Chapter 21 - Managing Liquidity Risk on the Balance Sheet 6th Edition

Chapter Twenty-One
Managing Liquidity Risk on the Balance Sheet

I. Chapter Outline
1. Liquidity Risk Management: Chapter Overview
2. Causes of Liquidity Risk
3. Liquidity Risk and Depository Institutions
a. Liability-Side Liquidity Risk
b. Asset-Side Liquidity Risk
c. Measuring a Depository Institution’s Liquidity Exposure
d. Liquidity Risk, Unexpected Deposit Drains, and Bank Runs
e. Bank Runs, the Discount Window, and Deposit Insurance
4. Liquidity Risk and Insurance Companies
a. Life Insurance Companies
b. Property-Casualty Insurance Companies
c. Guarantee Programs for Life and Property-Casualty Insurance Companies
5. Liquidity Risk and Investment Funds
Appendix 21A: Sources and Uses of Funds Statement: Bank of America, June 2013
(available on Connect or from your McGraw-Hill representative)
Appendix 21B: New Liquidity Risk Measures Implemented by the Bank for International
Settlements (available on Connect or from your McGraw-Hill representative)

II. Learning Goals

1. Identify the causes of liquidity risk.
2. Define the two methods financial institutions use to manage liquidity risk.
3. Describe how depository institutions measure liquidity risk.
4. Examine the components of a liquidity plan.
5. Explain why abnormal deposit drains occur.
6. Consider the extent to which insurance companies are exposed to liquidity risk.
7. Clarify the extent to which investment funds are exposed to liquidity risk.

III. Chapter in Perspective

This chapter discusses sources of liquidity risk and how these risks can be managed with
both assets and liabilities. Liquidity risk arises from the need to obtain cash before funds
from maturing assets are available. Sources of funds are decreases in an asset or
increases in a liability or equity account. Liquidity can thus be ‘stored’ by holding cash
and near cash assets (sometimes called primary and secondary reserves) or liquidity
can be obtained by borrowing additional funds as needed. Measuring prior period
expected and unexpected liquidity needs can help FI managers plan for future expected
and unexpected liquidity requirements. All DIs operate on a fractional reserve system
where they retain only a small portion of deposits and other borrowings in the form of
liquid assets. Each institution is dependent upon the public’s belief in the soundness and
safety of the individual institution and the financial system. A perceived erosion of the

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safety of deposits can quickly generate bank runs and liquidity crises although federal
deposit insurance and the Fed’s role as lender of last resort limit the likelihood of banks
runs in the U.S. Deposit insurance in particular has largely eliminated bank runs by the
general public, but DI liquidity crises still occur and are a normal part of market
discipline. Insurance companies and mutual funds normally face lower amounts of
liquidity risk than DIs, but liquidity problems can still occur at these institutions.

IV. Key Concepts and Definitions to Communicate to Students

Fire sale prices Peer group ratios

Core deposits Liquidity index

Net deposit drains Financing Gap

Financing Requirement Full pay vs prorated claims

Purchased liquidity Liquidity Plan

Stored liquidity Bank runs and bank panics

Excess reserves Surrenders and surrender value

Net liquidity statement Insurance guaranty funds

Net stable funding ratio Contagion

Credit Crunch Subprime Crisis

Primary Dealer Credit Facility Liquidity Coverage Ratio

V. Teaching Notes

1. Liquidity Risk Management: Chapter Overview

All FI managers must deal with liquidity planning and liquidity risk on a daily basis,
although DIs have substantially more liquidity risk than other types of FIs. The main
goal of liquidity management is to maintain ‘just enough’ liquid assets in combination
with liability funding sources to be able to meet expected and unexpected liquidity needs.
FIs do not wish to hold excessive amounts of liquid assets because they earn low rates of
return. Banks and DIs generally have more liquidity risk than insurers, mutual funds and
hedge funds. Nevertheless several hedge funds have gone bankrupt recently. Hedge
funds and securities brokers pledge their security holdings for collateral on short term
loans used to provide liquidity. When the subprime problems reduced the value of
mortgage backed securities lenders to these funds and dealers refused to renew loans
without better collateral. Two Bear Stearns hedge funds collapsed as a result, eventually
bringing Bear down with them. As the credit problems spread throughout the economy

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liquidity problems emerged as well. Interbank offering rates such as LIBOR soared from
2.57% in September 2008 to 6.88% on September 30, 2009. Without reasonable cost
funding banks curtailed lending to non-bank customers further exacerbating liquidity
problems in other markets. Central banks around the world pumped liquidity into
markets to limit the crisis.

