Chapter 21 - Managing Liquidity Risk on the Balance Sheet

Chapter Twenty-One
Managing Liquidity Risk on the Balance Sheet
I. Chapter Outline
1. Liquidity Risk Management: Chapter !er!ie"
2. Causes o# Liquidity Risk
$. Liquidity Risk and %epository &nstitutions
a. Lia'ility Side Liquidity Risk
'. (sset Side Liquidity Risk
c. Measuring a Bank)s Liquidity *+posure
d. Liquidity Risk, -ne+pected %eposit %rains, and Bank Runs
e. Bank Runs, the %iscount .indo", and %eposit &nsurance
/. Liquidity Risk and &nsurance Companies
a. Li#e &nsurance Companies
'. 0roperty-Casualty &nsurance Companies
c. 1uarantee 0rograms #or Li#e and 0roperty-Casualty &nsurance Companies
2. Liquidity Risk and &n!estment 3unds
(ppendi+ 21(: 4e" Liquidity Risk Measures &mplemented 'y the Bank #or &nternational
Settlements 5a!aila'le on the "e' only at """.mhhe.com6sc2e7
(ppendi+ 21B: Sources and -ses o# 3unds Statement: Bank o# (merica, 8une 2919 5a!aila'le on
the "e' only at """.mhhe.com6sc2e7
II. Learning oals
1. &denti#y the causes o# liquidity risk.
2. %e#ine the t"o methods #inancial institutions use to manage liquidity risk.
$. %escri'e ho" depository institutions measure liquidity risk.
/. *+amine the components o# a liquidity plan.
2. *+plain "hy a'normal deposit drains occur.
:. Consider the e+tent to "hich insurance companies are e+posed to liquidity risk.
;. Clari#y the e+tent to "hich in!estment #unds are e+posed to liquidity risk.
21-1
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
III. Chapter in !erspecti"e
<his chapter discusses sources o# liquidity risk and ho" these risks can 'e managed "ith 'oth
assets and lia'ilities. Liquidity risk arises #rom the need to o'tain cash 'e#ore #unds #rom
maturing assets are a!aila'le. Sources o# #unds are decreases in an asset or increases in a
lia'ility or equity account. Liquidity can thus 'e =stored) 'y holding cash and near cash assets
5sometimes called pri#ary and secondary reser"es7 or liquidity can 'e o'tained 'y 'orro"ing
additional #unds as needed. Measuring prior period e+pected and une+pected liquidity needs can
help 3& managers plan #or #uture e+pected and une+pected liquidity requirements. (ll %&s
operate on a #ractional reser!e system "here they retain only a small portion o# deposits and
other 'orro"ings in the #orm o# liquid assets. *ach institution is dependent upon the pu'lic)s
'elie# in the soundness and sa#ety o# the indi!idual institution and the #inancial system. (
percei!ed erosion o# the sa#ety o# deposits can quickly generate 'ank runs and liquidity crises
although #ederal deposit insurance and the 3ed)s role as lender o# last resort limit the likelihood
o# 'anks runs in the -.S. %eposit insurance in particular has largely eliminated 'ank runs 'y the
general pu'lic, 'ut %& liquidity crises still occur and are a normal part o# market discipline.
&nsurance companies and mutual #unds normally #ace lo"er amounts o# liquidity risk than %&s,
'ut liquidity pro'lems can still occur at these institutions.
I$. %ey Concepts and &e'initions to Co##unicate to Students
3ire sale prices 0eer group ratios
Core deposits Liquidity inde+
4et deposit drains 3inancing 1ap
3inancing Requirement 3ull pay !s prorated claims
0urchased liquidity Liquidity 0lan
Stored liquidity Bank runs and 'ank panics
*+cess reser!es Surrenders and surrender !alue
4et liquidity statement &nsurance guaranty #unds
Maturity ladder Contagion
Credit Crunch Su'prime Crisis
0rimary %ealer Credit 3acility
$. Teaching (otes
21-2
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
). Liquidity Risk Manage#ent* Chapter O"er"iew
(ll 3& managers must deal "ith liquidity planning and liquidity risk on a daily 'asis, although
%&s ha!e su'stantially more liquidity risk than other types o# 3&s. <he main goal o# liquidity
management is to maintain =>ust enough) liquid assets in com'ination "ith lia'ility #unding
sources to 'e a'le to meet e+pected and une+pected liquidity needs. 3&s do not "ish to hold
e+cessi!e amounts o# liquid assets 'ecause they earn lo" rates o# return. Banks and %&s
generally ha!e more liquidity risk than insurers, mutual #unds and hedge #unds. 4e!ertheless
se!eral hedge #unds ha!e gone 'ankrupt recently. ?edge #unds and securities 'rokers pledge
their security holdings #or collateral on short term loans used to pro!ide liquidity. .hen the
su'prime pro'lems reduced the !alue o# mortgage 'acked securities lenders to these #unds and
dealers re#used to rene" loans "ithout 'etter collateral. <"o Bear Stearns hedge #unds collapsed
as a result, e!entually 'ringing Bear do"n "ith them. (s the credit pro'lems spread throughout
the economy liquidity pro'lems emerged as "ell. &nter'ank o##ering rates such as L&BR soared
#rom 2.2;@ in Septem'er 299A to :.AA@ on Septem'er $9, 299B. .ithout reasona'le cost
#unding 'anks curtailed lending to non-'ank customers #urther e+acer'ating liquidity pro'lems
in other markets. Central 'anks around the "orld pumped liquidity into markets to limit the
crisis.
