BFC3170 MANAGEMENT OF

FINANCIAL INTERMEDIARIES
Liquidity Risk Management

HASSAN NAQVI

monash.edu
Recap
• OBS items and net worth
• OBS asset
• OBS liability
• Valuation of OBS items
• Returns and risks of OBS activities
• Loan commitments
• Upfront fee
• Backend fee
• Documentary letters of credit
• Standby letters of credit
• Derivative contracts
• Forward purchases and sale of when-issued securities
• Loans sold (with and without recourse)
• Loan Syndications
Learning objectives
• What is liquidity risk and its sources.
• How a depository institution (DI) can utilise either
stored liquidity or purchased liquidity.
• How liquidity risk arises on both the liability side
and asset side of the balance sheet of a DI.
• How to measure a DI’s liquidity risk and determine
its liquidity needs.
• The importance of liquidity planning to a DI.
• Why liquidity risk is generally more critical for
depository institutions than for other financial
institutions.
Learning objectives

• The main reasons why depositors of DIs

which are perceived to be in trouble may
have very strong incentives to engage in bank
runs.
• The ways in which the Australian government,
the RBA and APRA support liquidity in the
Australian financial system.
• Liquidity risk in life insurance companies,
general insurers and managed funds.
Outline

• Introduction
• Causes of liquidity risk
• Liquidity risk at depository institutions
• Liquidity risk in other financial institutions
• Summary
Introduction

• Liquidity risk is a normal aspect of everyday

management of an FI.
– Depository institutions (DIs) are more exposed to
liquidity risk than others.
– In extreme cases liquidity risk can threaten the
solvency of an FI.
– The global financial crisis commencing in 2008 was,
in part, due to liquidity risk.
– Global credit markets froze and LIBOR more than
doubled
• Liquidity risk may result from asset side or liability
side.
• Focus on the risk exposure of DIs.
Introduction
Introduction
Introduction
Causes of liquidity risk

• Liquidity risk can arise on both sides of the balance

sheet: the asset side as well as the liability side.

• Asset side
– Risk from OBS loan commitments and other credit
lines
– Problems associated with ‘quick’ asset sales/fire-
sales
 High costs for turning illiquid assets into cash
 Low sales price; in worst case, fire-sale price
Causes of liquidity risk

• Liability side
– Depositors and other claimholders decide to cash
in their financial claims immediately.
Consequence: the DI has to borrow additional funds
or sell assets.
– DI needs to be able to predict the distribution of net
deposit drains.
 Net deposit drains: the difference between deposit
withdrawals and deposit additions on any specific
normal banking day.
• After a run on PBS, 
the State Treasurer 
Rob Jolly and 
attorney general 
Andrew McCutcheon 
held a press 
conference assuring 
the public that PBS 
was sound…
– But it wasn’t…
• Source: http://nnimgt‐a.akamaihd.net/transform/v1/crop/frm/wuVuNQBDX65fDbDigdChk4/f19d6a7c‐
c934‐4ad8‐b329‐dc71d6cae406.jpg/r0_36_400_248_w1200_h678_fmax.jpg
Liquidity risk at depository institutions

Liability-side liquidity risk

• Large reliance on demand deposits and deposits
raised through other transaction accounts (mostly
at-call deposits)
• However, DIs can rely on core deposits
Liquidity risk at depository institutions

Liability-side liquidity risk

• Core deposits: those deposits that provide a DI
with a long-term funding source
• Most demand deposits act as consumer core
deposits on a day-by-day basis
• In panel (a) DI expects approximately 5% of its net deposit
funds to be withdrawn on any given day
=> New deposits insufficient to offset withdrawals
 DI not growing but contracting
• In panel (b) DI is growing as new deposit funds on average
higher than withdrawals
Liquidity risk at DIs: managing liquidity

• Generally can be managed by:

– purchased liquidity management
– stored liquidity management.

