1. Drake DRAKE UNIVERSITY Fin 129 Liquidity Risk

2. Drake Drake University Fin 129 Liquidity Risk Liquidity risk deals with the everyday aspect of doing business. Interest rate risk, credit risk, off balance sheet risk, operational risk all created solvency risk for the FI, liquidity risk generally does not. Liquidity risk represents the risk of the FI not having

3. Drake Drake University Fin 129 Causes of Liquidity Risk Asset side May be forced to liquidate assets too rapidly resulting n “fire sale prices” May result from loan commitments Traditional approach: reserve asset management Alternative: liability management.

4. Drake Drake University Fin 129 Causes of Liquidity Risk Liability side Reliance on demand deposits Core deposits (provide long term source of funds) Need to be able to predict the distribution of net deposit drains. Managed by:

5. Drake Drake University Fin 129 Net Deposit Drains Deposit withdraws are in part offset by the inflow of new funds and income generated by from both on and off balance sheet activities. The amount by which the cash withdraws exceed the new cash inflows is the Net Deposit Drain. Positive NDD implies withdraws are greater than inflows. Negative NDD implies that inflows are greater than withdraws

6. Drake Drake University Fin 129 Net Deposit Drain The decrease in liabilities must be offset with an increase in liabilities or a decrease in assets if new inflows do not replace the outflow of funding sources.

7. Drake Drake University Fin 129 Net Deposit Drain Predictable Unpredictable

8. Drake Drake University Fin 129 Balance Sheet Before the NDD AssetsLiabilities Assets100Deposits70 Borrowed Funds10 Other20 Total100 100

9. Drake Drake University Fin 129 Balance Sheet After the NDD AssetsLiabilities Assets100Deposits Borrowed Funds Other Total100

10. Drake Drake University Fin 129 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. Deposits are insured Regulatory concerns:.

11. Drake Drake University Fin 129 Liability Management Note the tradeoff between funding risk and funding cost. Demand deposits are a source of cheap funds but there is high risk of withdrawal. NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.

12. Drake Drake University Fin 129 Deposit Accounts Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month. Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.

13. Drake Drake University Fin 129 Time Deposits and CDs Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.

14. Drake Drake University Fin 129 Fed Funds Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. Fed funds rate can be highly variable Prior to July 1998: especially around the second Tuesday and Wednesday of each period. (as high as 30% and lows close to 0% on some Wednesdays).

15. Drake Drake University Fin 129 Repurchase Agreements RPs are collateralized fed funds transactions. Usually backed by government securities. Can be more difficult to arrange than simple fed funds loans. Generally below fed funds rate

16. Drake Drake University Fin 129 Other Borrowings Bankers acceptances Commercial paper Medium-term notes Discount window loans

17. Drake Drake University Fin 129 Liability Management Borrowing Funds Advantages: Disadvantages

18. Drake Drake University Fin 129 Asset Based 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 noninterest-bearing assets

19. Drake Drake University Fin 129 Using Cash The most obvious asset side management technique is to use the cash reserves of the firm.

20. Drake Drake University Fin 129 Balance Sheet Before the NDD AssetsLiabilities Cash 9Deposits70 Other 91Borrowed Funds10 Other20 Total 100 100

21. Drake Drake University Fin 129 Balance Sheet Before the NDD AssetsLiabilities Cash Deposits Other 91Borrowed Funds10 Other20 Total

22. Drake Drake University Fin 129 Cash vs. Liquid Assets Cash Assets Vault Cash, Demand deposits at Fed Reserve, Demand Deposits at private financial institutions, cash items in the process of collection Liquid Assets Fed Funds Sold and Reverse Repos, US Treasury and Agency Securities with < 1 yr maturity, Corporate obligations and Municipal Securities with < 1yr maturity, Loans that can be readily sold or securitized.

23. Drake Drake University Fin 129 Storing Liquid Assets If you attempt to store funds in liquid asset they must have

24. Drake Drake University Fin 129 Costs of using liquid assets Opportunity cost of foregone earnings if sold Opportunity cost of other assets ( liquid assets have lower return) Transaction costs Higher risk of capital loss Weakens balance sheet position

25. Drake Drake University Fin 129 Historical Notes Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid. Securitization of DI loans In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.

26. Drake Drake University Fin 129 Historical Notes During the period since 1960: Noticeable differences between large and small banks with respect to use of low withdrawal risk funds. Reliance on borrowed funds does have its own risks as with Continental Illinois.

27. Drake Drake University Fin 129 Final alternative It is also possible and likely that the FI can combine purchased and stored liquidity management techniques.