Teaching Tip:
There is an old saying that I heard from a fund manager several years ago, “Liquidity
doesn’t matter until it matters, and then it is the only thing that matters.” Liquidity is a
necessary condition for well functioning markets and is a necessary component for
successful hedging of risk. Since virtually all hedging models assume adequate liquidity,
when liquidity dries up all models of risk fail and outcomes can be much more extreme
than anticipated. This is a lesson that investors who rely on math based modeling to
assess risk must learn.

2. Causes of Liquidity Risk

 Unexpected withdrawals of liabilities
Unexpected withdrawals of deposits or unanticipated policy claims can force FIs to
sell assets or borrow more funds. If the FI does not have enough liquid assets to sell,
or cannot borrow enough additional funds at short notice they may have to liquidate
longer term investments, perhaps at prices below market value (at so called ‘fire-sale’
prices). If the liquidated assets must be marked down to market, balance sheet losses
occur and equity write downs would result.
For example, a bank faces net deposit withdrawals of $30 million of uninsured
deposits as word hits the street that the bank faces large loan losses from a
regional collapse in real estate values. 1 The bank liquidates $15 million in liquid
assets at fair market value, borrows an additional $10 million in short term debt
markets, and liquidates longer term investments at below book value, and even
below fair market value because it needs the money now. The book value of the
long term investments is $7 million but the bank obtains only $5 million net of
transaction costs. The bank must bear a $2 million loss due to its illiquidity.
 Unexpected increases in assets
Unexpected drawdowns on credit lines and unanticipated loan demand are two
sources of asset side liquidity risk. Unanticipated defaults on loans can also generate
additional cash needs, as can unexpected payments on contingent items such as
bankers’ acceptances and financial standby letters of credit.

3. Liquidity Risk and Depository Institutions (DIs)

a. Liability-Side Liquidity Risk
DIs have large amounts of transaction and savings deposits that customers can make due
immediately if they choose. These accounts give depositors a put option with the
exercise price equal to the amount of their deposit. Banks estimate the amount of core
deposits that are usually relatively stable on a day to day basis and estimate expected
growth in deposits. Core deposits are low turnover accounts that are at the bank for

1
Amounts over the $250,000 insurance limit are uninsured.

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reasons other than the interest rate earned.2 They may be placed at the bank for
convenience needs, or because the customer has some other relationships with the
institution. Net deposit withdrawals are called net deposit drains. Although net deposit
drains usually have a seasonal component, increasing at Christmas and vacation time for
example, they are usually quite predictable on a daily basis, particularly if a FI has a
substantial core deposit component.

Purchased liquidity
Banks can obtain funds by borrowing additional cash in the money markets. This
practice is termed ‘purchasing liquidity’ or sometimes ‘liability management.’
Purchased liquidity sources were harder to obtain during the financial crisis. It is riskier
for banks to overly depend on purchased or wholesales funds sources to provide liquidity.

Teaching Tip: The practice of purchasing liquidity is fairly recent. It began in the 1960s
with the advent of a secondary market for negotiable CDs and it has been spurred on by
the growth in the fed funds market. Purchasing liquidity can be expensive and can
increase the interest rate sensitivity of a bank’s liabilities because the bank adds interest
rate sensitive funds to meet liquidity needs, thus reducing the proportion of funding from
core deposits. The tradeoff is that if a bank is willing to rely on purchased liquidity
sources, it need not hold as many low earning liquid assets. More funds can then be
placed in riskier investments and loans that promise higher rates of return. Purchased
liquidity allows a bank to maintain a given size and distribution asset portfolio while still
allowing the institution to obtain the cash needed to fund withdrawals or additional loan
demand.

