exposure DIs Highly-leveraged hedge funds  Moderate Exposure Life Insurance Companies Leveraged hedge funds  Low exposure Mutual funds, hedge funds with minimal, pension funds, property—casualty insurance companies.  Typically low, does not mean zero: September 2006, Amaranth Advisors, a hedge fund forced to shut down

17-5 Causes of Liquidity Risk  Asset side May be forced to liquidate assets too rapidly  Faster sale may require much lower price May result from OBS loan commitments  Traditional approach: cash and reserves asset management.  Alternative: liability management.

17-6 Causes of Liquidity Risk for DIs  Liability side  Reliance on demand deposits Core deposits Depository Institutions need to be able to predict the distribution of net deposit drains.  Seasonality effects in net withdrawal patterns  Early 2000s problem with low rates: finding suitable investment opportunities for the large inflows Managed by:  purchased liquidity management  stored liquidity management

17-7 Summary B/S – Commercial Banks

17-8 Borrow to Cover Deposit Outflow Note that the B/S in the upper right is the “instantaneous effect”. The B/S must balance. Also note that equity = 0 in these examples.

17-9 Use Cash to Pay Off Deposit Withdrawal

17-10 Two Ways to Fund Loan Drawdown

17-11 Liquidity Issue Due to Market Risk

17-12 Liquidity Exposure for Two Banks What is impact of: Variance in reliance on borrowings versus deposits? Variance in level of commitments to lend?

17-13 Liability Management  Purchased liquidity Federal funds market or repo market. Managing the liability side preserves asset side of balance sheet. Borrowed funds likely at higher rates than interest paid on deposits. Deposit insurance allows even distressed institution to gather deposits  Can be high cost in broker market Regulatory concerns:  growth of wholesale funds and the potential for serious problems in credit crunch

17-14 Liability Management  Alternative: Stored Liquidity Management Liquidate assets.  In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves. Decreases size of balance sheet Requires holding excess non-interest-bearing assets  Institutions today typically combine purchased and stored liquidity management

17-15 Asset Side Liquidity Risk  Risk from loan commitments and other credit lines: met either by borrowing funds or by running down reserves  Current levels of loan commitments are dangerously high according to regulators.

17-16 Investment portfolio & asset side liquidity risk  Interest rate risk and market risk of the investment portfolio.  Technological improvements have increased liquidity in financial markets. Some argue that “herd” behavior may actually reduce liquidity.

17-17 Measuring Liquidity Exposure  Net liquidity statement: shows sources and uses of liquidity. Sources: (i) Cash type assets, (ii) maximum amount of borrowed funds available, (iii) excess cash reserves  With liquidity improvements gained via securitization and loan sales, many banks have added loan assets to statement of sources Uses include: borrowed or money market funds already utilized, and any amounts already borrowed from the Fed.

17-18 Other Measures:  Peer group comparisons: usual ratios include borrowed funds/total assets, loan commitments/assets etc.  Liquidity index: Weighted sum of “fire sale price” P to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets. I =  w i (P i /P i *)

17-19 Liquidity Index Example in Text (p502) 50% T-bills $99 versus $100 50% RE Loans $85 versus $92 Normal RE Market I= {.50x (99/100)} + {.50x(85/92)} = =.957 Slow RE Market I= {.50x (99/100)} + {.50x(65/92)} = =.848

17-20 Measuring Liquidity Risk  Financing gap and the financing requirement:  Financing gap = Average loans - Average deposits or, financing gap + liquid assets = financing requirement.  The gap can be used in peer group comparisons or examined for trends within an individual FI. Example of excessive financing requirement: Continental Illinois, 1984.

17-21 c Financing Gap = Loans – Deposits = $25 - $20 = $5 Financing requirements = Financing Gap + Liquid Assets = $5 + $5 = $10 In other words, beyond the $20 in deposits, the institution must find another $10 in financing somewhere.

