1. 5. Liquidity Risks and Management
Liability side
Distribution of deposit drain
How would you estimate this distribution? Is it stable over time? Does the distribution change quickly or slowly?
Asset side
Risk from loan commitments and other credit lines
Loans may default so bank becomes insolvent
Both risks can be offset by (1) Liability (2) Reserves and (3) Fire-sales of assets.

2. 5.1 Liability Management
Liability management is (1)borrowing and (2) managing deposits
Managing the liability side preserves asset side of balance sheet. Borrowed funds likely at higher rates than interest paid on deposits. Deposits are a cheap source of funding.

3. 5.2 Types of borrowing Wholesale depositors (GICs, CDs)
Risk they will not be rolled over at maturity
Wholesale depositors (banks, corporations, wealthy individuals) are more sensitive than depositors
Cost: Rate greater than depositors
Interbank borrowing
Thin market in Canada compared to US
Northbound funds
uncollateralized

4. 5.2 Types of borrowing REPOs Government Deposits Collateralized
10 bp lower than interbank rates
Government Deposits
Extremely volatile because (1) Change in government disbursements (2) Monetary Policy (Open Market Operations)
Show the difference between the two policies using balance sheets
Show the multiplier affect
Cost: Interbank auction of government deposit rate

5. 5.2 Types of borrowing
Bank of Canada: (1) Clearing Account (2) Discount Window
Clearing Account is used on a regular basis.
Discount Window is used as a last resort

6. 5.2 Types of borrowing Clearing Account at the Bank of Canada
Direct clearers hold accounts with the Bank of Canada
With reserve requirement, needed to hold 10% of assets in the clearing account.
Now zero reserve requirement
Accounts used for interbank trading
In 1997, changed the clearing account system
Indirect clearers hold accounts with direct clearers

7. 5.2 Types of borrowing Old Clearing Account System
Zero balance meant held required reserve level
Difficult to maintain zero balance before real time processing introduced 1997
Bank of Canada would lend to clearing accounts using an overdraft loan at the Bank Rate (+ 25bp)
Cost to having too much in clearing account
Cost to having too little in clearing account
Cumulative settlement balance

8. 5.2 Types of borrowing New Clearing Account System
Zero balance means hold zero in the account
Easier to maintain zero balance since interbank trading is allowed after markets close
Bank of Canada still lend to clearing accounts using an overdraft loan at the Bank Rate (+ 25bp)
Credit balances paid Bank Rate (-50 bp)
No cumulative settlement balance
Under the old clearing system, why would a direct clearer wish to target a debit (-) balance? How has this changed?

9. 5.2 Types of borrowing
Assume that the new Bank of Canada clearing account system, with daily interest accruing is in place. The Bank Rate is 3.5%. It is 6:29 pm. Your FI has a $5 million net credit balance with the Bank of Canada. A competing FI bids to buy $10 million in settlement balances at 3.375%. What should you do?

10. 5.3 Types of deposit controls
Notice Deposits and Passbook Savings
Non-chequable and the bank can delay payment
Change explicit interest rate
Why have Notice Deposits experienced the biggest decrease since the early 1980s?
Retail Term Deposits: GICs and CDs
Penalty for early withdrawal, <$100,000
What is more liquid: retail or wholesale GICs?

11. 5.3 Types of deposit controls
Demand Deposits
Alter the fees to make it more/less attractive
Indirect interest rate
Chequing-Savings Accounts
Change explicit interest rate and minimum balance
What are the core deposits?

12. 5.4 Questions about liability management
“Retail transaction accounts are subject to deposit insurance premiums, but purchased money and interbank funds are not. Therefore, an FI should fund all its assets wholesale.” Do you agree?
What is the difference between interbank loans and repurchase agreements?
Rank the following liability risks: retail deposit, Government of Canada, Royal Bank, BoC
Rank the following by cost of funding: retail deposit, REPO, interbank loan, discount window,
Are international liquidity risks riskier?

13. 5.5 Reserve Management
Instead of changing the liability side of the balance sheet, one can change the asset side and liquidate assets
Previously in Canada and still in the US, banks required 10% reserves.
Primary, secondary, tertiary (buffer) reserves.
In times of crisis, these reserves could be used to pay deposit withdrawals.
Show how changing reserves to offset a deposit drain would affect the balance sheet.

14. 5.5 Reserve Management
Why did the Bank of Canada move to a zero reserve requirement?
Why do Canadian banks still hold reserves? What kind of reserves are they more likely to hold?
Do you think zero reserve requirement makes Canadian banks more risky?

15. 5.6 Signs of Liquidity Crisis
Fire-sale of assets
Accessing Bank of Canada discount window
Other funding sources such as interbank loans usually are withdrawn

16. 5.7 Measuring Liquidity Risk Sources and Uses
Net liquidity statement: shows sources and uses of liquidity.
Sources: (i)primary, secondary, tertiary reserves (ii) maximum amount of borrowed funds available
Uses include: borrowed or money market funds already utilized, and any amounts already borrowed from the Fed/ Bank of Canada.

