1. Liquidity Risk
Class 18, Chap 17

2. 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

3. Liquidity Risk at Depository Institutions

4. Do Investment Banks Face liquidity risk?
Jim Cramer

5. 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

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

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

8. Liability Side Liquidity Risk
Sources:
Bank Runs
Net Deposit Drain

9. Bank Runs

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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?

17. Net Deposit Drain

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. Remember Net Depository Drain is: Liability Side Liquidity Risk

25. 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

26. 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

27. 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

28. Asset Side Liquidity Risk

29. 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

30. 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

31. 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

32. 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

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

34. 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

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

36. 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

37. 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

38. 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”

39. 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

40. Government Prevention

41. 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

42. 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

43. Discount Window Borrowing

44. Liquidity risk for other Financial Institutions

45. 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

46. 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

47. 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

48. Appendix

49. 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

50. 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

51. 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