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Chapter Twenty-two

Chapter Twenty-two . Balancing Risk on the Balance Sheet II: Liquidity Risk. Causes of Liquidity Risk. Two types of liquidity risk: when depositors or insurance policyholders seek to cash in or withdraw their financial claims when OBS commitments are exercised

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Chapter Twenty-two

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  1. Chapter Twenty-two Balancing Risk on the Balance Sheet II: Liquidity Risk

  2. Causes of Liquidity Risk • Two types of liquidity risk: • when depositors or insurance policyholders seek to cash in or withdraw their financial claims • when OBS commitments are exercised • Fire-sale price • the price received for an asset that has to be liquidated (sold) immediately

  3. Liability Side Liquidity Risk • Core deposits • deposits that provide a relatively stable, long-term funding source to a bank • Net deposit drains • the amount by which cash withdrawals exceed additions; a net cash outflow • can be managed two ways: • purchased liquidity management • stored liquidity management (continued)

  4. Liability Side Liquidity Risk • Purchased liquidity • federal funds market • repurchased (repo) agreement market • issue additional fixed-maturity CD’s, notes, and/or bonds • Stored liquidity • can use or sell off some of it’s assets (such as T-bills) • utilize its stored liquidity (i.e., cash in vault)

  5. Measuring a Bank’s Liquidity Exposure • Net liquidity statement • measures liquidity position by listing sources and uses of liquidity • Peer group ratio comparisons • a comparison of its key ratios and balance sheet features with those for banks of a similar size and geographic location • Liquidity index • measures the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to the amount it would receive at a fair market value established under normal market conditions

  6. Calculation of the Liquidity Index N I =  [(wi)(Pi/ Pi*)] i = 1 where wi = Percentage of each asset in the FI’s portfolio  wi = 1

  7. Financing Gap and the Financing Requirement • Financing gap • the difference between a bank’s average loans and average (core) deposits • if the financing gap is positive, the bank must fund it by using its cash and liquid assets and/or borrowing funds in the money market • Financing requirement • the financing gap plus a bank’s liquid assets • the larger a bank’s financing gap and liquid asset holdings, the higher the amount of funds it needs to borrow on the money markets and the greater is its exposure to liquidity problems

  8. Liquidity Planning • Allows managers to make important borrowing priority decisions • Components of a liquidity plan • delineation of managerial details and responsibilities • detailed list of fund providers most likely to withdraw and the pattern of fund withdrawals • identification of the size of potential deposit and fund withdrawals over various time horizons in the future • sets internal limits on separate subsidiaries and branches borrowing and bounds for acceptable risk premiums to pay • details a sequencing of assets for disposal

  9. Deposit Drains and Bank Run Liquidity Risk • Deposit drains may occur for a variety of reasons • concerns about a bank’s solvency • failure of a related bank • sudden changes in investor preferences • Bank run • a sudden and unexpected increase in deposit withdrawals from a bank • Bank panic • a systemic or contagious run on the deposits of the banking industry as a whole

  10. Deposit Insurance and Discount Window • Deposits insured for $100,000 • Federal Reserve provides a discount window facility to meet banks’ short-term nonpermanent liquidity needs • loans made by discounting short-term high-quality securities such as T-bills and banker’s acceptances with central bank • leads to increased monitoring from the Federal Reserve which acts as a disincentive for banks to use for ‘cheap’ funding

  11. Liquidity Risk and Insurance Companies • Early cancellation of a life insurance policy results in the insurer having to pay the surrender value • the amount that an insurance policyholder receives when cashing in a policy early • when premium income is insufficient to meet surrenders, the insurer can sell liquid assets such as government bonds • Property-Casualty • PC insurers have greater need for liquidity due to uncertainty so ten to hold shorter term assets • Guarantee Programs for Life and PC Insurance Co.

  12. Liquidity Risk and Mutual Funds • Open-end mutual funds must stand ready to buy back issued shares from investors at their current market price or net asset value • If a mutual fund is closed and liquidated, the assets would be distributed on a pro rata basis

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