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Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University

Chapter 1 7. Liquidity Risk. Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University. I. What is liquidity risk?. the uncertainty that an FI will be unable to generate sufficient cash to meet cash outflows. II. What creates liquidity risk?.

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Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University

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  1. Chapter 17 Liquidity Risk Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University

  2. I. What is liquidity risk? the uncertainty that an FI will be unable to generate sufficient cash to meet cash outflows.

  3. II. What creates liquidity risk? Liquidity risk is derived from the balance sheet .

  4. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Liability side reasons involve liability holders (i.e., depositors) cashing in their financial claims (i.e. deposits).

  5. $ $ $ Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2400 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $2,700 • Deposits went down by $300 because of withdrawals

  6. $ $ $ Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2400 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $2,700 • A positive net deposit drain occurs when a FI receives insufficient additional deposits to offset deposit withdrawals.

  7. $ $ $ Cost of drain= (.06-.05)(300)= $3 Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2400 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $2,700 BYOD decides to sell $ 300 of its securities to meet the drain. The cost of deposits is 5% and the return on securities is 6%. What is the cost for BYOD?

  8. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Asset side reasons involve demands from those holding loan commitments.

  9. $ $ Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2600 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Asset side reasons involve demands from those holding loan commitments.

  10. III. What are the sources for meeting liquidity needs? • A. Purchasing liquidity using the markets for purchased funds is a liability management tool.

  11. 1. What instruments are involved? • a) Federal funds market • b) Repurchase Agreements (Repo) market • c) Wholesale (Negotiable) Certificates of Deposit • a) Bankalararası Para Piyasası • b) T.C. Merkez Bankası Kredileri • c) Repo

  12. 2.What is the effect on the balance sheet? • Using purchased funds, there is no reduction in the size of the balance sheet.

  13. a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals), Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2400 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total L and O E $2,700

  14. …….one type of liability is being replaced with another and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Fed Funds Purchase 300 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total L and O E $3,000

  15. BOYD decides to buy $ 300 in Fed Funds to cover the drain. The cost of Fed Funds is 5.5%, but this allows BOYD to keep securities earning 6%. What is the cost for BOYD? Cost of drain= (.055-.05)(300)= $1.5 Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Fed Funds Purchase 300 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total L and O E $3,000

  16. b) If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2600 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000

  17. …..the additional assets are funded by additional liabilities and the size of the institution increases. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Repos 300 Corporate Bonds 400 Net Loans 2600Total Liabilities 3000 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,300

  18. III. What are the sources for meeting liquidity needs? • B. Stored liquidity is an asset management tool where assets are reserved to be sold or used when cash is needed.

  19. 1. What instruments are involved? • a) Vault Cash • b) Reserves at the Federal Reserve Banks • c) Securities such as Treasury Bills

  20. 2.What is the effect on the balance sheet? Using stored liquidity, there is no growth in the size of the balance sheet.

  21. a) If the need for liquidity is derived from the liability side of the balance sheet (i.e., deposit withdrawals), Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2000 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2400 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total L and O E $2,700

  22. …….both liabilities and assets are removed and the size of the institution contracts. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $50Deposits 2000 Securities 250 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$2,700 Total Owners’ Equity $300 Total L and O E $2,700

  23. b) If the need for liquidity is derived from the asset side of the balance sheet (i.e., the drawing-down of loan commitments ), Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2600 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000

  24. …. one type of asset (i.e., loans) replaces another (i.e., cash and securities ) and the size of the institution remains the same. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $50 Deposits 2300 Securities250 Corporate Bonds 400 Net Loans 2600Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000

  25. IV. How is a bank’s liquidity exposure measured? The methodologies include:

  26. A. The net liquidity statement lists the sources and uses of liquidity. A FI manager must be able to measure its liquidity position on a daily basis, if possible. What are the sources of liquidity? • a) Cash-type assets (i.e., T-bills)that can be sold. • b) The maximum amount of funds the bank can borrow on the money/purchased funds market. • c) Excess cash reserves not needed to meet regulatory reserve requirements

  27. A. The net liquidity statement lists the sources and uses of liquidity. • 2. What are the uses of liquidity? A) Deposit withdrawals B) The increase in loans That have already been met by drawing down sources of liquidity (i.e. Borrowing in the fed funds market or from the discount window)

  28. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Sources of liquidity= 50+50+300+5=$405 million BOYD has $50m in cash, $50 m in cash reserves at the Fed not needed to meet reserve requirements, $300m in Treasury bills, and, a $5m line of credit to borrow in the repo market. What is the $ amount of their sources of funds?

  29. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Uses of Liquidity= $3 million Net Liquidity= $405 - $3 million = $402 million BOYD has repos of $3 million. What is their $ uses of liquidity? What is their net liquidity position?