<eaching <ip:
<here is an old saying that & heard #rom a #und manager se!eral years ago, CLiquidity doesn)t
matter until it matters, and then it is the only thing that matters.D Liquidity is a necessary
condition #or "ell #unctioning markets and is a necessary component #or success#ul hedging o#
risk. Since !irtually all hedging models assume adequate liquidity, "hen liquidity dries up all
models o# risk #ail and outcomes can 'e much more e+treme than anticipated. <his is a lesson
that in!estors "ho rely on math 'ased modeling to assess risk must learn.
+. Causes o' Liquidity Risk
,ne-pected withdrawals o' lia.ilities
-ne+pected "ithdra"als o# deposits or unanticipated policy claims can #orce 3&s to sell
assets or 'orro" more #unds. &# the 3& does not ha!e enough liquid assets to sell, or cannot
'orro" enough additional #unds at short notice they may ha!e to liquidate longer term
in!estments, perhaps at prices 'elo" market !alue 5at so called /'ire-sale0 prices7. &# the
liquidated assets must 'e marked do"n to market, 'alance sheet losses occur and equity "rite
do"ns "ould result.
3or e+ample, a 'ank #aces net deposit "ithdra"als o# E$9 million o# uninsured deposits
as "ord hits the street that the 'ank #aces large loan losses #rom a regional collapse in real
estate !alues.
1
<he 'ank liquidates E12 million in liquid assets at #air market !alue,
'orro"s an additional E19 million in short term de't markets, and liquidates longer term
in!estments at 'elo" 'ook !alue, and e!en 'elo" #air market !alue 'ecause it needs the
money no". <he 'ook !alue o# the long term in!estments is E; million 'ut the 'ank
o'tains only E2 million net o# transaction costs. <he 'ank must 'ear a E2 million loss due
to its illiquidity.
1
(mounts o!er the E229,999 insurance limit are uninsured.
21-$
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
,ne-pected increases in assets
-ne+pected dra"do"ns on credit lines and unanticipated loan demand are t"o sources o#
asset side liquidity risk. -nanticipated de#aults on loans can also generate additional cash
needs, as can une+pected payments on contingent items such as 'ankers) acceptances and
#inancial stand'y letters o# credit.
1. Liquidity Risk and &epository Institutions 2&Is3
a. Lia.ility Side Liquidity Risk
%&s ha!e large amounts o# transaction and sa!ings deposits that customers can make due
immediately i# they choose. <hese accounts gi!e depositors a put option "ith the e+ercise price
equal to the amount o# their deposit. Banks estimate the amount o# core deposits that are usually
relati!ely sta'le on a day to day 'asis and estimate e+pected gro"th in deposits. Core deposits
are lo" turno!er accounts that are at the 'ank #or reasons other than the interest rate earned.
2

<hey may 'e placed at the 'ank #or con!enience needs, or 'ecause the customer has some other
relationships "ith the institution. 4et deposit "ithdra"als are called net deposit drains.
(lthough net deposit drains usually ha!e a seasonal component, increasing at Christmas and
!acation time #or e+ample, they are usually quite predicta'le on a daily 'asis, particularly i# a 3&
has a su'stantial core deposit component.
!urchased liquidity
Banks can o'tain #unds 'y 'orro"ing additional cash in the money markets. <his practice is
termed =purchasing liquidity) or sometimes =lia.ility #anage#ent.) 0urchased liquidity
sources "ere harder to o'tain during the #inancial crisis. &t is riskier #or 'anks to o!erly depend
on purchased or "holesales #unds sources to pro!ide liquidity.
<eaching <ip: <he practice o# purchasing liquidity is #airly recent. &t 'egan in the 1B:9s "ith the
ad!ent o# a secondary market #or negotia'le C%s and it has 'een spurred on 'y the gro"th in the
#ed #unds market. 0urchasing liquidity can 'e e+pensi!e and can increase the interest rate
sensiti"ity o# a 'ank)s lia'ilities 'ecause the 'ank adds interest rate sensiti!e #unds to meet
liquidity needs, thus reducing the proportion o# #unding #rom core deposits. <he tradeo## is that
i# a 'ank is "illing to rely on purchased liquidity sources, it need not hold as many lo" earning
liquid assets. More #unds can then 'e placed in riskier in!estments and loans that promise higher
rates o# return. 0urchased liquidity allo"s a 'ank to maintain a gi!en siFe and distri'ution asset
port#olio "hile still allo"ing the institution to o'tain the cash needed to #und "ithdra"als or
additional loan demand.
Stored Liquidity
Liquidity can 'e stored 'y in!esting in cash and6or liquid securities that earn a rate o# return.
