You are on page 1of 61


Lecture 4: Liquidity Risk and Liability

Dr Lixiong Guo
Semester 2 ,2014

Part I


Liquidity Risk
Liquidity risk is a normal aspect of the everyday management of

the an FI. For example, DIs must manage liquidity to meet

demands for daily withdrawals. Only in extreme cases do liquidity
risk problems develop into insolvency risk problems.
The FI can usually meet the liquidity demand by
Run down cash assets.
Sell off other liquid assets.

Borrow additional funds.

When all the above measures fail, an FI has to liquidate illiquid

assets at usually fire-sale prices for immediate sale. From this

point on, the liquidity risk begins to threaten the solvency of the

Liquidity Risk (cont.)

Example 7-3: Impact of liquidity risk on an FIs equity value
The FI is forced to liquidate $10 million illiquid assets at a $5
million loss in order to meet the demand for withdrawals.
This reduces the amount equity in the FI by $5 million.
If there is another $5 million demand for withdrawal, the FI would
incur at least another $5 million in losses and become insolvent.

Liquidity risk arises for two reasons

Liability-side liquidity risk:
The FI may not have enough cash to meet the requests for
Asset-side liquidity risk:
The FI may not have enough cash to fund the exercise of loan
commitment or other commitments for lending.
The value of a FIs investment portfolio may fall unexpectedly,
although the loss can be absorbed by equity, the FI still need to
fund the loss such that it has enough liquid assets to meet loan
requests and unexpected deposit withdrawals.

Like maturity mismatch, liquidity risk is inherent in an FIs asset

transformation function.
A DI use a large amount of short-term liabilities to finance longterm assets.

Liability-Side Liquidity Risk

Liquidity risk is inherent in an DIs asset transformation function

because DIs typically use a large amount of short-term liabilities

to finance long-term assets.
A DI knows that only a small proportion of its deposits will be
withdrawn on a given day and part of these withdrawals are also
offset by the inflow of new deposits. The difference between
deposit withdrawals and deposit additions is called the net
deposit drain.
Over time, a DI manager can normally predict the probability
distribution of net deposit drain with a good degree of accuracy.
Most demand deposits act as consumer core deposits on a dayby-day basis, providing a relatively stable or long-term source of
funds for the DI.

Managing Deposit Drains using Purchased Liquidity

A DI can purchase liquidity by
Borrowing on the market for purchased funds
The Federal Funds Market or Repurchase Agreement Market

Issuing wholesale CDs or even sell some notes and bonds.

The benefit is that it insulates the size and composition of asset

side of the balance sheet from normal deposit drains.

The cost is that
it can be expensive for the DI since it has to pay the usually higher
market rates for funds in the wholesale money market to offset net
drains on low-interest-bearing deposits.
Furthermore, the availability of these funds can be limited when
the lenders are concerned about the solvency of the DI.

Managing Deposit Drains using Purchased Liquidity

Example: the DI purchased (borrowed) $5 million to meet the

deposit drain.

Managing Deposit Drains using Stored Liquidity

A DI can utilize its stored liquidity to meet positive net deposit

Run down cash assets.
Sell liquid assets.

The benefit is that it does not rely on the availability of funds on

the market.
The cost to the DI is that, apart from decreased asset size, it
must hold excess low-rate assets on the balance sheet and thus
forgo the returns that it could otherwise earn by investing these
funds in loans and other higher-income-earning assets.
The Federal Reserve sets minimum reserve requirements for the
cash reserve the DIs must hold. DIs tend to hold cash in excess
of the minimum requirement to meet liquidity drains.


Managing Deposit Drains using Stored Liquidity

Example: The DI run down $5 million cash to meet the withdraw

demand. The balance sheet shrinks by $5 million.


Managing Asset-Side Liquidity Risk

Can use both purchased and stored liquidity management

Example: An exercise of $5 million loan commitment.


