Risk
Class Liquidity 18, Chap 17
Exam II
Mean = 84.91
Liquidity Risk at Depository
Institutions
INDY MAC
Do Investment Banks Face liquidity
risk?
Jim Cramer
Daily show vs. CNBC
What happened to Bear Stearns
Gary W. Parr is currently the Deputy Chairman of Lazard Frres
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 Frres & 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 individual
4
Liquidity Risk of Different FIs
Depository Institutions
Life insurance companies
Property Causality insurance companies
Investment funds
Causes of Liquidity Risk
Two
main types of liquidity risk:
1.
Liability side liquidity
2.
Asset side liquidity
Liability Side Liquidity Risk
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
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
1,159.90
Sell Cash Assets = $97.0M
983.40
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
0
Total Deposits
885.80
Marketable Securities
Commercial paper
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
154
Total Assets
$97.60M
52.90
1,062.30
Total Liabilities
1,062.30
Sell Cash Assets = $97.0M
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)
Total cash Assets
Liabilities
0
Total Deposits
885.80
Marketable Securities
Commercial paper
10.3
Mortgages
945.30
Interbank loans
12.2
Other loans
64.10
Equity Capital
154
Total Assets
$97.60M
52.90
1,062.30
Total Liabilities
1,062.30
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
0
Total Deposits
Marketable Securities
0
Commercial paper
835.80
10.3
Mortgages
$50M
Interbank loans
12.2
64.10
Equity Capital
151.1
Total Assets
$97.60M
945.30
Other loans
1,009.40
Total Liabilities
1,009.40
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
0
Total Deposits
Marketable Securities
0
Commercial paper
835.80
10.3
Mortgages
Interbank loans
12.2
64.10
Equity Capital
151.1
Total Assets
$97.60M
945.30
Other loans
1,009.40
Total Liabilities
1,009.40
$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
0
Commercial paper
Mortgages
0
Interbank loans
12.2
Other loans
64.10
Equity Capital
-344.2
Total Assets
$50M
Total Deposits
Marketable Securities
$97.60M
0
64.10
Total Liabilities
64.10
$450M
Sell Mortgages = $450.0M
385.80
10.3
Liability Side Liquidity Risk
Could we solve the problem by requiring banks to hold
enough cash to satisfy all of their liabilities
Sure what is wrong with this plan?
Banks will not earn any money if they can not lend capital
Capital Raising in crisis:
a) Cash reserves: They can use reserves in the vault to at the fed
b) Borrow Funds: They could try to borrow or purchase funds
c) 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
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
Banks can almost always count on having some level of deposits
core deposits
Core Deposits at DIs
Are core deposits easy to predict?
Net Deposit Drain > 0
Core deposits
are decreasing
WHY?
1.
2.
Net Deposit Drain < 0
Core deposits
are increasing
WHY?
Core deposits are predictable
The amount of deposits a DI holds depends on the
net deposit drain = withdrawals incoming deposits
Day-to-day Liability Side Liquidity Risk
On a day-to-day basis and under normal market conditions liability side
liquidity risk arises from net deposit drain
i.e. if the bank looses core deposits, it needs to replace them with deposits or another
source of financing
Consider the net deposit drain for two banks:
The distribution is very
concentrated (sharp peek)
what does that mean?
Bank A
The distribution is
centered around 5%
What does that mean for
the bank?
Bank A is almost certainly going
out of business
Bank B
The distribution
is spread out (flat)
What does that mean?
The distribution is
centered around -2%
What does that mean for
the bank?
On average bank Bs core
deposits will grow but the net
deposit drain is harder to predict
Main Take Away:
On a day-to-day basis banks need to manage the net deposit drain
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:
funds rate
Over-night bank-to-bank lending at LIBOR or Fed
DI sells assets with agreement to repurchase then
at a slightly higher price the difference between the purchase and sale price
Repurchase Agreements:
is the repo rate
The DI could try to increase deposits issue wholesale
certificates of deposits
Deposits:
Typically larger banks use purchased funds
Managing Net Deposit Drain (contd)
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 meet net deposit drain
Stored vs. Purchased: Balance-Sheet
Effects
Purchased liquidity
$5 million
deposit drain
Assets and liabilities
do not match we
need to adjust
Notice that with purchased
liquidity the total size of the
firm does not change
With purchased
liquidity we borrow $5
million to satisfy the
net deposit drain
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
$5 million deposit
drain reduces deposits
from $70 to $65 mill
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 simple balance sheet of Pomona Bank is shown below. Rewrite their balance sheet after the
bank experiences a $10 million depository drain if:
Assets
Liabilities
a) The bank wants to maintain the same size
Cash
52.5 Deposits
352
b) The bank decides to shrink its balance sheet
Mortgages
367 Commercial paper
56
C&I Loans
Consumer loans
Credit lines (drawn)
Total Assets
215
65
28
727.5
Long-term debt
153
Repo agreements
Equity
127
39.5
Total liabitlities
727.5
Asset Side Liquidity Risk
Asset side liquidity
Asset side liquidity risk result from unexpected demand
for funds from the FIs assets
How would that occur?
Loan commitments
When these off balance sheet items are exercised the
FI is required to provide liquidity (loan) to the company.