Stored Liquidity
Liquidity can be stored by investing in cash and/or liquid securities that earn a rate of
return. Primary reserves are vault cash, CIPC, correspondent balances and deposits at
the Federal Reserve. Recall that the Fed imposes minimum liquidity requirements on DIs
(basically 10% on transaction deposits), but banks generally hold substantial excess
reserves (reserves beyond the Fed requirements) that can be used for liquidity purposes.

Banks normally utilize both purchased and stored liquidity. The costs of each can be
easily illustrated via an example:
NorthView Bank (NVB)
Assets Liabilities and Equity
Amount Rate of Amount Cost
(mill$) Return (mill$) Rate
Cash $ 20 0% Deposits $ 560 4%
Securities 230 7% Borrowings 160 6%
Loans 550 10% Equity 80
Total $800 Total $800

NVB is expecting a $35 million deposit drain and only $5 million in cash is available for
liquidation since required reserves are $15 million. NVB faces the choice of purchasing

2
Core deposits typically include all consumer accounts, some business accounts and retail CDs.

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liquidity by borrowing or by liquidating cash and securities. Let’s examine the costs of
each alternative:3
1. Borrow $35 million to replace lost deposits: Deposit cost is 4% and borrowing cost is
assumed to remain at 6% so the pre–tax change in net income from the deposit drain is
2% * $35,000,000 = –$700,000. The advantage of borrowing is that no part of the
asset portfolio has to be liquidated.

2. a) Pay off depositors with $5 million in cash excess reserves and liquidate $30 million
in securities on which the bank is earning 7%. The change in pre–tax net income in
this case is ($35,000,000 * 0.04) – ($30,000,000 * 0.07) = –$700,000. In this case the
costs of alternatives 1 and 2 are identical, but alternative 2 decreases the bank size by
$35 million and decreases the amount of leverage. The drop in size may be a concern
if the bank loses economies of scale.

2. b) Pay off depositors with $5 million in cash excess reserves and liquidate $30 million
in securities on which the bank is earning 7%. This alternative is the same as 2. a), but
in this case suppose the securities liquidity index is 97% (the liquidity index is
described below). This implies that the bank can only receive 97 cents per dollar of
fair market value on the securities liquidated because they must be liquidated rapidly.
The bank has to liquidate $30 million / 0.97 = $30,927,835 in securities to raise $30
million. This results in an additional loss of $927,835. The change in pre–tax net
income in this case is ($35,000,000 * 0.04) – ($30,927,835 * 0.07) – $927,835 =
–$1,692,783. The loss represented by the sale below fair market value reduces equity
as well.

b. Asset-Side Liquidity Risk

Exercise of loan commitments by borrowers can also generate liquidity needs. Loan
commitments at banks grew tremendously in the 2000s. An unused loan commitment
provides fee income to the bank. The ratio of unused loan commitments to cash was
about 529% in 1994, and rose to 1014.6% in October 2008. The crisis led to a decline to
about 609%. This can be dangerous if the bank has not planned properly because net
unexpected asset increases lead to immediate funding requirements. As before the FI can
choose to meet the need by purchasing liquidity (and allowing the bank’s assets to grow)
or by using stored liquidity (maintaining the same amount of assets). Text Tables 21-6
and 21-7 illustrate two possible adjustments to a $5 million exercise of a loan
commitment. Table 21-6 illustrates the immediate effect of the loan exercise and Table
21-7 illustrates two possible adjustments, first, the bank could borrow an additional $5
million (Purchased Liquidity Management) or, second, the bank could instead reduce
cash assets by $5 million. The instructor may wish to encourage a student discussion of
the pros and cons of each alternative. The second require holding low earning cash assets
but is safer, while the first may increase interest expense, expense volatility and may be
riskier in stress scenarios where purchased funds may be more expensive or not available.

c. Measuring a Depository Institution’s Liquidity Exposure

Tools to measure liquidity exposure include the following (two more methods are
3
All examples ignore changes in required reserves resulting from the change in deposits.

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presented in Appendix 21B):

 Net liquidity statement
A net liquidity statement is a report of net available liquid sources of funds. For
example:

Net Liquidity Position (millions $)

Sources
1. Total near cash assets $ 5,000
2. Excess cash reserves $ 2,000
3. Maximum new borrowings $ 9,000
Total $16,000
Uses
1. Funds already borrowed $ 8,000
2. Discount Window loans that
must be repaid quickly $ 1,000
Total $ 9,000
Total Net Liquidity $ 7,000
The FI can handle unanticipated liquidity needs of $7,000 millions.