!ri#ary reser"es are !ault cash, C&0C, correspondent 'alances and deposits at the 3ederal
Reser!e. Recall that the 3ed imposes minimum liquidity requirements on %&s 5'asically 19@ on
transaction deposits7, 'ut 'anks generally hold su'stantial e-cess reser"es 5reser!es 'eyond the
3ed requirements7 that can 'e used #or liquidity purposes.
2
Core deposits typically include all consumer accounts, some 'usiness accounts and retail C%s.
21-/
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
Banks normally utiliFe 'oth purchased and stored liquidity. <he costs o# each can 'e easily
illustrated !ia an e+ample:
NorthView Bank (NVB)
Assets Liabilities and Equity
Amount
(mill$)
Rate of
Return
Amount
(mill$)
Cost
Rate
Cash $ ! !" #e$osits $ %&! '"
(e)urities *! +" Borrowin,s -&! &"
Loans %%! -!" Equity .!
/otal $.!! /otal $.!!
4GB is e+pecting a E$2 million deposit drain and only E2 million in cash is a!aila'le #or
liquidation since required reser!es are E12 million. 4GB #aces the choice o# purchasing liquidity
'y 'orro"ing or 'y liquidating cash and securities. Let)s e+amine the costs o# each alternati!e:
$
1. Borro" E$2 million to replace lost deposits: %eposit cost is /@ and 'orro"ing cost is assumed
to remain at :@ so the preHta+ change in net income #rom the deposit drain is 2@ I
E$2,999,999 J HE;99,999. <he ad!antage o# 'orro"ing is that no part o# the asset port#olio
has to 'e liquidated.
2. a7 0ay o## depositors "ith E2 million in cash e+cess reser!es and liquidate E$9 million in
securities on "hich the 'ank is earning ;@. <he change in preHta+ net income in this case is
5E$2,999,999 I 9.9/7 H 5E$9,999,999 I 9.9;7 J HE;99,999. &n this case the costs o#
alternati!es 1 and 2 are identical, 'ut alternati!e 2 decreases the 'ank siFe 'y E$2 million and
decreases the amount o# le!erage. <he drop in siFe may 'e a concern i# the 'ank loses
economies o# scale.
2. '7 0ay o## depositors "ith E2 million in cash e+cess reser!es and liquidate E$9 million in
securities on "hich the 'ank is earning ;@. <his alternati!e is the same as 2. a7, 'ut in this
case suppose the securities liquidity inde- is B;@ 5the liquidity inde+ is descri'ed 'elo"7.
<his implies that the 'ank can only recei!e B; cents per dollar o# #air market !alue on the
securities liquidated 'ecause they must 'e liquidated rapidly. <he 'ank has to liquidate E$9
million 6 9.B; J E$9,B2;,A$2 in securities to raise E$9 million. <his results in an additional
loss o# EB2;,A$2. <he change in preHta+ net income in this case is 5E$2,999,999 I 9.9/7 H
5E$9,B2;,A$2 I 9.9;7 H EB2;,A$2 J
HE1,:B2,;A$. <he loss represented 'y the sale 'elo" #air market !alue reduces equity as "ell.
$
(ll e+amples ignore changes in required reser!es resulting #rom the change in deposits.
21-2
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
.. 4sset Side Liquidity Risk
*+ercise o# loan commitments 'y 'orro"ers can also generate liquidity needs. Loan
commitments at 'anks gre" tremendously in the 2999s. (n unused loan commitment pro!ides
#ee income to the 'ank. <he ratio o# unused loan commitments to cash "as a'out 22B@ in 1BB/,
and rose to 191/.:@ in cto'er 299A. <he crisis led to a decline to a'out :9B@. <his can 'e
dangerous i# the 'ank has not planned properly 'ecause net une+pected asset increases lead to
immediate #unding requirements. (s 'e#ore the 3& can choose to meet the need 'y purchasing
liquidity 5and allo"ing the 'ank)s assets to gro"7 or 'y using stored liquidity 5maintaining the
same amount o# assets7.
c. Measuring a Bank0s Liquidity 5-posure
<ools to measure liquidity e+posure include the #ollo"ing 5t"o more methods are presented in
(ppendi+ 21(7:
(et liquidity state#ent
( net liquidity statement is a report o# net a!aila'le liquid sources o# #unds:
(et Liquidity !osition 2#illions 63
Sources
1. <otal near cash assets E 2,999
2. *+cess cash reser!es E 2,999
$. Ma+imum ne" 'orro"ings E B,999
<otal E1:,999
,ses
1. 3unds already 'orro"ed E A,999
2. %iscount .indo" loans that
must 'e repaid quickly E 1,999
<otal E B,999
Total (et Liquidity E ;,999
<he 3& can handle unanticipated liquidity needs o# E;,999 millions.
<eaching <ip: <he 3& management must decide i# the amount o# liquidity co!erage 5E;,999.7 is
reasona'le in light o# the likely amount o# net deposit drains. *+amining the historical
distri'ution o# drains ad>usted #or any seasonality can help the 3& ascertain the likely amount o#
drains. <he 3& does not "ant to hold e+cessi!e amounts o# liquid assets 'ecause their lo" return
is a drag on pro#ita'ility and competiti!eness.
