Lecture 7

Liquidity Risk
Sherry Zhang
xueting.zhang@unsw.edu.au
Overview of lecture topics 2

 This lecture discusses the problems created by liquidity risk for

depository institutions (DIs).

 We first explain how liquidity risk affects DIs and the causes.

 We then discusses in details the methods to manage liquidity risk

and the measurement of liquidity risk.

 We also discusses extreme liquidity event and the regulatory

measures to address systematic liquidity risk.
▪ Bank run and its causes.
▪ Deposit insurance
▪ Discount window
What do we mean by liquidity? 3

 Different meanings of liquidity

▪ Funding liquidity: whether there is sufficient amount of cash flows
▪ Market liquidity: the easiness to liquidate an asset

 Liquidity risk in our context

▪ Funding liquidity
▪ But market liquidity is related to the causes and solutions to liquidity risk
events.
Liquidity Risk 4

 Liquidity risk is a normal aspect of the everyday management of an FI.

▪ For example, DIs must manage liquidity to meet demands for daily
withdrawals or loan requests.
▪ 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.
Liquidity Risk 5

 When all the above measures fail, an FI has to liquidate illiquid assets at
usually fire-sale prices for immediate cash transactions. From this point
on, liquidity risk begins to threaten the solvency of the FI.

 Like maturity mismatch, liquidity risk is inherent in an FI’s asset

transformation function.
– A DI use a large amount of short-term liabilities to finance long-term assets.
Causes of Liquidity Risk 6

 Liquidity risk at depository institutions occurs because of situations that

develop from economic and financial transactions that are reflected on
either the asset side of the balance sheet or the liability side of the
balance sheet of an FI.

 Liability-side liquidity risk:

▪ The FI may not have enough cash to meet unexpected requests for
withdrawals.
 Asset-side liquidity risk:
▪ The FI may not have enough cash to fund the exercise of loan commitments
or other commitments for lending
Liability-side Liquidity Risk

 DIs typically rely largely on demand deposits and deposits

raised through other transaction accounts (mostly at-call
deposits) which in theory the DIs should stand ready to pay
out if requested.

 The decisions by depositors and other claimholders to cash in

their financial claims immediately may pose DIs liquidity
problems.

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Liability-side Liquidity Risk: Example 8

 Example: Impact of liquidity risk on an FI’s equity value

▪ The FI is forced to liquidate $10 million illiquid assets at a $5 million loss in
order to meet the demand for $15 million 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.
Liability-side Liquidity Risk
 However, not all deposits are likely to be cashed out at a time
▪ Core deposits: relatively stable or long-term funding source
▪ Cash inflows from new deposits and DI’s other business activities
▪ So what matters is: Net deposit drains = deposit withdrawals – deposit
additions

 Abnormal net deposit drains expose DIs to significant liquidity risk.

 DI managers need to predict the probability distribution of net deposit

drains and estimate the demand of liquidity with a good degree of
accuracy.

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Asset-side Liquidity Risk
 Unexpected events on the asset-side of an FI’s balance sheet can also
cause liquidity risk.
▪ The immediate need to finance assets
▪ The exercise by borrowers of their loan commitments and other
credit lines;
▪ immediate loan requests.
▪ Unexpected fall in the value of investment portfolio
▪ Large increase in interest rates
▪ Market liquidity dries up

 Most liquidity crises are caused by the combination of both sides.

▪ For example, the cases of most investment banks in GFC

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 11

How to Manage Liquidity Risk?

Managing Liquidity
 Two major ways to manage liquidity shock or potential
liquidity risk:

▪ Purchased liquidity management: borrow funds from

capital markets

▪ Stored liquidity management: invest in liquid assets and

liquidate assets to meet cash outflows

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Managing Liquidity - Purchased Liquidity
Management

 Liquidity can be ‘purchased’ in financial markets, e.g.

borrowing funds from other banks and other institutional
investors.
▪ Interbank fund markets such as federal funds market in the U.S. and
the repurchase agreement (repo) market
▪ Issuance of other debt instruments such as wholesale CDs, notes or
bonds

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Purchased Liquidity Management - 14
Example
 Managing Deposit Drains using Purchased Liquidity Management
▪ the DI purchased (borrowed) $5 million to meet the $5 million deposit drain.
Managing Liquidity - Purchased Liquidity
Management
 Benefit:
▪ preserving the size and composition of asset-side of the balance sheet.

 Downsides:
▪ Borrowed funds are likely to be at higher rates than interest paid on deposits,
i.e. funds to be borrowed at market rates.
▪ The availability of there funds can be limited, especially for DIs in insolvency
difficulty.
▪ Funding risk is high and is not as stable as retail deposits, especially during
credit crisis period.

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Managing Liquidity - Stored Liquidity
Management
 FI can also meet liquidity needs by utilizing its “stored”
liquidity
▪ Run down excess cash reserve
▪ Sell other liquid assets

 Managers need to maintain sufficient liquid assets on the

balance sheet

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Stored Liquidity Management - Example 17

 Managing Deposit Drains using Stored Liquidity Management

▪ the DI ran down $5 million cash to meet the $5 million deposit drain.
Managing Liquidity - Stored Liquidity
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Management
 Benefit:
▪ Liquidity needs could be easily met by liquidating these liquid assets.
▪ It does not rely on the availability of funds on the market.

 Downside:
▪ Opportunity cost of holding excessive liquid assets: low returns
▪ Decreases size of balance sheet by liquidating assets to meet liquidity
needs
▪ Cost of liquidating illiquid assets could be very high
▪ Low sales price; in worst case, fire-sale price lower than market
price
Example 19

 Managing the exercise of loan commitment using both

purchased and stored liquidity management methods
▪ An exercise of $5 million loan commitment.
▪ Purchased liquidity: borrow $5 million
▪ Stored liquidity: run down $5 million cash
 20

Managing Bank Liquid Assets and Liabilities

Managing liquid assets
 Liquid assets
▪ Being able to be converted into cash quickly and at low costs
▪ Examples: T-bills, T-notes, T-bonds, cash (ultimate liquid asset)

 Managing liquid assets

▪ Managing liquid asset reserve as required by regulators, for example, in the
U.S. (regulatory details are not required)
▪ Maintaining an optimal portfolio of liquid assets
▪ Cash
▪ Securities eligible for repurchase transactions with RBA, e.g. government
bonds
▪ Bank bills and CDs issued by other ADIs, provided that the issue is rated
at least ‘investment grade’
▪ Deposits held with other DIs net of placements by the other DIs
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Liquid Asset Management 22

 Generally, the more liquid an asset, the lower the yield, eg. Cash, T-bills,
T-notes etc.
▪ Return-risk trade-off for liquid assets

 A DI need to achieve an optimal mix of lower yielding, liquid assets and

higher yielding, less liquid assets.

 A knife-edge optimization problem

Liability Management
 A DI can manage its liability structure to reduce the need for large
amounts of liquid assets to meet liability withdrawals

 Trade-off between funding cost and funding risk

▪ Low-cost liabilities often carry high withdrawal (funding) risk.
▪ Liabilities with low funding risk often comes with high cost.

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Liability Management 24

 Debt instruments available:

▪ Demand Deposits
▪ Savings Accounts
▪ Fixed-term Deposits
▪ Certificates of Deposits (CDs)
▪ Interbank Funds
▪ Repurchase Agreements
▪ Bank Accepted Bills
▪ Commercial Papers
▪ Medium-Term and mong-term borrowings
(Withdrawal risk decreases and the funding cost increases down the list)

 Overall aim of liability management:

▪ To construct an optimal liability portfolio balancing the trade-off between funding
cost and funding risk.
Demand deposits
 Current deposits or other at-call funds.
 Withdrawal risk: very high, instantaneous in nature
 Funding cost: very low
▪ Normally zero explicit interest rate
▪ Implicit interest rate (IIR) = (DI’s average management cost per account p.a. –
average fees earned per account p.a.) / average annual size of account

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Savings Accounts 26

 Call or demand deposits

 Historically, stable source of funds
 Withdrawal risk: high
▪ Less liquid than cheque accounts, but allow electronic funds transfer and ATM
use
 Funding cost: low
▪ explicit interest payments
Fixed-term deposits
 Fixed-term deposits: funds held with DIs for a specified and predetermined
maturity date with usually a minimum deposit, e.g. $5,000.
▪ Mainly for retail funds.
 Withdrawal risk – low
▪ Penalties apply when withdraw the fund before the maturity
 Relative high funding cost in terms of explicit interest payments.