Teaching Tip: The FI management must decide if the amount of liquidity coverage
($7,000.) is reasonable in light of the likely amount of net deposit drains. Examining the
historical distribution of drains adjusted for any seasonality can help the FI ascertain the
likely amount of drains. The FI does not want to hold excessive amounts of liquid assets
because their low return is a drag on profitability and competitiveness.

 Peer group ratios

Banks will often monitor key liquidity ratios such as
March 20084 March 2011 Dec 2013
Loans to deposits 81.33% 71.66% 71.77%
Loans to core deposits 102.84% 78.64% 77.55%
Short Term Non-Core Funding to 17.08% 5.76% 4.94%
Assets
Core deposits to total liabilities & 65.24% 77.75% 78.81%
equity
Commitments to lend to assets 8.57%

 Liquidity Index
The liquidity index is the ratio of the fire sale price required to liquidate assets in
an emergency situation divided by the fair market value of the assets liquidated.
The lower the index the greater the liquidity risk. For instance, suppose a
securities portfolio contains two securities with the following data:

4
Source: FFIEC; all banks in the nation, Peer Group Average Distribution report, report date s 3/31/11,
3/31/08 and 12/31/13.

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Fair market value

Value if liquidated if liquidated in 1 % invested in
Securities immediately month each (at FMV)
Treasury Bills $ 9,700,000 $ 9,850,000 38.58%
Bonds $15,000,000 $15,675,000 61.42%

The liquidity index is calculated as:

[38.58% * ($9.7 mill / $9.85 mill)] + [61.42%*($15 mill / $15.675 mill)] = 96.76%

Teaching Tip: Discount instruments increase in price as they approach maturity but non-
discount instruments receive interest income. The liquidity index should measure not
only any loss in fair market value, but also any loss in income due to a required change in
FI behavior. For example, a T-bill may be priced at fair market value at 99% of par prior
to maturity. Nevertheless, if the FI planned to hold the bill until maturity but had to sell it
to meet liquidity needs, the required sale at the fair market value of $99 per $100 of par
still represents a loss due to liquidity risk. Thus, the index should account for lost interest
as well as losses in current fair market value.

Teaching Tip: The index is a better measure of the cost of liquidity risk than the
likelihood of occurrence of liquidity problems.

 Financing Gap and the Financing Requirement

(Uses) (Sources)
Financing Gap = Average loans – Average (core) deposits
If the financing gap is positive, (as it is for the typical bank) the DI must obtain
additional financing either by borrowing or liquidating assets.

The Financing Requirement is the amount of funds that must be borrowed and it is
found as:
Financing Requirement = Financing Gap + Required liquid asset holdings5

An increasing financing requirement may indicate future liquidity problems for a

bank since this indicates greater borrowing requirements for the DI.

 New Liquidity Risk Measures Implemented by the Bank for International

Settlements (BIS)
The BIS has created two new liquidity requirements, the liquidity coverage ratio
(LCR) and the Net Stable Funding Ratio (NSFR). The LCR is the ratio of the

cash outflow over the next 30 days. This ratio must be ≥ 100%, but the
stock of high quality assets that can be liquidated at short notice to the total net

requirement is being phased in from 2015 to 2019. The total net cash outflow in
the denominator is estimated under an acute stress scenario that includes
institutional and systemic shocks as developed by the regulators. The NSFR must
5
The textbook does not indicate that the assets must be required although this is implied in a footnote.
Logically the bank could liquidate its liquid assets and reduce its financing requirement. Note that in this
formulation these numbers are not flows, they are balance sheet levels. Because these are levels, there is
also an implicit assumption that the level of non-earning assets equals the amount of equity.

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be reported quarterly beginning in 2018. This ratio is amount of available stable

funding over 1 year divided by the required amount of stable funding over the
year. The NSFR ratio must be > 100% and it is meant to limit the reliance on
short term funding for longer term assets. In addition as of 2013 the BIS is
requiring internationally active banks to more robustly measure and understand
their intraday liquidity requirements.

