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