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CDs
 Time deposits with fixed maturity and face values above some threshold
(for example, $100,000).
 Withdrawal risk - low
▪ Negotiable instruments: can be easily sold into a deep secondary market.
▪ The risk comes from the possibility of no roll-over after expiration.
 Funding Costs
▪ Generally competitive with other whole-sale money market rates, like
commercial paper and T-bills
▪ Generally issuers have high credit rating.
▪ The liquidity in the secondary market also affects the rate paid.

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Interbank Funds
 Short-term (typically overnight) uncollateralized loans between FIs (Federal
fund market in the U.S.)
 Funding risk - rollover risk, normally occur only in periods of extreme crisis
 Cost: short-term money market rate
▪ Federal fund rate in the U.S.
▪ Cash rate in the Australia

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Repurchase Agreements (REPOS)
 Collateralized interbank transactions – the sale of securities with a promise
to repurchase the securities at a specified rate and price in future
▪ 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 basis.

 Funding risk - rollover risk

 Cost
▪ The discount rate used to calculate repurchase price (Yield)
▪ generally below the market interbank rate due to collateralized nature.

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Other borrowings 31

 Bank Accepted Bills

▪ A short-term debt instrument (usually 30 – 180 days) that lists a bank as
the acceptor of the bill.
 Commercial paper
▪ An unsecured, short-term debt instrument issued by a corporation,
typically for the financing of accounts receivable, inventories and meeting
short-term liabilities.
▪ Commercial paper is not usually backed by any form of collateral, so only
firms with high-quality debt ratings will easily find buyers without having
to offer a substantial discount (higher cost) for the debt issue.

 Medium-term and long-term borrowings

 32

How to Measure Liquidity Risk?

Measuring a DI’s Liquidity Exposure 33

 Four Measures of Liquidity Risk

1) Net liquidity Statement
2) Peer Group Ratio Comparisons
3) Liquidity index
4) Financing Gap
Net liquidity statement 34

 Net liquidity statement lists sources and uses of liquidity

▪ Sources include: 1) sale of liquid assets with minimum price risk; 2)
maximum funds to borrow in the money market; 3) excess cash
reserves.
▪ Minus the use of these sources
▪ Help to predict future liquidity issues
Peer Group Ratio Comparison 35

 Comparing certain key ratios and balance sheet features with other
similar DIs.

 Measures related to potential liquidity needs in the future, such as loan

commitments to assets ratio

 Measures related to the availability of liquidity sources, such as loans to

deposits ratio and borrowed funds/total assets
▪ 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

 Developed by James Pierce.

 The index measures the potential loss a DI could suffer from a sudden
disposal of assets, compared to the amount it would receive under normal
market conditions - which might take time due to careful search and bidding
process
N   Pi 
I =  (Wi ) * 

i =1 
  Pi 
where:
Wi = the value weight of each asset in the DI’s portfolio
Pi = the immediate sales price
Pi* = the fair market price.

 The liquidity index always lies between 0 and 1.

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Liquidity Index - Example

Assume a DI has two assets: 40% in one-month Treasury bonds and the
remaining 60% in personal loans. If the DI liquidates the Treasury bonds
today, it receives $98 per $100 face value, but it would receive the full
face value on maturity (in one month’s time). If the DI liquidates its
loans today, it receives $82 per $100 face value, whereas liquidation
closer to maturity, i.e. in one month’s time, would lead to $93 per $100
of face value. What is the one-month liquidity index?