Part II



Net Liquidity Statement

It is important that a DI manager can measure its liquidity

position on a daily basis. A useful tool today is a net liquidity

statement which lists the sources and uses of liquidity and thus
provides a measure of the DIs liquidity position.
The DI can obtain liquid funds in three ways.
First, It can sell its liquid assets with little price risk and low
transaction cost.
Second, it can borrow funds in the money/purchased funds market
up to a maximum amount. The market would impose such a limit
based on the DIs debt capacity.
Third, it can use any excess cash reserve over and above the
amount held to meet regulatory imposed reserve requirements.


Net Liquidity Statement

An example Net Liquidity Statement.


Peer Group Ratio Comparisons

Compare certain key ratios and balance sheet feature of the DI

with those of DIs of a similar size and geographic location.

Loan to deposit ratio
Borrowed funds to total assets

Commitment to lend to total assets.

Funding from short-term money market is less reliable than core

For example, during the financial crisis of 2008-2009, banks
stopped lending to each other at anything but high overnight rates.
The commercial paper market also froze.

A high ratio of loans to deposits and borrowed funds to total

assets means that the DI relies heavily on the short-term money

market rather than core deposits to fund loans.


Liquidity Index
This index measures the potential losses an FI could suffer from

a sudden or fire-sale disposal of assets compared with the

amount it would receive at a fair market value established under
normal market (sale) conditions which might take a lengthy
period of time as a result of a careful search and bidding


where is the weight of asset i in total asset, is asset is firesale price and * is asset is fair market price.
0 < 1 and the higher the the more liquid the DIs portfolio of


Financing Gap
Although demand deposits can be withdrawn anytime, most

depositors do not do so in normal conditions. As a result, most

demand deposits stay at DIs for quite long periods often two
years or more. Thus, they are considered to be a core source of
A positive financing gap must be funded by either running down
cash and liquid assets or borrowing on the market
= +
+ =

The larger a DIs financing gap and liquid asset holdings, the

larger the amount of funds it needs to borrow in the money

markets and the greater is the exposure to liquidity problems
from such an reliance.


Part III



The Liquidity Coverage Ratio Under Basel III

The liquidity coverage ratio (LCR) aims to ensure that a DI

maintains its high-quality assets that can be converted into cash

to meet liquidity needs for a 30-day time horizon under an acute
liquidity stress scenario specified by supervisors.


The stock of high quality assets is defined as follows

Liquid asset must remain liquid in times of stress (i.e. convertible
into cash at little loss of value and can be used at the central bank
discount window as collateral).
The liquid assets must be unencumbered


The Liquidity Coverage Ratio Under Basel III

Liquid assets are divided into level 1 and level 2. Level 2 is
capped at 40% of total liquid assets
Level 1 = Cash + Central Bank Reserve + Sovereign debt
Level 2A = MBS that are government guaranteed + Corporate bonds
rated at lest AA Level 2B = RMBS that are not government guaranteed + Lower-rated
corporate bonds + Blue chip equities.
Level 2B assets cannot exceed 15% of total liquid assets.

A minimum 15% haircut has to be applied to the value of each

level 2 asset.

Total net cash outflows over the next 30 calendar days

= Outflows Min(inflows, 75% of outflows)



Net Stable Funding Ratio Under Basel III

The net stable funding ratio (NSFR) requires a minimum amount

of stable funding be held over a one-year time horizon based on

the liquidity risk factors assigned to liquidity exposures of on- and
off-balance sheet assets.

> 100%

Available stable funding includes

Bank capital
Preferred stock with a maturity > 1 year
Liabilities with maturities > 1 year
The portion of retail deposits and wholesale deposit expected to say
with bank during a period of idiosyncratic stress.


Net Stable Funding Ratio Under Basel III

The available amount of stable funding (ASF) is calculated by

first assigning the value of a DIs equity and liabilities to one of

five categories and then multiply the amount by an ASF factor.
The total ASF is the sum of the weighted amounts.
The required stable funding (RSF) is calculated as the sum of the
value of the on-balance-sheet assets held and funded by the DI,
multiplied by a corresponding required stable funding factor, plus
the amount of OBS activities multiplied by the associated RSF
The RSF factors assigned to various types of assets are
intended to approximate the amount of a particular asset that
could not be sold or used as collateral in a secured borrowing
during a severe liquidity event lasting one year.





