CHAPTER 17 Liquidity Risk
FIN701 Financial Institutions Management
CHAPTER 17 Liquidity Risk INTRODUCTION Liquidity risk – risk that sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices CAUSES OF LIQUIDITY RISK Liquidity risk arises for two reasons: 1. Liability-side reason occurs when an FI’s liability holders, such as depositors or insurance policyholders, seek to cash in their financial claims immediately When liability holders demand cash by withdrawing deposits, FI needs to borrow additional funds or sell assets to meet withdrawal Fire-sale price – price received for an asset that has to be liquidated (sold) immediately 2. Asset-side reason occurs as ability to fund the exercise of off-balance-sheet loan commitments When borrower draws on loan commitment, FI must fund loan on the balance sheet immediately which creates a demand for liquidity LIQUIDITY RISK AT DEPOSIT-TAKING INSTITUTIONS Liability-Side Liquidity Risk In theory, DTI that as 20% of its liabilities in demand deposits and other transaction accounts must stand ready to pay out that amount by liquidating an equivalent amount of assets on any banking day Core deposits – those deposits that provide a DTI with a long-term funding source Net deposit drains – amount by which cash withdrawals exceed additions; a net cash outflow o Withdrawals may in part be offset by the inflow of new deposits and income generated from DTIs on- and offbalance-sheet activities DTI can manage train on deposits in two major ways: 1. Purchased liquidity management – adjustment to a deposit drain that occurs on the liability side of the balance sheet DTI who purchases liquidity may turn to inter-bank markets for short-term funds Large Value Transfer System (LVTS) participant – member of the Canadian Payments Association who settles directly with the Bank of Canada and participates in the LVTS DTI is paying market rates to offset net drain, thus, the higher the cost of purchase funds relative to rates earned on assets, the less attractive this approach to liquidity management becomes 2. Stored liquidity management – adjustment to a deposit drain that occurs on the asset side of balance sheet DTI would liquidate some of its assets, utilizing its stored liquidity Cost to DTI from using stored liquidity, apart from decreased asset size, is that it must hold excess non-interest-bearing assets in the form of cash on its balance sheet Asset-Side Liquidity Risk Risk can arise from exercise by borrowers of their loan commitments and other credit lines, and are drawn down Risk arises from FI’s investment portfolio when unexpected changes in interest rates can cause investment portfolio values to fluctuate significantly or of deteriorate market traders (herd behaviour for trading) Measuring a DTI’s Liquidity Exposure Six different ways to measure liquidity exposure 1. Net liquidity statement – lists sources and uses of liquidity and thus provides a measure of DTI’s net liquidity position DTI can obtain liquid funds in three ways: i. Sell its liquid assets with little price risk and low transaction cost ii. Borrow funds in the money/purchased funds market up to a maximum amount iii. Use any excess cash 2. Peer group ratio comparison – comparing key ratios and balance sheet features on FTI, such as loans to deposits, borrowed funds to total assets, and commitments to lend to asset ratio Higher ratio of loans on deposits means DTI relies heavily on short-term money market rather than on core deposits to fund loans
FIN701 Financial Institutions Management
3.
High ratio of loans and commitments to assets indicates need for high degree of liquidity to fund any unexpected drawdown of these loans Liquidity index – measure of the potential losses FI could suffer as the result of sudden (or fire-sale) disposal of assets The greater the difference between immediate fire-sale asset prices (Pi) and fair market prices (P*i), the less liquid is the DTI’s portfolio of assets (
4.
)(
)
Financing gap and financing requirement Financing gap – difference between DTI’s average loans and average (core) deposit
If financing gap is positive, DTI must fund it using cash and liquid assets and/or borrowing funds in money market
Financing requirement – financing gap plus a DTI’s liquid assets (
)
5.
6.
