1

Chapter 17

Liquidity Risk

Power Point Presentation Created by Dr. Halit Gonenc for Bus 423 at Hacettepe University
I. What is liquidity risk? 2

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 .
 Balance Sheet 4
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 $3,000Total 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).
 Balance Sheet 5
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $2,700
$
Deposits went down by $300 because of
withdrawals
 Balance Sheet 6
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.
 Balance Sheet 7
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?
Cost of drain= (.06-.05)(300)= $3
 Balance Sheet 8
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.
 Balance Sheet 9
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 $3,300Total 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.
a) If the need for liquidity is derived from the 13
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 $3,000Total 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 $3,000Total Owners’ Equity $300
Total L and O E $3,000
BOYD decides to buy $ 300 in Fed Funds to 15
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 $3,000Total Owners’ Equity $300
Total L and O E $3,000
b) If the need for liquidity is derived from the
16
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 $3,300Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000
…..the additional assets are funded by 17
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 2600 Total Liabilities 3000
Premises
& Fixed Assets 100 Owner’s Equity
Total Assets $3,300Total 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.
a) If the need for liquidity is derived from the 21
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 $3,000Total 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 $50 Deposits 2000
Securities 250 Corporate Bonds 400
Net Loans 2300 Total Liabilities 2700
Premises
& Fixed Assets 100 Owner’s Equity
Total Assets $2,700Total Owners’ Equity $300
Total L and O E $2,700
b) If the need for liquidity is derived from the
23
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 $3,300Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000
…. one type of asset (i.e., loans) replaces 24
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
Securities 250 Corporate Bonds 400
Net Loans 2600 Total Liabilities 2700
Premises
& Fixed Assets 100 Owner’s Equity
Total Assets $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000
IV. How is a bank’s liquidity exposure 25
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
A. The net liquidity statement lists 27
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)
 Balance Sheet 28
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

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?
Sources of liquidity= 50+50+300+5=$405 million
 Balance Sheet 29
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

BOYD has repos of $3 million. What is their $ uses of

liquidity?
Uses of Liquidity= $3 million
What is their net liquidity position?
Net Liquidity= $405 - $3 million = $402 million
B. Peer group comparisons where 30
ratio analysis is used.

What ratios are examined to

make inferences about
liquidity?
 Balance Sheet 31
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

Loans 2300
= = 1
Deposits 2300
 Balance Sheet 32
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

Borrowed Funds 400

= = 13.3%
Total Assets 3000
 Balance Sheet 33
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 $3,000Total 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.
 Balance Sheet 34
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

Loan Commitments 300

= = 10%
Total Assets 3000
 Balance Sheet 35
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 $3,000Total Owners’ Equity $300
Total Liabilities and
Owners Equity $3,000

Loan Commitments 300

= = 10%
Total Assets 3000

Off-Balance Sheet Item

 Balance Sheet 36
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 $3,000Total 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.

N Pi
I  [( wi) ]
i 1 Pi *
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.
D. The Financing Gap and the Financing 39
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
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.

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
V. What are the causes of unexpected 41
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:
V. What are the causes of unexpected 42
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
V. What are the causes of unexpected 43
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
V. What are the causes of unexpected 44
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
VI. What tools have regulators provided 46
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.
V!I. Do financial institutions, other than 47
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.