1. Chapter 15
Liquidity Risk

2. Overview This chapter explores the problems created by liquidity risk.
Liquidity risk is a normal aspect of the everyday management of a DI.
Only in limited cases does liquidity risk threaten the solvency of a DI.
We discuss the causes of liquidity risk, methods of measuring liquidity risk, and its consequences.
The chapter also discusses the regulatory mechanisms put in place to control liquidity risk.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

3. Causes of Liquidity Risk
Liquidity risk can arise on both sides of the balance sheet: the asset side as well as the liability side.
Liability side:
Depositors and other claimholders decide to cash in their financial claims immediately.
Consequence: the DI has to borrow additional funds or sell assets.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

4. Causes of Liquidity Risk
Problems associated with ‘quick’ asset sales:
High costs for turning illiquid assets into cash.
Low sales price; in worst case, fire-sale price.
Asset side:
Borrowers decide to use the loan commitment facilities provided by the DI.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

5. Liquidity Risk at Depository Institutions
Liability-Side Liquidity Risk:
Large reliance on demand deposits and deposits raised through other transaction accounts (mostly at-call deposits).
However, DIs can rely on core deposits.
Need to be able to predict the distribution of net deposit drains, i.e. the amount by which cash withdrawals exceed cash additions.
Managed by:
purchased liquidity management,
stored liquidity management.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

6. Managing Liquidity
Two major ways to manage drains on deposits or exercise of loan commitments:
Purchased liquidity management, and/or
Stored liquidity management.
Traditionally, DIs have relied on stored liquidity management.
Today, most DIs rely on purchased liquidity management.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

7. Purchased Liquidity Management
Liquidity can be purchased in financial markets, e.g. borrowed funds from competitor banks and other institutional investors.
Managing the liability side preserves asset side of balance sheet.
Borrowed funds are likely to be at higher rates than interest paid on deposits, i.e. funds to be borrowed at market rates.
Purchased liquidity management allows DIs to increase their overall balance sheet size.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

8. Stored Liquidity Management
Liquidate assets.
In absence of reserve requirements, banks tend to hold excess reserve assets, i.e. over 0.6% of total assets are held in the form of cash.
Downside of excess cash: opportunity cost of reserves.
Decreases size of balance sheet.
Requires holding excess non-interest bearing assets.
Better to combine purchased and stored liquidity management.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

9. Measuring a DI’s Liquidity Exposure
Sources and Uses of Liquidity:
Shown on net liquidity statement
Sources include:
Sale of liquid assets with minimum price risk,
Borrowing funds in the money market,
Using excess cash reserves.
Uses include: borrowed or money market funds already utilised.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

10. Measuring a DI’s Liquidity Exposure
Peer Group Ratio Comparison:
Comparison of certain key ratios and balance sheet features of the DI with similar DIs.
Usual ratios include:
Borrowed funds/total assets,
Loan commitments/assets.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

11. Measuring a DI’s Liquidity Exposure
Liquidity Index:
Developed by James Pierce.
Measures the potential loss a DI could suffer from a sudden disposal of assets, compared to the amount it would receive under normal market conditions.
Where: Wi = the per cent of each asset in the DI’s portfolio Pi = the immediate sales price Pi* = the fair market price.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

12. Measuring a DI’s Liquidity Exposure
Liquidity Index (cont):
The liquidity index always lies between 0 and 1.
Example: Assume a DI has two assets: 40% in one-month Treasury bonds and the remaining 60% in personal loans. If the DI liquidates the Treasury bonds today, it receives $98 per $100 face value, but it would receive the full face value on maturity (in one month’s time). If the DI liquidates its loans today, it receives $82 per $100 face value, whereas liquidation closer to maturity, i.e. in one month’s time, would lead to $93 per $100 of face value. What is the one-month liquidity index?
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

13. Measuring a DI’s Liquidity Exposure
Liquidity Index (cont):
Solution
We have:
P1 = P*1 = 1.00 P2 = 0.82
P*2 = W1 = 0.4 W2 = 0.6
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

14. Measuring a DI’s Liquidity Exposure
Financing Gap and the Financing Requirement:
Financing gap = average loans – average deposits.
A positive gap means that the DI requires funding.
Thus the financing gap can also be defined as: – Liquid assets + borrowed funds.
The financing requirement is defined as the financing gap plus a DI’s liquid assets.
The larger a DI’s financing gap and liquid asset holdings, the greater the exposure.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

15. Measuring a DI’s Liquidity Exposure
The 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.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

16. Web Resources
For further information on the BIS maturity ladder approach, visit the Bank for International Settlements:
For information on prudential standards for liquidity measurement and management in Australia, visit APRA:
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