When borrowing increases, sophisticated lenders in money market may be concerned with DTI’s credit-worthiness and impose higher risk premiums on borrowed funds or establishing stricter credit limits by not rolling over funds lent to DTI BIS approach: maturity ladder/scenario analysis – framework for liquidity risk management for banks and their supervisors that incorporated 17 principles, including governance, measurement and management, disclosure, and supervisor’s role in liquidity risk of banks Maturity ladder assesses all cash inflows against outflows, and makes comparisons on day-to-day basis and/or over a series of specified time periods o Daily and cumulative net funding requirements can be determined from maturity ladder DTI must manage liquidity in the short-term, long-term, and under abnormal conditions Scenario analysis examines timing of cash flows for each type of asset and liability by assessing the probability of the behaviour of those cash flows under scenario being examined Liquidity planning – allows managers to make important borrowing priority decisions before liquidity problems arise Components of a liquidity plan i. Delineation of managerial details and responsibilities Responsibilities assigned to key management personnel should liquidity crisis occur and are responsible for interacting with various government agencies ii. Detailed list of fund providers who are most likely to withdraw, as well as the pattern of fund withdrawal iii. Identification of size of potential deposit and fund withdrawals over various time horizons in the future as well as alternative private market funding sources to meet such withdrawals iv. Set internal limits on separate subsidiaries’ and branches’ borrowings as well as boundaries for acceptable risk premiums to pay each market v. Sequencing of assets for disposal in anticipation of various degrees or intensities of deposit/fund withdrawals
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs Abnormal deposit drains (shocks) may occur for a number of reasons: 1. Concerns about DTI’s solvency relative to that of another DTIs 2. Failure of related DTI leading to heightened depositor concerns about solvency of other DTIs (the contagion effect)
FIN701 Financial Institutions Management
3. Sudden changes in investor preferences regarding holding non-bank financial assets relative to deposits Bank run – sudden and unexpected increase in deposit withdrawals from a DTI Demand deposit contract are first-come, first-served contracts in the sense that depositor’s place in line determines about he or she will be able to withdraw from DTI Bank panic – systematic or contagious run on the deposits of the banking industry as a whole
Bank Runs, the Bank of Canada, and Deposit Insurance Two major liquidity risk insulation devices are 1. Deposit insurance - government regulators of DTIs have established guarantee programs offering deposit holders varying degrees of insurance protection to deter runs and contagious runs and panics 2. Borrowing from the Bank of Canada – provides overnight lending facilities to meet DTIs’ short-term nonpermanent liquidity needs Lender of last resort (LLR) – role of central bank providing funds to country’s FIs during liquidity crisis Bank of Canada has three roles in providing liquidity to financial system i. Provides daily and overnight funds to cover temporary shortfalls of an FI ii. Provides emergency lending assistance (ELA) to solvent DTIs for a longer period of time iii. Bank of Canada can also buy securities issued by financial and non-financial Canadian or foreign firms and government entities LIQUIDITY RISK AND LIFE INSURANCE COMPANIES Surrender value – amount received by insurance policy holder when cashing in a policy early Liquid assets act as a buffer or reserve asset source of liquidity for the insurer in the event premium income is insufficient to meet surrenders LIQUIDITY RISK AND PROPERT AND CASUALTY INSURERS P&C insurers’ assets tend to be shorter term and more liquid than those of life insurers, so problems caused by policy surrenders are less severe Greatest liquidity exposure occurs when policyholders cancel or fail to renew policies with an insurer because of insolvency risk, pricing, or competitive reasons INVESTMENT FUNDS AND PENSION FUNDS Investment funds, such as mutual funds and hedge funds, sell shares as liabilities to investors and invest proceeds in assets such as bonds and equities o Closed-end fund – an investment fund that sells fixed number of shares in the fund to outside investors o Open-end fund – an investment fund that sells an elastic or non-fixed number of shares in the fund to outside investors Net asset value (NAV) – price at which investment fund shares are sold (or can be redeemed); equals total market value of assets divided by number of shares in the fund outstanding
