Liquidity Risk -

Measurement and
Management
Lecture Week 12

BANK3011 BANK FINANCIAL MANAGEMENT

PAUL MARTIN
Objectives for this Week
– To explore:
– The problem of liquidity risk, which is faced to a greater or
lesser extent by all banks.
– The methods of measuring liquidity risk, and its consequences.
– The regulatory mechanisms in place to control liquidity risk.
– Identify:
– How Liquidity risk is managed, including the motives for holding
liquid assets
– Specific issues associated with liability and liquidity risk
management.
– To examine the developments in Liquidity Risk management
in the Basel III Capital Accord

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Liquidity Risk Management

Liquidity management involves ensuring that the institution has the

ability to meet all legitimate demands for funds from depositors and
all loan facilities committed to borrowers as they fall due.
– In measuring liquidity risk, however, it is necessary to assess what
demands for funds are likely to be placed on banks because not
all deposits will be demanded for repayment and not all loan
and other commitments will be called upon at the same time
– The factors in liquidity management and measurement
– Potential cash flows
– The Bank’s capacity to borrow in the market
– The Bank’s stock of readily available quality liquid assets

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Causes of Liquidity Risk

– Asset side; a bank:

– May be forced to liquidate assets too rapidly
– The need to meet commitments, importantly loan commitments
» This has traditionally involved reserve asset management.
» In Australia these were in the order of 27% of total assets in 2011
– Liability side: a bank relies on demand deposits
– These are “Core” deposits
– The requires a bank to predict the distribution of net deposit drains.
– The Comprehensive response to liquidity management:
– Purchased liquidity management
– Stored liquidity management

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Liability & Liquidity Management

– The activities of the Government (and the Central Bank)

also affect bank liquidity via Fiscal Policy and Monetary
Policy
– Banks are typically exposed to liquidity risk because:
– A bank’s assets are relatively illiquid (long term loans) ie difficult to
call in
– A bank’s liabilities are liquid ie can be called or withdrawn quickly
– Thus the active management of the liquidity structure of
both the asset & liabilities portfolios is required, thus
involving two approaches
– Approach 1 – Purchased Liquidity management
– Approach 2 – Stored Liquidity management

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Ensuring Adequate Liquidity – Approach 1

– Purchased liquidity
– Interbank Cash market or repo market.
• Banks borrow to cover cash outflows
• In the US this is the Federal Funds Market
– Managing the liability side preserves asset side of balance
sheet.
– Borrowed funds are likely to be at higher rates than interest
paid on deposits.
– Regulatory concerns are focused on the increasing reliance
on the use of wholesale funding sources

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The Inter-bank Cash Market

– Australia’s banks operate in the overnight “inter-bank

cash” market (p556)
– In the US the Fed funds is the “interbank” market for
excess reserves.
– 90% have maturities of 1 day.
– Fed funds and the overnight cash rates have been highly
volatile
– Prior to July 1998 (as high as 30% and lows close to 0%)
– The rates are now far more stable
– High rollover or withdrawal risk exists in these markets
but the market is highly liquid

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Repurchase Agreements
– Repos are collateralised inter-bank cash market transactions.
(p556)
– Usually backed by Government - in Australia
Commonwealth Government Securities (CGS).
– In theory may be more difficult to arrange than simple inter-
bank loans.
– In practice this is not the case
– Generally trade below the interbank cash rate if backed by
CGS
– Used by the RBA to manage the level of market liquidity and
is the means by which Open-market Operations (OMO) are
conducted. (p546)
– The aggregate of daily OMO ranges from $1bio to $3bio.

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 Ensuring Adequate Liquidity - Approach 2
– Stored Liquidity Management
– Requires Banks to liquidate assets in response to cash outflows
• In absence of reserve requirements, banks tend to hold
reserves. e.g. In U.K. reserves ~ 1% or more. Downside:
opportunity cost of reserves.
– This action decreases size of balance sheet
– Requires holding excess non-interest bearing or low interest
bearing assets
Therefore banks typically combine purchased & stored
liquidity management approaches

