Lecture 5:

Liquidity Risk
 Introduction

• Liquidity of a firm is the ability of a firm to pay off the

current liabilities with the current assets it possess.

• Liquidity risk: a normal aspect of FI’s everyday

management.
• E.g.: FIs must manage liquidity so they can pay out
cash as deposit holders request withdrawals of their
funds.

• Only in extreme cases do liquidity risk problems

develop into solvency risk problems (not enough cash
to pay creditors as promised).

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 Funding liquidity vs Market liquidity

• Funding liquidity risk is the risk that a bank will be

unable to pay its debts when they fall due.
• In simple terms, it is the risk that the bank cannot
meet the demand of customers wishing to withdraw
their deposits.

• Market liquidity risk, on the other hand, is the risk of

not being able to sell assets in a timely fashion without
having to offer a heavy discount.

• Research has shown that funding liquidity issues can

often lead to market liquidity risk and vice versa.

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 Introduction
• What is the most liquid asset?

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 Difference Exposure to Liquidity Risks

• Different levels of exposure:

• High risk: Depository institutions
• Medium risk: Life insurance companies
• Low risk: Mutual funds, hedge funds, pension funds,
and property–casualty insurance companies

• Example: liquidity risk of a hedge fund:

• In Sep 2006, Amaranth Advisors, a hedge fund with assets of
$9.2 billion, lost $6.5 billion when its position in natural gas
future contracts became too big to liquidate.

→The hedge fund was forced to shut down, due to Amaranth’s

lack of liquid fund.

Read more on Amaranth Advisor

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“Black Monday”: Stock market crash in 1987

On Oct. 19,1987:
• The Dow Jones Industrial Average plunged almost 23%
• The largest one-day percentage drop in history
• Significant selling created steep price declines
throughout the day

Source: https://en.wikipedia.org/wiki/Black_Monday_(1987)
 Liquidity Risk: Liability-side causes

• Liquidity risk may result from asset side or liability side.

• 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

Net deposit drains = deposit withdrawals – deposit additions

• DI needs to predict the distribution of net deposit drains and

estimate the demand of liquidity
• Abnormal net deposit drains expose DIs to significant
liquidity risk.
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 Two Possible Distributions of Net Deposit Drains

5% of net deposit funds to be FI receive 2% of net deposit funds

withdrawn with the highest probability inflow with the highest probability at
at any day any day
 Example: Liability-side of Liquidity Risk
• Asset side of the balance sheet: DI holds $9 mil cash
• $3 mil of the $9 mil: to meet regulator’s minimum reserve requirements
• $6 mil: in an “excess” cash reserves

• As depositors withdraw $5 mil in deposits, the DI can meet this directly by

using the excess cash of $6 mil.

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 Liquidity Risk at Depository Institutions

❑ Asset-side liquidity risk

• The exercise of loan commitments and other credit lines by borrowers
• Change of the value of investment securities portfolios due to
unexpected changes of interest rates

❑ 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.

Core deposits: relatively stable, and provide stable long-term funding

source for the DI.

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 Managing Liquidity

• Two major ways to manage liquidity shock:

– Purchased liquidity management: to borrow from capital
markets
– Stored liquidity management: to invest in liquid assets and
liquidate assets to meet cash outflows demand

• Traditionally, DIs have relied on stored liquidity

management.

• Nowadays, most DIs rely on purchased liquidity

management.

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 Purchased Liquidity Management
• Liquidity can be ‘purchased’ (or borrowed) in financial
markets, e.g. borrowed funds from other peer banks and other
institutional investors.
– Interbank fund markets such as federal funds market in the U.S.
or the repurchase agreement (repo) market
– Issuance of debt instruments such as wholesale CDs, notes
or bonds

• Benefit:
– Preserve asset side of balance sheet
– Allow DIs to maintain their overall balance sheet size

• Downsides:
– Borrowed funds are likely to be at higher rates than interest paid
on deposits, i.e. funds to be borrowed at market rates.
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Managing Liquidity - Stored Liquidity Management