CHAPTER 17 Liquidity Risk INTRODUCTION Liquidity risk – risk that sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices CAUSES OF LIQUIDITY RISK Liquidity risk arises for two reasons: 1. Liability-side reason occurs when an FI’s liability holders, such as depositors or insurance policyholders, seek to cash in their financial claims immediately When liability holders demand cash by withdrawing deposits, FI needs to borrow additional funds or sell assets to meet withdrawal Fire-sale price – price received for an asset that has to be liquidated (sold) immediately 2. Asset-side reason occurs as ability to fund the exercise of off-balance-sheet loan commitments When borrower draws on loan commitment, FI must fund loan on the balance sheet immediately which creates a demand for liquidity LIQUIDITY RISK AT DEPOSIT-TAKING INSTITUTIONS Liability-Side Liquidity Risk In theory, DTI that as 20% of its liabilities in demand deposits and other transaction accounts must stand ready to pay out that amount by liquidating an equivalent amount of assets on any banking day Core deposits – those deposits that provide a DTI with a long-term funding source Net deposit drains – amount by which cash withdrawals exceed additions; a net cash outflow o Withdrawals may in part be offset by the inflow of new deposits and income generated from DTIs on- and offbalance-sheet activities DTI can manage train on deposits in two major ways: 1. Purchased liquidity management – adjustment to a deposit drain that occurs on the liability side of the balance sheet DTI who purchases liquidity may turn to inter-bank markets for short-term funds Large Value Transfer System (LVTS) participant – member of the Canadian Payments Association who settles directly with the Bank of Canada and participates in the LVTS DTI is paying market rates to offset net drain, thus, the higher the cost of purchase funds relative to rates earned on assets, the less attractive this approach to liquidity management becomes 2. Stored liquidity management – adjustment to a deposit drain that occurs on the asset side of balance sheet DTI would liquidate some of its assets, utilizing its stored liquidity Cost to DTI from using stored liquidity, apart from decreased asset size, is that it must hold excess non-interest-bearing assets in the form of cash on its balance sheet Asset-Side Liquidity Risk Risk can arise from exercise by borrowers of their loan commitments and other credit lines, and are drawn down Risk arises from FI’s investment portfolio when unexpected changes in interest rates can cause investment portfolio values to fluctuate significantly or of deteriorate market traders (herd behaviour for trading) Measuring a DTI’s Liquidity Exposure Six different ways to measure liquidity exposure 1. Net liquidity statement – lists sources and uses of liquidity and thus provides a measure of DTI’s net liquidity position DTI can obtain liquid funds in three ways: i. Sell its liquid assets with little price risk and low transaction cost ii. Borrow funds in the money/purchased funds market up to a maximum amount iii. Use any excess cash 2. Peer group ratio comparison – comparing key ratios and balance sheet features on FTI, such as loans to deposits, borrowed funds to total assets, and commitments to lend to asset ratio Higher ratio of loans on deposits means DTI relies heavily on short-term money market rather than on core deposits to fund loans
FIN701 Financial Institutions Management
3.
High ratio of loans and commitments to assets indicates need for high degree of liquidity to fund any unexpected drawdown of these loans Liquidity index – measure of the potential losses FI could suffer as the result of sudden (or fire-sale) disposal of assets The greater the difference between immediate fire-sale asset prices (Pi) and fair market prices (P*i), the less liquid is the DTI’s portfolio of assets (
4.
)(
)
Financing gap and financing requirement Financing gap – difference between DTI’s average loans and average (core) deposit
If financing gap is positive, DTI must fund it using cash and liquid assets and/or borrowing funds in money market
Financing requirement – financing gap plus a DTI’s liquid assets (
)
5.
6.