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 Typical Assets held for the purposes of Stored
Liquidity Management in Australia
– Commonwealth Government Bonds and Treasury Notes
– Treasury Notes are issued for terms of up to 180 days
– Bonds are issued for terms of up to between 10 and 15 years.
– Bank Accepted Bills and Commercial Bills (p558)
– These are bills of exchange that have ben accepted or endorsed by a
bank
– Generally for terms of up to 6 months.
– Negotiable Certificates of Deposit (p555)
– These are securities issued by other banks (i.e. borrowings supported
by a security)
– Generally for terms of up to 6 months.
– Cash with RBA – Exchange Settlement Accounts (ESA) (p545)
– ESA balances are held at a minimum level, because a penalty rate of
the Overnight Cash Rate less 0.25%pa applies
• These are the banks’ accounts with the central bank and are use to
settle transaction through the payments system.
 Off Balance Sheet (OBS) Liquidity Risk
– Drawdowns against loan commitments and other credit lines (OBS
items), must also be met either:
– by borrowing additional funds or
– by running down reserves
– Banks must ensure that the levels of loan commitments are
therefore not excessive
– Relative to what?
• Their ability to raise immediate (same day) funds or holdings of liquid
assets that can be readily liquidated
– The levels of these commitments are high according to some
regulators
• APRA has expressed concern about the level of Australian banks
commitments; as noted earlier, in Australia these were 27% of banks’ total
assets in 2011.

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Techniques to Measure Estimate Liquidity Risk -
1. Sources and Uses of Liquidity Statement
– Measures the sources of and current utilisation of liquidity
(p518)
– Sources of Liquidity:
• Cash type assets
• Maximum amount of borrowed funds available
(estimate)
• Excess cash reserves
– Current Liquidity Utilisation:
• Borrowed or money market funds already utilised
• Assets already subject to Repo

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 Measuring Liquidity Risk (Cont.)
Measures 2 and 3
Other Measures:
2. Peer group comparisons: usual ratios include borrowed
funds/total assets, loan commitments/assets etc. (p519)
3. Liquidity index: weighted sum of “fire sale price” P to fair
market price, P*, where the portfolio weights are the
percent of the portfolio value formed by the individual
assets. (p520)
I = Σ wi(Pi /Pi*)

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Example of Liquidity Index : Ch. 14 Q13

– Liquidity Index
– An FI has the following assets in its portfolio:
• $20 million in cash reserves with the central bank;
• $20 million in T-Bills;
• $50 million in mortgage loans; and
• $10 million in fixed assets.
– If the assets need to be liquidated at short notice, the FI will
receive only 99 percent of the fair market value of the T-Bills
and 90 percent of the fair market value of the mortgage loans,
estimate the liquidity index using the above information.

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Measuring Liquidity Risk (Cont.)
4. Financing Gap
Financing gap and the financing requirement (pp521-523):
– Financing gap:
– Average loans - Average core deposits
– Financing Requirement:
– Financing gap + liquid assets
– The gap can be used in peer group comparisons or trends
within a bank.
– Example of excessive financing requirement: Continental
Illinois, 1984.
– It also indicates the extent of professional funds which
the bank relies on to fund its operations. These are more
volatile than retail deposits.

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Measuring Liquidity Risk (Cont.)
5. The BIS Approach:
– Adopted by APRA (p524)
– Refer APRA additional reference material, see also p558
– The FSA approach is an extension/variation of this model
– The approach involves the use of Maturity ladders
and Scenario Analysis
– For each maturity, assess all cash inflows versus outflows
– Daily and cumulative net funding requirements can be
determined in this manner
– Must also evaluate “what if” scenarios in this framework

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Example of the use of a Maturity Cashflow
Ladder
Shareholders Funds Liquid Assets

Capital 8,778,000 1 year Government Securities 6.05% 14,156,000

(semi annual)
Liabilities Business Loans

- Call Deposits (Retail) 5.25% 31,289,000 - Overdrafts 7.25% 7,423,000

- 6 months (180 days) 5.85% 22,987,000 - 6 months (180 days) 6.80% 11,000,000
(Professional)

- 3 years (semi annual) 5.15% 8,171,000 - 3 years (semi annual) 6.35% 18,759,000

- 5 years (semi annual) 4.95% 4,953,000 - 5 years (semi annual) 6.75% 15,245,000

67,400,000 - 10 years (semi annual) 8.00% 9,595,000

76,178,000 76,178,000

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Liquidity Risk Measurement Problems

– Problems in Determination of Liquidity

– Outflows
– Not all deposits may be called
– Cheque accounts are at call but may be considered core deposits
– Wholesale deposits likely to be more volatile than retail deposits (in
terms of the ability to roll them over)
– Must include the effects of off balance sheet
• e.g. overdrafts, undrawn loans & commitments
– Inflows
• Not all cash inflows will be received
» e.g. overdrafts

The behavioural (BIS) approach is the only effective

way to do this currently available, but requires the
imposition of significant assumptions 18
An Extension of the BIS Approach -
The use of the FSA* Guidelines
– The FSA requirements for stress testing sets out their assessment of
the liquidity stress that a bank might suffer in a liquidity crisis.
– A bank will need to make its own assessments.
– Some of the key items are:
– 90% of professional deposits may be withdrawn in the first week
of a liquidity crisis.
– 8% of call deposits which are retail based may be withdrawn in a
liquidity crisis.
– Liquid Government Securities can be generally sold on the basis of
obtaining funds next day, and are treated as such for liquidity
assessment. They must be recorded at market value but the FSA
requirements for a stress testing sets out they may not expected to
realise more than 95% of their value in a fire sale.
– 4% of overdrafts are likely to be received in a liquidity crisis.