21-:
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
!eer group ratios
Banks "ill o#ten monitor key liquidity ratios such as
March 299A
/
March 2911
Loans to deposits A1.$$@ ;1.::@
Loans to core deposits 192.A/@ ;A.:/@
Short <erm 4on Core 3unding to (ssets 1;.9A@ 2.;:@
Core deposits to total lia'ilities K equity :2.2/@ ;;.;2@
Commitments to lend to loans 1/.21@
2
1$.//@
Liquidity Inde-
<he liquidity inde+ is the ratio o# the #ire sale price required to liquidate assets in an
emergency situation di!ided 'y the #air market !alue o# the assets liquidated. <he lo"er the
inde+ the greater the liquidity risk. 3or instance, suppose a securities port#olio contains t"o
securities "ith the #ollo"ing data:
Securities
Galue i# liquidated
immediately
3air market !alue
i# liquidated in 1
month
@ in!ested in
each 5at 3MG7
<reasury Bills E B,;99,999 E B,A29,999 $A.2A@
Bonds E12,999,999 E12,:;2,999 :1./2@
<he liquidity inde+ is calculated as:
L$A.2A@ I 5EB.; mill 6 EB.A2 mill7M N L:1./2@I5E12 mill 6 E12.:;2 mill7M J B:.;:@
<eaching <ip: %iscount instruments increase in price as they approach maturity 'ut non-discount
instruments recei!e interest income. <he liquidity inde+ should measure not only any loss in #air
market !alue, 'ut also any loss in income due to a required change in 3& 'eha!ior. 3or e+ample,
a <-'ill may 'e priced at #air market !alue at BB@ o# par prior to maturity. 4e!ertheless, i# the 3&
planned to hold the 'ill until maturity 'ut had to sell it to meet liquidity needs, the required sale
at the #air market !alue o# EBB per E199 o# par still represents a loss due to liquidity risk. <hus,
the inde+ should account #or lost interest as "ell as losses in current #air market !alue.
<eaching <ip: <he inde+ is a 'etter measure o# the cost o# liquidity risk than the likelihood o#
occurrence o# liquidity pro'lems.
/
Source: 33&*CO all 'anks in the nation, 0eer 1roup %ata Report, report date s $6$1611and $6$169A.
2
<his num'er "as taken #rom the 299A data column in the $6$1611 report date.
21-;
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
7inancing ap and the 7inancing Require#ent
2,ses3 2Sources3
3inancing 1ap J (!erage loans H (!erage 5core7 deposits
&# the #inancing gap is positi!e, 5as it is #or the typical 'ank7 the %& must o'tain additional
#inancing either 'y 'orro"ing or liquidating assets.
<he 3inancing Requirement is the amount o# #unds that must 'e 'orro"ed and it is #ound as:
3inancing Requirement J 3inancing 1ap N Required liquid asset holdings
:
(n increasing #inancing requirement may indicate #uture liquidity pro'lems #or a 'ank since
this indicates greater 'orro"ing requirements #or the %&.
Maturity Ladder8Bank o' International Settle#ents 2BIS3 scenarios
<he B&S recommends 'anks #ollo" a maturity ladder approach to managing liquidity. <he
ladder method measures cash in#lo"s and out#lo"s o!er short 5daily7 and longer time periods
such as out to : months, calculating cumulati!e #unding needs o!er the di##erent time
periods. <he purpose is to help %& managers understand their upcoming liquidity needs and
to plan #or upcoming cash short#alls and e+cesses. <he B&S also recommends 'anks
construct liquidity analyses under !arious scenarios and to ha!e a contingency plan to o'tain
liquidity in the e!ent the "orst case scenario occurs.
Liquidity !lan
( liquidity plan should include the #ollo"ing key components:
o Managerial guidelines and assignment o# responsi'ilities
o List o# #und pro!iders ranked 'y likelihood o# "ithdra"al 5&nstitutional and corporate
in!estors are more likely to "ithdra" #unds quickly.7
o *stimation o# seasonal components o# liquidity 5Christmas, planting time, har!est
time, !acation season, etc.7
o *stimation o# amounts o# "ithdra"als o!er speci#ied time inter!als.
o &nternal limits on su'sidiary and 'ranch 'orro"ings #rom parents and ma+imum
'orro"ing rates.
o 0lanned order o# disposition o# assets in the e!ent liquidations 'ecome necessary.
:
<he te+t'ook does not indicate that the assets must 'e required although this is implied in a #ootnote. Logically the
'ank could liquidate its liquid assets and reduce its #inancing requirement. 4ote that in this #ormulation these
num'ers are not #lo"s, they are 'alance sheet le!els. Because these are le!els, there is also an implicit assumption
that the le!el o# non-earning assets equals the amount o# equity.