• Maintain sufficient liquid assets on balance sheet

1. Minimum cash reserve as required by the regulator
2. Excess cash reserve
3. Other liquid assets

• Disadvantages
• Decreasing the size of balance sheet
• Opportunity cost of holding excessive liquid assets: low returns
• Cost of liquidating illiquid assets could be very high
– Low sales price; in worst case, fire-sale price
– Historical liquidity events: Stock market crash in 1987
(Black Monday), 2010 Flash Crash

→ It is better to combine purchased and stored liquidity management

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 Example: Loan Commitment Exercise
• After loan commitment exercise: Other assets increase $5 mil from $91mil to
$96 mil
→Assets side: Other assets increase $5 mil

1) Purchased liquidity management: borrow $5 million in the money market and

lending these funds to the borrower.
2) Stored liquidity management: decrease the DI’s cash from $9 mil to $4 mil.

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 Measuring a DI’s Liquidity Exposure

Method 1: Net Liquidity Statement

• Show the sources and uses of liquidity: a measure of a DI’s
net liquidity position

Sources include:
1) Sale of liquid assets such as T-bills: little price risk and low transaction cost
2) Borrow funds from money market
3) Excess cash reserves over and above the amount held to meet regulatory
imposed reserve requirements

Uses include:
borrowed funds or money market funds already utilised

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 Net Liquidity Position Example

• Net Liquidity Position of a U.S. bank (in $mil)

– Total sources of liquidity = $14,500 mil
– Total uses of liquidity = $7,000 mil

→ The DI has a positive net liquidity position of $7,500 mil

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 Measuring a DI’s Liquidity Exposure
Method 2: Peer Group Ratio Comparison
• Compare certain key ratios and balance sheet features
with other similar Dis

For example:
• Ratios related to potential liquidity needs in the future, such
as loan commitments to assets ratio
• Ratios related to the availability of liquidity sources, such as
loans to deposits ratio and borrowed funds/total
assets ratio

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Liquidity Ratio for Non-Financial Firms

𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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 Measuring a DI’s Liquidity Exposure
Example 1:
A high loans to deposits ratio or borrowed funds to total assets
ratio indicates
→DI relies heavily on the short-term money market rather than on
core deposits to fund loans.
→lead to future liquidity problems if the DI is at or near its
borrowing limits in the purchased funds market.

Example 2:
A high ratio of loan commitments to assets indicates
→ The need for a high degree of liquidity to fund any unexpected
takedowns of loans
→ High liquidity risk

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 Peer Group Ratio Comparison

• Liquidity Exposure Ratios for Two Banks, 2006 Values

• Which one has more liquidity risk?

BoA

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 Measuring a DI’s Liquidity Exposure

Method 3: Liquidity Index

• Developed by James Pierce at Federal Reserve
• 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.
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.

Note: the liquidity index always lies between 0 and 1.

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 Method 3: Liquidity Index
Example:
Assume a DI has two assets: 40% in one-month Treasury bonds and
the remaining 60% 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, i.e. in one month’s time,
would lead to $93 per $100 of face value.
Question: What is the one-month liquidity index?

Solution:
P1 = 0.98 P*1 = 1.00 W1 = 0.4
P2 = 0.82 P*2 = 0.93 W2 = 0.6
0.98 0.82
I = 0.4 * 1.00 + 0.6 * 0.93 = 0.392 + 0.529 = 0.921

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 Method 4: Financing Gap

Below is a simplified balance sheet of a DI

Asset Liability
Loans Deposits
Liquid assets Borrowed funds (financing requirement)

Financing gap = average loans – average deposits

Positive Gap: DI requires funding

Financing gap = - Liquid assets + Borrowed funds

i.e., Financing requirement (Borrowed funds)
= financing gap + liquid assets

• The larger a DI’s financing gap and liquid asset holdings, the greater
the exposure.
→ The larger the amount of funds it needs to borrow in the money
markets.
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 Method 4: Financing Gap

• Implication from Financing Gap:

– A widening financing gap: a warning of future liquidity problems
– 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.

