©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Twenty-One Managing Liquidity Risk on the Balance Sheet

©2009, The McGraw-Hill Companies, All Rights Reserved 21-2 McGraw-Hill/Irwin Liquidity Risk Management Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs) At the extreme, liquidity risk can lead to insolvency Some FIs are more exposed to liquidity risk than others –depository institutions (DIs) are highly exposed –mutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs) At the extreme, liquidity risk can lead to insolvency Some FIs are more exposed to liquidity risk than others –depository institutions (DIs) are highly exposed –mutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk

©2009, The McGraw-Hill Companies, All Rights Reserved 21-3 McGraw-Hill/Irwin Liquidity Risk Management One type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claims –FIs must meet the withdrawals with stored or borrowed funds –alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices A second type of liquidity risk arises when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holder –unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes –FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down One type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claims –FIs must meet the withdrawals with stored or borrowed funds –alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices A second type of liquidity risk arises when commitments made by the FI and recorded off-the-balance-sheet are exercised by the commitment holder –unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes –FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down

©2009, The McGraw-Hill Companies, All Rights Reserved 21-4 McGraw-Hill/Irwin Liquidity Risk and Depository Institutions DIs’ balance sheets typically have –large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors –large amounts of relatively illiquid long-term assets such as commercial loans and mortgages DIs know that normally only a small portion of demand deposits will be withdrawn on any given day –most demand deposits act as core deposits—i.e., they are a stable and long-term funding source Deposit withdrawals are normally offset by the inflow of new deposits DIs’ balance sheets typically have –large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors –large amounts of relatively illiquid long-term assets such as commercial loans and mortgages DIs know that normally only a small portion of demand deposits will be withdrawn on any given day –most demand deposits act as core deposits—i.e., they are a stable and long-term funding source Deposit withdrawals are normally offset by the inflow of new deposits

©2009, The McGraw-Hill Companies, All Rights Reserved 21-5 McGraw-Hill/Irwin Liquidity Risk and Depository Institutions DI managers monitor net deposit drains—i.e., the amount by which cash withdrawals exceed additions; a net cash outflow DIs manage deposit drains with: –stored liquidity relied on most heavily by community banks –purchased liquidity relied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds DI managers monitor net deposit drains—i.e., the amount by which cash withdrawals exceed additions; a net cash outflow DIs manage deposit drains with: –stored liquidity relied on most heavily by community banks –purchased liquidity relied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds

©2009, The McGraw-Hill Companies, All Rights Reserved 21-6 McGraw-Hill/Irwin Liquidity Risk and Depository Institutions Purchased liquidity –allows FIs to maintain the overall size of their balance when faced with liquidity demands –purchased liquidity is expensive relative to stored liquidity –purchased liquidity includes: interbank markets for short-term loans –fed funds –repurchase agreements fixed-maturity certificates of deposits notes and bonds Purchased liquidity –allows FIs to maintain the overall size of their balance when faced with liquidity demands –purchased liquidity is expensive relative to stored liquidity –purchased liquidity includes: interbank markets for short-term loans –fed funds –repurchase agreements fixed-maturity certificates of deposits notes and bonds

©2009, The McGraw-Hill Companies, All Rights Reserved 21-7 McGraw-Hill/Irwin Liquidity Risk and Depository Institutions Stored liquidity –may involve the use of existing cash stores or the sale of existing assets –banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements –when managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes Most DIs utilize a combination of stored and purchased liquidity management Stored liquidity –may involve the use of existing cash stores or the sale of existing assets –banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements –when managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes Most DIs utilize a combination of stored and purchased liquidity management

©2009, The McGraw-Hill Companies, All Rights Reserved 21-8 McGraw-Hill/Irwin Liquidity Risk and Depository Institutions Loan commitments and other credit lines can cause liquidity problems –as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity If stored liquidity is used, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet If purchased liquidity is used, the composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet Loan commitments and other credit lines can cause liquidity problems –as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity If stored liquidity is used, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet If purchased liquidity is used, the composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet

©2009, The McGraw-Hill Companies, All Rights Reserved 21-9 McGraw-Hill/Irwin Measuring Liquidity Risk Exposure The liquidity position of banks is measured by managers on a daily basis A net liquidity statement lists sources and uses of liquidity Peer group ratio comparisons are used to compare a bank’s liquidity position against its competitors –loans to deposit ratio –borrowed funds to total assets ratio –commitments to lend to assets ratio Ratios are often compared to those of banks of a similar size and in the same geographic location The liquidity position of banks is measured by managers on a daily basis A net liquidity statement lists sources and uses of liquidity Peer group ratio comparisons are used to compare a bank’s liquidity position against its competitors –loans to deposit ratio –borrowed funds to total assets ratio –commitments to lend to assets ratio Ratios are often compared to those of banks of a similar size and in the same geographic location

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Measuring Liquidity Risk Exposure The liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions wherew i = the percent of each asset i in the FI’s portfolio Pi = the price it gets if an FI liquidates asset i today P i * = the price it gets if an FI liquidates asset i under normal market conditions The liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions wherew i = the percent of each asset i in the FI’s portfolio Pi = the price it gets if an FI liquidates asset i today P i * = the price it gets if an FI liquidates asset i under normal market conditions

