Professional Documents
Culture Documents
FINANCIAL INTERMEDIARIES
Liquidity Risk Management
HASSAN NAQVI
monash.edu
Recap
• OBS items and net worth
• OBS asset
• OBS liability
• Valuation of OBS items
• Returns and risks of OBS activities
• Loan commitments
• Upfront fee
• Backend fee
• Documentary letters of credit
• Standby letters of credit
• Derivative contracts
• Forward purchases and sale of when-issued securities
• Loans sold (with and without recourse)
• Loan Syndications
Learning objectives
• What is liquidity risk and its sources.
• How a depository institution (DI) can utilise either
stored liquidity or purchased liquidity.
• How liquidity risk arises on both the liability side
and asset side of the balance sheet of a DI.
• How to measure a DI’s liquidity risk and determine
its liquidity needs.
• The importance of liquidity planning to a DI.
• Why liquidity risk is generally more critical for
depository institutions than for other financial
institutions.
Learning objectives
• Introduction
• Causes of liquidity risk
• Liquidity risk at depository institutions
• Liquidity risk in other financial institutions
• Summary
Introduction
• Asset side
– Risk from OBS loan commitments and other credit
lines
– Problems associated with ‘quick’ asset sales/fire-
sales
High costs for turning illiquid assets into cash
Low sales price; in worst case, fire-sale price
Causes of liquidity risk
• Liability side
– Depositors and other claimholders decide to cash
in their financial claims immediately.
Consequence: the DI has to borrow additional funds
or sell assets.
– DI needs to be able to predict the distribution of net
deposit drains.
Net deposit drains: the difference between deposit
withdrawals and deposit additions on any specific
normal banking day.
• After a run on PBS,
the State Treasurer
Rob Jolly and
attorney general
Andrew McCutcheon
held a press
conference assuring
the public that PBS
was sound…
– But it wasn’t…
• Source: http://nnimgt‐a.akamaihd.net/transform/v1/crop/frm/wuVuNQBDX65fDbDigdChk4/f19d6a7c‐
c934‐4ad8‐b329‐dc71d6cae406.jpg/r0_36_400_248_w1200_h678_fmax.jpg
Liquidity risk at depository institutions
Optimum
= minimise
total cost
0.98 0.82
I 0.4 * 0 .6 * 0.392 0.529 0.921
1.00 0.93
Measuring a DI's liquidity exposure
Maturity ladder
Measuring a DI's liquidity exposure
Scenario analysis
Measuring a DI's liquidity exposure
Source: Shin, Hyun Song, (2008) Reflections on modern bank runs: A case study
on Northern Rock
Source: Shin, Hyun Song, (2008) Reflections on modern bank runs: A case study
On Northern Rock
Unexpected deposit drains and bank runs
Regulatory mechanisms: Deposit insurance
• Guarantee programs offering deposit holders varying
degrees of insurance-type protection.
• Deters bank runs and contagion as deposit holders’ place in
line no longer affects ability to recover their financial claims.
• Many countries have explicit deposit insurance schemes
(not offered in Australia until 2008).
• Overseen by Financial Claims Scheme (FCS) similar to
FDIC in US
• Deposit insurance introduced in Australia during GFC up to
$1m
• Now limit is $250,000
• APRA is responsible for the administration of FCS
Unexpected deposit drains and bank runs
Regulatory mechanisms
• Discount window
– Discount window facility to meet DI's short-term
non-permanent liquidity needs
– Offered by the RBA in the form of rediscount
facilities and repurchase agreements (repo)
– Repo: short-term borrowing usually for one day.
Dealer sells underlying security (usually
government bonds) and buys back shortly
afterwards at a slightly higher price
Liquidity and financial system stability
Managed funds
• Closed-end funds
– Sell a fixed number of shares in the fund to outside
investors
• Open-end funds
– Majority of Australian funds
– Sell an elastic (non-fixed) number of shares in the
fund to outside investors
– Must stand ready to buy back issued shares at
current market prices
Liquidity risk of other FIs
Managed 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.
• Dramatic runs if investors become nervous (e.g.
during GFC US$170b was liquidated)
• Nevertheless liquidity problems not as extreme as
DIs
• Deposit contracts should be structured similar to
managed funds or equity contracts
Summary