Liquidity Risk

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 Liquidity Risk – To be discussed
• This chapter identifies the causes of liquidity risk on the liability side
of an FI’s balance sheet as well as on the asset side.
• The methods used to measure an FI’s liquidity risk exposure and
consequences of extreme liquidity risk.

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 What is Liquidity risk (LR)?
• Liquidity risk is the risk that the Firm will be unable to meet its
contractual and contingent obligations.
• Thus, liquidity risk management is intended to ensure that the Firm
has the appropriate amount, composition and tenor of funding and
liquidity in support of its assets.

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 What cause LR?
LR can be caused for two reasons:
1. Liability side
The liability-side reason occurs when an FI’s liability holders, such as
depositors or insurance policyholders, seek to cash in their financial
claims immediately.
- To pay the required cash, FI needs to borrow additional funds or sell
assets.
- As Fis’ don’t keep large cash reserves as assets, since, it pays no
interest .
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 What cause LR?
Another reason for LR is:
2. Asset side
The second cause of liquidity risk is asset-side liquidity risk, such as the
ability to fund the exercise of off-balance-sheet loan commitments.
- A loan commitment allows a customer to borrow funds from an FI (over
a commitment period) on demand.
- When borrower draws on such a loan, FI must fund the loan
immediately on the balance sheet, creating a demand for cash.
- So FI can meet this demand by running down its cash assets, selling off
other liquid assets, or borrowing additional funds.
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 LR in Depository Institutions (DIs)
• Balance sheet of DI normally have large amount of short term
liabilities (e.g. DD) and money market deposit accounts
(MMDAs),they fund relatively long term assets.
• For instance, an individual demand deposit account holder with a
balance of $10,000 can demand cash to be repaid immediately, as can
a corporation with $100 million in its demand deposit account.
• Theoretically speaking, DI’s can have at least 20% of their liabilities
in DD , MMDAs & other transaction accounts. They can pay out this
amount by liquidating an equal amount of assets on any banking day.

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 Managing Liability side LR
• DI manager overtime can normally predict—with a good degree of
accuracy—the probability distribution of net deposit drains (the
difference between deposit withdrawals and deposit additions) on any
given normal banking day.
• A DI can manage a drain on deposits in two major ways:
(1) Purchased liquidity (liability) management and/or
(2) Stored liquidity management.

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 Purchased Liquidity Management
A DI manager who purchases liquidity turns to external market to
purchase funds like:
• the markets such as the Government funds market and/or the
repurchase agreement markets, which are interbank markets for short-
term loans.
• Alternatively, the DI manager could issue additional fixed-maturity
wholesale certificates of deposit or even sell some notes and bonds.
• However, it comes at a cost! High market rates than DI’s assets &
limited availability.
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 Stored Liquidity Management
• FI could liquidate some of its assets, utilizing its stored liquidity.
• The cash reserves DIs‘ keep to meet liquidity drains.
• The cost to the DI from using stored liquidity:
• decreased asset size
• It must hold excess low-rate assets in the form of cash on its balance sheet.
• SBP requires cash reserves to be maintained at an average of 5 percent
of total of demand liabilities and time deposits with tenor of less than
1 year, during the reserve maintenance period; however it is subject to
a daily minimum requirement of 3 percent.
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 Asset side LR
• Loan requests and the exercise by borrowers of their loan
commitments and other credit lines can cause liquidity problems for
DIs‘.
• DIs, especially commercial banks, have increased their loan
commitments tremendously with the belief they would not be used.
• Another type of asset-side liquidity risk arises from the FI’s
investment portfolio. Specifically, unexpected changes in interest rates
can cause investment portfolio values to fluctuate significantly.

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 Measuring a DI’s Liquidity Risk Exposure
Broadly speaking there are FOUR ways to measure liquidity risk
exposure by the DIs'.
1. Financing Gap and the Financing Requirement
2. Use and sources of Liquidity or NLS
3. Peer group ratio comparisons
4. Liquidity Index

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 Measuring a DI’s Liquidity Risk Exposure
The first way to measure liquidity risk exposure is to determine the DI’s
financing gap.
• Financing Gap and the Financing Requirement
The difference between a DI’s average loans and average (core) deposits.
Financing gap= Average loans – Average deposits
FG >0 ==== the DI must fund it by using its cash and liquid assets
and/or borrowing funds in the money market:
FG= - Liquid assets (LA) + Borrowed funds (BF) or
FG+LA = BF (financing requirement)
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 Measuring a DI’s Liquidity Risk Exposure
• Thus, 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 its exposure to liquidity problems from such a
reliance.
• Table 12-6, for discussion.

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 2. Uses & Sources of Liquidity or Net Liquidity
Statement (NLS)
• A second measure of liquidity risk exposure a DI manager might use is
to measure the DI’s liquidity position on a daily basis, if possible.

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 • Sources of liquid funds (3): Sell LA, borrow funds, use excess cash reserves.
• Uses of liquid funds: Amount borrowed/purchased already utilized, cash
borrowed from central bank.

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 3. Peer Group Ratio Comparisons
• A third way to measure a DI’s liquidity exposure is to compare certain
key ratios and balance sheet features of the DI with those of DIs of a
similar size and geographic location.
• Like:
• loans to deposits
• borrowed funds to total assets,
• commitments to lend to assets ratios

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 Peer Group Ratio Comparisons

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 4. Liquidity Index
• A final measure of liquidity risk is to use a liquidity index.
• This 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 process.
• The greater the differences between immediate fire-sale asset prices ()
and fair market prices () the less liquid is the DI’s portfolio of assets.

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 Liquidity Index

Where: () = immediate fire-sale asset prices ; () = fair market

prices
is the percent of each asset in the FI’s portfolio
Decision: I lies between 0 and 1. Also, yhe liquidity
index for this DI could also be compared with
indexes calculated for a peer group of similar DIs.
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 Liquidity Index
Practice problem: Example 12-1

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 Reference
• Saunders, A. & Cornett, M.M. (2017). Liquidity risk (9 th edition),
Financial institutions management: A risk management approach.
McGraw-Hill Education.

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