 Liquidity Plan
A liquidity plan should include the following key components:
o Managerial guidelines and assignment of responsibilities
o List of fund providers ranked by likelihood of withdrawal (Institutional and
corporate investors are more likely to withdraw funds quickly.)
o Estimation of seasonal components of liquidity (Christmas, planting time,
harvest time, vacation season, etc.)
o Estimation of amounts of withdrawals over specified time intervals.
o Internal limits on subsidiary and branch borrowings from parents and
maximum borrowing rates.
o Planned order of disposition of assets in the event liquidations become
necessary.

An example liquidity plan may look like the following:

Potential Deposit Withdrawals and Associated Required Asset Liquidations (Mill $)

Potential Deposit From most likely to withdraw to least

Withdrawals likely
Mutual Funds $ 70
Pension Funds $ 40
Correspondent banks $ 50
Large corporations $ 45
Small businesses $ 25
Consumers $ 75
Total $305

Expected total withdrawals per period Average Maximum Likely

One week $ 60 $100
One month $ 70 $150
Three months $130 $220
Total $260 $470

Sequence of funding
options as needed One Week One month Three month
New deposits $ 15 $ 35 $ 75
Sale liquid assets $ 15 $ 25 $ 55
Sale investment portfolio $ 30 $ 40 $ 50
Borrowings from other FIs $ 30 $ 40 $ 35
Borrowings from Fed $ 10 $ 10 $ 5

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Total $100 $150 $220

In the event the maximum likely withdrawals actually occur, the bank has already
determined how the withdrawals will be funded in the bottom panel. The numbers in the
bottom panel are developed in conjunction with the necessary strategies that can be used
if needed to bring about the increases shown. For instance, in the one week period,
deposit rates may have to be increased 15 basis points to attract $15 million in new
deposits.

d. Liquidity Risk, Unexpected Deposit Drains and Bank Runs

Abnormal deposit drains can threaten a FI’s solvency. These usually arise due to
problems in the management of some other area of risk such as credit or interest rate risk.

Demand and other deposits are first-come, first-served contracts that are full pay or no
pay contracts. They are not pro-rata claims that are apportioned based on a fair
distribution of the liquidation value of the DI’s assets. Hence, there is always a
possibility of a bank run when banks maintain only partial reserves to back deposits
because only the first depositors to demand their money receive anything. A bank run
occurs when the fundamental assumption underlying fractional reserve banking is
violated; namely, that all depositors do not wish to obtain their money at the same time.
Since all deposits in all institutions are this way, failure, or fear of failure, at one or more
institutions can quickly spread (the dreaded contagion effect) potentially causing
widespread bank panics or system wide runs on banks. Contagion effects are
particularly serious in countries or situations where there is no credible deposit
insurance.6

In 2008 IndyMac faced a bank run after Senator Schumer’s letters warning of problems at
the bank became public. Over the 11 days following the public release of his letter
depositors withdrew over $1.3 billion from IndyMac. Schumer was right; the bank was
in trouble due to its mortgage holdings. This is another case where problems in credit
spilled over into liquidity problems when investors lost confidence in the bank’s ability to
meet its obligations.

e. Bank Runs, the Discount Window and Deposit Insurance

The two major stabilizing factors that limit bank runs are the discount window and
deposit insurance.

 Deposit Insurance
In the U.S. deposits are currently insured up to $250,000 per account. The amount
was increased from $100,000 during the financial crisis. Actually unlimited
insurance was temporarily provided during the crisis. When an institution is
deemed too big to fail and a bailout or buyout is arranged then all depositors
6
A bank run can still occur even if there is credible deposit insurance if inflation is high enough or if
depositors fear upcoming restrictions on repatriation. Panics may occur because the value of money is its
purchasing power. Any threat to the purchasing power of the money could conceivably cause a run.
Moreover there can be payment delays in the event of bank failure and concerned depositors (insured or
not) may withdraw their funds as a result.

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receive defacto 100% insurance, regardless of the size of their deposits. This
removes a market discipline requiring large depositors to evaluate the riskiness of
large institutions.
 When deposit insurance was established in 1933, bank runs were virtually
eliminated at federally insured institutions. State insurance is not sufficient to
prevent widespread bank runs because the insurance funds do not have enough
reserves to maintain public confidence in a crisis. The FDIC now assesses risk
based deposit insurance premiums. Capital adequacy and supervisory judgment
are used to assign DIs to risk categories. DIs have to pay more to maintain
deposit liquidity when they take on more risk.