21-A
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
(n e+ample liquidity plan may look like the #ollo"ing:
0otential %eposit .ithdra"als and (ssociated Required (sset Liquidations 5Mill E7
!otential &eposit
9ithdrawals
3rom most likely to "ithdra" to least
likely
Mutual 3unds E ;9
0ension 3unds E /9
Correspondent 'anks E 29
Large corporations E /2
Small 'usinesses E 22
Consumers E ;2
<otal E$92
5-pected total withdrawals per period 4"erage Ma-i#u# Likely
ne "eek E :9 6)::
ne month E ;9 6);:
<hree months E1$9 6++:
<otal E2:9 E/;9
Sequence o' 'unding
options as needed One 9eek One #onth Three #onth
4e" deposits E 12 E $2 E ;2
Sale liquid assets E 12 E 22 E 22
Sale in!estment port#olio E $9 E /9 E 29
Borro"ings #rom other 3&s E $9 E /9 E $2
Borro"ings #rom 3ed E 19 E 19 E 2
<otal 6):: 6);: 6++:
&n the e!ent the ma+imum likely "ithdra"als actually occur, the 'ank has already determined
ho" the "ithdra"als "ill 'e #unded in the 'ottom panel. <he num'ers in the 'ottom panel are
de!eloped in con>unction "ith the necessary strategies that can 'e used i# needed to 'ring a'out
the increases sho"n. 3or instance, in the one "eek period, deposit rates may ha!e to 'e
increased 12 'asis points to attract E12 million in ne" deposits.
d. Liquidity Risk< ,ne-pected &eposit &rains and Bank Runs
('normal deposit drains can threaten a 3&)s sol!ency. <hese usually arise due to pro'lems in the
management o# some other area o# risk such as credit or interest rate risk.
21-B
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
%emand and other deposits are #irst-come, #irst-ser!ed contracts that are 'ull pay or no pay
contracts. <hey are not pro-rata claims that are apportioned 'ased on a #air distri'ution o# the
liquidation !alue o# the %&)s assets. ?ence, there is al"ays a possi'ility o# a 'ank run "hen
'anks maintain only partial reser!es to 'ack deposits 'ecause only the #irst depositors to demand
their money recei!e anything. ( .ank run occurs "hen the #undamental assumption underlying
#ractional reser!e 'anking is !iolatedO namely, that all depositors do not "ish to o'tain their
money at the same time. Since all deposits in all institutions are this "ay, #ailure, or #ear o#
#ailure, at one or more institutions can quickly spread 5the dreaded contagion e''ect7 potentially
causing "idespread .ank panics or system "ide runs on 'anks. Contagion e##ects are
particularly serious in countries or situations "here there is no credi'le deposit insurance.
;

&n 299A &ndyMac #aced a 'ank run a#ter Senator Schumer)s letters "arning o# pro'lems at the
'ank 'ecame pu'lic. !er the 11 days #ollo"ing the pu'lic release o# his letter depositors
"ithdre" o!er E1.$ 'illion #rom &ndyMac. Schumer "as rightO the 'ank "as in trou'le due to its
mortgage holdings. <his is another case "here pro'lems in credit spilled o!er into liquidity
pro'lems "hen in!estors lost con#idence in the 'ank)s a'ility to meet its o'ligations.
e. Bank Runs< the &iscount 9indow and &eposit Insurance
<he t"o ma>or sta'iliFing #actors that limit 'ank runs are the discount "indo" and deposit
insurance.
&eposit Insurance
&n the -.S. deposits are currently insured up to E229,999 per account. <he amount "as
increased #rom E199,999 during the #inancial crisis. (ctually unlimited insurance "as
temporarily pro!ided during the crisis. .hen an institution is deemed too 'ig to #ail and a
'ailout or 'uyout is arranged then all depositors recei!e de#acto 199@ insurance, regardless
o# the siFe o# their deposits. <his remo!es a market discipline requiring large depositors to
e!aluate the riskiness o# large institutions.
.hen deposit insurance "as esta'lished in 1B$$, 'ank runs "ere !irtually eliminated at
#ederally insured institutions. State insurance is not su##icient to pre!ent "idespread 'ank
runs 'ecause the insurance #unds do not ha!e enough reser!es to maintain pu'lic con#idence
in a crisis. <he 3%&C no" assesses risk 'ased deposit insurance premiums. Capital
adequacy and super!isory >udgment are used to assign %&s to risk categories. %&s ha!e to
pay more to maintain deposit liquidity "hen they take on more risk.
;
( 'ank run can still occur e!en i# there is credi'le deposit insurance i# in#lation is high enough or i# depositors
#ear upcoming restrictions on repatriation. 0anics may occur 'ecause the !alue o# money is its purchasing po"er.
(ny threat to the purchasing po"er o# the money could concei!a'ly cause a run. Moreo!er there can 'e payment
delays in the e!ent o# 'ank #ailure and concerned depositors 5insured or not7 may "ithdra" their #unds as a result.