17-22 BIS Approach:  Maturity ladder/Scenario Analysis For each maturity, assess all cash inflows versus outflows Daily and cumulative net funding requirements can be determined in this manner Must also evaluate “what if” scenarios in this framework

17-23 BIS Liquidity Ladder Note that, despite the “requirement” terminology, positive numbers in the last line are really the expected liquidity cushion

17-24 Liquidity Planning  Important to know which types of depositors are likely to withdraw first in a crisis.  Composition of the depositor base will affect the severity of funding shortfalls. Example: mutual funds/pension funds more likely to withdraw than correspondent banks and small businesses  Allow for seasonal effects.  Delineate managerial responsibilities clearly.

17-25 Sample Analysis of Potential Withdrawals by Depositor type

17-26 Bank Runs  Can arise due to concern about bank’s solvency.  Failure of a related FI.  Sudden changes in investor preferences.  Demand deposits are first come first served.  Depositor’s place in line matters.  Bank panic: systemic or contagious bank run.

17-27 Alleviating Bank Runs:  Regulatory measures to reduce likelihood of bank runs: FDIC Discount window  Not without economic costs. FDIC protection can encourage DIs to increase liquidity risk. (moral hazard)

17-28 Mutual Fund with Zero and Max Leverage No Leverage: Cash2 Securities 98Equity 100 Maximum Leverage (50% net assets): Cash3Borrowings 50 Securities147Equity 100

17-29 Investors withdraw $10MM No Leverage: Cash1Borrowings0 Securities 89Equity 90 Use $1 cash and sell $9 assets to redeem $10, or Cash2Borrowings10 Securities 98Equity 90 Borrow $10 to redeem $10 Maximum Leverage (50% net assets): Cash2Borrowings 45 Securities133Equity 90 Used up $1 cash and had to sell $14 of securities to pay $10 to redeeming investors and pay down $5 in borrowings to bring leverage back to 50%

17-30 Securities Market Value Falls 10% No Leverage: Cash2Borrowings0 Securities 88.2Equity 90.2 Note that for the mutual fund with no leverage, there is no transaction required from a liquidity or leverage limit standpoint. The story is quite different with leverage. See the next slide.

17-31 Securities Market Value Falls 10% Maximum Leverage (50% net assets) Start: Cash3Borrowings 50 Securities147Equity 100 First Cut: Securities decline by 14.7 & equity falls the same Cash3Borrowings 50 Securities132.3Equity 85.3 But now, the fund is in violation of the SEC leverage limit: 50/85.3 = 58.6% & the limit is 50% Max borrowings =.5 x 85.3 = 42.65, so need to sell 7.35 of securities Cash3Borrowings Securities124.95Equity 85.3

17-32 Market Value of Securities Falls 25% No Leverage: (note that there is no transaction) Cash2Borrowings0 Securities 73.5Equity 75.5 Maximum Leverage (50% net assets): (start) Cash3Borrowings 50 Securities147Equity 100 Loss on securities is 36.75: Cash3Borrowings 50 Securities110.25Equity But, our equity now only supports borrowings of.5x63.25=31.6 Cash3Borrowings 31.6 Securities91.85Equity Fund must sell $18.4 of securities in a bad market to pay off excess borrowings.

17-33 What About Hedge Funds?  A hedge fund without leverage is in a similar situation to that of the unlevered mutual fund Except that the assets may be less liquid or more concentrated  Both of these increase liquidity risk

17-34 Hedge Fund With 900% Leverage Start: Cash50Borrowings900 Securities 950Equity 100 Investors withdraw $30: Cash20Borrowings630 Securities 680Equity 70 Manager would use cash to meet the redemption request. The manager would then very quickly (frantically) try to sell securities to get the leverage ratio back down. To reach 900% again, would need to sell $270!!! Remember that unlevered funds would sell none and the mutual fund with maximum leverage would have to sell only$7.35.

17-35 Hedge Fund With 900% Leverage Start: Cash50Borrowings900 Securities 950Equity 100 Securities Decline 10% Cash50Borrowings900 Securities 855Equity 5 Do you think that the lenders might call their loans? Now, consider that Long Term Capital ran 2000% leverage routinely and reached 10000% (100:1) at the end.