28. Drake Drake University Fin 129 Asset Side Liquidity Risk Risk from loan commitments and other credit lines: met either by borrowing funds or by running down reserves

29. Drake Drake University Fin 129 Measuring Liquidity Exposure Net liquidity statement: shows sources and uses of liquidity. Sources: incoming deposits, revenue from sale of non deposit services, Customer Loan repayments, Sale of bank Assets, Borrowing in money market Uses include: Deposit Withdraws, Volume of Acceptable loan requests, repayments of bank borrowing, other operating expenses, dividend payments

30. Drake Drake University Fin 129 Other Measures: Peer group comparisons: usual ratios include: borrowed funds/total assets, loan commitments/assets Loan Losses / Net loans Total Deposits./ Total Assets Core Deposits/Total Assets Fed Funds Purchased / Total Assets Reserve for Loan losses / Net Loans

31. Drake Drake University Fin 129 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 *)

32. Drake Drake University Fin 129 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.

33. Drake Drake University Fin 129 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

34. Drake Drake University Fin 129 Liquidity Planning Important to know which types of depositors are likely to withdraw first in a crisis. Allow for seasonal effects. Delineate managerial responsibilities clearly.

35. Drake Drake University Fin 129 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.

36. Drake Drake University Fin 129 Alleviating Bank Runs: Regulatory measures to reduce likelihood of bank runs: FDIC Discount window Not without economic costs.

37. Drake Drake University Fin 129 Liquidity Risk for Other FIs Life Cos. Hold reserves to offset policy cancellations. The pattern is normally predictable. An example: First Capital in California, 1991. CA regulators placed limits on ability to surrender policies.

38. Drake Drake University Fin 129 Mutual 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.

39. Drake Drake University Fin 129 Liability and Liquidity Management Depository institutions and life insurance companies are highly exposed to liquidity risk. The second half of the liquidity risk portion of class discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.

40. Drake Drake University Fin 129 Liquid Assets Liquid assets are assets that can be turned quickly into cash Low transaction costs Little or no loss in principle value Traded in large market (trading does not move the market)

41. Drake Drake University Fin 129 Liquid Asset Management Examples: T-bills, T-notes, T-bonds Benefits of holding large quantities of liquid assets Costs of holding liquid assets

42. Drake Drake University Fin 129 Liquid Asset Management: Reserve Requirements Reasons for regulating minimum holdings of liquid assets: Monetary policy Enables Monetary policy by forcing Depository Institutions to participate in the Central Banking System. Taxation Forcing a reserve requirement places a form of Tax on the Depository Institution Facilitates Clearinghouse Function

43. Drake Drake University Fin 129 Liquid Asset Management: Reserve Requirements Use of Reserve Requirements as a monetary Policy tool has decreased. Fed’s new emphasis on the control of short term interest rates Use of Sweep Accounts

44. Drake Drake University Fin 129 Composition Composition of liquid asset portfolio Breakdown between cash and other securities Determined by regulations by government and earnings of the firm Liquid assets ratio=Liquid Assets / Total Assets Cash and government securities in countries such as U.K Similar case for U.S. life insurance companies (regulated at state level)

45. Drake Drake University Fin 129 U.S. Cash Reserve Requirements for Depository Institutions Incremental reserve requirements for transaction accounts (all deposits on which account holders can make immediate withdrawals): First $5.5 million 0.0% $5.5 million to $42.8 million 3.0% $42.8 million + 10.0%

46. Drake Drake University Fin 129 Lagged Reserve Accounting The system for calculating and maintaining reserves is based on a lagged reserve accounting system. In the system the computation of the reserves and the reserve maintenance period do not overlap.

47. Drake Drake University Fin 129 Reserve Management Problem Computation period runs from a Tuesday to a Monday, 14 days later. First a period for transaction balances, then a cash computation period. Reserves based upon the balance must be maintained over a Reserve Maintenance Period. Average daily reserves are computed as a fraction of the average daily deposits over the period.

48. Drake Drake University Fin 129 Lagged Computation Period Bank Vault Computation Period SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat SunMonTuesWedThursFriSat Reserve Maintenance Period

49. Drake Drake University Fin 129 Reserve Management The reserve maintenance period, differs from the computation period by 17 days. Lagged reserve accounting as of July 1998. Previously, contemporaneous (2-day lag). Benefits and Costs of lagged reserve accounting

50. Drake Drake University Fin 129 Undershooting/Overshooting Allowance for up to a 4% error in average daily reserves or $50,000 which ever is greater without penalty. Surplus reserves required for next 2-week period Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall.

