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Chapter 17 Liquidity Risk.docx

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Department
Finance
Course
FIN 701
Professor
Patricia Mc Graw
Semester
Fall

Description
FIN701 Financial Institutions Management CHAPTER 17 Liquidity Risk INTRODUCTION  Liquidity risk – risk that sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices CAUSES OF LIQUIDITY RISK  Liquidity risk arises for two reasons: 1. Liability-side reason occurs when an FI’s liability holders, such as depositors or insurance policyholders, seek to cash in their financial claims immediately  When liability holders demand cash by withdrawing deposits, FI needs to borrow additional funds or sell assets to meet withdrawal  Fire-sale price – price received for an asset that has to be liquidated (sold) immediately 2. Asset-side reason occurs as ability to fund the exercise of off-balance-sheet loan commitments  When borrower draws on loan commitment, FI must fund loan on the balance sheet immediately which creates a demand for liquidity LIQUIDITY RISK AT DEPOSIT-TAKING INSTITUTIONS Liability-Side Liquidity Risk  In theory, DTI that as 20% of its liabilities in demand deposits and other transaction accounts must stand ready to pay out that amount by liquidating an equivalent amount of assets on any banking day  Core deposits – those deposits that provide a DTI with a long-term funding source  Net deposit drains – amount by which cash withdrawals exceed additions; a net cash outflow o Withdrawals may in part be offset by the inflow of new deposits and income generated from DTIs on- and off- balance-sheet activities  DTI can manage train on deposits in two major ways: 1. Purchased liquidity management – adjustment to a deposit drain that occurs on the liability side of the balance sheet  DTI who purchases liquidity may turn to inter-bank markets for short-term funds  Large Value Transfer System (LVTS) participant – member of the Canadian Payments Association who settles directly with the Bank of Canada and participates in the LVTS  DTI is paying market rates to offset net drain, thus, the higher the cost of purchase funds relative to rates earned on assets, the less attractive this approach to liquidity management becomes 2. Stored liquidity management – adjustment to a deposit drain that occurs on the asset side of balance sheet  DTI would liquidate some of its assets, utilizing its stored liquidity  Cost to DTI from using stored liquidity, apart from decreased asset size, is that it must hold excess non-interest-bearing assets in the form of cash on its balance sheet Asset-Side Liquidity Risk  Risk can arise from exercise by borrowers of their loan commitments and other credit lines, and are drawn down  Risk arises from FI’s investment portfolio when unexpected changes in interest rates can cause investment portfolio values to fluctuate significantly or of deteriorate market traders (herd behaviour for trading) Measuring a DTI’s Liquidity Exposure  Six different ways to measure liquidity exposure 1. Net liquidity statement – lists sources and uses of liquidity and thus provides a measure of DTI’s net liquidity position  DTI can obtain liquid funds in three ways: i. Sell its liquid assets with little price risk and low transaction cost ii. Borrow funds in the money/purchased funds market up to a maximum amount iii. Use any excess cash 2. Peer group ratio comparison – comparing key ratios and balance sheet features on FTI, such as loans to deposits, borrowed funds to total assets, and commitments to lend to asset ratio  Higher ratio of loans on deposits means DTI relies heavily on short-term money market rather than on core deposits to fund loans FIN701 Financial Institutions Management  High ratio of loans and commitments to assets indicates need for high degree of liquidity to fund any unexpected drawdown of these loans 3. Liquidity index – measure of the potential losses FI could suffer as the result of sudden (or fire-sale) disposal of assets  The greater the difference between immediate fire-sale asset prices (P) ani fair market prices (P*), i the less liquid is the DTI’s portfolio of assets ( )( ) 4. Financing gap and financing requirement  Financing gap – difference between DTI’s average loans and average (core) deposit  If financing gap is positive, DTI must fund it using cash and liquid assets and/or borrowing funds in money market  Financing requirement – financing gap plus a DTI’s liquid assets ( )  When borrowing increases, sophisticated lenders in money market may be concerned with DTI’s credit-worthiness and impose higher risk premiums on borrowed funds or establishing stricter credit
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