17. 5.7 Measuring Liquidity Risk Ratios
Peer group comparisons:
borrowed funds/total assets,
loan commitments/assets,
loans/deposits
Are larger values better or worse for liquidity

18. 5.7 Measuring Liquidity Risk Financing Gap
Financing gap = Average loans - Average deposits
Average deposits are core funds
Financing requirement = Financing gap + liquid assets
Liquid assets are reserves
The gap can be used in peer group comparisons and examined for trends within an individual FI. Therefore, changes in financing requirement are important.

19. 5.8 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.
Do not want to rely too heavily on interbank borrowing as it can easily dry up
Delineate managerial responsibilities clearly to prevent rumours.

20. 5.9 Bank Runs Causes of bank runs
Can arise due to concern about bank’s solvency.
Failure of a related bank. (Contagion)
Sudden changes in investor preferences.
Rumours
Demand deposits are first come first served. Depositor’s place in line matters.

21. 5.10 Questions on Bank Runs
Do you think transparency would help prevent or promote banking panics?
Could a panic happen to a mutual fund?
What measures could the bank impose to prevent a banking panic?
What characteristics about a bank result in a banking panic?
Does a bank have to be insolvent for there to be a banking panic?
Can a liquidity problem result in insolvency? How?

22. 5.11 Liquidity Problems of Life Insurance Companies
Life Insurers hold reserves to offset policy cancellations.
Match asset maturity with maturity of cancellations: a mixture of bonds and long-term mortgages
Hold T-bills and BAs for unexpected surrendered policies
Regulators placed limits on surrender policies.
Sources of liquidity: new and old premiums, reserves set aside for insured, cash holdings
Uses of liquidity: policy payments

23. 5.12 Liquidity Problems of P&C Insurance Companies
Problem is less severe for P&C insurers since assets tend to be shorter term and more liquid.
Reinsurance helps alleviate disasters that can cause massive claims

24. 5.13 Liquidity Problems of Pension Funds
Problem of unpredictable retirement
Early retirement
Quitting
Firing
Downsizing
Pensions hold about 7-8% in cash or liquid assets

25. 5.14 Liquidity Risks of 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
Still, what would you do if you thought the NAV of your mutual fund were declining? Is there liquidity risk from fees?
Could a bank offer deposit contracts like a mutual fund?

26. 5.15 Continental Bank Before 1982 6th largest US bank, 45.1 billion
Heavily invested in energy, oil, loans (20%). Many loans through Penn Square (3%)
Small core deposit base because US banking laws prevent banking across state lines
Because of small core deposits, relied on borrowing--large financing requirement..

27. 5.15 Continental Bank June 1982 Penn Square goes bankrupt
Contagion: Worries of Continental’s insolvency (although it was still solvent)
Continental places $20 billion of collateral with Chicago Fed
Loses access to CD and interbank market
Replaces CDs with Eurodollar borrowings in interbank (more expensive)

28. 5.15 Continental Bank 1982-1984 Loan portfolio continued to worsen
Nonperforming assets were $2 billion in 1982 and 1983, or 7% of all loans jumping to 10% in the first quarter of 1984
Net losses $371 million in 1982 and $349 million in 1983
Restructuring caused Eurodollars replaced CDs
Publicly announce loan loss provisions

29. 5.15 Continental Bank May 1984
Two erroneous media reports (May 8) cause bank run. News in Tokyo suggested bankruptcy although this was untrue and unsubstantiated
OCC does not release any new private info and states “not aware of any significant changes in the bank’s operations…”
On May 11, Continental borrows from the Chicago Fed (through the discount window) $3.6 billion almost half its funding requirement
On May 14, 16 bank consortium provides 30 day $4.5 bil line of credit

30. 5.15 Continental Bank May 1984
CD rates widened from 40 bp to 180 bp between May 10 to July 1, 1984
On May 17, FDIC guarantees depositors and creditors and provides $2 billion cash. Consortium increases to 28 banks and $5.5 bil.
By the end of May, $20 billion deposit run-off paid for by: $5 billion asset sales, $5 bil borrowing Chicago Fed, $2 billion FDIC, $5.5 bil 28 bank consortium, $3.5 bil banks in safety net

31. 5.15 Continental Bank Questions
Why did the banks form a consortium to support Continental?
Why did the FDIC step in with Continental and not Penn Square?
Why was a bank run prevented in 1982 and not in 1984?

32. 5.16 Summary
Two causes of liquidity crisis: (1) liability depletion or (2) asset devaluation
Three management techniques to offset liquidity crises: (1) liability management (borrowing and deposits) (2) reserve management (3) fire-sales of assets
The first-come-first-serve basis of a bank makes it more subject liquidity problems than a mutual fund or other FI

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