Part IV




Bank Runs
Bank run is a sudden and unexpected increase in deposit

withdrawals from a DI.

Abnormal deposit drains can occur for a number of reasons,
Concerns about a DIs solvency relative to those of other DIs.
Failure of a related DI leading to heightened depositor concerns
about the solvency of other DIs.
Sudden changes in investor preferences regarding holding
nonbank financial assets (such as mutual funds) relative to


The 2008 Run on Washington Mutual (WaMu)

In early July 2008, hundreds of people lined up outside the headquarters

of IndyMac Bank in Pasadena, Calif. On July 11, the FDIC seized

IndyMac. WaMu suffered a $9.4 billion run seven times bigger than
IndyMacs. However, no lines were formed outside the block and the run
was kept secret.
On Sept. 11, 2008, Moodys downgraded WaMus debt to junk status,
rated the companys financial strength at D+ and issued a negative
outlook on the company, citing its asset quality and the potential for
future losses. WaMu customers pulled $600 million out of WaMu that
Soon, other rating agencies followed suit. In the next three days,
customers pulled another $2.3 billion out of WaMu.
On Sept 25, 2008, WaMu was seized by OTS. J.P. Morgan agreed to
pay $1.9 billion to the government for WaMu's banking operations and
will assume the loan portfolio of the thrift, which has $307 billion in


The 2008 Run on Washington Mutual (WaMu)


Number of Failed U.S. Banks by Year, 1934-2012


Demand Deposit Contracts and Bank Runs

Demand deposit contracts are first-come, first-served contracts.

A depositor either gets paid in full or nothing. When a DIs assets

are valued at less than its deposits, only certain proportion of the
depositors will be paid in full and a depositors place in line
determines the amount he or she will be able to withdraw from
the DI. Knowing this, any line outside a DI encourages other
depositors to join the line immediately even if they do not need
cash today for normal consumption purposes.
The incentives for depositors to run first and ask questions later
creates a fundamental instability in the banking system in that an
otherwise sound DI can be pushed into insolvency and failure by
unexpected large depositor drains and liquidity demands.
Regulator have recognized this inherent instability of the banking
system and put in place two mechanisms to ease the problem.


Deposit Insurance
FDIC insurance covers all deposit accounts. The standard

insurance amount is $250,000 per depositor, per insured bank,

for each account ownership category.
In Australia, the Financial Claims Scheme provides a guarantee
on bank deposits of up to $250,000 per customer and per
If a deposit holder believes a claim is totally secure, even if the
DI is in trouble, the holder has no incentive to run.
The undesirable effect of deposit insurance:
Knowing that deposit holders are less likely to run even if there is
perceived bank solvency problem, deposit insurance creates a
situation that DIs are more likely to increase the liquidity risk on
their balance sheets.


Discount Window
Discount window loans are meant to provide temporary liquidity

for inherently solvent DIs, not permanent, long-term support for

otherwise insolvent DIs.
To borrow from the discount window, a DI generally needs highquality liquid assets to pledge as collateral. The interest rate
charged on the loans is called the discount rate and is set by the
central bank.
In the U.S., the Fed had historically set the discount rate below
market rates and required borrowers to prove they could not get
funds from the private sector. The latter put a stigma on discount
window borrowing.
In January 2003, the Fed implemented changes to its discount
window lending. With the changes, the Fed lends to all banks,
but the subsidy is gone.


Discount Window
Three lending programs are offered through the Feds discount

Primary credit is available to generally sound DIs on a very shortterm basis, typically, overnight, at a rate above the Federal Funds
rate. Primary credit may be used for any purposes.

