Liquidity Risk Chapter 17 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

17-2 Overview  This chapter explores the problem of liquidity risk faced to a greater or lesser extent by all FIs. Methods of measuring liquidity risk, and its consequences are discussed. The chapter also discusses the regulatory mechanisms put in place to control liquidity risk.

17-3 FIs and Typical Liquidity Risk Exposure  High exposure DIs  Moderate Exposure Life Insurance Companies Highly leveraged hedge funds  Low exposure Mutual funds, hedge funds, pension funds, property—casualty insurance companies.  Typically low, does not mean zero: September 2006, Amaranth Advisors, a hedge fund forced to shut down

17-4 Causes of Liquidity Risk  Asset side May be forced to liquidate assets too rapidly  Faster sale may require much lower price May result from OBS loan commitments  Traditional approach: cash and reserves asset management.  Alternative: liability management.

17-5 Causes of Liquidity Risk for DIs  Liability side  Reliance on demand deposits Core deposits Depository Institutions need to be able to predict the distribution of net deposit drains.  Seasonality effects in net withdrawal patterns  Early 2000s problem with low rates: finding suitable investment opportunities for the large inflows Managed by:  purchased liquidity management  stored liquidity management

17-6 Liability Management  Purchased liquidity 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. Deposit insurance allows even distressed institution to gather deposits  Can be high cost in broker market Regulatory concerns:  growth of wholesale funds and the potential for serious problems in credit crunch

17-7 Liability Management  Alternative: Stored Liquidity Management 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. Decreases size of balance sheet Requires holding excess non-interest-bearing assets  Institutions today typically combine purchased and stored liquidity management

17-8 Asset Side Liquidity Risk  Risk from loan commitments and other credit lines: met either by borrowing funds or by running down reserves  Current levels of loan commitments are dangerously high according to regulators.

17-9 Investment portfolio & asset side liquidity risk  Interest rate risk and market risk of the investment portfolio.  Technological improvements have increased liquidity in financial markets. Some argue that “herd” behavior may actually reduce liquidity.

17-10 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  With liquidity improvements gained via securitization and loan sales, many banks have added loan assets to statement of sources Uses include: borrowed or money market funds already utilized, and any amounts already borrowed from the Fed.

17-11 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 =  w i (P i /P i *)

17-12 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.

17-13 BIS Approach:  Maturity ladder/Scenario Analysis For each maturity, assess all cash inflows versus outflows Daily and cumulative net funding requirements can be determined in this manner Must also evaluate “what if” scenarios in this framework

17-14 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. Example: mutual funds/pension funds more likely to withdraw than correspondent banks and small businesses  Allow for seasonal effects.  Delineate managerial responsibilities clearly.

17-15 Bank Runs  Can arise due to concern about bank’s solvency.  Failure of a related FI.  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.

17-16 Alleviating Bank Runs:  Regulatory measures to reduce likelihood of bank runs: FDIC Discount window  Not without economic costs. FDIC protection can encourage DIs to increase liquidity risk.

17-17 Liquidity Risk for Other FIs Life Cos. Hold reserves to offset policy cancellations. The pattern is normally predictable. An example: First Capital in California, 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.  However, spikes in claims can be problematic. Hurricane Andrew precipitated 11 bankruptcies and wholesale restructuring of Florida insurance. Claims due to sequence of hurricanes Charlie, Frances, Ivan, and Jeanne (fall 2004) as large as losses from Andrew.

17-18 Investment Funds  Mutual funds, hedge 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.  Hedge funds implicated in some severe liquidity crises Example: Long Term Capital Management