Lecture 11: Liquidity risk management

Introduction

GFC (in 2008) was due to liquidity risk

liquidity risk may result from an asset or liability side

asset side

risk from OBS loan commitments and other credit lines

problems associated with quick asset sales

high cost for turning assets into cash

low sale price, in worst case, fire sale price

liability side

depositors and other claim holders decide to cash in their financial claim immediately => DI has to borrow additional funds or sell assets

DI needs to predict the distribution of net deposit drains (positive deposit drains => new deposits insufficient to offset withdrawals => DI not growing but contracting)

Net deposit drains: the difference between deposit withdrawals and deposit additions on any specific normal banking day

Liquidity risk at depository institutions

liability side

large reliance on demand deposits and deposits raised through other transaction accounts (mostly at call deposits)

DI can rely on core deposits

core deposits: long- term funding source

most demand deposits act as core deposits on a day- by- day basis

Managing liquidity

purchased liquidity management (nowadays)

stored liquidity management (traditionally)

liquidity can be purchased in financial markets (borrow funds from other banks or institutional investors)

borrow funds are likely to be at higher rates than interest paid on deposits (borrowed at market rate) => expensive

allows DI to maintain their overall balance sheet size

liability side adjustment

asset side adjustment

liquidate assets: banks tend to hold excess reserve assets (in the form of cash)

downside of excess cash: opportunity cost of reserves

decreases size of balance sheet?

requires holding excess non- interest bearing assets

APRA introduces two new requirements for ADIs to ensure they hold sufficient liquidity

the liquidity coverage ratio (LCR)

the net stable funding ratio (NSFR)

Asset- side liquidity risk

the exercise of loan commitments and other credit lines by borrowers

unexpected changes of interest rate => change in value of investment securities portfolios

Herd behaviour: traders want to make the same type of trade at any particular time

sell off => liquidity dries up => securities sold at fire- sale prices (sell at discounted price) => value of investment portfolio falls => stored liquidity decreases => liquidity risk increases

Net liquidity statement

show the sources and uses of liquidity

sources

sale of liquid assets with minimum price risk

borrowing funds in money market

using excess cash reserves

uses

borrowed or money market funds already utilized