Question 1

Discuss the following quote by Gary Gorton (2010, 16-17) from Slapped by the Invisible Hand: The Panic of 2007. 
"Uninsured bank debt is vulnerable to panic …[t]he panic starting in August 2007 involved firms withdrawing from other firms by increasing repo haircuts. [A] banking panic occurs when information-insensitive debt becomes information sensitive due to a shock, in this case, the shock to subprime mortgage values due to house prices falling."
Explain why financial institutions, including security firms, and particularly depository institutions, need to be concerned about holdings of uninsured short-term debt. Give an example associated with the U.S. Subprime Loan Crisis or the following Great Recession for global financial institutions.

Accepted Answer

Financial institutions by their nature often have short-term liabilities that must be rolled over when they mature, so if there is bad news about a financial institution or there is a disruption in short-term liability markets or a sharp rise in interest rates for short-term debt, then a financial institution can face a liquidity crisis. Depository institutions are particularly vulnerable to volatile (uninsured large deposits) leaving the bank if other banks offer higher interest rates or if there is bad news about the bank or a contagion effect (uncertainty about the quality of other individual banks with a large bank failure). There are many examples during the U.S. Subprime Loan Crisis, including Bear Stearns and Lehman Brothers, as security firms that depended on short-term financing with repurchase agreements, which with a shortage of collateral for large short-term repo financing used mortgage securities as a source of collateral. With the collapse of the MBS market with huge defaults on subprime loans and mortgage backed securities, the value of mortgage backed securities fell and they became unmarketable, resulting in a liquidity crisis, and firms having an inability to roll over short-term borrowings. Similarly, with large bank failures there were contagion effects with uninsured deposits and other short-term liability holders withdrawing funds from failing banks, as well as other banks, with a loss of confidence in the banking system, and difficulties determining which banks were having problems and which were safe.

Question 2

A quote from the Basel Committee on Banking Supervision (Bank for International settlements) on "Principles for Sound Liquidity Risk Management and Supervision," is as follows:
"Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses… Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management."
Discuss the above quote in terms of why liquidity risk and its management has become more complex and entails more risk in the past decade.

Accepted Answer

With technology and the ease to withdraw funds, and the widespread use by financial institutions of liability management entailing for instance repurchase agreements using less traditional collateral for agreements, and large financial institutions having huge amounts of short-term liabilities globally, liquidity risk and liability management have become more complex, with the inability of large financial institutions to roll over short-term liabilities during the Subprime Loan Crisis, resulting in severe liquidity crises for large financial institutions, such as Lehman Brothers and Bear Stearns that contributed to their failures. Hence, most large financial institutions have invested in data and technology to improve their liquidity risk management frameworks from a strategic perspective.

Question 3

Give an overview of the new liquidity requirements under Basel III and the Dodd-Frank Act.

Accepted Answer

The new Basel III rules require the liquidity coverage ratio (LCR) to be met from January 2015-on for large international financial institutions, following previous observation and adjustment periods. The net stable funding ratio (NSFR) will also be required that will have a longer observation period with an introduction planned for January 2018 (EY 2011).
The liquidity coverage ratio (LCR) applies to internationally active banking organizations with $250 billion or more in consolidated assets or $10 billion or more in off-balance sheet foreign exposure. In the U.S. the Federal Reserve Board separately adopted in 2015 a less stringent, modified LCR requirement for bank holding companies and saving and loan holding companies with $50 billion or more in total consolidated assets that are not internationally active and or not have significant non-banking types of activities, such as insurance operations.
Basically, the LCR ratio is the ratio of an institution's high-quality liquid assets (HQLA) relative to its projected net cash outflows over a 30-day period. At full implementation, a large, international depository institution will be required to maintain an LCR equal or greater than 100 percent (i.e. hold HQLA that is equal or greater than its projected total net cash outflows over this 30-day period). There are three different levels of HQLA (level 1, level 2A, and level 2B) that are defined including qualifying criteria and limits for inclusion in HQLA. The transition for LCR is 80% by January 1, 2015, 90% for January 1, 2016, and 100% by January 1, 2017.
The net stable funding ratio is basically the amount of stable funding that is available (based on the reliable portion of capital and liabilities over a given time period) divided by the required amount of stable funding required for specific institutions. The amount of stable funding required is based on the liquidity characteristics and residual maturities of various assets held by the institution as well as off-balance sheet exposures.

Question 4

Give an overview of the BIS Principles for Sound Liquidity Risk Management for large international banks.

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Question 5

Discuss the risk/return trade-off for a financial institution in terms of holding stored liquidity for liquidity needs versus depending more on liability management. What type of liquidity management do smaller banks typically have versus very large banks?

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Question 6

Why do central banks require depository institutions to hold reserves with the central bank as a percentage of primarily transaction deposits? Why is it important for depository institutions to manage reserves?

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Question 7

Give an example of reserve requirements using the U.S. Federal Reserve's reserve requirements for U.S. depository institutions, including the typical reserve requirements and how they are calculated.

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Question 8

What are the requirements for borrowing from the Federal Reserve's discount window?

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Question 9

What are FHLB Advances, and what are requirements to be able to use them?

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Question 10

What are sources of borrowing for credit unions?

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Question 11

What are different goals for banks for holding securities?

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Question 12

What are different stored liquidity strategies for depository institutions?

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Question 13

Discuss some of the rules for security holdings in the U.S.

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Question 14

Give an overview of different types of agency and mortgage backed securities.

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Question 15

Give a summary of different types of money market securities that are used as short-term sources of funds for large banks for liability management and also held as short-term investments by banks for liquidity needs.

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Question 16

How are Treasury bills priced and how are their yields calculated?

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Question 17

How are yields for negotiable CDs and Fed Funds that sell at par value and pay interest and principal at maturity?

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Question 18

Explain how the yield on commercial paper is calculated.

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Question 19

Discuss liquidity risks at other financial institutions.

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Question 20

Which of the following are not sources of liquidity for large financial institutions?

Accepted Answer

All of the options listed are sources of liquidity for large financial institutions.

Quiz 10: Liquidity and Liability Management