Letters of credit
This represent a cash out flow Example AIG
Lines of credit
Losses in asset value (loan portfolio)
The FI has 2 options to manage asset side liquidity risk
Purchase liquidity
Stored liquidity
Stored vs. Purchased: Balance-Sheet
Effects
Purchased liquidity loan commitment $5 mill
After the loan commitment is taken down the
FI adds a $5 mill 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 5 mill in funds
For asset side liquidity, using purchased funds
increases assets both and liabilities the firm grows
Main Take Away:
Purchasing liquidity creates new liability to finance the new asset. In this
case the balance sheet and the size of the firm grow
Stored vs. Purchased: Balance-Sheet
Effects
Stored liquidity loan commitment
After the loan commitment is taken down the
FI adds a $5 mill loan to its assets
It will fund the new
loan with cash reserves
For asset side liquidity, using purchased funds
increases both assets and liabilities the firm grows
Main Take Away:
Stored liquidity swaps one asset for another. This preserves the size of the
balance sheet and the size of the firm
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
Assets
Liabilities
sheet if:
Cash
72.5 Deposits
392
a) Unica purchase liquidity to satisfy the draw.
Mortgages
567 Commercial paper
156
b) Unica uses stored liquidity to satisfy the draw.
C&I Loans
215 Long-term debt
253
c) Which method grows the balance sheet?
Credit lines(drawn)
Total Assets
36
890.5
Equity
Total liabilities
89.5
890.5
Measuring Liquidity
1.
2.
3.
4.
5.
Sources and uses of liquidity
Pear Group Comparison
Liquidity Index
Financing Gap
BIS approach maturity ladder
Sources & Uses of Liquidity
1.
DIs obtain liquidity from 3 sources
1.
2.
3.
Observing how FIs obtain liquidity gives us an idea of their
liquidity risk exposure:
.
.
Selling liquid assets
Borrowing funds
Excess cash reserves
A FI that relies mainly on purchased liquidity suffers when liquidity in
those markets dry up or borrowing costs increase (Bear Stearns)
FIs that rely on deposits are exposed to net deposit drain and bank runs
All FIs report historical sources of liquidity in their annual
report
Bank of America Example
Page 119/121
Page 87/89 (VaR)
2.
Pear Group Ratios
BorrowedFunds
T otal Assest
Larger values means that the bank relies more on
borrowed funds for liquidity
Core Deposits
T otal Assest
Larger values means that the bank relies more on core
deposits for liquidity
Loans
Deposits
Portion of loans financed using deposits (LTD ratio)
Commitments
T otal Assets
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 requirement
BoA is more exposed to liquidity risk
from future loan commitment take downs
Use the following in formation to calculate the pear comparison ratios and assess the liquidity
risk of the two banks.
Bank A
Assets
Bank B
Liabilities
Assets
Cash
52.5
Deposits
352
Cash
Loans
Mortgages
167
228
Total debt
Equity
56
39.5
Loans
Mortgages
447.5
total Assets
Core Deposits = 300M
447.5 Total liabilities
Commitments = 136
Total Assets
Liabilities
100.5
67
145
Core Deposits = 290M
312.5
Commitments = 16
Deposits
295
Total debt
Equity
5
12.5
Total liabilities
312.5
Liquidity Index
3.
Measure 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
Fraction of asset value
invested in asset i
Pi
I = i
Pi *
i =1
N
Pi = fire s ale price of asset i
Pi * = normal market price asset i
i = proportion of asset value (weight)
0 I 1
Percent of assets is value that
could be recovered in a fire sale
Larger value of I = less liquidity risk exposure a larger
percent of total assets can be recovered in a fire sale
Example: Suppose a DI has 50% of its assets in T-bills and 50% in real estate mortgages. Calculate the
liquidity index given the following fire sale and normal market prices.
Asset
Today
1 month later
Market collapse
T-Bill
$99
$100
$99
Mortgage
$85
$92
$65
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:
1.
2.
3.
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
1.
2.
Insured deposits We will talk about later
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 extern disturbances
.
Primary Credit: Set up to lend to financially sound FIs 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 variation in
loans and deposits
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 premium dries up
Existing contracts are canceled and the surrender is paid
To meet the demand for fund the life insurer may have to liquidate assets
(T-Bills, bonds RMBS) at fire sale prices
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 fluctuation 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
DI
Mutual Fund
Assets
Assets
Liabilities
$90
Liabilities
$100
$90
$100
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
NAV =
value of assets
90
=
= $ 0 .9
s hares out standing 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
Financing Gap = (Average Loans) (Average Core Deposits)
Rewrite the equation Consider a simple balance sheet
Loans =
Total Assets
Liquid Assets
Core Deposits = ( Total Liabilities Financing Requirements
)
Loans Core Deposits = Liquid Assets + Financing Requirements
Financing Gap = (Liquid Assets) + (Financing Requirements)
Financing Requirements = Financing Gap + (Liquid Assets)
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
BIS Maturity Ladder
In Feb 2000 BIS introduced the maturity ladder method
The idea is to asses 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
The laddering approach allows DI manages to see when they will cash surplus in 1 month
mill have excess
c accordingly to
liquidity and when they will need liquidity they can then borrowumulative $46 mill deficit
manage their risk
Note that the laddering method is for use in normal market conditions NOT
DURING CRISIS