Solution
P1 = 0.98 P*1 = 1.00 W1 = 0.4
P2 = 0.82 P*2 = 0.93 W2 = 0.6
 0.98   0.82 
I = 0.4 *   + 0.6 *   = 0.392 + 0.529 = 0.921
 1.00   0.93 

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Financing Gap and Financing Requirement
38

 Although demand deposits can be withdrawn at 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
funding.

 Financing Gap = average loans – average deposits

 Financing Requirement (i.e., the amount of funds to borrow)
▪ If financing gap is positive, then DI must fund it by either: a) running down
cash and liquid assets; b) borrowing from the capital market
▪ Financing gap = Borrowed funds –Liquid assets
▪ Financing gap + Liquid assets = Financing Requirement
▪ The larger a DI’s 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 a reliance.
Liquidity Exposure Requirement under
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Basel III

 Two measures under the requirement:

1) Liquidity Coverage Ratio (LCR)
2) Net Stable Funding Ratio (NSFR)

 Since 1 January 2015, ADIs in Australia are required to hold a stock of

high-quality liquid assets (HQLA) sufficient to survive a severe liquidity
stress scenario lasting 30 days.

 Since 1 January 2018, the NSFR were implemented.

Measuring a DI’s Liquidity Exposure - the BIS approach

 Liquidity coverage ratio (LCR) = Stock of high-quality liquid assets / Total net
cash outflows over the next 30 calendar days
▪ Must be above 100%: the DIs can survive a severe liquidity stress scenario for at least 30 days.
▪ Liquid assets included: cash, reserves, government debts/bonds, mortgage-backed bonds,
corporate bonds, and even blue chip stocks
▪ Three levels of included assets based on liquidity, and very detailed regulations regarding the
valuation and the maximum amount to be included for different levels of liquid assets
▪ Also very detailed regulations regarding the estimation of net cash outflows
 Net stable funds ratio (NSFR) = Available amount of stable funding / Required
amount of stable funding
▪ Must be above 100%
▪ Long-term perspective: make sure that a minimum amount of stable funding to be held over
one-year horizon
▪ Calculating available stable funding: Grouping liabilities into different stableness categories
and assigning a conversion factor (ASF factor)
▪ Calculating required stable funding: Grouping assets into different horizon categories and
assigning a conversion factor (RSF factor)
▪ Essential idea: ensure long-term assets are funded with sufficient stable liabilities
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Liquidity coverage ratio (LCR) 41

 Liquidity coverage ratio (LCR) =

 Liquid assets:
▪ Three levels of included assets based on liquidity:
▪ Level 1 = Cash + Central Bank Reserve + Sovereign debt
▪ Level 2A = MBS that are government guaranteed + Corporate bonds
rated at least AA-
▪ Level 2B = RMBS that are not government guaranteed + Lower-rated
corporate bonds + Blue chip equities.
▪ 15% “haircut” need to be applied to each level 2
▪ Level 2 capped at 2/3 of Level 1
 Net cash outflow = Outflows – Min(inflows, 75% of outflows)
LCR - Example 42
WallsFarther Bank has the following balance sheet (in millions of $).

Cash inflows over the next 30 days from the bank’s performing assets are $5.5 million.
Calculate the LCR for WallsFarther Bank.

Step1: determine the value of high-quality liquid assets

Level 1 assets = $12 + $19 + $125 = 156
15% “haircut” to level 2: Level 2 assets = ($94 + $138 + $106) x 0.85 = $287.30
Capped at 2/3 of Level 1 = $156 x 2/3 = 104
Stock of highly liquid assets = 156 + 104 = $260
LCR - Example 43

Step2: determine net cash outflows

Cash outflows = $55 x 0.03 + $20 x 0.10 + $80 x 0.05 + $49 x 0.10 + $250 x
0.75 = $200.05
Total net cash outflows over next 30 day = $200.05 – 5.5 = $194.55

Liquidity coverage ratio = $260 / $194.55 = 133.64% > 1.

The bank is in compliance with liquidity requirements based on the LCR.
Net Stable Funding Ratio (NSFR) 44

 Net Stable Funding Ratio (NSFR) =

 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 stay with
bank during a period of idiosyncratic stress.