 The Discount Window

The Fed provides short term emergency lending to qualifying DIs. The Fed has
shown a willingness to open the discount window during risky events such as the
2001 terrorist attacks, during several stock market crashes and most recently the
subprime crisis. In the 2001 attacks on the World Trade Center phone and
computer outages, grounding of plans that carried checks and building
evacuations led to many disruptions of payment systems. These problems led to
unexpected shortages at other institutions expecting to be paid by New York
banks. On September 11th, the Fed announced the window was open and
encouraged all FIs to borrow as needed to cover unexpected shortfalls. It was
particularly important that the Fed offered discount window services to banks and
securities dealers who finance their substantial securities inventory with short
term call loans. If banks had called in large numbers of these loans some of the
major investment banks could have been in danger of severe liquidity crises
forcing them to liquidate their securities inventories and causing sharp declines in
asset prices.
 Typically DIs must pledge short term, high quality assets as collateral that are
‘discounted,’ hence the term discount window loans. The discount rate used to be
kept below open market rates and at that time the Fed actively discouraged use of
the discount window except as an emergency source of short term borrowing.
The Fed has now changed the discount window policy. See Chapter 4 for details
but basically the Fed operates three types of loan programs. The first is termed
primary credit. Primary credit is available to sound institutions on a short term
basis at a rate 100 basis points above the FOMC target fed funds rate. Primary
credit loans may be used for any purpose and loan terms can be as long as several
weeks. Secondary credit is available for overnight loans to sound institutions
that are having temporary funding problems at a rate 150 basis points above the
FOMC target fed funds rate. Secondary credit may not be used to finance
institutional growth. Finally, seasonal credit is available on a longer term basis
at a rate below the target FOMC fed funds rate. The borrower must demonstrate
seasonality.
 In response to the liquidity problems caused by the credit crunch in 2007 and
2008 the Fed announced in March 2008 that it would lend up to $200 billion to
both commercial and investment banks through its new Primary Dealer Credit
Facility (PDCF). Under the PDCF, firms borrowed an average of $31.3 billion

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per day from the Fed in the first three operating days of the facility. The
borrowers could swap mortgage backed securities for Treasuries. The borrower
could swap some securities that the Fed would not ordinarily have accepted. The
Fed took this extraordinary step because many institutions were unable to borrow
against mortgage securities, creating a liquidity crunch. Not all agree that this
was a sound move by the Fed. Some analysts believe the bailout of Bear Stearns
and the intervention into the markets will create or exacerbate the moral hazard
problem over the long run and encourage other institutions to take excessive risks
believing that the Fed will come to their rescue if needed. New borrowing
programs emerged over the succeeding months providing funding to money
market mutual funds, commercial paper, insurance companies and others. The
Fed also lowered interest rates to near zero and reduced the spread between the
discount rate and the Fed funds rate.

Teaching Tip: One of the original functions of the Fed was to serve as a lender of
last resort to DIs. If the Fed was willing to supply unlimited amounts of loans to a
DI facing insolvency, there would theoretically be no need for deposit insurance
to prevent bank runs. The Fed could create whatever money was needed to
prevent a DI from becoming insolvent and the public would have no reason to
withdraw their deposits. The conditions the Fed imposes on discount window
loans limit its effectiveness as a deterrent to bank runs. Indeed the Fed was
around during the Crash of 1929 and it was either unable or unwilling to prevent
the widespread bank runs that led to the failure of thousands of banks at that time.
Several aspects of normal Fed policy limited the usefulness of the ‘lender of last
resort’ in preventing bank runs. These include:
a) The requirement to pledge high quality assets to back the loan eliminates the ability
of most failing institutions to obtain a sufficient amount of discount window loans.
The Fed has weakened this requirement due to the crisis however.
b) The Fed does not automatically grant discount window loans for extended periods,
so depositors cannot count on this method as a sufficient means of financing to
ensure that the value of all deposits will be preserved even with the Fed’s new
policies.
c) The purpose of the discount window is to provide short term financing to solvent
institutions not to keep afloat failing institutions. Indeed, loans to troubled,
undercapitalized institutions are specifically limited to no more than 60 days in any
120 day period unless the FDIC and any other primary regulator certify that the
bank is viable. The discount window is designed to limit bank’s need to liquidate
assets at fire sale prices in order to fund required liquidity needs, not to protect
depositors.
The Fed evidenced a willingness to go beyond the normal functions of the Discount
Window during and after the financial crisis.

