2. 1 Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University Chapter 17 Liquidity Risk

3. 2 I.What is liquidity risk? the uncertainty that an FI will be unable to generate sufficient cash to meet cash outflows.

4. 3 II.What creates liquidity risk? Liquidity risk is derived from the balance sheet.

5. 4 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity $3,000 Assets Liabilities Liability side reasons involve liability holders (i.e., depositors) cashing in their financial claims (i.e. deposits).

6. 5 Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2400 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity $2,700 Assets Liabilities Deposits went down by $300 because of withdrawals $ $ $

7. 6 Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2400 Premises & Fixed Assets 100Owner’s Equity Total Assets$3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$2,700 Assets Liabilities A positive net deposit drain occurs when a FI receives insufficient additional deposits to offset deposit withdrawals. $ $ $

8. 7 Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2400 Premises & Fixed Assets 100Owner’s Equity Total Assets$3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$2,700 Assets Liabilities BYOD decides to sell $ 300 of its securities to meet the drain. The cost of deposits is 5% and the return on securities is 6%. What is the cost for BYOD? $ $ $ Cost of drain= (.06-.05)(300)= $3

9. 8 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets$3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Asset side reasons involve demands from those holding loan commitments.

10. 9 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2600Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,300Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Asset side reasons involve demands from those holding loan commitments. $ $

11. 10 III. What are the sources for meeting liquidity needs? A.Purchasing liquidity using the markets for purchased funds is a liability management tool.

12. 11 1. What instruments are involved?  a)Federal funds market  b)Repurchase Agreements (Repo) market  c)Wholesale (Negotiable) Certificates of Deposit  a) Bankalararası Para Piyasası  b)T.C. Merkez Bankası Kredileri  c)Repo

13. 12 2.What is the effect on the balance sheet? Using purchased funds, there is no reduction in the size of the balance sheet.

14. 13 a)If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals), Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2400 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total L and O E$2,700 Assets Liabilities

15. 14 ……. one type of liability is being replaced with another and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Fed Funds Purchase300 Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total L and O E$3,000 Assets Liabilities

16. 15 Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Fed Funds Purchase300 Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total L and O E$3,000 Assets Liabilities BOYD decides to buy $ 300 in Fed Funds to cover the drain. The cost of Fed Funds is 5.5%, but this allows BOYD to keep securities earning 6%. What is the cost for BOYD? Cost of drain= (.055-.05)(300)= $1.5

17. 16 b)If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2600Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,300Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities

18. 17 …..the additional assets are funded by additional liabilities and the size of the institution increases. Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Repos300 Corporate Bonds 400 Net Loans2600Total Liabilities3000 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,300Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,300 Assets Liabilities

19. 18 III. What are the sources for meeting liquidity needs? B.Stored liquidity is an asset management tool where assets are reserved to be sold or used when cash is needed.

20. 19 1. What instruments are involved?  a)Vault Cash  b)Reserves at the Federal Reserve Banks  c) Securities such as Treasury Bills

21. 20 2.What is the effect on the balance sheet? Using stored liquidity, there is no growth in the size of the balance sheet.

22. 21 a)If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals), Balance Sheet The Bank of your Dreams Cash$150Deposits2000 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2400 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total L and O E$2,700 Assets Liabilities

23. 22 ……. both liabilities and assets are removed and the size of the institution contracts. Balance Sheet The Bank of your Dreams Cash$50Deposits2000 Securities250Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $2,700Total Owners’ Equity$300 Total L and O E$2,700 Assets Liabilities

24. 23 b)If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2600Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,300Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities

25. 24 …. one type of asset (i.e., loans) replaces another (i.e., cash and securities ) and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Cash$50Deposits2300 Securities250Corporate Bonds 400 Net Loans2600Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities

26. 25 IV.How is a bank’s liquidity exposure measured? The methodologies include:

27. 26 A. The net liquidity statement lists the sources and uses of liquidity. A FI manager must be able to measure its liquidity position on a daily basis, if possible. What are the sources of liquidity? a)Cash-type assets (i.e., T-bills) that can be sold. b)The maximum amount of funds the bank can borrow on the money/purchased funds market. c)Excess cash reserves not needed to meet regulatory reserve requirements

28. 27 A. The net liquidity statement lists the sources and uses of liquidity. 2.What are the uses of liquidity? A) Deposit withdrawals B) The increase in loans That have already been met by drawing down sources of liquidity (i.e. Borrowing in the fed funds market or from the discount window)

29. 28 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities BOYD has $50m in cash, $50 m in cash reserves at the Fed not needed to meet reserve requirements, $300m in Treasury bills, and, a $5m line of credit to borrow in the repo market. What is the $ amount of their sources of funds? Sources of liquidity= 50+50+300+5=$405 million

30. 29 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities BOYD has repos of $3 million. What is their $ uses of liquidity? Uses of Liquidity= $3 million What is their net liquidity position? Net Liquidity= $405 - $3 million = $402 million

31. 30 B. Peer group comparisons where ratio analysis is used. What ratios are examined to make inferences about liquidity?