21-19
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
The &iscount 9indow
<he 3ed pro!ides short term emergency lending to quali#ying %&s. <he 3ed has sho"n a
"illingness to open the discount "indo" during risky e!ents such as the 2991 terrorist
attacks, during se!eral stock market crashes and most recently the su'prime crisis. &n the
2991 attacks on the .orld <rade Center phone and computer outages, grounding o# plans that
carried checks and 'uilding e!acuations led to many disruptions o# payment systems. <hese
pro'lems led to une+pected shortages at other institutions e+pecting to 'e paid 'y 4e" Pork
'anks. n Septem'er 11
th
, the 3ed announced the "indo" "as open and encouraged all 3&s
to 'orro" as needed to co!er une+pected short#alls. &t "as particularly important that the 3ed
o##ered discount "indo" ser!ices to 'anks and securities dealers "ho #inance their
su'stantial securities in!entory "ith short term call loans. &# 'anks had called in large
num'ers o# these loans some o# the ma>or in!estment 'anks could ha!e 'een in danger o#
se!ere liquidity crises #orcing them to liquidate their securities in!entories and causing sharp
declines in asset prices.
<ypically %&s must pledge short term, high quality assets as collateral that are =discounted,)
hence the term discount "indo" loans. <he discount rate used to 'e kept 'elo" open market
rates and at that time the 3ed acti!ely discouraged use o# the discount "indo" e+cept as an
emergency source o# short term 'orro"ing. <he 3ed has no" changed the discount "indo"
policy. See Chapter / #or details 'ut 'asically the 3ed operates three types o# loan programs.
<he #irst is termed pri#ary credit. 0rimary credit is a!aila'le to sound institutions on a
short term 'asis at a rate 199 'asis points a'o!e the 3MC target #ed #unds rate. 0rimary
credit loans may 'e used #or any purpose and loan terms can 'e as long as se!eral "eeks.
Secondary credit is a!aila'le #or o!ernight loans to sound institutions that are ha!ing
temporary #unding pro'lems at a rate 129 'asis points a'o!e the 3MC target #ed #unds rate.
Secondary credit may not 'e used to #inance institutional gro"th. 3inally, seasonal credit is
a!aila'le on a longer term 'asis at a rate 'elo" the target 3MC #ed #unds rate. <he
'orro"er must demonstrate seasonality.
&n response to the liquidity pro'lems caused 'y the credit crunch in 299; and 299A the 3ed
announced in March 299A that it "ould lend up to E299 'illion to 'oth commercial and
in!estment 'anks through its ne" 0rimary %ealer Credit 3acility 50%C37. -nder the 0%C3,
#irms 'orro"ed an a!erage o# E$1.$ 'illion per day #rom the 3ed in the #irst three operating
days o# the #acility. <he 'orro"ers could s"ap mortgage 'acked securities #or <reasuries.
<he 'orro"er could s"ap some securities that the 3ed "ould not ordinarily ha!e accepted.
<he 3ed took this e+traordinary step 'ecause many institutions "ere una'le to 'orro" against
mortgage securities, creating a liquidity crunch. 4ot all agree that this "as a sound mo!e 'y
the 3ed. Some analysts 'elie!e the 'ailout o# Bear Stearns and the inter!ention into the
markets "ill create or e+acer'ate the moral haFard pro'lem o!er the long run and encourage
other institutions to take e+cessi!e risks 'elie!ing that the 3ed "ill come to their rescue i#
needed. 4e" 'orro"ing programs emerged o!er the succeeding months pro!iding #unding to
money market mutual #unds, commercial paper, insurance companies and others. <he 3ed
also lo"ered interest rates to near Fero and reduced the spread 'et"een the discount rate and
the 3ed #unds rate.
21-11
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
<eaching <ip: ne o# the original #unctions o# the 3ed "as to ser!e as a lender o# last resort
to %&s. &# the 3ed "as "illing to supply unlimited amounts o# loans to a %& #acing
insol!ency, there "ould theoretically 'e no need #or deposit insurance to pre!ent 'ank runs.
<he 3ed could create "hate!er money "as needed to pre!ent a %& #rom 'ecoming insol!ent
and the pu'lic "ould ha!e no reason to "ithdra" their deposits. <he conditions the 3ed
imposes on discount "indo" loans limit its e##ecti!eness as a deterrent to 'ank runs. &ndeed
the 3ed "as around during the Crash o# 1B2B and it "as either una'le or un"illing to pre!ent
the "idespread 'ank runs that led to the #ailure o# thousands o# 'anks at that time. Se!eral
aspects o# normal 3ed policy limited the use#ulness o# the =lender o# last resort) in pre!enting
'ank runs. <hese include:
a7 <he requirement to pledge high quality assets to 'ack the loan eliminates the a'ility o#
most #ailing institutions to o'tain a su##icient amount o# discount "indo" loans. <he 3ed
has "eakened this requirement due to the crisis ho"e!er.
'7 <he 3ed does not automatically grant discount "indo" loans #or e+tended periods, so
depositors cannot count on this method as a su##icient means o# #inancing to ensure that
the !alue o# all deposits "ill 'e preser!ed e!en "ith the 3ed)s ne" policies.
c7 <he purpose o# the discount "indo" is to pro!ide short term #inancing to sol!ent
institutions not to keep a#loat #ailing institutions. &ndeed, loans to trou'led,
undercapitaliFed institutions are speci#ically limited to no more than :9 days in any 129
day period unless the 3%&C and any other primary regulator certi#y that the 'ank is !ia'le.