Secondary credit is available to DIs that are not eligible for primary
credit. It is extended on a very short-term basis at a rate that is
above the primary credit rate. Its use should be consistent with a
timely return to a reliance on market sources of funding or the orderly
resolution of a troubles institution.
The Feds Seasonal credit program is designed to assist small DIs in
managing significant seasonal swings in their loans and deposits.
Eligible institutions are usually located in agricultural


Liquidity Risk in Investment Funds

Most investment funds are open-end funds, which means that

they can issue an unlimited supply of shares to investors and

must also stand ready to buy back previously issued shares from
investors at the current market price for the fund shares.
The price at which an open-end fund stands ready to sell new
shares or redeem existing shares is the net asset value (NAV).
Investment funds are exposed to similar liquidity problems to
banks. Indeed, investment funds can be the subject of dramatic
liquidity runs if investors became nervous about the NAV of the
funds assets.
However, the fundamental difference in the way investment fund
contracts are valued compared with the valuation of DI deposit
contracts mitigates the incentives for fund shareholders to
engage in runs.


An Example of Redeeming Shares in A Mutual Fund

At the beginning of the day
Assume a mutual fund has $1 million assets under management,
with no liabilities, and 10,000 shares outstanding.


= $100

NAV is calculated at the close of market every day.

During the day, suppose the asset value falls to $500,000 and

there is a outflow of 5,000 shares.



= $50

The shares are redeemed at $50 per share. After the redemption,
the mutual fund has 5,000 shares outstanding and $250,000
assets under management.

Key point: All investments and redemptions during the day are

priced at the closing NAV.


Part V



Liquid Asset and Liability Management

A DI manager can optimize over both liquid assets and liability

structures to insulate the DI against liquidity risk.

On the one hand, the DI manager needs to build up a prudential
level of liquid assets while minimizing the opportunity costs of
funds. A DI manager should try to achieve an optimal mix of
lower-yielding, liquid assets and higher-yielding, less liquid assets.
Holding too many liquid assets penalizes earnings, while holding
too few liquid assets exposes the FI to enhanced liquidity crises.
On the other hand, the DI manager needs to structure the
liabilities so that the need for large amounts of liquid assets is
reduced while trading off funding risk and funding costs.


Funding Risk and Cost

A DI must trade off the benefits of attracting liabilities with a low

funding cost with a high chance of withdrawal against liabilities at

a high funding cost and low liquidity.


Demand Deposits, NOW Accounts

Demand Deposit
It has a high degree of withdrawal risk. In the U.S., demand
deposits have paid zero explicit interest since the 1930s by law.
However, this does not mean this is a costless source of funds for
DIs because DIs provide a whole set of associated services which
absorb real resources. Hence, DIs pay implicit interests on these
accounts and they can use the implicit interest they pay to control
the withdrawal risk.
Interest-Bearing Checking (NOW) Accounts
These are checkable deposits that pay interest and can be
withdrawn on demand. They are called negotiable order of
withdrawal (NOW) accounts.
Depositors are required to maintain a minimum balance to earn


NOW Accounts, Passbook Savings, MMDAs

The DIs can influence withdrawal risk of NOW accounts by
adjusting explicit interest, minimum balance requirement and
implicit interest.

Passbook Savings
These accounts are non-checkable and usually involve physical
presence at the DI to withdrawal. The DI has the legal power to
delay payment or withdrawal requests for as long as a month.
The principal costs to the DI are the explicit interest payments on
these accounts.

Money Market Deposit Accounts (MMDAs)

These accounts are used to control the risk of funds
disintermediating from DIs and flowing into money market mutual
funds (MMMFs).


In the U.S., MMDAs are checkable but subject to restrictions on
the number of checks written on each account per month, the
number of preauthorized automatic transfers per month, and the
minimum denomination of the amount of each check. In addition,
the MMDAs impose minimum balance requirements on
depositors. The Fed does not require the DIs to hold reserves
against MMDAs. Accordingly, DIs generally pay a higher rates on
MMDAs than on NOW accounts.
The explicit interest paid to depositors is the major cost of
MMDAs. The DI managers can use the spread on MMMF-MMDA
accounts to influence the net withdrawal rate on MMDAs.
The rate that MMMFs pay on their shares directly reflects the rates
earned on the underlying money market assets. However, the rates on
MMDAs are not based directly on any underlying portfolio of money
market assets.

MMDAs are insured by FDIC but MMMFs not.