• Traditionally, DIs have relied on stored liquidity

management.
• Today, most DIs rely on purchased liquidity
management.
Liquidity risk at DIs: managing liquidity
Purchased liquidity management
• Liability-side adjustment
• Liquidity can be purchased in financial markets, e.g.
borrowed funds from competitor banks and other
institutional investors
• Managing the liability side preserves asset side of
balance sheet
• Borrowed funds are likely to be at higher rates than
interest paid on deposits, that is, funds to be borrowed
at market rates
• Purchased liquidity management allows DIs to
maintain their overall balance sheet size
Liquidity risk at DIs: managing liquidity

Purchased liquidity management

• This can be expensive for DI since it is paying market rates

for wholesale money market to offset low-interest-bearing
deposits
Liquidity risk at DIs: managing liquidity
Stored liquidity management
• Asset-side adjustment
• Liquidate assets
– In absence of reserve requirements, banks tend to
hold excess reserve assets; that is, more than 0.6 per
cent of total assets are held in the form of cash
– Downside of excess cash: opportunity cost of reserves
• Decreases size of balance sheet
• Requires holding excess non-interest-bearing
assets
• Better to combine purchased and stored liquidity
management
Liquidity risk at DIs: managing liquidity

Stored liquidity management

• Federal Reserve sets minimum reserve
requirements
• Similar requirements existed in Australia in the
past but were abandoned during the 1990s.
• However, APRA introduced two new requirements
for ADIs to ensure they hold sufficient liquidity
Liquidity risk at DIs: managing liquidity

Stored liquidity management

• The two new requirements have been specifically
designed to improve the resilience of liquidity risk
Australia’s DIs:
– the liquidity coverage ratio (LCR)
– the net stable funding ratio (NSFR)

With or without minimum cash reserve requirements, DIs

tend to prudently hold excess reserve assets to meet
liquidity drains — Australian banks hold 4 per cent of
assets in the form of cash.
Liquidity risk at DIs: managing liquidity

Stored liquidity management

• Both sides of balance sheet contract

• Opportunity cost of using cash to meet liquidity needs
Optimum bank liquidity
Trading off the cost of maintaining liquidity against the cost of insufficient liquidity

Optimum
= minimise
total cost

Source: Gup, 2007, p 358, Figure 11.2

Liquidity risk at depository institutions

Asset-side liquidity risk

• The exercise of loan commitments and other
credit lines by borrowers
• Bank commitments grew more than 15x from
1989 to 2014
• Change of the value of investment securities
portfolios due to unexpected changes of interest
rates
Liquidity risk at DIs: managing liquidity
Liquidity risk at depository institutions

Asset-side liquidity risk

• Change of the value of investment securities
portfolios due to unexpected changes of interest
rates
• ‘Herd behaviour’: traders want to make the same
type of trade at any particular time
• Sell-off => liquidity dries up => securities sold at
fire-sale prices => value of investment portfolio
falls => stored liquidity decreases => liquidity risk
increases
Liquidity risk at DIs: managing liquidity
Measuring a DI's liquidity exposure

Net liquidity statement

• Show the sources and uses of liquidity
• Sources include
– Sale of liquid assets with minimum price risk
– Borrowing funds in the money market
– Using excess cash reserves
• Uses include: borrowed or money market funds
already utilized
• Track liquidity sources and uses on a day-by-day
basis
Measuring a DI's liquidity exposure

Net liquidity statement

Measuring a DI's liquidity exposure

Peer group ratio comparisons

• Comparison of certain key ratios and balance
sheet features of the DI with similar DIs.
• Similar Dis => size and geographical location
• Usual ratios include:
– Loans/deposits
– Borrowed funds/total assets
– Loan commitments/assets.
Measuring a DI's liquidity exposure
Liquidity index
• Developed by James Pierce (banker at Fed)
• 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.
• Liquidity index given by 0 < I < 1:
N   Pi 
I   Wi  * 

i 1 
  Pi 
Where:
Wi = the percent of each asset in the DI’s portfolio
Pi = the immediate sales price
Pi* = the fair market price
Measuring a DI's liquidity exposure

