Liquidity

1. Liquidity

2. Students should be able to • Define liquidity risk and explain why it is important for banks. • Describe assets used for liquidity inventory purposes or debts used for liability management. • Describe some strategies for calculating liquidity needs. • Describe and calculate some ratios for measuring liquidity risk. • Explain economy theory of bank runs.

3. Liquidity is a product of banks • Banks are profitable as an enterprise through their access to relatively cheap funding from core deposits. • Depositors are willing to lend money to banks at low interest rates because the banks offer unique liquidity services that facilitate regular transactions and protect liquidity position of depositors wealth. • But if banks are unreliable in providing liquidity services, their access to cheap funding and ultimately their profits will disappear.

4. Liquidity Services • Banks provide a number of liquidity services • Cash Withdrawal • Checking • Electronic Payments • Electronic Transfers These require Interbank transactions: Payments between banks

5. Cash Demand is relatively predictable, though subject to seasonal factors. HK Currency subject to sharp annual rises in demand. Source: HKMA, CEIC

6. Interbank Transactions • Most payments (by value) are done through checks, credit cards, debit cards, and electronic transfers. • Final settlement of these transactions will be done through the accounts that banks hold at the HKMA, called clearing balances. • Unlike USA, banks face no minimum reserve requirement on accounts at central bank. Only requirement is must meet obligations.

7. Transactions at Hong Kong Interbank Clearance Ltd.Jan 2006: HK$12trillion (approx.) Large and Volatile Fluctuations in Transactions Volume and Available Reserves

8. Daily Liquidity Management • Banks are able to borrow intraday liquidity from the central bank to meet transactions demand using repo operations with Exchange Fund bills. • Exchange fund bills are debt securities issued by central bank. • Banks may borrow overnight liquidity from: • Other banks at HIBOR rate • Central bank discount window at base rate • Discount Window Rate: 150 points above US rate

9. Banks and Liquidity • Liquidity Deficit = Gap between liquid liabilities and assets • Banking firms especially likely to face a liquidity deficit because of mortgage lending (non-liquid assets) and short-term deposits (liquid liabilities) [Maturity Mismatch] • Reliance on Time Deposits which are sensitive to changes on interest rates relative to other assets or on risk relative to other assets.

10. Strategies for Liquidity ManagementAsset management • Asset Conversion Strategy: Maintain an inventory of liquid assets convertible to cash. • Liquid assets must have • ready market, • reasonably steady price • or, reversible so original investment can be easily obtained.

11. Liquid Assets • Treasury Bills • Other Government Securities • Lending to/Deposits at Other Banks • Purchasing Securities for Resale (Repos) • Commercial Paper

12. Exchange Fund Bills • Exchange Fund Bills and Notes are Hong Kong dollar debt securities issued by the Hong Kong Monetary Authority (HKMA). The Exchange Fund Bills and Notes constitute direct, unsecured, unconditional and general obligations of the Hong Kong SAR • The Exchange Fund Bills and Notes Issuance Programme ensures the supply of a significant amount of high quality Hong Kong dollar debt paper, which can be employed as trading, investment and hedging instruments. • Authorized Institutions that maintain Hong Kong dollar clearing accounts with the HKMA can use their holdings of Exchange Fund papers to borrow overnight Hong Kong dollar from the Discount Window. • An active primary and secondary market for the trading of Exchange Fund Bills and Notes, and the establishment of a reliable benchmark yield curve for up to 10 years has facilitated the development of a sophisticated Hong Kong dollar debt market. Source: HKMA Website

13. Strategies for Liquidity ManagementLiability management • Borrowed Liability Strategy: Maintain lines of credit to make up for temporary cash short-falls. • Accessing money market requires some prior planning and potentially lines of credit. • Sources of funds • Borrowing in Interbank market • Issuing large CD’s to money market mutual funds or large depositors. (Brokered deposits) • Borrowing from central bank.

14. Liquidity Ratio: • All authorized institutions in Hong Kong are required to meet a minimum monthly average liquidity ratio of 25%. This is calculated as the ratio of liquefiable assets (e.g. marketable debt securities and loans repayable within one month subject to their respective liquidity conversion factors) to qualifying liabilities (basically all liabilities due within one month). -GUIDE TO HONG KONG MONETARY AND BANKING TERMS

15. Estimating Liquidity NeedsSources and Uses of Funds Approach • Estimate net liquidity needs for a time period based on economic factors E[Liquidity Surplus] = E[ΔTotal Deposits]- E[ΔTotal Loans] Use economic data to forecast these outcomes. E[ΔTotal Deposits] = f(Money Growth, Income Growth, Inflation, Interest Rates) or time series forecast E[ΔTotal Loans] = f(GDP growth, corporate profits growth, inflation, interest rates) or time series forecast . • Construct best and worst case scenarios and strategies for dealing with expected liquidity surplus and deficits.