17. Liquidity Planning
The overall aim of successful liquidity planning is to ensure that there will be sufficient funds to settle outflows as they become due.
Liquidity falls into a number of different categories:
Immediate liquidity obligations.
Seasonal short-term liquidity needs.
Trend liquidity needs.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

18. Liquidity Planning Immediate liquidity obligations:
Occur in contractual and relationship form.
Seasonal short-term liquidity needs:
Can be predictable (e.g. Christmas period) or unpredictable (disproportionate influence of large borrowers and large depositors).
Seasonal factors may affect deposit flows and loan demand.
Trend liquidity needs:
Can be predicted over a longer time horizon.
Likely to be associated with a DI’s particular customer base.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

19. Trend Liquidity Planning
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

20. Determining Seasonal and Trend Liquidity Needs
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

21. Other Types of Liquidity Needs
Cyclical liquidity needs:
Liquidity needs that vary with the business cycle.
Difficult to predict.
Out of the control of a single DI.
Contingent liquidity needs:
Liquidity needs necessary to meet an unforeseen event.
Basically impossible to predict.
APRA requires DIs to hold sufficient liquid assets to meet a specific institution or name crisis situation.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

22. Liquidity Risk, Unexpected Deposit Drains, and Bank Runs
Reasons for abnormal deposit drains (shocks) :
Concerns about a DI’s solvency relative to other DIs.
Failure of a related DI, leading to heightened depositor concerns about the solvency of other DIs (contagion).
Sudden changes in investor preferences regarding holding non-bank financial assets relative to deposits.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

23. Liquidity Risk, Unexpected Deposit Drains and Bank Runs
Abnormal deposit drains can cause a bank run:
That is, a sudden and unexpected increase in deposit withdrawals from a DI.
A bank run, justified or not, can force a DI into insolvency.
Bank runs can have contagious effects, i.e. because of the failure of one bank, investors lose faith in DIs overall and start running on their banks.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

24. Liquidity Risk, Unexpected Deposit Drains and Bank Runs
Underlying cause of bank runs: demand deposit contract.
Demand deposit contract implies a ‘first come, first served’ principle.
Depositors are paid their full claims until the DI has no funds left.
Depositors who ‘come late’ will not receive the full amount of their financial claims or, in the worst case, will receive nothing at all.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

25. Dealing with Bank Runs Deposit insurance:
Guarantee programs offering deposit holders varying degrees of insurance-type protection.
Deters bank runs and contagion as deposit holders’ place in line no longer affects ability to recover their financial claims.
Mainly used in the USA.
Not offered in Australia.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

26. Dealing with Bank Runs Discount window:
Discount window facility to meet DI’s short-term non-permanent liquidity needs.
Offered by the RBA in the form of rediscount facilities and repurchase agreements.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

27. Financial System Stability and Liquidity
Responsibility of RBA.
Defined as the absence of financial crises that are sufficiently severe to threaten the health of the economy.
Financial crises are costly, e.g. Asian financial crisis in 1997/1998.
RBA’s responsibility to implement policies that prevent financial instability.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

28. RBA Role in Maintaining Financial System Stability
RBA is able to use its balance sheet to provide liquidity to the financial system.
Open market operations, i.e. intervention in the short-term money markets to affect the cash interest rate.
RBA affects liquidity by buying or selling Commonwealth Government securities.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

29. Financial Institution Instability: Australia – the 1990s
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

30. Financial Institution Instability: Australia – the 2000s
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

31. Australian DI Liquidity Regulations
ADIs are required to have sufficient liquidity to meet obligations as they fall due.
The responsibility for liquidity management and strategy lies within an ADI’s board of directors and management (APS 210).
ADI needs to show APRA how it manages liquidity under normal market conditions and in ‘worst case scenarios’.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

32. Australian DI Liquidity Regulations
ADIs must provide APRA with quarterly liquidity reports.
Liquidity reports need to contain scenario analysis for:
Going concern, and
Name crisis.
Small ADIs are exempt from these regulations and need to hold a minimum of 9% of their liabilities in specified high-quality liquid assets.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

33. Liquidity Risk and Life Insurance Companies
Life insurers are affected by early cancellation of an insurance policy.
Life insurance company needs to pay the surrender value, i.e. the amount received by an insurance policy holder when cashing in a policy early.
Recent events that have affected general insurers:
Hurricane Katrina, USA, 2005.
Bushfires and floods in Australia.
Newcastle earthquake, 1989.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

34. Managed Funds Closed-end funds: Open-end funds:
Sell a fixed number of shares in the fund to outside investors.
Open-end funds:
Sell an elastic (non-fixed) number of shares in the fund to outside investors.
Must stand ready to buy back issued shares at current market prices.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher

35. Managed Funds and Liquidity
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.
Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher