Liquidity Risk Class 18, Chap 17

Lecture Outline Purpose: Introduce the challenges banks face in managing asset liquidity and present techniques used to measure liquidity risk. Types of Liquidity Risk Liability Side Bank runs Net depository drain Asset Side OBS commitments Portfolio loses Measuring Liquidity Risk Sources and uses of liquidity Pear Group Comparison Liquidity Index

Liquidity Risk at Depository Institutions

Do Investment Banks Face liquidity risk? Jim Cramer

Do Investment Banks Face Liquidity Risk? What happened to Bear Stearns Gary W. Parr is currently the Deputy Chairman of Lazard Frères Lazard Ltd is the parent company of Lazard Group LLC, a global, independent investment bank with approximately 2,300 employees in 42 cities across 27 countries throughout Europe, North America, Asia, Australia, Central and South America. Formerly known as Lazard Frères & Co. the firm's origins date back to 1848, the firm provides advice on mergers and acquisitions, restructuring and capital raising, as well as asset management services to corporations, partnerships, institutions, governments, and individuals

Liquidity Risk of Different FI’s Depository Institutions Life insurance companies Property Casualty insurance companies Investment funds

Causes of Liquidity Risk Two main types of liquidity risk: Liability side liquidity Asset side liquidity

Liability Side Liquidity Risk Sources: Bank Runs Net Deposit Drain

Bank Runs

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash-in claims immediately. Assets (Millions) Liabilities Total cash Assets 97.6 Total Deposits 983.40 Marketable Securities 52.90 Commercial paper 10.3 Mortgages 945.30 Interbank loans 12.2 Other loans 64.10 Equity Capital 154 Total Assets 1,159.90 Total Liabilities Sell Cash Assets = $97.6M

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash in claims immediately. Assets (Millions) Liabilities Total cash Assets Total Deposits 885.80 Marketable Securities 52.90 Commercial paper 10.3 Mortgages 945.30 Interbank loans 12.2 Other loans 64.10 Equity Capital 154 Total Assets 1,062.30 Total Liabilities $97.60M Sell Cash Assets = $97.6M

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash-in claims immediately. Assets (Millions) Liabilities Total cash Assets Total Deposits 885.80 Marketable Securities 52.90 Commercial paper 10.3 Mortgages 945.30 Interbank loans 12.2 Other loans 64.10 Equity Capital 154 Total Assets 1,062.30 Total Liabilities $97.60M Sell Marketable securities = $50.0M

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash-in claims immediately. Assets (Millions) Liabilities Total cash Assets Total Deposits 835.80 Marketable Securities Commercial paper 10.3 Mortgages 945.30 Interbank loans 12.2 Other loans 64.10 Equity Capital 151.1 Total Assets 1,009.40 Total Liabilities $97.60M $50M Sell Marketable securities = $50.0M

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash-in claims immediately. Assets (Millions) Liabilities Total cash Assets Total Deposits 835.80 Marketable Securities Commercial paper 10.3 Mortgages 945.30 Interbank loans 12.2 Other loans 64.10 Equity Capital 151.1 Total Assets 1,009.40 Total Liabilities $97.60M $50M Sell Mortgages = $450.0M

Liability Side Liquidity Risk Occurs when there is a run on the bank Many liability holders (depositors/insurance policy holders) seek to cash-in claims immediately. Assets (Millions) Liabilities Total cash Assets Total Deposits 385.80 Marketable Securities Commercial paper 10.3 Mortgages Interbank loans 12.2 Other loans 64.10 Equity Capital -344.2 Total Assets Total Liabilities $97.60M $50M $450M Sell Mortgages = $450.0M

Liability Side Liquidity Risk Could we solve the problem by requiring banks to hold enough cash to satisfy all of their liabilities Banks will not earn any money if they can not lend capital Liquidating assets in crisis: Cash reserves: They can use reserves in the vault or at the fed Borrow Funds: They could try to borrow or purchase funds Fire Sale: They can sell their long-term assets, but the price they will get for immediate sale is usually far less than what they would accept for a longer horizon sale Sure – what is wrong with this plan?

Net Deposit Drain

DI Liability side Liquidity risk Aggregate balance sheet for all national banks 2009 Banks do not have enough cash to payoff all depositors But depositors will almost never demand their full balance – Bank runs are very rare! Banks can almost always count on having some stable level of deposits – core deposits

Core Deposits at DI’s Are core deposits easy to predict? Core deposits are decreasing WHY? Core deposits are increasing WHY? Net Deposit Drain > 0 Net Deposit Drain < 0 Core deposits are predictable The amount of deposits a DI holds depends on the net deposit drain = withdrawals – incoming deposits

What have we learned so far? There are two types of liability side liquidity risk Bank Runs – Very rare unpredictable events with extreme losses Net Depository Drain – the day-to-day changes in core deposits Trying to manage this risk at the bank level is extremely difficult and inefficient DIs could be required to hold large amounts of excess capital to protect against losses in a bank run but this reduces the amount they can lend which reduces profits This is why the risk is managed at the aggregate level through the FDIC and Fed NDD = -2% Banks core deposits will grow on average over time Gives the bank access to a stable and inexpensive source of financing The bank should become a larger more profitable and more stable firm NDD = 5% Banks core deposits will decrease on average over time Must replace deposits with alternative and more costly sources of financing Banks cost of capital increases which decreases profits. The bank may eventually become financially distressed and file for bankruptcy

What have we learned so far? There are two types of liability side liquidity risk Bank Runs – Very rare unpredictable events with extreme losses Net Depository Drain – the day-to-day changes in core deposits Trying to manage this risk at the bank level is extremely difficult and inefficient DIs could be required to hold large amounts of excess capital to protect against a losses in a bank run but this reduces the amount they can lend and reduces profits This is why the risk is managed at the aggregate level through the FDIC and Fed To be healthy and profitable banks must be able to manage their net depository drain NDD = -2% Banks core deposits will grow on average over time Gives the bank access to a stable and inexpensive source of financing The bank should become a larger more profitable and more stable firm NDD = 5% Banks core deposits will decrease on average over time Must replace deposits with alternative and more costly sources of financing Banks cost of capital increases which decreases profits. The bank may eventually become financially distressed and file for bankruptcy

Managing Net Deposit Drain Option #1 - Purchased Liquidity Management A DI manager can borrow funds to satisfy short-term liquidity shortfalls DIs borrow in the markets for purchased funds Federal funds market: Repurchase Agreements: Deposits: Typically larger banks use purchased funds Purchased funds replace low cost deposits with higher cost financing the higher the rate for purchased funds the less demand for this option Over-night bank-to-bank lending at LIBOR or Fed funds rate DI sells assets under an agreement to repurchase them at a slightly higher price – the difference between the purchase and sale price is the repo rate The DI could try to increase deposits – issue wholesale certificates of deposits

Managing Net Deposit Drain (cont’d) Option #2 - Used Stored Liquidity: Exactly what it sounds like: DIs store liquidity in the form of cash reserves and assets Cash reserves are held at the Federal Reserve and in their vault Fed requires 3% of the first 44.4 million in deposits 10% of remaining deposits The bank can sell assets to satisfy their net deposit drain

Remember Net Depository Drain is: Liability Side Liquidity Risk

Stored vs. Purchased: Balance-Sheet Effects Purchased liquidity $5M deposit drain Assets and liabilities do not match we need to adjust With purchased liquidity we borrow $5M to satisfy the net deposit drain Notice that with purchased liquidity the total size of the firm does not change Main Take Away: Purchasing liquidity basically swaps one liability for another. This insulates the asset side of the balance sheet and preserves the size of the firm

Stored vs. Purchased: Balance-Sheet Effects Stored liquidity: With stored liquidity we use cash to pay the net deposit drain $5M deposit drain reduces deposits from $70M to $65M Using stored liquidity causes both the asset and liability side of the balance sheet to shrink Main Take Away: Stored liquidity uses assets to compensate for the loss of liabilities. This contracts the balance sheet and reduces the size of the firm

The bank wants to maintain the same size The simple balance sheet of Pomona Bank is shown below. Rewrite their balance sheet after the bank experiences a $10M depository drain if: The bank wants to maintain the same size The bank decides to shrink its balance sheet Assets   Liabilities Cash 52.5 Deposits 352 Mortgages 367 Commercial paper 56 C&I Loans 215 Long-term debt 153 Consumer loans 65 Repo agreements 127 Credit lines (drawn) 28 Equity 39.5 Total Assets 727.5 Total liabitlities