 ASF factors and RFS factors

 45

Bank Runs
Bank run in 1929: American Union 47

Bank
Bank run in 2008: Northern Rock 48

Bank
Abnormal deposit drains and bank runs
 Bank run is a sudden and unexpected increase in deposit withdrawals
from a DI.

 Reasons for abnormal deposit drains (shocks) :

▪ Concerns about a DI’s solvency relative to other DIs.
▪ Failure of a related DI, leading to heightened depositor concerns about the
solvency of other DIs (contagion).
▪ Sudden changes in investor preferences regarding holding non-bank financial
assets relative to deposits

 Underlying cause of bank runs: demand deposit contract.

▪ Demand deposit contract implies a ‘first come, first served’ principle.
▪ Depositors are paid their full claims until the DI has no funds left.
▪ Depositors who ‘come late’ will not receive the full amount of their financial
claims or, in the worst case, will receive nothing at all.

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The cycle mechanism of a bank run 50

Liquidation of
Abnormal
increasingly
withdrawal
illiquid assets

Lack of
Losses due to
confidence in
fire sale
the solvency
discount
of the FI
Number of Failed U.S. Banks by Year, 1934-2012 51
Bank runs and regulatory measures
 Bank runs can have contagious effects.
▪ The demand deposit contracts create the incentives for depositors to run first
and ask questions later.
▪ The failure of one DI could cause depositors to worry about the safety of
deposits in other banks and run on an otherwise sound DI.
▪ A bank run, justified or not, can force a DI into insolvency.

 Regulator have recognized this inherent instability of the banking system

and put in place two mechanisms to ease the problem.
▪ Deposit insurance schemes
▪ Discount window loans

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How to Deal with Toilet Paper Run? 53
Deposit insurance

 Guarantee programs offering deposit holders varying degrees of insurance-

type protection.
▪ Alleviate the “late comers” concern of deposit safety
▪ Typically cover only small to medium sized deposits, for example, capped at
US$250,000 in the U.S. federal deposit insurance scheme and $1 million in the
Australian temporary deposit guarantee scheme implemented in Oct 2008.
▪ Deposit insurance premiums charged on banks based on the size and risk of
deposit portfolios, for example, FDIC’s risk-based deposit insurance program in
the U.S..
▪ For the deposit insurance/guarantee scheme in Australia, please refer to the
details following the link:
https://www.guaranteescheme.gov.au/qa/deposits.html

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Deposit insurance to stop the bank 55

run cycle
Liquidation of
Abnormal
increasingly
withdrawal
illiquid assets

Lack of
Losses due to
confidence in
fire sale
the solvency
discount
of the FI
Deposit insurance
 Benefits
▪ Deters bank runs and contagion as deposit holders’ place in line no longer
affects ability to recover their financial claims.
▪ If a deposit holder believes a claim is totally secure, even if the DI is in trouble,
the holder has no incentive to run.

 Moral hazard issues

▪ Insured deposits lack incentives to differentiate between good vs bad banks
and monitor risk-taking activities by banks
▪ Even uninsured deposits in large banks tend to get fully paid due to too-big-to-
fail issue.
▪ As such, the banks (management and shareholders) have strong incentives to
undertake excessively risky investment decisions.
▪ The key is to charge actuarially fairly priced premiums – which is a challenge.

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Discount window

 Lender of last resort

▪ Short-term lending programs offered by central banks for DI to meet
their short-term non-permanent liquidity needs.
▪ DIs typically use short-term high-quality securities as collateral to
borrow from the central bank’s discount window facility (by applying
the discount rate set by the central bank to calculate the securities’
value and loan amount).
▪ Offered by the RBA in the form of repurchase agreements (RBA Repos).
https://www.rba.gov.au/publications/bulletin/2019/sep/the-
committed-liquidity-facility.html

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Discount window loans to stop the bank run
58
cycle

Liquidation of
Abnormal
increasingly
withdrawal
illiquid assets

Lack of
Losses due to
confidence in
fire sale
the solvency
discount
of the FI