<he discount "indo" is designed to limit 'ank)s need to liquidate assets at #ire sale prices
in order to #und required liquidity needs, not to protect depositors.
<he 3ed e!idenced a "illingness to go 'eyond the normal #unctions o# the %iscount .indo"
during and a#ter the #inancial crisis.
=. Liquidity Risk 4nd Insurance Co#panies
a. Li'e Insurance Co#panies
Li#e insurers #ace liquidity risk due to une+pected policy cancellations and "orking capital
needs. &# an insurer cancels 5surrenders7 a policy "ith a cash !alue, the insurer must pay the
surrender "alue o# the policy to the insured. Some policies also allo" the insured to .orrow
against the !alue o# the policy. Both situations can cause #unds needs. &nsurers typically rely on
ne" premiums to help meet liquidity needs. <hey also hold liquid assets and can sell portions o#
their long term in!estment port#olio i# necessary although the latter sales may occur at
disad!antaged prices. ( run occurred on 3irst Capital &nsurer in 1BB1 due to >unk 'ond losses
"hen ne" premiums "ere not #orthcoming and surrenders increased dramatically.
.. !roperty-Casualty Insurance Co#panies
0KC insurers ha!e more liquidity risk than li#e insurers 'ecause the payouts on their lia'ilities
are more unpredicta'le and the maturity o# their claims is shorter than li#e insurance claims.
Consequently, 0KC insurers hold more liquid assets than li#e insurers, and they tend to reprice
their claims more #requently to help limit risk. Large une+pected claims and une+pected policy
terminations are ma>or sources o# liquidity risk #or 0KC #irms. Catastrophic e!ents such as the
2991 terrorist attacks, the slides in Cali#ornia and the se!ere hurricanes indicate ho"
unpredicta'le and large liquidity needs can 'e at this type insurer.
21-12
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
(&1 'ecame em'roiled in the #inancial crisis 'ecause the company sold e+tensi!e amounts o#
credit de#ault s"aps 5C%Ss7. C%S sellers must pay in the e!ent o# de#ault o# the underlying
credit. 0ro'lems in mortgages led to payouts and collateral requirements #ar 'eyond (&1)s
a'ility to pay and #orced the #irm into a 'ailout. (&1 recei!ed go!ernment assistance "orth E12;
'illion. <he 'reakdo"n consisted o# E/2 'illion #rom <(R0, E;; 'illion to 'uy collateraliFed
de't and mortgage 'acked securities and a E// 'illion 'ridge loan.
c. uarantee !rogra#s 'or Li'e and !roperty-Casualty Insurance Co#panies
(lthough insurers cannot o##er policyholders #ederal insurance, many states either sponsor or
require the insurance #irms in their state to operate insurance guarantee 'unds. Most states do
not ha!e permanent #unds, and the policy claims are not a lia'ility o# the state. Rather "hen a
#ailure o# an insurer occurs, the remaining insurance #irms are assessed a premium to help pay o##
the #ailed insurer)s claims to policyholders. <he payments are o#ten capped per year and there
can 'e long delays 'e#ore the policyholders o# the #ailed insurer recei!e all their promised !alue
i# they e!er do.
;. Liquidity Risk 4nd In"est#ent 7unds
pen end mutual #unds #ace liquidity risk 'ecause they must redeem shares #rom shareholders
upon demand. Runs on mutual #unds can occur 'ut #or di##erent reasons than 'ank runs. Mutual
#und shares are pro-rata clai#s, not #ull pay or no pay, so mutual #und in!estors lack the
incenti!e to try to 'e #irst in line to recei!e their cash. &t is the pay in #ull or no pay characteristic
o# deposits that encourages 'anks runs. &# in!estors #ear that the !alue o# the mutual #und shares
"ill drop, large num'ers o# in!estors may attempt to redeem their shares all at once, using up the
#und)s cash reser!e and #orcing the #und to liquidate some o# its holdings.
A
<his pro!ides a
similar e##ect as a run and could 'e termed as such. ?ea!y mutual #und redemptions may #urther
depress the prices o# the #und)s asset holdings, leading to additional redemptions and a repeat o#
the cycle. <his is essentially "hat happened in the stock market crash o# cto'er 1BA; and
happened in money market mutual #unds a#ter the 0rimary Reser!e 3und e+perienced large
losses on its Lehman holdings. <he #ollo"ing "eek in!estors liquidated E1;9 'illion o# money
#und in!estments, prompting the 3ed to 'ackstop all money #und assets.
A
Closed end mutual #unds do not #ace this risk. 3or them liquidity is needed only to 'e a'le to purchase
in!estments quickly "ithout ha!ing to liquidate some other part o# the in!estment port#olio.
