F446 Exam 3: Chapter 17

2 Reasons for Liquidity Risk
1. A liability-side reason

2. An asset-side reason

Liability-Side Reason
– occurs when an FI’s liability holders seek to cash in their financial claims immediately

**** (depositors and insurance policyholders are examples of liability holders)

Loan Commitments and Asset-Side Reason
– a loan commitment allows a customer to borrow funds from an FI on demand

– when a borrower draws on its loan commitment, the FI must fund the loan on the balance sheet immediately

– this creates a demand for liquidity

– a FI can meet such a liquidity need by running down its cash assets, selling off other liquid assets, or borrowing additional funds

Net Deposit Drains
– the difference between deposit withdrawals and deposit additions
Ways a DI Manages a Drain of Deposits
1. purchased liquidity management

2. stored liquidity management

Purchased Liquidity Management
– definition:

***increase liabilities by borrowing funds or issuing equity

– how:

*** issuing more Federal funds, long-term debt, or new issues of equity

– result on size:

*** the size of the firm remains the same

– operational benefit:

*** restore the financial stability and health of the DI

– costs:

*** entering the borrowed funds market normally requires paying market interest rates that are above those rates that it had been paying on low interest deposits

Stored Liquidity Management
– definition:

*** reduce assets

– how:

*** by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans

– result on size:

*** the size of the firm is reduced

– operational benefit:

*** restore the financial stability and health of the DI

– costs:

*** liquidating assets may occur only at fire-sale prices that will result in realized loss of value, or asset-mix instability

*** further, not renewing loans may result in the loss of profitable relationships that could have negative effects on profitability in the future

Repurchase agreement market
– interbank markets for short-term loans
Reason for Growth of Purchase Liquidity Management
– these types of liquidity adjustments are done on the liability side of the balance sheet, insulating the asset side of the balance sheet from normal drains on the liability side of the balance sheet
4 Measures of Liquidity Risk
1. sources and uses of liquidity

2. peer group ratio comparisons

3. liquidity index

4. financing gap and financing requirement

Net Liquidity Statement
– lists sources and uses of liquidity

– a useful tool that DI managers use to measure its liquidity position on a daily basis

– historical sources and uses of liquidity statements can assist the manager in determining where future liquidity issues may arise

– the total is the amount of liquidity available for the bank

Sources of Liquidity
— the amount of:

1. cash-type assets that can be sold with little price risk and low transaction cost

2. funds it can borrow in the money/purchased funds market up to a MAXIMUM AMOUNT

3. any excess cash reserves over the necessary reserve requirements

— also identifies the amount of each category the DI has utilized

The DI’s Uses of Liquidity
1. the amount of borrowed or purchased funds it has already utilized

2. the amount of cash it has already borrowed from the Fed through the discount window

Peer Group Ratio Comparison
– comparing certain key ratios and balance sheet features of the DI with those of DIs of a similar size and geographic location

– types of ratios

1. loans to deposits
2. borrowed funds to total assets
3. commitments to lend to assets

Loan to Deposit Ratio
– a high ratio means that the DI is relying more heavily on the short-term money market rather than on core deposits to fund loans

– this could mean future liquidity problems if the DI is at or near its borrowing limits in the purchased funds market

Borrowed funds to Total Assets Ratio
– a high ratio means that the DI is relying more heavily on the short-term money market rather than on core deposits to fund loans

– this could mean future liquidity problems if the DI is at or near its borrowing limits in the purchased funds market

Loan Commitments to Assets Ratio
– a high ratio indicates the need for a high degree of liquidity to fund any unexpected takedowns of these loans

– high-commitment DIs often face more liquidity risk exposure than low-commitment

Liquidity Index
– measures the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to a fair market value established under the conditions of normal sale

– the greater the differences between immediate fire-sale asset prices and fair market prices, the less liquid is the DI’s portfolio of assets

Financing Gap
= average loans – average deposits

= (-)liquid assets + borrowed funds

Financing gap + Liquid assets = financing requirement (borrowed funds)

– if this gap is positive, the DI must fund it by using its cash and liquid assets and/or by borrowing funds in the money market

– a negative gap implies that the DI must borrow funds or rely on liquid assets to fund the non-liquid assets

– a widening gap can warn of future liquidity problems

Maturity Ladder/Scenario Analysis
– this allows a comparison of cash inflows and outflows on a day-to-day basis and/or over a series of specified time periods

– this can determine daily and cumulative net funding requirements

Liquidity Planning
– allows managers to make important borrowing priority decisions BEFORE liquidity problems arise
Liquidity Plan Components
1. The delineation of managerial details and responsibilities (identifies managers responsible for interacting with various regulatory agencies or disclosing info to the public)

2. A detail list of fund providers who are most likely to withdraw, as well as the pattern of fund withdrawals

3. The identification of the size of potential deposit and fund withdrawals over various time horizons in the future, as well as alternative private market funding sources to meet such withdrawals

4. A set of internal limits on separate subsidiaries’ and branches’ borrowings as well as bounds for acceptable risk premiums to pay in each market

5. A detailed sequence of assets for disposal in anticipation of various degrees or intensities of deposit/fund withdrawals

Reasons for Abnormal Deposit Drains (Shocks)
1. concerns about a DI’s solvency relative to those of other DIs

2. the contagion effect

3. sudden changes in investor preferences regarding holding nonbank financial assets relative to deposits

The Contagion Effect
– failure of a related DI leading to heightened depositor concerns about the solvency of other DIs
Liquidity Risk Insulation Devices
1. Deposit Insurance

2. Discount Window

Fed Lending Programs
1. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the FOMC target rate for federal funds

2. Secondary credit is available to DIs that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate

3. The Fed’s seasonal credit program is designed to assist small DIs in managing significant seasonal swings in their loans and deposits. Available to DIs that can demonstrate a clear pattern of recurring intrayearly swings in funding needs