Peer Group Ratio Comparison

Chapter 21 Managing Liquidity Risk on the Balance Sheet 633

and lending these funds to the borrower) or by stored liquidity management (decreasing the DI’s excess cash assets from $9 million to $4 million). We present balance sheets that result from each of these two policies in Table 21–7 .

Measuring a Bank’s Liquidity Exposure

Having discussed the sources of liquidity risk for a DI, we next look at several methods currently used to measure the extent of a DI’s liquidity risk exposure. These methods take into account the DI’s excess cash reserves and its ability to raise additional purchased funds. Appendix 21A (located at the book’s Web site, www.mhhe.com/sc5e) looks at two additional measures of liquidity risk that will be used by DI regulators beginning in the mid- and late-2010s to evaluate DIs’ exposure to liquidity risk.

Sources and Uses of Liquidity. As discussed above, a DI’s liquidity risk arises from the ongoing conducting of business, such as a withdrawal of deposits or new loan demand, and the subsequent need to meet these demands by liquidating assets or borrowing funds. Therefore, a DI manager must be able to measure the DI’s liquidity position on a daily basis, if possible. A useful tool is a net liquidity statement, which lists sources and uses of liquidity and, thus, provides a measure of a DI’s net liquidity position. Such a statement for a hypothetical U.S. bank is presented in Table 21–8 .

The DI can obtain liquid funds in three ways. First, it can sell its liquid assets such as T-bills immediately with little price risk and low transaction costs. Second, it can borrow funds in the money/purchased funds market up to a maximum amount (this is an internal guideline based on the manager’s assessment of the credit limits that the purchased or borrowed funds market is likely to impose on the bank). Third, it can use any excess cash reserves over and above the amount held to meet regulatory imposed reserve requirements. In Table 21–8 , the DI’s sources of liquidity total $14,500 million. Compare this to the DI’s uses of liquidity—in particular, the amount of borrowed or purchased funds it has already utilized (e.g., fed funds, RPs borrowed) and the amount of cash it has already borrowed from the Federal Reserve through discount window loans. These total $7,000 million. As a

LG 21-3LG 21-3

TABLE 21–8 Net Liquidity Position (in millions)

Sources of Liquidity

1. Total cash-type assets $ 2,000 2. Maximum borrowed funds limit 12,000 3. Excess cash reserves 500

Total $14,500

Uses of Liquidity

1. Funds borrowed $ 6,000 2. Federal Reserve borrowing 1,000

Total $ 7,000 Total net liquidity $ 7,500

TABLE 21–7 Adjusting the Balance Sheet to a Loan Commitment Exercise (in millions)

Purchased Liquidity Management Stored Liquidity Management

Cash assets $ 9 Deposits $ 70 Cash assets $ 4 Deposits $ 70 Nonliquid assets 96 Borrowed funds 15 Nonliquid assets 96 Borrowed funds 10

Equity 20 Equity 20

$105 $105 $100 $100

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634 Part 5 Risk Management in Financial Institutions

result, the DI has a positive net liquidity position of $7,500 million. These liquidity sources and uses can be tracked easily on a day-by-day basis.

The net liquidity position in Table 21–8 lists management’s expected sources and uses of liquidity for a hypothetical bank. All DIs report their historical sources and uses of liquidity in their annual and quarterly reports. Appendix 21B to this chapter (located at the book’s Web site, www.mhhe.com/sc5e ) presents the June 2010 Sources and Uses of Funds Statement for Bank of America. As a DI manager deals with liquidity risk, historical sources and uses of liquidity statements can be useful tools for determining where future liquidity issues may arise.

Peer Group Ratio Comparisons. Another way to measure a DI’s liquidity exposure is to compare certain of its key ratios and balance sheet features—such as loans to deposits, core deposits to total assets, borrowed funds to total assets, and commitments to lend to assets ratios—with those for DIs of a similar size and geographic location (see Chapter 12 ). A high ratio of loans to deposits and borrowed funds to total assets and/or a low ratio of core deposits to total assets means that the DI relies heavily on the short-term money mar- ket rather than on core deposits to fund loans. This could mean future liquidity problems if the DI is at or near its borrowing limits in the purchased funds market. Similarly, a high ratio of loan commitments to assets indicates the need for a high degree of liquidity to fund any unexpected takedowns of these loans by customers—thus, high-commitment DIs often face more liquidity risk exposure than do low-commitment DIs.

Table 21–9 lists the 2010 values of these ratios for the banks we reviewed in Chapter 12 : Webster Financial Corporation (WBS) and Bank of America Corporation (BAC). Neither of these banks relied heavily on borrowed funds (short-term money market instruments) to fund loans. Their ratio of borrowed funds to total assets was 17.41 percent and 27.96 percent, respec- tively. Their ratio of core deposits (the stable deposits of the DI, such as demand deposits, NOW accounts, MMDAs, other savings accounts, and retail CDs) to total assets, on the other hand, was 70.54 percent and 57.20 percent, respectively. As a major money center bank, Bank of America gets more of its liquid funds from the borrowed funds markets than core deposit mar- kets. Webster Financial, a smaller, consumer-oriented bank, uses core deposits much more than borrowed funds to get its liquid funds. The result is that Bank of America is subject to greater liquidity risk than Webster Financial. Furthermore, WBS had a ratio of loan commitments to total assets of only 20.40 percent, while BAC had a much greater ratio of 70.48 percent. If these commitments are “taken down” (see Chapters 11 and 19 ), BAC must come up with the cash to fulfill these commitments, more so than WBS. Thus, BAC was exposed to substantially greater liquidity risk from unexpected takedowns of these commitments.

Liquidity Index. A third way to measure liquidity risk is to use a liquidity index . This index measures the potential losses a DI could suffer from a sudden or fire-sale disposal of assets compared to the amount it would receive at a fair market value established under normal mar- ket conditions. The larger the differences between immediate fire-sale asset prices ( P i ) and fair market prices ( P i

* ), the less liquid is the DI’s portfolio of assets. Define an index I such that:

I /! " !i

N

i i iw P P 1 [( )( )]*

liquidity index A measure of the potential losses a DI could suffer as the result of a sudden (or fire-sale) disposal of assets.

liquidity index A measure of the potential losses a DI could suffer as the result of a sudden (or fire-sale) disposal of assets.

TABLE 21–9 Liquidity Exposure Ratios for Two DIs

Webster Financial Bank of Corp. America

Borrowed funds to total assets 17.41% 27.96% Core deposits to total assets 70.54 57.20 Loans to deposits 76.42 84.06 Commitments to lend to total assets 20.40 70.48

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