Liquidity index: Example

Assume a DI has two assets: 40 per cent in one-
month Treasury Bonds and the remaining 60 per cent
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, that is, in one month’s time, would
lead to $93 per $100 of face value. What is the one-
month liquidity index?
Measuring a DI's liquidity exposure

Liquidity index: Example

Solution
We have:
P1 = 0.98 P*1 = 1.00 P2 = 0.82
P*2 = 0.93 W1 = 0.4 W2 = 0.6

 0.98   0.82 
I  0.4 *    0 .6 *    0.392  0.529  0.921
 1.00   0.93 
Measuring a DI's liquidity exposure

Financing gap and the financing requirement

• Financing gap = average loans – average
deposits.
• A positive gap means that the DI requires funding.
• Thus the financing gap can also be defined as:
– liquid assets + borrowed funds.
• The financing requirement is defined as:
financing gap + DI’s liquid assets.
• The larger a DI’s financing requirement, the
greater the exposure.
Measuring a DI's liquidity exposure

New Liquidity Risk Measures Implemented by the BIS

• 2 regulatory standards for liquidity risk in Dec

2010
• DIs are to maintain 2 ratios
1. Liquidity coverage ratio (LCR)
2. Net stable fund ratio (NSFR)
• Adopted by APRA.
Measuring a DI's liquidity exposure

Maturity ladder/Scenario analysis

• For each maturity, assess all cash inflows versus
outflows.
• Daily and cumulative net funding requirements
can be determined in this manner.
• Must also evaluate ‘what if’ scenarios in this
framework.
– For further information on the BIS maturity ladder
approach, visit the Bank for International
Settlements: www.bis.org
Measuring a DI's liquidity exposure

Maturity ladder
Measuring a DI's liquidity exposure

Scenario analysis
Measuring a DI's liquidity exposure

Other liquidity risk control measures

• Concentration of funding: identifying those
sources of significant wholesale funding the
withdrawal of which can trigger liquidity problems
• Available unencumbered assets: these assets
have potential to be used as collateral to raise
additional funding
• Market-related monitoring tools: monitor high
frequency market data – early warning signals
Liquidity planning
• Liquidity planning allows DI managers to make
important borrowing priority decisions before liquidity
problems arise.
– The overall aim is to ensure that there will be sufficient
funds to settle outflows as they become due.
• Liquidity falls into a number of different categories:
– Immediate liquidity obligations
– Seasonal short-term liquidity needs
– Trend liquidity needs
– Cyclical liquidity needs
– Contingent liquidity needs.
Liquidity planning

• Immediate liquidity obligations

– Occur in contractual and relationship form
• Seasonal short-term liquidity needs
– Can be predictable (e.g. Christmas period) or
unpredictable (disproportionate influence of large
borrowers and large depositors)
– Seasonal factors may affect deposit flows and loan
demand
• Trend liquidity needs
– Can be predicted over a longer time horizon
– Likely to be associated with a DI’s particular
customer base
Liquidity planning

• Cyclical liquidity needs

– Liquidity needs that vary with the business cycle
– Difficult to predict
– Out of the control of a single DI
• Contingent liquidity needs
– Liquidity needs necessary to meet an unforeseen
event
– Basically impossible to predict
– APRA requires DIs to hold sufficient liquid assets to
meet a specific institution or name crisis situation
Unexpected deposit drains and bank runs

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
Unexpected deposit drains and bank runs

Abnormal deposit drains can cause a bank run.

