Liquidity Risk Chapter 17 Financial Institutions Management, 3/e By Anthony Saunders

Causes of Liquidity Risk Liability side Asset side may be forced to liquidate assets too rapidly may result from loan commitments Need to be able to predict the distribution of net deposit drains. Traditional approach: reserve asset management. Alternative: liability management.

Liability Management 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. Alternative: 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.

Asset Side Liquidity Risk Risk from loan commitments and other credit lines: met either by borrowing funds or by running down reserves.

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 Uses include: borrowed or money market funds already utilized, and any amounts already borrowed from the Fed.

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 = S wi(Pi /Pi*)

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.

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. Allow for seasonal effects. Delineate managerial responsibilities clearly.

Bank Runs Can arise due to concern about bank’s solvency. Failure of a related bank. 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.

Alleviating Bank Runs: Regulatory measures to reduce likelihood of bank runs: FDIC Discount window Not without economic costs.

Liquidity Risk for Other FIs Life Cos. Hold reserves to offset policy cancellations. The pattern is normally predictable. An example: First Capital in California, 1991. CA regulators placed limits on ability to surrender policies. Problem is less severe for P&C insurers since assets tend to be shorter term and more liquid.

Mutual Funds Net asset value (NAV) of the fund is market value. The incentive for runs is not like the situation faced by banks. Asset losses will be shared on a pro rata basis so there is no advantage to being first in line.