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Measuring Liquidity Risk Exposure The financing gap is the difference between a bank’s average loans and average (core) assets –if the financing gap is positive, the bank must find liquidity to fund the gap The financing requirement is the financing gap plus a bank’s liquid assets –a widening financing gap can be an indicator of future liquidity problems The financing gap is the difference between a bank’s average loans and average (core) assets –if the financing gap is positive, the bank must find liquidity to fund the gap The financing requirement is the financing gap plus a bank’s liquid assets –a widening financing gap can be an indicator of future liquidity problems

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Measuring Liquidity Risk Exposure The BIS Approach: Maturity Ladder/Scenario Analysis –liquidity management involves assessing all cash inflows against cash outflows –the maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals –daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder –the BIS also suggests that DIs prepare for abnormal conditions using various “what if” scenarios The BIS Approach: Maturity Ladder/Scenario Analysis –liquidity management involves assessing all cash inflows against cash outflows –the maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals –daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder –the BIS also suggests that DIs prepare for abnormal conditions using various “what if” scenarios

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Planning Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise –lowers the costs of funds by determining an optimal funding mix –minimizes the amount of excess reserves that a bank needs to hold –liquidity plan components delineation of managerial responsibilities list of fund providers most likely to withdraw funds and a pattern of fund withdrawals identification of the size of potential deposit and fund withdrawals over various time horizons internal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise –lowers the costs of funds by determining an optimal funding mix –minimizes the amount of excess reserves that a bank needs to hold –liquidity plan components delineation of managerial responsibilities list of fund providers most likely to withdraw funds and a pattern of fund withdrawals identification of the size of potential deposit and fund withdrawals over various time horizons internal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Risk Major liquidity problems arise if deposit drains are abnormally large and unexpected Abnormal deposit drains can occur because –concerns about a bank’s solvency –failure of another bank (i.e., the contagion effect) –sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank deposits A bank run is a sudden and unexpected increase in deposit withdrawals from a bank Major liquidity problems arise if deposit drains are abnormally large and unexpected Abnormal deposit drains can occur because –concerns about a bank’s solvency –failure of another bank (i.e., the contagion effect) –sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank deposits A bank run is a sudden and unexpected increase in deposit withdrawals from a bank

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Risk Demand deposits are first-come, first-served contracts The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system –a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole Regulatory mechanisms are in place to ease banks’ liquidity problems and to deter bank runs and panics –deposit insurance –the discount window Demand deposits are first-come, first-served contracts The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system –a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole Regulatory mechanisms are in place to ease banks’ liquidity problems and to deter bank runs and panics –deposit insurance –the discount window

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Insurance Guarantee programs offer depositors varying degrees of insurance protection to deter bank runs Deposit insurance was first introduced in the U.S. in 1933 and gave coverage up to $2,500 Coverage was increased to $100,000 by 1980 Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI) The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement account from $100,000 to $250,000 Guarantee programs offer depositors varying degrees of insurance protection to deter bank runs Deposit insurance was first introduced in the U.S. in 1933 and gave coverage up to $2,500 Coverage was increased to $100,000 by 1980 Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI) The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement account from $100,000 to $250,000

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Insurance Individuals can achieve many times the $100,000 ($250,000) coverage cap on deposits by creatively structuring their deposits and by using multiple banks The FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiums –the safest institutions now pay 5¢ per $100 of deposits –the riskiest institutions now pay 43¢ per $100 of deposits Individuals can achieve many times the $100,000 ($250,000) coverage cap on deposits by creatively structuring their deposits and by using multiple banks The FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiums –the safest institutions now pay 5¢ per $100 of deposits –the riskiest institutions now pay 43¢ per $100 of deposits

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The Discount Window The Federal Reserve also provides a “discount window” lending facility Historically the borrowing rate was below market rates and borrowing was restricted In 2003 the Fed increased the costs of borrowing but eased the terms –primary credit is available to generally sound DIs on a very short-term basis –secondary credit is available to less sound DIs (at a higher rate than primary credit) on a very short-term basis –seasonal credit assists small DIs in managing seasonal swings in their loans and deposits The Federal Reserve also provides a “discount window” lending facility Historically the borrowing rate was below market rates and borrowing was restricted In 2003 the Fed increased the costs of borrowing but eased the terms –primary credit is available to generally sound DIs on a very short-term basis –secondary credit is available to less sound DIs (at a higher rate than primary credit) on a very short-term basis –seasonal credit assists small DIs in managing seasonal swings in their loans and deposits

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Risk and Insurance Companies Life insurance companies hold cash reserves and other liquid assets –to meet policy payments –to meet cancellation (surrender) payments the surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early –to fund working capital needs which can be unpredictable Property-casualty (P&C) insurance companies –the claims against P&C insurers are hard to predict –thus, P&C insurance companies have a greater need for liquidity than life insurance companies Life insurance companies hold cash reserves and other liquid assets –to meet policy payments –to meet cancellation (surrender) payments the surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early –to fund working capital needs which can be unpredictable Property-casualty (P&C) insurance companies –the claims against P&C insurers are hard to predict –thus, P&C insurance companies have a greater need for liquidity than life insurance companies

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Liquidity Risk and Mutual Funds Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assets However, the way MFs are valued reduces the incentive of fund shareholders to engage in bank- like runs on any given day –assets are distributed on a pro rate basis (i.e., rather than a first-come first-served basis) –losses are incurred to shareholders on a proportional basis Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assets However, the way MFs are valued reduces the incentive of fund shareholders to engage in bank- like runs on any given day –assets are distributed on a pro rate basis (i.e., rather than a first-come first-served basis) –losses are incurred to shareholders on a proportional basis