BFW 2401 Question

BFW 2401

What are the two reasons why liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?

• Liquidity risk occurs: because of situations that develop from the economic and financial transactions that are reflected on either side of the asset side/liability side of the balance sheet.
• Asset side risk: Arises from transactions that result in a transfer of cash to some other assets (such as: the exercise of a loan commitment or a line of credit)
• Liability side risk: Arises from transaction whereby, creditor, depositor, or other clain holders demands cash in exchange for the claim. The withdrawal of funds from the bank is an example of such a transaction. Another type of asset side liquidity risk arises from the FI’s investment portfolio. During the sell-off, liquidity dries up and investment securities can be sold only at fire-sale prices.
• A fire-sale price: refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress

What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains?

Core deposit are those deposits that will stay with the DI over an extended period of time. These deposits are relatively stable sources of funds and consist mainly of demand, savings, and retail time deposits. Because of their stability, a higher level of core deposits will increase the predictability of forecasting net deposit drains from the DI.

The probability distribution of the net deposit drain of a DI has been estimated to have a mean of 2 per cent of total deposits and a standard deviation of 1 per cent. Is this DI increasing or decreasing in size? Explain.

The DI is decreasing in size because less core deposit are being added to the bank than are being withdrawn. On average, the rate of decrease of deposits is 2 percent. If the distribution is normal, we can state with 95 percent confidence that the rate of decrease of deposits will be between 0 percent and 4 percent

(i.e., plus or minus two standard deviations).

Net deposit drain: Deposit withdrawal – Deposits addition

XYZ Conglomerate Corporation has acquired Rock Corporation. To help finance the takeover, Conglomerate will liquidate the overfunded portion of  Rock’s pension fund. The face values and current and one-year future liquidation values of the assets that will be liquidated are given below.

Total face value: $30,000

Calculate the one-year liquidity index for these securities.

Liquidity index = 10000/30000*9900/10500 + 5000/30000*4000/4500 + 15000/30000*13000/14000

                        = 0.9267

High liquidity index, lesser liquidity risk

A managed fund has the following assets in its portfolio: $40 million in fixed-income securities and $40 million in stocks at current market values. In the event of a liquidity crisis, the fund can sell the assets at 96 per cent of market value if they are disposed of in two days. The fund will receive 98 per cent if the assets are disposed of in four days. Two share/unit holders, A and B, own 5 per cent and 7 per cent of equity (share/units), respectively. 

• Market uncertainty has caused share/unit holders to sell their share/units back to the fund. What will the two share/unit holders receive if the managed fund must sell all the assets in two days? In four daysHow does this situation differ from a bank run? How have bank regulators mitigated the problem of bank runs?

This differs from bank run because:

• All claimants of the assets receive the same amount, as a % of their investment.
• In a bank run, the first to withdraw receive the full amount, some may not receive.
• One way of mitigating the problem is for regulators to offer deposit insurance/deposit guarantees such as that provided by the Australian Gov’t under the Financial Claim Scheme (FCS) which protects individual deposits up to $250,000.

How might a bank assess it liquidity position using the financing gap approach?

Financing Gap: Liquid assets + Borrowed funds

(Difference between a bank’s average loans & average core deposits)

• Widening of financing gap warns future liquidity problems, since it may indicate increased deposit withdrawals & increased exercise of loan commitments.

Financing requirement à The amount of borrowing that the bank must make/get to sustain in current balance sheet condition.

Discuss the risk return trade-off in the context of liquidity risk.

Insufficient liquidity = ^ liquidity risk

Excess liquidity = Low returns

Risk – Return Trade-off = Find the optimum

High liquidity à Low risk, Low return

Low liquidity à High risk, High return

Example:

Shareholders wealth ^ by ^ expected returns but   by the ^ risk, thus the risk return trade-off requires management to aim for an optimal level of liquidity which will maximise shareholders’ wealth.

Distinguish between deferred net settlement (DNS) and real time gross settlement (RTGS). How might the introduction of RTGS affect bank liquidity management?

Deferred Net Settlement (DNS): A group of payments that are collected & netted-out, only the net payment is made, usually at a specified later time. Liquidity will be loosen and increase in liquidity risk due to the lesser need of liquidity in the DNS.

Real-Time Gross Settlement (RTGA):

Each payment is processed separately in real time. It will help reduce the delay in payment and hence reduce settlement risk. It will also create incentive to to manage liquidity carefully.

Under APS210 Liquidity (see www.apra.gov.au) some Australian banks may be required to hold a minimum holding of liquid assets equal to 9% of liabilities.

Which type of bank is subject to this requirement and which type of bank is not subject to this requirement?

Smaller size bank is subjected to MLH which bigger size bank is subjected to LCR requirement.

XYZ Bank manages its liquidity risk “by a combination of positive cash flow management, the maintenance of portfolios of high quality liquid assets and diversification of its funding base.” Explain this statement using examples where possible.

1. Lange et al (2013), p 497
2. Lange et al (2013), p 498
3. Lange, 2013 pp. 498- 499
4. Lange et al (2013), 504
5. Lange et al (2013),  deposit insurance
6. Gup, 2007, pp 357 – 358.
7. Gup, 2007, pp 500 – 506.
8. See paragraph 9 of APS210 (www.apra.gov.au)
9. This relates to the three aspects of bank liquidity management –  asset liquidity and liability purchased liquidity .  See lange et al. (2013) pp. 527-528