Chapter Twenty-One

Managing Liquidity Risk

on the Balance Sheet

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 Liquidity Risk Management

• Unlike other risks, liquidity risk is a normal aspect

of the everyday management of financial institutions
(FIs)
• At the extreme, liquidity risk can lead to insolvency
• Some FIs are more exposed to liquidity risk than
others
– depository institutions (DIs) are highly exposed
– mutual funds, pension funds, and property-casualty insurers
have relatively low liquidity risk

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 Liquidity Risk Management
• One type of liquidity risk arises when an FI’s liability
holders seek to withdraw their financial claims
– FIs must meet the withdrawals with stored or borrowed funds
– alternately, FIs may have to sell assets to generate cash, which
can be costly if assets can only be sold at fire-sale prices
• A second type of liquidity risk arises when commitments
made by the FI and recorded off-the-balance-sheet are
exercised by the commitment holder
– unexpected loan demand can occur when off-balance-sheet loan
commitments are drawn down suddenly and in large volumes
– FIs are contractually obliged to supply funds through loan
commitments immediately should they be drawn down

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 Liquidity Risk and Depository Institutions

• DIs’ balance sheets typically have

– large amounts of short-term liabilities such as deposits and other
transaction accounts that must be paid out immediately if
demanded by depositors
– large amounts of relatively illiquid long-term assets such as
commercial loans and mortgages
• DIs know that normally only a small portion of demand
deposits will be withdrawn on any given day
– most demand deposits act as core deposits—i.e., they are a stable
and long-term funding source
• Deposit withdrawals are normally offset by the inflow of
new deposits

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 Liquidity Risk and Depository Institutions

• DI managers monitor net deposit drains—i.e.,

the amount by which cash withdrawals exceed
additions; a net cash outflow
• DIs manage deposit drains with:
– stored liquidity
• relied on most heavily by community banks
– purchased liquidity
• relied on most heavily by the largest banks with access to the
money market and other nondeposit sources of funds

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 Liquidity Risk and Depository Institutions

• Purchased liquidity
– allows FIs to maintain the overall size of their balance
when faced with liquidity demands
– purchased liquidity is expensive relative to stored
liquidity
– purchased liquidity includes:
• interbank markets for short-term loans
– fed funds
– repurchase agreements
• fixed-maturity certificates of deposits
• notes and bonds

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 Liquidity Risk and Depository Institutions

• Stored liquidity
– may involve the use of existing cash stores or the sale
of existing assets
– banks hold cash reserves in their vaults and at the
Federal Reserve in excess of minimum requirements
– when managers utilize stored liquidity to fund deposit
drains, the size of the balance sheet is reduced and its
composition changes
• Most DIs utilize a combination of stored and
purchased liquidity management

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 Liquidity Risk and Depository Institutions

• Loan commitments and other credit lines can cause

liquidity problems
– as with liability side liquidity risk, asset side liquidity risk can be
managed with stored or purchased liquidity
• If stored liquidity is used, the composition of the asset
side of the balance sheet changes, but not the size of the
balance sheet
• If purchased liquidity is used, the composition of both the
asset and liability sides of the balance sheet changes, and
increases the size of the balance sheet

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 Measuring Liquidity Risk Exposure
• The liquidity position of banks is measured by managers
on a daily basis
• A net liquidity statement lists sources and uses of
liquidity
• Peer group ratio comparisons are used to compare a
bank’s liquidity position against its competitors
– loans to deposit ratio
– borrowed funds to total assets ratio
– commitments to lend to assets ratio
• Ratios are often compared to those of banks of a similar
size and in the same geographic location

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 Measuring Liquidity Risk Exposure

• The liquidity index measures the potential losses a bank

could suffer from a sudden or fire-sale disposal of assets
versus the sale of the same assets at fair market value under
normal market conditions
N
I   [( wi )( Pi / Pi * )]
i 1
where wi = the percent of each asset i in the FI’s
portfolio
Pi = the price it gets if an FI liquidates asset i today
Pi* = the price it gets if an FI liquidates asset i under normal
market conditions

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 Measuring Liquidity Risk Exposure

• The financing gap is the difference between a

bank’s average loans and average (core) assets
– if the financing gap is positive, the bank must find
liquidity to fund the gap
• The financing requirement is the financing gap
plus a bank’s liquid assets
– a widening financing gap can be an indicator of future
liquidity problems