• That is, a sudden and unexpected increase in deposit
withdrawals from a DI.
• A bank run, justified or not, can force a DI into
insolvency.
• Bank runs can have contagious effects; that is, because
of the failure of one bank, investors lose faith in DIs
overall and start running on their banks.
 Bank panics
Unexpected deposit drains and bank runs

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.
• Liquidity problem => solvency problem
Northern Rock: Images of a Bank Run 

Source: Shin, Hyun Song, (2008) Reflections on modern bank runs: A case study
on Northern Rock
Source: Shin, Hyun Song, (2008) Reflections on modern bank runs: A case study
On Northern Rock
Unexpected deposit drains and bank runs
Regulatory mechanisms: Deposit insurance
• Guarantee programs offering deposit holders varying
degrees of insurance-type protection.
• Deters bank runs and contagion as deposit holders’ place in
line no longer affects ability to recover their financial claims.
• Many countries have explicit deposit insurance schemes
(not offered in Australia until 2008).
• Overseen by Financial Claims Scheme (FCS) similar to
FDIC in US
• Deposit insurance introduced in Australia during GFC up to
$1m
• Now limit is $250,000
• APRA is responsible for the administration of FCS
Unexpected deposit drains and bank runs

Regulatory mechanisms
• Discount window
– Discount window facility to meet DI's short-term
non-permanent liquidity needs
– Offered by the RBA in the form of rediscount
facilities and repurchase agreements (repo)
– Repo: short-term borrowing usually for one day.
Dealer sells underlying security (usually
government bonds) and buys back shortly
afterwards at a slightly higher price
Liquidity and financial system stability

Reserve Bank role

• The liquidity of the Australian financial system
impacts system stability
• Responsibility of RBA
• Defined as the absence of financial crises that are
sufficiently severe to threaten the health of the
economy
• Financial crises are costly, e.g. Asian financial
crisis in 1997/1998
• RBA’s responsibility to implement policies that
prevent financial instability
Liquidity and financial system stability

Reserve Bank role

• RBA is able to use its balance sheet to provide
liquidity to the financial system
– Open market operations, that is, intervention in the
short-term money markets to affect the cash interest
rate.
– RBA affects liquidity by buying or selling
Commonwealth Government securities.
– Intra-day Repurchase Agreement Facility and the
Overnight Repurchase Agreement Facility, able to
borrow from the RBA to generate intra-day liquidity
or to borrow overnight.
Liquidity risk of other FIs

Life insurance companies

• Life insurers are affected by early cancellation of
an insurance policy.
• Life insurance company needs to pay the
surrender value, that is, the amount received by
an insurance policyholder when cashing in a
policy early.
Liquidity risk of other FIs
General insurers
• Liquidity exposure occurs when policyholders
cancel or fail to renew policies because of
insolvency risk, pricing or competitive reasons.
• Large unexpected claims may materialise and
exceed the flow of premium income and income
returns from assets.
• Examples: Earthquakes in New Zealand in 2010
and Japan in 2011
• Queensland, NSW, Victoria flooding in Jan 2011
• HIH Insurance Group Insolvency: $5.3b losses
• AIG in GFC: $18b losses due to CDSs
Liquidity risk of other FIs

Managed funds
• Closed-end funds
– Sell a fixed number of shares in the fund to outside
investors

• Open-end funds
– Majority of Australian funds
– Sell an elastic (non-fixed) number of shares in the
fund to outside investors
– Must stand ready to buy back issued shares at
current market prices
Liquidity risk of other FIs
Managed funds
• Net asset value (NAV) of the fund is market value.
• The incentive for runs is not like the situation faced
by banks.
• Asset losses will be shared on a pro rata basis, so
there is no advantage to being first in line.
• Dramatic runs if investors become nervous (e.g.
during GFC US$170b was liquidated)
• Nevertheless liquidity problems not as extreme as
DIs
• Deposit contracts should be structured similar to
managed funds or equity contracts
Summary

• Discussed the liquidity risk faced by FIs, focusing on

the risk exposure of DIs.
• Liquidity risk is a normal aspect of the everyday
management of a DI.
• Only in limited cases does liquidity risk threaten the
solvency of a DI.
• We discussed the causes and consequences of
liquidity risk, and methods of measuring and
managing liquidity risk.
• Also discussed the regulatory mechanisms put in
place to control liquidity risk.