Asset Side Liquidity Risk

Asset side liquidity Asset side liquidity risk results from unexpected demand for funds from the FI’s assets How would that occur? Loan commitments Letters of credit Lines of credit Losses in asset value (loan portfolio) The FI has 2 options to manage asset side liquidity risk Purchase liquidity Stored liquidity When these off balance sheet items are “exercised” the FI is required to provide liquidity (loan) to the company. This represent a cash out flow – Example AIG

Stored vs. Purchased: Balance-Sheet Effects Purchased liquidity – loan commitment $5M After the loan commitment is taken down the FI adds a $5M loan to its assets Assets and Liabilities do not match so we need to adjust the B/S To finance the loan the FI purchases $5M in funds For asset side liquidity, using purchased funds increases both assets and liabilities – the firm grows Main Take Away: Purchasing liquidity creates new liabilities to finance the new assets. In this case the balance sheet and the size of the firm grow

Stored vs. Purchased: Balance-Sheet Effects Stored liquidity – loan commitment $5M After the loan commitment is taken down the FI adds a $5M loan to its assets It will fund the new loan with cash reserves For asset side liquidity, using stored liquidity keeps the size of the firm constant – the value of both assets and liabilities remain the same Main Take Away: Stored liquidity swaps one asset for another. This preserves the size of the balance sheet and the size of the firm

Unica purchase liquidity to satisfy the draw. The simple balance sheet of Unica Bank is shown below. Suppose Ford Motor Co., one of their preferred customers, draws down $20 Million on an existing credit line. Rewrite the balance sheet if: Unica purchase liquidity to satisfy the draw. Unica uses stored liquidity to satisfy the draw. Which method grows the balance sheet? Assets   Liabilities Cash 72.5 Deposits 392 Mortgages 567 Commercial paper 156 C&I Loans 215 Long-term debt 253 Credit lines(drawn) 36 Equity 89.5 Total Assets 890.5 Total liabilities

Measuring Liquidity Sources and uses of liquidity Pear Group Comparison Liquidity Index

Sources & Uses of Liquidity DIs obtain liquidity from 3 sources Selling liquid assets Borrowing funds Excess cash reserves Observing how FIs obtain liquidity gives us an idea of their liquidity risk exposure: A FI that relies mainly on purchased liquidity suffers when liquidity in external markets dries up or borrowing costs increase (Bear Stearns) FIs that rely on deposits are exposed to net deposit drain and bank runs FIs that rely on external markets are more exposed to market frictions All FIs report historical sources of liquidity in their annual report

Bank of America Example Page 50 & 106 Page 119/121 Page 87/89 (VaR)

Peer Group Ratios Larger values means that the bank relies more on borrowed funds for liquidity Larger values means that the bank relies more on core deposits for liquidity Portion of loans financed using deposits (LTD ratio) – Large values mean the bank may not have liquidity to cover unforeseen funding requirements 2008 values ranged from 56% - 170% over states Larger value – bank is more exposed to liquidity risk from future loan take downs BoA relies more on borrowed funds and less on deposits than NTB NTB is not as exposed to future shortfalls in funding requirements BoA is more exposed to liquidity risk from future loan commitment take downs

Use the following in formation to calculate the peer comparison ratios and assess the liquidity risk of the two banks. Bank A Assets   Liabilities Cash 52.5 Deposits 352 Loans 167 Total debt 56 Mortgages 228 Equity 39.5 Total Assets 447.5 Total liabilities Bank B Assets   Liabilities Cash 100.5 Deposits 295 Loans 67 Total debt 5 Mortgages 145 Equity 12.5 total Assets 312.5 Total liabilities Core Deposits = 300M Commitments = 136 Core Deposits = 290M Commitments = 16

Liquidity Index Measures the average percent of total assets that could be recovered in a fire sale Calculate the percent of fundamental value that could be recovered in a fire sale Multiply by the fraction of the firms asset value invested in asset “i” Sum over all assets Larger value of I = less liquidity risk exposure – a larger percent of total assets can be recovered in a fire sale Percent of assets i’s value that could be recovered in a fire sale Fraction of asset value invested in asset “i”

Example: Suppose a DI holds real estate mortgages and T-bills with face values shown below. Calculate the liquidity index given the following fire sale and normal market prices. Asset Face Value Fundamental Immediate sale T-Bill $100M $99M $97M Mortgage $98M $75M $45M