51. Drake Drake University Fin 129 Costs of Undershooting Explicit Cost Implicit Cost Opportunity Costs

52. Drake Drake University Fin 129 Undershooting DI has two options near the end of the maintenance period to increase reserves Liquidate less liquid assets or buffer reserves Borrow reserves Fed Funds Discount window repurchase agreements

53. Drake Drake University Fin 129 Discount Window Designed to cover surprise shortfalls Discount window borrowing Discount rate usually lower than market rates Meant to be used on a when needed basis and not used for profit. Risks of gaming the system

54. Drake Drake University Fin 129 Overshooting First 4 percent can be carried forward to next period Excess reserves typically low due to opportunity costs Knife-Edge problem Either under or over shooting can be costly to the institution and to the career of the manager of the liquidity position.

55. Drake Drake University Fin 129 Managing Liquidity When calculating reserves, Friday deposit figures count 3 times in the average. (used for Friday, Saturday and Sunday) “Weekend Game” Transferring foreign deposits to foreign subsidiaries for the weekend effectively lowers the total reserves required.

56. Drake Drake University Fin 129 Sweep Accounts Weekend Program Sweeping transaction deposits to money market or savings accounts at the close of business on Friday and returning the balance Monday. Eliminates need for reserves on that amount for Friday, Saturday and Sunday

57. Drake Drake University Fin 129 Sweep Accounts Threshold Accounts Funds are swept to a different account when the account exceeds a minimum level. Regulation D – limits the number of withdraws or transfers to 6 a month. If more than 6 withdraws or transfers the account is classified as as an ATS (automatic transfer to savings) and is subject to Reserve Requirements

58. Drake Drake University Fin 129 Business Sweep Accounts Regulation Q prohibits paying explicit interest on business demand deposits Commercial sweeps – moves money overnight (not counted as reserves at end of business day) into non interest earning assets (repos for example). Funds loose FDIC insurance.

59. Drake Drake University Fin 129 Return-Risk Trade-off Cash immediacy versus reduced return Constrained optimization Privately optimal reserve holdings Regulator imposed reserve holdings

60. Drake Drake University Fin 129 Liquidity Management Liquidity can be managed from either the asset side of the balance sheet or the liability side. Asset based management Main goal is storing liquidity in the form of liquid assets. Less risky and often used by smaller institutions Costs Opportunity cost of foregone earnings if sold Opportunity cost of liquid assets Transaction Costs Weakened Balance Sheet

61. Drake Drake University Fin 129 Liquidity Management Raising funds via borrowing if needed Advantages Only borrow if funds are needed Volume and composition of asset portfolio is unchanged Can always attract funds (by increasing rate) Disadvantages Dependent upon market rate Withdrawal risk (funding risk)

62. Drake Drake University Fin 129 Funding Risk versus Cost Funding Cost Funding Risk

63. Drake Drake University Fin 129 Choice of Liability Structure Demand Deposits High Withdrawal risk Low costs – interest costs are low, but service costs can be high Interest Bearing NOW Accounts Negotiable order of withdrawal accounts. Pay interest on checkable deposits, but require minimum balance High withdrawal risk Higher costs due to interest expenses. Can be managed by changing the minimum balance

64. Drake Drake University Fin 129 Choice of Liability Structure Passbook Savings Noncheckable and usually require physical presence for withdrawal Lower withdrawal risk. Institution has the right to delay withdrawal requests for up to one month. Pay a higher interest rate than NOW accounts Money Market Deposit Accounts Retail savings accounts with limited check writing DI do not hold reserves against MMDA’s Compete with MMMF for funds

65. Drake Drake University Fin 129 Choice of Liability Structure Retail Time Deposits and CD’s (<100,000) Structured to reduce withdrawal risk Wholesale CD’s (>100,000) Depositors can sell their positions in the secondary market instead of withdrawing funds.

66. Drake Drake University Fin 129 Choice of Liability Structure Federal Funds and Repos Since they are borrowed funds there are no reserve requirements Subject to settlement risk Other borrowings Commercial paper – issued by holding companies, no the DI Medium term Notes Discount Window Loans

67. Drake Drake University Fin 129 Liability Structure 19602001 Liability All banks All Banks Large Banks Small Banks Transaction Accounts61%9.7%9.8%11.8% Retail CD’s and time Deposits 29%40%38.2%54.6% Wholesale CD’s015.5%9.6%12.5% Borrowings2%28.2%34.2%10.1% Bank Capital8%6.6%8.2%11%

68. Drake Drake University Fin 129 Balanced Liquidity Management Combination of Asset and Liability Management Borrow only for unanticipated (usually short term needs) Plan for long term liquidity needs via asset management.