©2007, The McGraw-Hill Companies, All Rights Reserved 21-1 McGraw-Hill/Irwin Chapter Twenty-one Managing Liquidity Risk on the Balance Sheet

©2007, The McGraw-Hill Companies, All Rights Reserved 21-2 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 21-3 McGraw-Hill/Irwin Liability Side Liquidity Risk Core deposits Net deposit drains Purchased liquidity Stored liquidity Core deposits Net deposit drains Purchased liquidity Stored liquidity

©2007, The McGraw-Hill Companies, All Rights Reserved 21-4 McGraw-Hill/Irwin Loan requests that cannot be funded immediately because of exercise, by borrowers, of their loan commitments and other credit lines Asset Side Liquidity Risk

©2007, The McGraw-Hill Companies, All Rights Reserved 21-5 McGraw-Hill/Irwin Measuring a Bank’s Liquidity Exposure Net liquidity statement Peer group ratio comparisons Liquidity index Net liquidity statement Peer group ratio comparisons Liquidity index

©2007, The McGraw-Hill Companies, All Rights Reserved 21-6 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 21-7 McGraw-Hill/Irwin Financing Gap and the Financing Requirement Financing gap –the difference between a bank’s average loans and average (core) deposits Financing requirement –the financing gap plus a bank’s liquid assets Financing gap –the difference between a bank’s average loans and average (core) deposits Financing requirement –the financing gap plus a bank’s liquid assets

©2007, The McGraw-Hill Companies, All Rights Reserved 21-8 McGraw-Hill/Irwin Liquidity Planning Allows managers to make important borrowing priority decisions Components of a liquidity plan Allows managers to make important borrowing priority decisions Components of a liquidity plan

©2007, The McGraw-Hill Companies, All Rights Reserved 21-9 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Insurance and Discount Window Deposits insured for $100,000 Federal Reserve provides a discount window facility –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 –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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Risk and Insurance Companies Early cancellation of a life insurance policy results in the insurer having to pay the surrender value 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 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.

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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