Government Prevention

Bank Runs Under normal market conditions, banks can borrow funds or use excess cash reserves to manage net deposit drain Insolvency becomes a problem when there is abnormal or unexpected deposit drain which arises because of: Concerns about the DI solvency relative to other DIs Failure of a related DI leading to contagious runs Sudden changes in investors’ preference for holding non-bank financial assets Deposit contracts and runs Deposits contracts are first come first served – this is the driving force behind a run Because everyone lines up to be first or as close to first as possible, depositors will drain all the banks deposits including core deposits

Regulation – Maintain Stability First come first served deposit contracts introduce severe instability to the banking sector Regulators introduced 2 mechanisms to enhance stability Insured deposits Discount window Discount Window: A program set up to allow eligible FIs to borrow usually on a short-term basis from the Fed to meet temporary liquidity shortfalls cause by internal or external disturbances Primary Credit: Set up to lend to financially sound FI’s with temporary liquidity needs Secondary Credit: Set up to lend to less financially sound FIs with temporary liquidity needs Seasonal Credit: designed to assist small FIs with seasonal fluctuations in the variation of loan volume and deposits – We will talk about this later

Discount Window Borrowing

Liquidity risk for other Financial Institutions

Life Insurance Co. Liquidity Risk Life insurance companies are also exposed to liquidity risk from policy cancelation When a policy is canceled the holder is paid the surrender – a value less than 100% of face value Under normal market conditions the difference between surrenders and income from policies and other activities is relatively predictable However, concerns about the solvency of a life insurer can cause a run New contract premiums dries up Existing contracts are canceled and the surrenders are paid out To meet the demand for funds the life insurer may have to liquidate assets (T- Bills, bonds RMBS) at fire sale prices The proceeds will not likely be enough to save the FI

Property Causality Insurer Liquidity Risk PC insurers usually insure against large loss low probability events- earth quakes, hurricanes … Because claims are much harder to predict, PC insurers usually hold shorter- term and more liquid assets than life insurers For PC insurers, paying out surrenders from cancelation is not usually a problem Liquidity risk comes from fluctuations in premium income from cancelation or failure to renew (PC contracts are short term 1-3 yrs) – premiums may be insufficient to cover claims Natural disasters can also cause liquidity shortfalls

Investment funds Liquidity Risk Open-ended Mutual funds & some hedge funds allow investors to redeem shares for cash at any time. If investors simultaneously redeem shares the fund may be subject to large capital outflows which will likely cripple the fund The difference is that investment fund shares are not first come first serve – they are redeemed at the NAV which eliminates incentives for runs Example: Suppose 100 depositors (share holders) deposit $1 each in a DI (Mutual fund) Suppose asset values at the DI and mutual fund fell to $90 At the DI depositors run and the first 90 people get $1 the rest get $0 At the mutual fund each investor gets the NAV DI Mutual Fund Assets Liabilities $90 $100 Assets Liabilities $90 $100

Appendix

Financing GAP DI managers will usually consider core deposits a source of long-term financing The financing gap is the average loan amount not covered by core deposits Rewrite the equation – Consider a simple balance sheet In this form, the larger the financing GAP and the more liquid assets a bank holds, the more it must rely on borrowed funds to satisfy liquidity shortfalls. This makes the bank more exposed to liquidity risk Financing Gap (Average Loans) = (Average Core Deposits) – Loans = Total Assets – Liquid Assets – – ( ) Core Deposits = Total Liabilities – Financing Requirements Loans – Core Deposits = – Liquid Assets + Financing Requirements Financing Gap – (Liquid Assets) = (Financing Requirements) + Core deposits = total liabilties – financing requirements comes from the liabilities side of the balances sheet Financing Gap + (Liquid Assets) = Financing Requirements

The bank is expected to have a $4 mill cash surpluses in one day BIS Maturity Ladder In Feb 2000 BIS introduced the maturity ladder method The idea is to assess all cash inflows against outflows at different horizons The bank is expected to have a $4 mill cash surpluses in one day The bank expects to have a $50 mill cash deficit in 1 month – cumulative $46 mill deficit The bank expects to have a 1,150 mill cash surplus in 1 month – cumulative $46 mill deficit The laddering approach allows DI manages to see when they will have excess liquidity and when they will need liquidity they can then borrow accordingly to manage their risk Note that the laddering method is for use in normal market conditions NOT DURING CRISIS

Lecture Summary Types of Liquidity Risk Measuring Liquidity Risk Asset side Liability side Measuring Liquidity Risk Sources and uses of liquidity Pear Group Comparison Liquidity Index