  30. B. Peer group comparisons where ratio analysis is used. • What ratios are examined to make inferences about liquidity?

  31. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 2300 Loans 2300 Deposits 1 = =

  32. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Borrowed Funds 400 3000 Total Assets 13.3% = =

  33. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 A high ratio of loans to deposits and borrowed funds to total assets means that the bank relies heavily on the short term money market rather than on deposits to fund loans. Maturity differences on loans and deposits will also be important to judge liquidity position of the bank.

  34. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Loan Commitments 300 Total Assets 3000 10% = =

  35. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Loan Commitments 300 Total Assets 3000 10% = = Off-Balance Sheet Item

  36. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2300 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets$3,000 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 A high ratio of loan commitments to assets indicates the need for a high degree of liquidity to fund any unexpected takedowns of these loans by customers.

  37. C. The liquidity index • measures the potential losses suffered by an FI from the immediate sale of assets compared to the market value of the assets established under normal market conditions. Where Pi = fire sale prices Pi*= fair market prices wi is the percentage of each asset in the FI’s portfolio xi=1

  38. The liquidity Index • The greater the differences between immediate fire-sale asset prices and fair market prices, the less liquid the FI’s portfolio of assets. • Example: 50 percent in one month t-bills and 50 percent in real estate loans. If the FI has to liquidate its T-bills today, it will receive $99 per $100 of face value. If the FI had to liquidate its real estate loans today, it would receive $85 per $100 of face value, while liquidation at the end of one month would be expected to produce $92 per $100 of face value. Thus, one month liquidity index value for this FI’s asset portfolio would be; I=(1/2)[(.99/1.00)]+1/2[(.85/.92)]= 0.495+0.462= 0.957. • The liquidity index will always lie between 0 and maximum of 1. This index could also be compared to similar indexes for a peer group of similar Fis.

  39. D. The Financing Gap and the Financing Requirement capture liquidity by examining the following relationships: • Financing Gap= Average Loans - Average Deposits Financing Gap= -(liquid Assets) + Borrowed Funds • Financing Gap + Liquid Assets=Financing Requirement

  40. Balance Sheet The Bank of your Dreams Assets Liabilities Cash $150 Deposits 2300 Securities 450 Corporate Bonds 400 Net Loans 2600 Total Liabilities 2700 Premises & Fixed Assets 100 Owner’s Equity Total Assets $3,300 Total Owners’ Equity $300 Total Liabilities and Owners Equity $3,000 Financing Gap= Average Loans - Average Deposits Financing Gap= 2600 - 2300= 300 This must be funded by using liquid assets or borrowing in the money market.

  41. V. What are the causes of unexpected deposit drains and and more severe bank runs?We are not talking about the expected drains, for instance banks can have seasonal anticipated needs for liquidity. Major liquidity problem arise if deposit drains are abnormally large and unexpected. Such deposit withdrawal shocks may occur following reasons:

  42. V. What are the causes of unexpected deposit drains and and more severe bank runs? • A. Explicit triggers include: • 1. Public Concerns about a Bank’s Solvency • 2. Failure of Similar or Related Banks (Contagion Effects) • 3. Changes in Investor Preferences

  43. V. What are the causes of unexpected deposit drains and and more severe bank runs? • A. Explicit triggers include: • 1. Public Concerns about a Bank’s Solvency • 2. Failure of Similar or Related Banks (Contagion Effects) • 3. Changes in Investor Preferences

  44. V. What are the causes of unexpected deposit drains and and more severe bank runs? • A. Explicit triggers include: • 1. Public Concerns about a Bank’s Solvency • 2. Failure of Similar or Related Banks (Contagion Effects) • 3. Changes in Investor Preferences

  45. B. The structure of the demand deposit claim is an underlying factor that magnifies reactions. Demand deposits are first come, first served contracts

  46. VI. What tools have regulators provided to deal with the liquidity-based instabilities of the banking system?Regulatory mechanism • A. Deposit Insurance provides protection for the insured depositor that deters runs. • B. The discount window (of the Federal Reserve banks) exists to provide funds to institutions having liquidity problems to stabilize the banking system.

  47. V!I. Do financial institutions, other than depository institutions, have liquidity risk problems? • A. Life Insurance companies have exhibited liquidity risk problems when concerns about the solvency of the insurer have occurred. • B. Property-Casualty insurance companies have liquidity crises relating to disasters (i.e., Hurricane Andrew) • C. Mutual Funds exhibit more stability because mutual fund shares are distributed on a pro rata (proportional) basis at net asset value. (P= Value of assets / shares outstanding) thus eliminating the first-come, first-served incentives associated with other FIs’ contracts.

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