468-21 - Chapter 21 MANAGING LIQUIDITY RISK Liquidity risk...

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Chapter 21 – MANAGING LIQUIDITY RISK Liquidity risk is part of the normal operation of a FI, especially for DIs (Depository Institutions). Two types: a) Risk from unexpected deposit withdrawals (liabilities), and b) Risk from when loan commitments are exercised (assets). Options for unexpected deposit withdrawals: a) Borrow additional funds, or b) Sell assets (possibly illiquid) to generate cash, possibly at low or "fire-sale" prices (deep discount). See example in Table 21-1 on p. 582: Unexpected withdrawal of $20m in deposits from DI, possibly due to unexpected negative news about the bank. The DI has $10m of cash to cover half of the deposit outflow. Suppose that no other alternative is available (taking on more debt) except to sell some illiquid assets (loans) to cover the other $10m (or perhaps interest rates have __________). However, to generate cash immediately, it has to sell $20m of assets (book value) for only $10m (fire-sale price), and it loses $10m of equity. See Table 21-1, "After the Withdrawal." This example illustrates one type of liquidity risk for a FI: unexpected change on the liability side of the balance sheet. Another type of liquidity risk results from an unexpected change on the asset side of the balance sheet: An unexpected loan demand, resulting from the exercise of a previous off-balance-sheet "loan commitment." The FI must meet this contractual loan obligation by: a) Reducing or selling other assets like cash or securities or loans, or b) Borrowing additional funds. Liability Side Liquidity Risk . Potential liquidity problem results from the typical practice of "borrowing liquid deposits short, and lending illiquid assets (loans) long." Depositors can remove their short-term checking or savings deposits from DIs, and demand cash on short notice. Approximately 66% of a commercial bank's assets are held in short-term deposits (see Table 11-2 on p. 323), exposing a DI to liquidity risk, although a certain percentage of those deposits are typically "core deposits" that represent a relatively stable, long-term funding source to DI. Additionally, the bank managers can usually predict the probability of net deposit drains (using historical patterns), the amount by which withdrawals exceed deposits. See Figure 21-1 on p. 583. Unexpected deposit outflows can be managed in two ways: a) Purchased Liquidity, i.e., increases in
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This note was uploaded on 01/24/2012 for the course MGT 568 taught by Professor Staff during the Spring '11 term at University of Michigan.

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468-21 - Chapter 21 MANAGING LIQUIDITY RISK Liquidity risk...

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