1. What are the two reasons liquidity risk arises?

How does liquidity risk arising from the

liability side of the balance sheet differ from liquidity risk arising from the asset side
of the balance sheet? What is meant by fire-sale prices?

The two reasons for liquidity risk arising are demand deposits and loan commitments.
From the liability side, risk arises from holders demanding cash. On the asset side, it comes
from exercises of loan commitments, lines of credit, or transfers of cash to other assets. A
fire sale price refers to when an asset has to be sold below market value because it needs to
be sold immediately due to financial stress.

2. What are core deposits? What role do core deposits play in predicting the probability
distribution of net deposit drains?

Core deposits exist as a stable source of funds for banks, they remain over a long period of
time. They include checking accounts, savings, and other small accounts. Core deposits are
stable, so they will increase the predictability of net deposit drains.

3. What are two ways a DI can offset the liquidity effects of a net deposit drain of funds?
How do the two methods differ? What are the operational benefits and costs of each
method?

A DI can either increase its liabilities by borrowing, issuing equity, etc., or it can reduce its
assets by selling securities, not renewing loans, etc. Reducing assets will reduce the size of
the firm, and you may have to sell them at fire-sale prices. Gaining liabilities will not have
the effect of decreasing the size of the firm but borrowing may require you to pay higher
interest rates than you would be paying on deposits.

4. What are the sources and uses of a liquidity statement? How would a FI use one?

The sources of liquidity found on a liquidity statement include cash-type assets that can be
easily sold, funds it can borrow, and cash reserves over the reserve requirement. Uses
include borrowed and purchased funds already used and borrowed cash from the Fed using
the discount window. This information can be useful in monitoring a FIs current position,
looking for future problems by analyzing past histories, and following how much liquidity
is available to the FI at a given point in time.

5. How can the financing gap be used in the day-to-day liquidity management of the
bank?

As an example, a rising financing gap over a period of time may indicate future liquidity
problems due to increased deposit withdrawals or increased exercise of loan commitments.
A bank would use these trends to determine which policies they should instate. Perhaps
they will adopt stricter credit limits or raise interest rates on core deposit accounts to
encourage more people to open one.