When borrowing increases, sophisticated lenders in money market may be concerned with DTI’s credit-worthiness and impose higher risk premiums on borrowed funds or establishing stricter credit limits by not rolling over funds lent to DTI BIS approach: maturity ladder/scenario analysis – framework for liquidity risk management for banks and their supervisors that incorporated 17 principles, including governance, measurement and management, disclosure, and supervisor’s role in liquidity risk of banks Maturity ladder assesses all cash inflows against outflows, and makes comparisons on day-to-day basis and/or over a series of specified time periods o Daily and cumulative net funding requirements can be determined from maturity ladder DTI must manage liquidity in the short-term, long-term, and under abnormal conditions Scenario analysis examines timing of cash flows for each type of asset and liability by assessing the probability of the behaviour of those cash flows under scenario being examined Liquidity planning – allows managers to make important borrowing priority decisions before liquidity problems arise Components of a liquidity plan i. Delineation of managerial details and responsibilities Responsibilities assigned to key management personnel should liquidity crisis occur and are responsible for interacting with various government agencies ii. Detailed list of fund providers who are most likely to withdraw, as well as the pattern of fund withdrawal iii. Identification of size of potential deposit and fund withdrawals over various time horizons in the future as well as alternative private market funding sources to meet such withdrawals iv. Set internal limits on separate subsidiaries’ and branches’ borrowings as well as boundaries for acceptable risk premiums to pay each market v. Sequencing of assets for disposal in anticipation of various degrees or intensities of deposit/fund withdrawals
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs Abnormal deposit drains (shocks) may occur for a number of reasons: 1. Concerns about DTI’s solvency relative to that of another DTIs 2. Failure of related DTI leading to heightened depositor concerns about solvency of other DTIs (the contagion effect)
FIN701 Financial Institutions Management
3. Sudden changes in investor preferences regarding holding non-bank financial assets relative to deposits Bank run – sudden and unexpected increase in deposit withdrawals from a DTI Demand deposit contract are first-come, first-served contracts in the sense that depositor’s place in line determines about he or she will be able to withdraw from DTI Bank panic – systematic or contagious run on the deposits of the banking industry as a whole
Bank Runs, the Bank of Canada, and Deposit Insurance Two major liquidity risk insulation devices are 1. Deposit insurance - government regulators of DTIs have established guarantee programs offering deposit holders varying degrees of insurance protection to deter runs and contagious runs and panics 2. Borrowing from the Bank of Canada – provides overnight lending facilities to meet DTIs’ short-term nonpermanent liquidity needs Lender of last resort (LLR) – role of central bank providing funds to country’s FIs during liquidity crisis Bank of Canada has three roles in providing liquidity to financial system i. Provides daily and overnight funds to cover temporary shortfalls of an FI ii. Provides emergency lending assistance (ELA) to solvent DTIs for a longer period of time iii. Bank of Canada can also buy securities issued by financial and non-financial Canadian or foreign firms and government entities LIQUIDITY RISK AND LIFE INSURANCE COMPANIES Surrender value – amount received by insurance policy holder when cashing in a policy early Liquid assets act as a buffer or reserve asset source of liquidity for the insurer in the event premium income is insufficient to meet surrenders LIQUIDITY RISK AND PROPERT AND CASUALTY INSURERS P&C insurers’ assets tend to be shorter term and more liquid than those of life insurers, so problems caused by policy surrenders are less severe Greatest liquidity exposure occurs when policyholders cancel or fail to renew policies with an insurer because of insolvency risk, pricing, or competitive reasons INVESTMENT FUNDS AND PENSION FUNDS Investment funds, such as mutual funds and hedge funds, sell shares as liabilities to investors and invest proceeds in assets such as bonds and equities o Closed-end fund – an investment fund that sells fixed number of shares in the fund to outside investors o Open-end fund – an investment fund that sells an elastic or non-fixed number of shares in the fund to outside investors Net asset value (NAV) – price at which investment fund shares are sold (or can be redeemed); equals total market value of assets divided by number of shares in the fund outstanding