21-1$
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
(ppendi+ 21(: 4e" Liquidity Risk Measures &mplemented 'y the Bank #or &nternational
Settlements 5B&S7
<he #inancial crisis re!ealed that many institutions did not ha!e su##icient liquidity management
programs in place. (s a result the B&S de!eloped t"o ne" liquidity measures that "ill 'e phased
in. <he #irst the Liquidity Co"erage Ratio "ill 'e implemented in 2912:
?igh quality assets are de#ined to 'e assets that remain liquid e!en in times o# economic stress
and must 'e accepted as collateral at the 3ed)s %iscount .indo". <he assets must also 'e
unencum'ered. <he liquid assets are di!ided into t"o types, Le!el 1 and Le!el 2. Le!el 1
includes cash, central 'ank reser!es and so!ereign de't. <here is no limit on the amount o#
Le!el 1 assets that can 'e included. Le!el 2 liquid assets include mortgage 'acked securities
'acked 'y the go!ernment and ((- or high rated corporate 'onds. <he amount o# Le!el 2 assets
that count is capped at /9@ o# the total liquid assets. Moreo!er a 12@ haircut is applied to all
Le!el 2 assets. <he total high quantity o# liquid assets is the sum o# Le!el 1 assets and the
allo"a'le amount o# Le!el 2 assets. <otal net cash out#lo"s are equal to out#lo"s less in#lo"s.
ut#lo"s are 'ased on the deposit 'ase and composition, de't maturations and loan
commitments. &n#lo"s must 'e o# sound quality and are capped at ;2@ o# out#lo"s so that the
'ank does not e+cessi!ely depend on e+pected in#lo"s.
<he second measure is the (et Sta.le 7unding Ratio 54S3R7. <he 4S3R measures the
institution)s sta'le #unding sources to the liquidity o# its assets and #unding commitments that
may arise #rom o## 'alance sheet acti!ities. <he measure attempts to require a minimum le!el o#
sta'le #unding to o##set on and o## 'alance sheet liquidity requirements o!er a one year time
horiFon. &t limits o!erreliance on short term sources to #und long term assets. <he 4S3R is
measured as:
<he numerator consists o# 'ank capital, pre#erred stock and other lia'ilities "ith a maturity
greater than one year and the portion o# retail and "holesale deposits that could 'e counted on to
remain "ith the 'ank during periods o# economic stress. <he amounts o# each type that can 'e
counted are pro!ided in <e+t <a'le 21-12. <he required sta'le #unding is assigned 'y the
regulators and is summariFed in <e+t <a'le 21-1:. <he required sta'le #unding measures are
some"hat similar in concept to the risk 'ased asset "eightings used in calculating risk "eighted
assets.
21-1/
199@
days calendar $9 ne+t o!er out#lo"s cash net <otal
assets liquid quality high o# Stock
Ratio Co!erage Liquidity =
199@
#unding sta'le o# amount Required
#unding sta'le o# amount (!aila'le
4S3R > =
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
(ppendi+ 21B: Sources and -ses o# 3unds Statement: Bank o# (merica 5a!aila'le on the "e'
only at """.mhhe.com6sc2e7
<he "e' appendi+ presents a consolidated statement o# cash #lo"s #or Bank o# (merica.
$I. 9e. Links
http:66""".#ederalreser!e.go!6 .e'site o# the Board o# 1o!ernors o# the 3ederal Reser!e
http:66""".in!estors.com6 &n!estor)s %aily is a "e'site that pro!ides in!estors "ith
current in#ormation, it is a companion site to the &n!estor)s
Business %aily pu'lication.
http:66""".#dic.go!6 <he 3ederal %eposit &nsurance Corporation "e'site has net
charge o## rates #or 'anks and thri#ts.
http:66""".naic.org6 <he "e'site o# the 4ational (ssociation o# &nsurance
Commissioners
http:66""".sec.go!6 <he S*C)s "e'site.
http:66"""."s>.com6 .e'site o# the .all Street 8ournal &nteracti!e edition.
$II. Student Learning 4cti"ities
1. 'tain any 'ank)s 19Q report and estimate the current #inancing gap and #inancing
requirement. ?o" large is the requirement as a percentage o# assetsR .hat does your
estimate tell youR *+plain.
2. 'tain t"o 'anks) #inancial statements and calculate the #ollo"ing ratios:
Borro"ed #unds to total assets, Core deposits to total assets, Loans to deposits and
Commitments to lend to total assets. -sing these ratios compare the t"o 'anks) liquidity
positions. .hich is more likely to need to rely on 'orro"ed #undsR &n "hich 'ank "ould you
rather 'e a depositorR ( shareholderR *+plain.
$. &n!estigate a case "here an insurance #irm #ailed. .hat "as the cause o# #ailureR %id
liquidity risk cause the #ailure, or did liquidity pro'lems emerge as the institution)s other
pro'lems mountedR *+plain.
/. 'tain the #inancial data #or a li#e insurer and a 0KC insurer. Calculate the percentage o#
liquid assets held 'y each. *+plain the di##erences in your #indings.
2. *+plain "hy a mutual #und may need to maintain su'stantial liquid asset holdings 'ut a
similar closed end #und needs only #e"er liquid assets holdings.
21-12