* FSA’s responsibilities now subsumed into the Bank of England

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Using the BIS Measurement Framework

– Assess various scenarios

– “Going Concern” approach
– Bank specific crisis to:
• Assess probability of rolling over deposits in each scenario
• Can VaR techniques be used?
– The use of scenarios involving different assumptions
– Proportion of maturing liabilities which can be rolled over
– Effect of pressure to support paper in markets
– Marketability of assets & timing of receipt of sale proceeds
– Level of market access
– Convertibility of foreign currencies
– Must recognise Off-Balance Sheet positions
– Access to standby facilities

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The Key Initiatives Basel III -
Liquidity Changes (pp560 to 565)
– Liquidity Coverage Ratio (LCR)
– Requires high quality liquid assets to be held that are able to be
sold to cover cash-outflows under a 30 day stress scenario.
– These assets include:
• Covered bonds
• Committed liquidity facilities from the RBA
– Net Stable Funding Ratio (NSFR)
– Aims to ensure that long term assets are funded by at lest a
minimum of stable liabilities.
• Available stable funding (ASF)weights liabilities and
borrowings for the ability to be withdrawn, with capital and
liabilities greater than 1 year 100%
• Required stable funding (RSF) weights on and off-balance
sheet assets for their liquidity risk profile e.g. cash is zero and
loans to FI greater than 1 year are 100%.
• ASF must be greater than or equal to RSF.
– Established a non-risk weighted leverage ratio to be used as a
backstop
– A 3% ratio is used
Liquidity Coverage Ratio (LCR) – e.g. CBA

Source: CBA - Basel III Pillar 3Capital Adequacy and Risks Disclosures as at 31 Dec 2018
Net Stable Funding Ratio (NSFR) – e.g. CBA

Source: CBA - Basel III Pillar 3Capital Adequacy and Risks Disclosures as at 31 Dec 2018
 Liquidity Planning and Management

– Identify which types of depositors are likely to withdraw first in a

crisis and obtain a spread of borrowers across industry sectors and
countries is borrowing offshore.
– The composition of the depositor base will affect the severity of
funding shortfalls.
– Manage maturity profile of assets and liabilities
– Note the maturity profile is actual maturity of assets and liabilities not their
repricing maturity (as used for interest risk)
– Ensure maturing assets exceed maturing liabilities over near dates
– Avoid excessive bunching of the maturities of liabilities

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Bank Runs

– Can arise due to:

– Concern about a individual bank’s solvency.
– The failure of a related financial institution.
– Sudden changes in investor preferences.
– Demand deposits are first come first served. Depositors’ place
in line to receive payment in the event of a bank failure is
important.
– Bank panic: systemic or contagious bank run
• As seen in the GFC, Northern Rock and IndyMac
• More recently in Greece

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Funding Risk versus Cost
Liquid assets have low
liquidity risk (highly liquid)
(Funding Cost) but return is low, i.e.
funding cost is high

Call deposits have high funding

risk (immediately callable) but
the funding cost is low.

Liquidity
(Funding Risk)26
The Liquidity Risk/Return Trade Off

– Assets
– Cash is the most liquid asset, but its return is zero
– Short dated government securities are very liquid but returns are less than
longer term investments
– Long dated securities often carry a bigger return (also often greater
interest rate risk as well) but may be less liquid
– Liabilities
– Call deposits (e.g. cheque accounts) are low cost but funds can be
withdrawn by writing a cheque or clicking a mouse
– Wholesale fixed deposits have low withdrawal risk (early repayment) but
the costs are high
– Negotiable securities issued have no actual early repayment risk although
there may be some moral risk, but the cost of these funds are at market
levels

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 – Liquidity risk is difficult to measure. Unlike
market risk where the risk manager is
trying to anticipate future market
movements, in liquidity risk management
the risk manager is trying to anticipate the
actions of the bank’s customers.
– The problem is that the level of liquidity in
assets and liabilities is inversely correlated
The Challenges to return
– More liquid assets have lower returns,
in Managing whilst longer terms assets have higher
returns
Liquidity – More callable (subject to withdrawal)
liabilities have lower costs, whilst
more stable liabilities have higher
costs
– As with all bank risk management
activities, managing liquidity risk requires
assessing the trade off between risk and
return.

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