4. Liquidity Risk And Insurance Companies

a. Life Insurance Companies
Life insurers face liquidity risk due to unexpected policy cancellations and working
capital needs. If an insurer cancels (surrenders) a policy with a cash value, the insurer

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must pay the surrender value of the policy to the insured. Some policies also allow the
insured to borrow against the value of the policy. Both situations can cause funds needs.
Insurers typically rely on new premiums to help meet liquidity needs. They also hold
liquid assets and can sell portions of their long term investment portfolio if necessary
although the latter sales may occur at disadvantaged prices. A run occurred on First
Capital Insurer in 1991 due to junk bond losses when new premiums were not
forthcoming and surrenders increased dramatically.

b. Property-Casualty Insurance Companies

P&C insurers have more liquidity risk than life insurers because the payouts on their
liabilities are more unpredictable and the maturity of their claims is shorter than life
insurance claims. Consequently, P&C insurers hold more liquid assets than life insurers,
and they tend to reprice their claims more frequently to help limit risk. Large unexpected
claims and unexpected policy terminations are major sources of liquidity risk for P&C
firms. Catastrophic events such as the 2001 terrorist attacks, the slides in California and
Hurricanes Katrina and Sandy indicate how unpredictable and large liquidity needs can
be at this type insurer.

AIG became embroiled in the financial crisis because the company sold extensive
amounts of credit default swaps (CDSs). CDS sellers must pay in the event of default of
the underlying credit. Problems in mortgages led to payouts and collateral requirements
far beyond AIG’s ability to pay and forced the firm into a bailout. AIG received
government assistance worth $127 billion. The breakdown consisted of $45 billion from
TARP, $77 billion to buy collateralized debt and mortgage backed securities and a $44
billion bridge loan.

c. Guarantee Programs for Life and Property-Casualty Insurance Companies

Although insurers cannot offer policyholders federal insurance, many states either
sponsor or require the insurance firms in their state to operate insurance guarantee
funds. Most states do not have permanent funds, and the policy claims are not a liability
of the state. Rather when a failure of an insurer occurs, the remaining insurance firms are
assessed a premium to help pay off the failed insurer’s claims to policyholders. The
payments are often capped per year and there can be long delays before the policyholders
of the failed insurer receive all their promised value if they ever do.

5. Liquidity Risk And Investment Funds

Open end mutual funds face liquidity risk because they must redeem shares from
shareholders upon demand. Runs on mutual funds can occur but for different reasons
than bank runs. Mutual fund shares are pro-rata claims, not full pay or no pay, so
mutual fund investors lack the incentive to try to be first in line to receive their cash. It is
the pay in full or no pay characteristic of deposits that encourages banks runs. If
investors fear that the value of the mutual fund shares will drop, large numbers of
investors may attempt to redeem their shares all at once, using up the fund’s cash reserve
and forcing the fund to liquidate some of its holdings.7 This provides a similar effect as a

7
Closed end mutual funds do not face this risk. For them liquidity is needed only to be able to purchase
investments quickly without having to liquidate some other part of the investment portfolio.

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run and could be termed as such. Heavy mutual fund redemptions may further depress
the prices of the fund’s asset holdings, leading to additional redemptions and a repeat of
the cycle. This is essentially what happened in the stock market crash of October 1987
and happened in money market mutual funds after the Primary Reserve Fund experienced
large losses on its Lehman holdings. The following week investors liquidated $170
billion of money fund investments, prompting the Fed to backstop all money fund assets.

