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Chapter 18 Liability and Liquidity Management.docx

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Ryerson University
FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 18 Liability and Liquidity Management INTRODUCTION  Risk of FI’s assets becoming relatively illiquid when liquid claims are suddenly withdrawn (or no renewed)  To reduce risk of liquidity crisis, FI can insulate balance sheets from liquidity risk by managing liquid asset positions or managing liability structure of portfolio LIQUID ASSET MANAGEMENT  Liquid assets traded in active market where even large transactions in asset do not move market price or move it very little  Non-liquid assets promise additional returns or liquidity risk premiums to compensate FI for relative lack of marketability and often greater default risk of the instrument  Excessive illiquidity exposes FI to risk of bank run, inability to meet required payments on liability claims, insolvency, and contagious effects that negatively impact other FIs  Minimum liquid asset reserve requirements depend on liquidity risk exposure perceived for FI’s type and other regulatory objectives THE COMPOSITION OF THE LIQUID ASSET PORTFOLIO  Composition of FI’s liquid asset portfolio, especially cash and government securities, determined by earnings considerations and type of minimum liquid asset reserve requirements central bank imposes  Liquid asset ratio – minimum ratio of liquid assets to total assets set by the central bank  Secondary or buffer reserves – non-reserve assets that can be quickly turned into cash RETURN-RISK TRADE-OFF FOR LIQUID ASSETS  In optimizing holdings of liquid assets, FI must trade benefit of cash immediacy for lower returns  In jurisdictions that do not impose reserve requirements, can optimize liquid asset holdings by matching assets with liquidity needs of short-term liabilities  Liquid asset mix is a requirement for members of the Large Value Transfer System (LVTS) to provide collateral on daily basis for largest transaction they expect to clear through payment system o LVTS transactions are instantaneous and irrevocable, collateral acts as form of co-insurance to protect other LVTS participants  Liquidity management is managing securities portfolio by determining optimal combination of lower-yield, liquid assets versus high-yield, less-liquid assets o Other ways to maintain liquidity is through loan sale or securitization LIABILITY MANAGEMENT  Management of liability structure is to reduce need for large amounts of liquid assets to meet liability withdrawals o Excessive use of purchased funds in liability structure can result in liquidity crisis if investors lose confidence in DTI and refuse to roll over funds Funding Risk and Cost  DTI must trade off benefits of attracting liabilities at low funding cost with high chance of withdrawal against liabilities with high funding cost and low liquidity o Funding costs generally inversely related to period of time liability is likely to remain on DTI’s balance sheet  Guaranteed Investment Certificate (GIC) – a fixed-maturity instrument offered to retail clients that is non-redeemable, carries a term from 30 days to 5 years, and pays interest at specified rate at the end of the term  Consequence of undershooting liquidity needs and being unable to settle payments though clearing system or meet its customer’s deposit withdrawals are a loss of confidence of depositors and regulators, potential for long-term damage to reputation, and insolvency CHOICE OF LIABILITY STRUCTURE Demand Deposits  High degree of withdrawal risk which can be instantaneous and largely expected by DTI managers, such as pre-weekend cash withdrawals, or unexpected, as occur during economic crisis situation  Lowest interest rate, making them low-cost source of funds  Can adjust levels of interest rates and fees charged in order to partially control for withdrawal risk associated with contracts FIN701 Financial Institutions Management  DTI must provide whole set of associated services from providing chequebooks, to clearing of cheques, to sending out statements with cleared cheques or cheque images o Recovers costs by charging fees and receives subsidy or implicit interest payment  Payment of implicit interest means DTI is not absolutely powerless to mitigate deposit withdr
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