Appunti Financial Markets, Credit and Banking

LIQUIDITY RISK MANAGEMENT

Managers must deal with liquidity risk daily, although depository institutions have more liquidity risk than other fis. The main goal of liquidity management is to maintain just enough liquid assets in combination with liquidity funding sources to be able to meet expected and unexpected liquidity needs. Financial institutions don't wish to hold excessive amounts of liquidity assets, because they earn to low rates of returns (or even negative). Banks have more liquidity risk than mutual funds, insurers and hedge funds, but several hedge funds have gone bankrupt. They pledge their security holdings for collateral on short term loans used to get liquidity. When the subprime problems reduce the behaviour of mortgage bank securities, lenders to hedge funds and dealers refuse to renew loans without better collateral. This is a problem because hedge fuds had a lot of mortgage backed securities in their portfolio and couldn't get the liquidity needed anymore.

had to reduce the positions, the performances collapsed, and they went bankrupt as the clients asked their money back.

Liquidity Is a necessary condition for well-functioning markets and is a necessary component for successful hedging of risk. Since all hedging model assume adequate liquidity when liquidity dries up all models fail, and outcomes can be more extreme than anticipated. This is a lesson that investors who rely too much on mathematical based model to assess risk must learn.

LIQUIDITY RISK CAUSES:

• Liability side reason: when unexpected withdrawn of liability happens, because of unexpected withdrawals of deposits or anticipated policy claims that force the fi to sell assets or borrow more funds. if the FI doesn't have liquidity enough or cannot borrow, it may have to liquidate long term investments, perhaps at prices below market value (fire sale price). If the liquidate asset must be priced at market value, then there could be balance sheet losses and equity.

• Write-downs.
• Asset side reason: when there's unexpected increase in assets, it could be like a drawdown or unanticipated loan demand, default of loans, unexpected payment etc. the FI may need to sell asset or borrow funds.

LIQUIDITY RISK AND DEPOSITORY INSTITUTIONS:

DIs' balance sheets typically have Large amounts of short-term liabilities, such as demand deposits and other transaction accounts, that must be paid out immediately if demanded by depositors, but also large amounts of relatively illiquid (hard to sell) long-term assets, such as commercial loans and mortgages.

Dis have large amount of transactions and deposits that can be withdrawn immediately. These accounts give depositors a put option with the exercise price equal to the amount of their deposit. Banks estimate the amount of called deposit and estimate expected growth deposits.

Core deposits are low turnover accounts, that means relatively stable and placed at banks core convenient needs because the customer has

• Insurance.
• Purchased liquidity management is an adjustment to a deposit drain that occurs on the liability side of the balance sheet: banks can obtain funds by borrowing additional cash.
• FIs rely on the ability to acquire funds from brokered deposits and borrowings. They are used primarily by the largest banks with access to the money market and other non-deposit sources of funds.
• Purchased liquidity instruments include:
  • Market for purchased funds, such as fed funds market (overnight borrowing between banks to keep their reserve requirements) and repurchase (repo) agreement markets (short-term loan with a security pledge for collateral).
  • Issue additional fixed-maturity certificates of deposit.
  • Issue additional notes and bonds.
• Purchased liquidity management allows FIs to maintain the overall size of their balance when faced with liquidity demands without disturbing the size/composition of the asset side of the balance sheet. It may be more expensive relative to stored liquidity.

could add volatility of interest ex-pense. It is riskier for banks to depend too much on purchase of funds.

LIQUIDITY RISK AND DEPOSITORY INSTITUTIONS

Loan commitments and other credit lines can cause liquidity needs. As with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity. If stored liquidity is used to fund commitments, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet. Earnings are lower but safer. If purchased liquidity is used to fund commitments, the composition of both the asset and liability sides of the balance sheet changes, and the size of the balance sheet increases. Volatility and riskier when purchased funds may be more expensive or not available. Unused loan commitments provide fee income to the bank.

FINANCING GAP AND THE FINANCING REQUIREMENT

The first way to measure liquidity risk exposure is to determine the DI's financing gap which is the difference

in-creased deposit withdrawals and increasing loans due to more exercise of loan commitments.

SOURCES AND USES OF LIQUIDITY

The liquidity position of banks is measured by managers on a daily basis, if possible, through the net liquidity statement. A net liquidity statement lists sources and uses of liquidity, and, thus, provides a measure of a DI's net liquidity position. This is a tool used by DI managers, serving as the second method by which to measure liquidity risk exposure.

DI can obtain liquid funds in the following ways:

1. Sell its liquid assets, such as T-bills, immediately with very little price risk and low transaction costs, because the market is very large and liquid for T bills
2. Borrow funds in the money/purchased funds market up to a maximum amount. Fed funds or certificate of deposits
3. Use any excess cash reserves over and above the amount held to meet regulatory imposed reserve requirements

NET LIQUIDITY POSITION

In this case the FI can handle unanticipated

Liquidity needs of 7.5 billion. FI does not want to hold excessive amount of liquid asset because the low return is a drag on profitability and on competitiveness.

PEER GROUP RATIO COMPARISON

The third way to measure a DI's liquidity exposure is to use peer group ratio comparisons. Peer group ratio comparisons are when certain key ratios and balance sheet features of a DI are compared against those same key ratios and balance sheet features of another DI.

Key liquidity ratios are, for example, loans to deposits, loans to core deposits, core deposits to total liabilities and equity. Ratios are often compared to those of banks of a similar size and in the same geographic location. Usually, a ratio like loans to deposit should be below 100% and if a deposit institution also has the loans to core deposit (deposit of customers) below 100%, it is very virtuous. Usually, the ratio loans to core deposit is higher than the ratio of loans to deposit because banks usually are taking deposits as well.

From the market. It means that they can get deposit from other banks and if there is a problem, banks are the first one stopping giving money to other banks. DI should be very careful in the quality of the deposit. The higher the percentage of core deposits, the better it is for the bank.

LIQUIDITY INDEX

It is the ratio of the fire sale price required to liquidate assets in emergency situations divided by the fair market value of the assets liquidated. The lower the index, the greater the liquidity risk. A final way to measure liquidity risk is to use a liquidity index, which measures the potential losses a bank could suffer from a sudden (or fire-sale) disposal of assets

Example:

Liquidity risk of 96.76%, pretty high

The liquidity index is a better measure for the cost of the liquidity risk

NEW LIQUIDITY RISK MEASURES IMPLEMENTED BY THE BANK OF INTERNATIONAL SETTLEMENT (BIS)

Two regulatory standards were developed by BIS for liquidity risk supervisions.

Standards are intended to "enhance tools,

"metrics, and benchmarks that supervisors can use to assess the resilience of banks' liquidity cushion and constrain any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices"

The liquidity coverage ratio is the ratio of stock of highly quality assets that can be liquidated at short notice over the total net cash outflows over the next 30 days. This ratio must be >= than 100%.

The net stable funding ratio must be reported quarterly beginning 2018. This ratio is the available amount of stable funding, over the required amount of stable funding over the year. This ratio must be >100% and it is meant to limit the reliance on the short-term funding for longer term assets.

LIQUIDITY PLANNING

Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise. It could lower the costs of funds by determining an optimal funding mix and minimizes the amount of excess reserves that a DI needs.

to hold. Liquidity plan components should include:

Delineation of managerial responsibilities