Retail Time Deposits and CDs

Retail CDs
They are fixed-maturity instruments with face values under
$100,000. Regulation empowers the DIs to impose penalties on
early withdrawals of time deposits or CDs. Although this does not
stop withdrawals when the depositors perceive the DI to be
insolvent, under normal conditions, these instruments have
relatively low withdrawal risk compared with transaction accounts.
The major cost of these instruments is the explicit interest
Wholesale CDs
They have a minimum denomination of $100,000 or more.
The unique feature of these instruments is that they are
negotiable, i.e. they can be sold by title assignment on a
secondary market to other investors.


Wholesale CDs
A depositor can sell a relatively liquid wholesale CD without
causing adverse withdrawal risk exposure for the DI. The only
withdrawal risk is that these CDs are not rolled over and
reinvested by the holder of the deposit claim on maturity.
The rates paid on these instruments are competitive with other
wholesale money market rates, especially those on commercial
papers and T-bills. In addition, required yield on CDs reflect
investors perception of the depth of the secondary market for
Only the first $250,000 (per investor, per institution) invested in
these CDs is covered by deposit insurance.


Federal Funds
Besides funding their assets by issuing deposits, DIs also can

borrow in various market for purchased funds.

Since the funds generated from these purchases are borrowed
funds, not deposits, they are subject to neither reserve
requirements nor deposit insurance premium payments to the

The largest market available for purchased funds is the federal

funds market. This refers to the interbank market for excess cash
reserves where DIs with excess reserves can lend their surplus
balances to DIs in need of those balances to earn interest.
Federal funds are short-term uncollateralized loans made by one
DI to another; more than 90 percent of such transactions have
maturities of one day.


Federal Funds
The cost of fed funds for the purchasing institution is the federal

funds rate, which is the interest rate at which depository

institutions lend reserve balances to each other overnight.
However, the Fed establishes target for the federal funds rate
and keeps it around that target through buying and selling U.S.
Treasury securities.
Since fed funds are uncollateralized loans, institutions selling fed
funds normally impose maximum bilateral limits or credit caps on
borrowing institutions.
For the liability-funding DIs, the main risk of funding by federal
funds is that the fed funds will not be rolled over by the lending
bank the next day if rollover is desired by the borrowing DI. In
reality, this has occurred only in periods of extreme crisis, such
as during the 2008-2009 financial crisis.


Repurchase Agreement (RPs or Repos)

Repurchase agreement can be viewed as collateralized federal

funds transactions where the funds-selling DI receives

government securities as collateral from the funds-purchasing DI.
That is the funds-purchasing DI temporarily exchanges securities
for cash. The next day, this transaction is revered. The fundspurchasing DI sends back the fed funds it borrowed plus interest.
It receives in return (or repurchases) its securities used as
collateral in the transaction.
As with the fed funds, the RP market is a highly liquid and flexible
source of funds for DIs needing to increase their liabilities and to
offset deposit withdrawals.
Because of their collateral nature, RP rates normally lie below
federal fund rates.


Repurchase Agreement
A major liability management difference between fed funds and

RPs is that a fed funds transaction can be entered into at any

time in the business day, while it is difficult to transact a RP
borrowing late in the day since the DI sending the fed funds must
be satisfied with the type and quality of the securities collateral
proposed by the borrowing institution.
Negotiations over the collateral package can delay RP
transactions and make them more difficult to arrange than simple
uncollateralized fed fund loans.


A General Definition of Repurchase Agreement

Repurchase agreements (RPs): a sale of securities coupled with

an agreement to repurchase the same securities at a higher price

on a later date.
The difference between the selling and buying price effectively
represents the interest payment on the borrowing.
The maturity date is either fixed or extended on a day-to-day

The interest rate (repo rate) can depend on a number of factors,

such as the quality of the collateral and the identity of the

The repos are commonly renewed with the same dealer or
replaced by new repos with other dealers.
Economically, repo is a collateralized loan. The cash provider
receives the repo rate.