Appendix 21A: Sources and Uses of Funds Statement: Bank of America (available in
Connect or from your McGraw-Hill representative)
The appendix presents a consolidated statement of cash flows for Bank of America
reproduced below:

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Chapter 21 - Managing Liquidity Risk on the Balance Sheet 6th Edition

Appendix 21B: New Liquidity Risk Measures Implemented by the Bank for International
Settlements (BIS) (available on Connect or from your McGraw-Hill representative)
The financial crisis revealed that many institutions did not have sufficient liquidity
management programs in place. As a result the BIS developed two new liquidity
measures that will be phased in. The first the Liquidity Coverage Ratio will be
implemented in 2015:

High quality assets are defined to be assets that remain liquid even in times of economic
stress and must be accepted as collateral at the Fed’s Discount Window. The assets must
also be unencumbered. The liquid assets are divided into two types, Level 1 and Level 2.
Level 1 includes cash, central bank reserves and sovereign debt. There is no limit on the
amount of Level 1 assets that can be included. Level 2 liquid assets are subdivided into
Level 2A and Level 2B. Level 2A includes mortgage backed securities backed by the
government and AA- or high rated corporate bonds. Level 2B assets include
conventional residential MBS, lower rated corporate bonds and blue chip equities. The
amount of Level 2B assets is capped at 15% of the stock of high quality liquid assets. The
amount of overall Level 2 assets that count is capped at 40% of the total high quality
assets. Moreover a 15% haircut is applied to all Level 2 assets. The total quantity of
high quality liquid assets is the sum of Level 1 assets and the allowable amount of Level
2 assets.

Total net cash outflows are equal to outflows minus the minimum of the following
(expected inflows or 75% of outflows). Outflows are based on the deposit base and
composition, debt maturations and loan commitments. Inflows must be of sound quality
and are capped at 75% of outflows so that the bank does not excessively depend on
expected inflows. Details are provided in Appendix Table 21-14.

The second measure is the Net Stable Funding Ratio (NSFR). The NSFR measures the
institution’s stable funding sources to the liquidity of its assets and funding commitments

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that may arise from off balance sheet activities. The measure attempts to require a
minimum level of stable funding to offset on and off balance sheet liquidity requirements
over a one year time horizon. It limits overreliance on short term sources to fund long
term assets. The NSFR is measured as:

The numerator consists of bank capital, preferred stock with a maturity > 1 year, other
liabilities with a maturity greater than one year and the portion of retail and wholesale
deposits that could be counted on to remain with the bank during periods of economic
stress. The amounts of each type that can be counted are provided in Text Table 21-15.
The required stable funding is assigned by the regulators and is summarized in Text
Table 21-16. The required stable funding measures are somewhat similar in concept to
the risk based asset weightings used in calculating risk weighted assets.

Regulators also examine other factors such as contractual maturity mismatches and
concentrations of funding sources that may not be available in a crisis. In addition the
LCR can be monitored for different currencies and high frequency trade data may be
monitored by regulators.

VI. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal

Reserve

http://www.investors.com/ Investor’s Daily is a website that provides investors

with current information, it is a companion site to
the Investor’s Business Daily publication.

http://www.fdic.gov/ The Federal Deposit Insurance Corporation website

has net charge off rates for banks and thrifts.

http://www.naic.org/ The website of the National Association of

Insurance Commissioners

http://www.sec.gov/ The SEC’s website.

http://www.wsj.com/ Website of the Wall Street Journal Interactive

edition.

VII. Student Learning Activities

1. Obtain any bank’s 10K report and estimate the current financing gap and
financing requirement. How large is the requirement as a percentage of assets? What
does your estimate tell you? Explain.

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2. Obtain two banks’ financial statements and calculate the following ratios:
Borrowed funds to total assets, Core deposits to total assets, Loans to deposits and
Commitments to lend to total assets. Using these ratios compare the two banks’
liquidity positions. Which is more likely to need to rely on borrowed funds? In which
bank would you rather be a depositor? A shareholder? Explain.

3. Investigate a case where an insurance firm failed. What was the cause of
failure? Did liquidity risk cause the failure, or did liquidity problems emerge as the
institution’s other problems mounted? Explain.

4. Obtain the financial data for a life insurer and a P&C insurer. Calculate the
percentage of liquid assets held by each. Explain the differences in your findings.

5. Explain why a mutual fund may need to maintain substantial liquid asset
holdings but a similar closed end fund needs only fewer liquid assets holdings.

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