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 Measuring Liquidity Risk Exposure

• The BIS Approach: Maturity Ladder/Scenario

Analysis
– liquidity management involves assessing all cash inflows against
cash outflows
– the maturity ladder allows a comparison of cash inflows versus
outflows on a day-to-day basis and over a series of specified time
intervals
– daily, maturity segment, and cumulative net funding requirements
are determined from the maturity ladder
– the BIS also suggests that DIs prepare for abnormal conditions
using various “what if” scenarios

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 Liquidity Planning
• Liquidity planning allows managers to make important
borrowing priority decisions before liquidity problems arise
– lowers the costs of funds by determining an optimal funding mix
– minimizes the amount of excess reserves that a bank needs to hold
– liquidity plan components
• delineation of managerial responsibilities
• list of fund providers most likely to withdraw funds and a pattern of
fund withdrawals
• identification of the size of potential deposit and fund withdrawals over
various time horizons
• internal limits on separate subsidiaries’ and branches’ borrowings as
well as acceptable risk premiums to pay in each market

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 Liquidity Risk

• Major liquidity problems arise if deposit drains

are abnormally large and unexpected
• Abnormal deposit drains can occur because
– concerns about a bank’s solvency
– failure of another bank (i.e., the contagion effect)
– sudden changes in investors’ preferences regarding
holding nonbank financial assets relative to bank
deposits
• A bank run is a sudden and unexpected increase
in deposit withdrawals from a bank

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 Liquidity Risk

• Demand deposits are first-come, first-served contracts

• The incentives for depositors to withdraw their funds at
the first sign of trouble creates a fundamental instability in
the banking system
– a bank panic is a systemic or contagious run on the deposits of
the banking industry as a whole
• Regulatory mechanisms are in place to ease banks’
liquidity problems and to deter bank runs and panics
– deposit insurance
– the discount window

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 Deposit Insurance
• Guarantee programs offer depositors varying degrees of
insurance protection to deter bank runs
• Deposit insurance was first introduced in the U.S. in 1933
and gave coverage up to $2,500
• Coverage was increased to $100,000 by 1980
• Beginning in 2011 the Federal Deposit Insurance
Corporation (FDIC) will increase coverage every year
based on the Consumer Price Index (CPI)
• The Federal Deposit Insurance Reform Act of 2005
increased deposit insurance for retirement account from
$100,000 to $250,000

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 Deposit Insurance

• Individuals can achieve many times the $100,000

($250,000) coverage cap on deposits by creatively
structuring their deposits and by using multiple
banks
• The FDIC now uses a risk-based deposit
insurance program to evaluate and assign deposit
insurance premiums
– the safest institutions now pay 5¢ per $100 of deposits
– the riskiest institutions now pay 43¢ per $100 of
deposits

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 The Discount Window
• The Federal Reserve also provides a “discount window”
lending facility
• Historically the borrowing rate was below market rates
and borrowing was restricted
• In 2003 the Fed increased the costs of borrowing but
eased the terms
– primary credit is available to generally sound DIs on a very
short-term basis
– secondary credit is available to less sound DIs (at a higher rate
than primary credit) on a very short-term basis
– seasonal credit assists small DIs in managing seasonal swings in
their loans and deposits

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 Liquidity Risk and Insurance Companies

• Life insurance companies hold cash reserves and other

liquid assets
– to meet policy payments
– to meet cancellation (surrender) payments
• the surrender value of a life insurance policy is the amount that an
insurance policyholder receives when cashing in a policy early
– to fund working capital needs which can be unpredictable
• Property-casualty (P&C) insurance companies
– the claims against P&C insurers are hard to predict
– thus, P&C insurance companies have a greater need for liquidity
than life insurance companies

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 Liquidity Risk and Mutual Funds

• Mutual funds (MFs) can be subject to dramatic

liquidity needs if investors become nervous about
the true value of the funds’ assets
• However, the way MFs are valued reduces the
incentive of fund shareholders to engage in bank-
like runs on any given day
– assets are distributed on a pro rate basis (i.e., rather
than a first-come first-served basis)
– losses are incurred to shareholders on a proportional
basis

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