A General Definition of Repurchase Agreement

If the collateral provider were to default on its obligation to repay

the cash, the cash provider is entitled to sell the pledged

If the cash provider fails to return the securities, the collateral
provider can keep the cash.
A reverse repo is simply the same repurchase agreement from
the buyer's viewpoint, not the seller's. Hence, the seller executing
the transaction would describe it as a "repo", while the buyer in
the same transaction would describe it a "reverse repo". So
"repo" and "reverse repo" are exactly the same kind of
transaction, just being described from opposite viewpoints.


An Example Repo Transaction

Example: Dealer A can borrow $10,000,000 overnight at an repo

rate of 3% per annum by selling Treasury securities to a mutual

fund and simultaneously agreeing to repurchase the securities
the following day. How much would dealer A pay to repurchase
the securities?
Answer: $10,000,000 1 +


0.03 = $10,000,833


Bankers Acceptance
A bankers acceptance (BA) is created when a time draft drawn

on a bank, usually to finance the shipment or temporary storage

of goods, is stamped accepted by the bank. By accepting the
draft, the bank makes an unconditional promise to pay the holder
of the draft a stated amount at a specified date.
If the bank pays foreign exporters bank for the acceptance
before the maturity date, the bank can either hold the acceptance
as investment until it matures or sell the bankers acceptance in
the secondary market and are, thus, a source of financing for the
Thus, BA sales to the secondary market are an additional
funding source.


Commercial Papers
Commercial paper is an unsecured short-term promissory note

issued by a corporation to raise short-term cash.

Commercial paper is one of the largest money market
instruments. Companies with strong credit ratings can generally
borrow money at a lower interest rate by issuing commercial
paper than by directly borrowing from other sources such as
commercial banks.
Commercial paper generally has a maturity of less than 270
Although a DI subsidiary itself cannot issue commercial paper, its
parent holding company can. This provides DIs owned by holding
companies with an additional funding source.


Medium-Term Notes and Discount Window Loans

A number of DIs in search of more stable sources of funds with

low withdrawal risk have begun to issue medium-term notes,

often in the five- to seven-year range. These notes are
additionally attractive because they are subject to neither reserve
requirements nor deposit insurance premiums.
DIs facing temporary liquidity crunches can borrow from the
central banks discount window at the discount rate.


Best Strategy of Liability Management

Too heavy a reliance on borrowed funds can be a risky strategy

in itself.
Even though withdrawal risk may be reduced if lenders in the
market for borrowed funds have confidence in the borrowing DI,
perceptions that the DI is risky can lead to sudden nonrenewals of
fed funds and RP loans and the nonrollover of wholesale CDs and
other purchased funds as they mature.

Thus, excessive reliance on borrowed funds may be as bad an

overall liability management strategy as excessive reliance on

transaction accounts and passbook savings.
A well-diversified portfolio of liabilities may be the best strategy to
balance withdrawal risk and funding cost considerations.


Supplemental Materials




Open Market Operations in the U.S.

The Federal Open Market Committee (FOMC), a committee

within the Federal Reserve, establishes the target for the federal
funds rate and oversee the open market operations (i.e., the
Fed's buying and selling of United States Treasury securities) to
keep the federal funds rate within a narrow band of the target.
The FOMC holds eight regularly scheduled meetings per year.
Open market operations is a main tool of U.S. monetary policy.
Changes in the federal funds rate trigger a chain of events that
affect other short-term interest rates, foreign exchange rates,
long-term interest rates, the amount of money and credit, and,
ultimately, a range of economic variables, including employment,
output, and prices of goods and services.


Federal Funds Target Rate


Domestic Market Operations in Australia

The Reserve Bank Board's operational target for monetary policy

is the cash rate the rate at which banks borrow and lend to
each other on an overnight, unsecured basis.
To meet the Board's target, the Reserve Bank operates in
financial markets to maintain an appropriate level of exchange
settlement (ES) balances. ES balances are liabilities of the Bank
and are used by financial institutions to settle their payment
obligations with each other and with the Bank.
The Bank pays interest on ES balances at a rate 25 basis points
below the Board's cash rate target. ES account holders are not
permitted to overdraw their accounts, although the Bank is willing
to advance overnight funds, against appropriate securities, to
account holders at an interest rate 25 basis points above the
cash rate target.


RBA Cash Rate