16. Estimating Liquidity NeedsStructure of Funds Approach • Calculate a rule of thumb for liquidity holdings applied to deposits of different types. • Customer Relationship model for loan expansion. Don’t turn good borrowers away for want of liquidity.

17. Example: • A bank has the following liability positions • Currently has $135 million in loans. Has had as much as $140 million viewed as potential. Anticipates 10% loan growth. How much liquidity should we keep? (.95*25)+(.3*24)+(.15*100)+(154-135)=64.95

18. Liquidity Indicators • Bank managers, regulators and analysts may watch a number of indicators

19. Bank Depositors Game • Banks have very illiquid assets (loans) and obligations to repay their depositors in full at any time. • If all of the depositors at a bank withdraw their funds at the same time, the bank will have to sell their loans at a discount, and they will not have enough funds to pay all of their depositors. • If all of their depositors keep their money in the bank, most banks will be able to repay all of their depositors with interest. • Thus, the payoff to any individual depositor depends on what other depositors decide to do.

20. Bank Run Game: Withdraw or Don’t Withdraw • Depositors each deposit $1000 at 10% interest. • They can choose to withdraw their funds before collecting interest or keep their funds with the bank. • The right hand table shows pay-offs for each decision under two possible situations. • All other depositors keep their funds in the bank and the bank survives. • All other depositors withdraw funds and the bank must liquidate. • Payoffs • If an individual keeps their funds with the bank and everyone else does likewise, everyone gets their funds with interest. • If an individual doesn’t withdraw, but everyone else does, the bank will have nothing left to pay the individual who gets nothing. • If the individual depositor withdraws but no one else does, the depositor loses only interest. • If an individual depositor withdraws and everyone else does, they have some chance of getting some funds (say $500) back.

21. Bank Deposit Game has Multiple Equilibria • If no one else withdraws their funds, the best strategy of any individual is not to withdraw their funds. • Thus, a situation in which no-one withdraws their funds and the bank pays interest to all is a Nash Equilibria. • If everyone withdraws their funds, an individuals best strategy is to withdraw before everyone else does. • Thus, a bank run, a situation in which everyone withdraws their funds and a bank is forced to liquidate its assets is also a Nash equilibrium.

22. Bank Runs • The phenomenon in which all depositors compete to withdraw their funds at the same time is called a bank run or a bank panic. • Depositors lack complete information about the value of banks assets. • If depositors believe that there is a significant fraction of loans which will not be repaid, depositors may have an incentive to immediately withdraw funds. • Bank deposits are first come, first serve. If you withdraw your funds before the bank declares losses you may not suffer at all. • Further, even if you believe that banks assets are sound you may have an incentive to immediately withdraw, if you believe that other depositors will also withdraw their funds.

23. Costs of Bank Panics • Bank runs can destroy the value of the illiquid assets of otherwise healthy banks or worsen the problems at banks suffering minor or major loan losses. • Panic is contagious. Since banks lend money to each other, a bank run at one bank may lead to beliefs that the resulting bankruptcy will affect the loan quality of other assets. • Banks play a large role in the financial intermediation system. A collapse in the banking system will disrupt lending.

24. Remedial Responses to Banking Panics • The damage from a banking panic are so severe that central banks often step in during a crisis and provide almost unlimited liquidity. • An emergency source of liquidity is the “lender of last resort.” Central banks are the natural lender of last resort as they can create infinite liquidity through their control of the money supply. • Before 1993, there was no central bank in Hong Kong. Role of lender of last resort was taken by note issuing banks.

25. Effects of Lender of Last Resort • The confidence brought by the knowledge that the central bank will provide liquidity in the case of a bank run, can actually reduce the chance that a bank run will occur. • Conversely, the fears of depositors of bankruptcies are an important source of discipline in the economy. A lender of last resort may encourage depositors to ignore the excessive risk taking of their banks, encouraging banks to take excessive risks. • Lenders of last resort encourages moral hazard.

26. HK Lenders of Last Resort • For most of HK’s history, the note-issuing banks (HSBC and Chartered) acted as the lender of last resort. • During banking crisis of 1965 sparked by collapse of a real estate bubble, HSBC and SC fully backed many local banks. Eventually HSBC took over Hang Seng. • During DTC crisis of 1981, sparked by collapse of a real estate bubble, HSBC and SC pledge vague support for DTC’s. • During bank crises of 1984-1986, the government took over various bankrupt banks, backing deposits with the Exchange fund.