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 Measuring a DI’s Liquidity Exposure

Method 5: Maturity Ladder/Scenario Analysis

• For each maturity, assess all cash inflows versus outflows.
• Daily and cumulative net funding requirements can be determined from the
maturity ladder.
• Must also evaluate ‘what if’ scenarios in this framework.

Example
• Excess cash of $4 million is available over the one-day time horizon.
• However, a cumulative net cash shortfall of $46 million is expected to exist
over the next month.
• Over the six-month period, the DI has cumulative excess cash of $1,104
million.

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Net Funding Requirement Using the Maturity
Ladder Analysis

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 Measuring a DI’s Liquidity Exposure

Method 5: Maturity Ladder/Scenario Analysis

• Scenario analysis: Evaluate ‘what if’ scenarios in this framework, i.e.,.
– Normal conditions
– General market crisis
– DI-specific crisis

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 Measuring a DI’s Liquidity Exposure

• Liquidity Planning
– Allows DI managers to make important borrowing
priority decisions before liquidity problems arise

• The overall aim:

– To ensure that there will be sufficient funds to settle
outflows when due

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 Different Categories of Liquidity Exposure
1) Immediate liquidity obligations:
• Occur in contractual and relationship form

2) 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

3) Cyclical liquidity needs

• Liquidity needs that vary with the business cycle
• Difficult to predict
• Out of the control of a single DI

4) Contingent liquidity needs

• Liquidity needs necessary to meet an unforeseen event
• Basically impossible to predict

Trend of liquidity needs:

• Can be predicted over a longer time horizon
• Likely to be associated with a DI’s particular customer base
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Deposit Distributions and Possible Withdrawals Involved
in a DI’s Liquidity Plan (in $mil)

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 Unexpected Deposit Drains, and Bank Runs

• Bank run: Sudden and unexpected increase in deposit

withdrawals from a DI.

• Reasons for abnormal deposit drains (shocks) :

1) Concerns about a DI’s solvency relative to other DIs.
2) Failure of a related DI, leading to heightened depositor
concerns about the solvency of other DIs (contagion).
3) Sudden changes in investor preferences regarding holding
non-bank financial assets relative to deposits

• Sudden and unexpected surges in net deposit withdrawals

risk could trigger a bank run
• (justified or not) can eventually force a bank into insolvency
• May have contagious effects：due to the failure of one bank,
investors lose faith in DIs overall and start running on their
banks. 33
 Deposit Drains and Bank Run Liquidity Risk
• Underlying cause of bank runs: demand deposit contract
• On a ‘first come, first served’ basis
• 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.

• Contagious runs, or bank panics: A systemic or contagious run

on the deposits of the banking industry as a whole.
• Any line outside a DI encourages other depositors to join the line
immediately even if they do not need cash today for normal
consumption purposes.
• Incentives for depositors to run first and ask questions later

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 Bank Run in 1929: American Union Bank

The Great Crash of 1929 signalled the beginning of the 10-year Great Depression.
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 Bank Run in 2008: Northern Rock

• Customers queued for hours to take out their savings.

• The collapse of Northern Bank was the first sign in Britain of the
coming global financial crisis
 Regulatory mechanisms to deal with bank runs
• The two major liquidity risk insulation devices:
1) Deposit insurance
2) Discount window

1) 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.
– Potential moral hazard issues

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 Regulatory mechanisms to deal with bank runs
2) Discount window facility:
– Short-term lending programs offered by central banks for DI to
meet their short-term non-permanent liquidity needs.

• Primary credit is available to generally sound DIs on a very short-

term basis, typically overnight, at a rate above the Federal Open
Market Committee’s (FOMC’s) target rate for federal funds.

• Secondary credit is available to depository institutions that are

not eligible for primary credit.
– It is extended on a very short-term basis, typically overnight, at
a rate that is above the primary credit rate.

• Seasonal credit program: assist small DIs to manage seasonal

swings in their loans and deposits.

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Bernanke supportive of liquidity provision
 Summary

• 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.

• Causes and consequences of liquidity risk, and methods of

measuring and managing liquidity risk.

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