32. 31 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Loans Deposits 2300 = = 1

33. 32 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Borrowed Funds Total Assets 400 3000 = = 13.3%

34. 33 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities A high ratio of loans to deposits and borrowed funds to total assets means that the bank relies heavily on the short term money market rather than on deposits to fund loans. Maturity differences on loans and deposits will also be important to judge liquidity position of the bank.

35. 34 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Loan Commitments Total Assets 300 3000 = = 10%

36. 35 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Loan Commitments Total Assets 300 3000 = = 10% Off-Balance Sheet Item

37. 36 Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2300Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets $3,000Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities A high ratio of loan commitments to assets indicates the need for a high degree of liquidity to fund any unexpected takedowns of these loans by customers.

38. 37 C. The liquidity index measures the potential losses suffered by an FI from the immediate sale of assets compared to the market value of the assets established under normal market conditions. Where P i = fire sale prices P i *= fair market prices wi is the percentage of each asset in the FI’s portfolio  xi=1

39. 38 The liquidity Index The greater the differences between immediate fire-sale asset prices and fair market prices, the less liquid the FI’s portfolio of assets. Example: 50 percent in one month t-bills and 50 percent in real estate loans. If the FI has to liquidate its T-bills today, it will receive $99 per $100 of face value. If the FI had to liquidate its real estate loans today, it would receive $85 per $100 of face value, while liquidation at the end of one month would be expected to produce $92 per $100 of face value. Thus, one month liquidity index value for this FI’s asset portfolio would be; I=(1/2)[(.99/1.00)]+1/2[(.85/.92)]= 0.495+0.462= 0.957. The liquidity index will always lie between 0 and maximum of 1. This index could also be compared to similar indexes for a peer group of similar Fis. The liquidity index will always lie between 0 and maximum of 1. This index could also be compared to similar indexes for a peer group of similar Fis.

40. 39 D.The Financing Gap and the Financing Requirement capture liquidity by examining the following relationships: Financing Gap= Average Loans - Average Deposits Financing Gap= -(liquid Assets) + Borrowed Funds Financing Gap + Liquid Assets=Financing Requirement

41. 40 Financing Gap= Average Loans - Average Deposits Balance Sheet The Bank of your Dreams Cash$150Deposits2300 Securities450Corporate Bonds 400 Net Loans2600Total Liabilities2700 Premises & Fixed Assets 100Owner’s Equity Total Assets$3,300Total Owners’ Equity$300 Total Liabilities and Owners Equity$3,000 Assets Liabilities Financing Gap= 2600 - 2300= 300 This must be funded by using liquid assets or borrowing in the money market.

42. 41 V.What are the causes of unexpected deposit drains and and more severe bank runs? We are not talking about the expected drains, for instance banks can have seasonal anticipated needs for liquidity. Major liquidity problem arise if deposit drains are abnormally large and unexpected. Such deposit withdrawal shocks may occur following reasons:

43. 42 V.What are the causes of unexpected deposit drains and and more severe bank runs? A.Explicit triggers include: 1.Public Concerns about a Bank’s Solvency 2.Failure of Similar or Related Banks (Contagion Effects) 3.Changes in Investor Preferences

44. 43 V.What are the causes of unexpected deposit drains and and more severe bank runs? A.Explicit triggers include: 1.Public Concerns about a Bank’s Solvency 2.Failure of Similar or Related Banks (Contagion Effects) 3.Changes in Investor Preferences

45. 44 V.What are the causes of unexpected deposit drains and and more severe bank runs? A.Explicit triggers include: 1.Public Concerns about a Bank’s Solvency 2.Failure of Similar or Related Banks (Contagion Effects) 3.Changes in Investor Preferences

46. 45 B.The structure of the demand deposit claim is an underlying factor that magnifies reactions. Demand deposits are first come, first served contracts

47. 46 VI.What tools have regulators provided to deal with the liquidity-based instabilities of the banking system? Regulatory mechanism A.Deposit Insurance provides protection for the insured depositor that deters runs. B.The discount window (of the Federal Reserve banks) exists to provide funds to institutions having liquidity problems to stabilize the banking system.

48. 47 V!I.Do financial institutions, other than depository institutions, have liquidity risk problems? A.Life Insurance companies have exhibited liquidity risk problems when concerns about the solvency of the insurer have occurred. B.Property-Casualty insurance companies have liquidity crises relating to disasters (i.e., Hurricane Andrew) C.Mutual Funds exhibit more stability because mutual fund shares are distributed on a pro rata (proportional) basis at net asset value. (P= Value of assets / shares outstanding) thus eliminating the first-come, first-served incentives associated with other FIs’ contracts.