Topic 6 Liquidity risk

If purchased liquidity management is used for liquidity drain

Liability side adjustment, borrowed funds increase and loans increase.

If stored liquidity management is used for liquidity drain

Asset side adjustment, securities decrease and loans increase.

Causes of liquidity risk

Asset side: risk from OBS loan commitments and other credit lines. Liability side: depositors cash in their financial claims silmutaneously.

Core funding ratio

• Defined as core funding amount relative to total loans and advances. • Core funding (stable and to stay in place for at least one year) vs. core lending business (which needs to be funded on a continuing basis). • Minimum requirement: increased to 75% since 1 January 2013.

Needs of liquidity

• Immediate liquidity obligations • Seasonal short-term liquidity needs • Trend liquidity needs • Cyclical liquidity needs • Contingent liquidity needs

Mismatch ratio

•Defined as mismatch dollar amount (expected cash inflows against expected outflows) divided by total funding. •Ratio must be greater than zero (effectively means that the mismatch amount must be positive).

Consequences of the liquidity rules

•More deposits and funding for longer maturities. • More emphasis on retail deposits. • Reduced reliance on wholesale (and non-resident) funding.

Purchased liquidity management

• A liability-side adjustment to the balance sheet to cover a deposit drain. • Liquidity can be purchased in financial markets, e.g. borrowed funds from competitor banks and other institutional investors. • Managing the liability side preserves asset side of the balance sheet; purchased liquidity management allows DIs to maintain their overall balance sheet size.

Stored liquidity management

• An asset-side adjustment to the balance sheet to cover a deposit drain. • FI could liquidate some of its assets. • Decreases size of the balance sheet.

Market funding

- Professional wholesale market funding that would all be withdrawn from the bank on maturity at the first sign of problems. - Funding provided by other FIs, and funding raised by means of tradable debt securities.

Non-market funding

- The rest of the bank's funding. - The larger the deposits, the less reliable the funding (i.e. the more alert the depositors are to the safety of their funds, so the higher the probability they will withdraw).

What is a bank run? What are some possible withdrawal shocks that could initiate a bank run? What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run?

A bank run is an unexpected increase in deposit withdrawals from a bank. Bank runs can be triggered by several economic events including (a) concern's about solvency relative to other banks, (b) failure of related banks, and (c) sudden changes in investor preferences regarding the holding of nonbank financial assets. The first come, first serve (full pay or no pay) nature of a demand deposit contract encourages priority positions in any line for payment of deposit accounts. Thus, even though money may not be needed, customers have incentive to withdraw their funds.

Bank run

A bank run occurs when a large number of people withdraw their money from a bank, because they believe the bank may cease to function in the near future.