Question

4.a. Explain the two causes of liquidity risk.

b. What are two ways a depository institution can offset the effects of asset - side liquidity risk such as the drawing down of a loan commitment?

c.What are the four measures of liquidity risk? Explain how each of them could be implemented and utilized and utilized by a depository institution.

Answer 1

4 (a)

Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of a Financial institution

Two types

(i) Asset-side risk arises from transaction that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit.

(ii) Liability-side risk arises from transactions whereby a creditor, depositor, or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction.

4 (b)

A Depository Institution can use either liability management or reserve adjustment strategies. Liability management involves borrowing funds in the money/purchased funds market. Reserve adjustments involve selling cash-type assets, such as treasury bills, or simply reducing excess cash reserves to the minimum level required to meet regulatory imposed reserve requirements.

4 (c)

i.      Sources and uses of liquidity.

         This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds it can borrow in the money/purchased funds market, and any excess cash reserves over the necessary reserve requirements. The statement also identifies the amount of each category the bank has utilized. The difference is the amount of liquidity available for the bank. This amount can be tracked on a day-to-day basis.

ii.   Peer group ratio comparisons

         Banks can easily compare their liquidity with peer group banks by looking at several easy to calculate ratios. High levels of the loan to deposit and borrowed funds to total asset ratios will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future.

iii.   Liquidity index.

         The liquidity index measures the amount of potential losses suffered by a DI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower is the index, the less liquidity the DI has on its balance sheet. The index should always be a value between 0 and 1.

iv.   Financing gap and financing requirement

         The financing gap can be defined as average loans minus average deposits, or alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds.