Deck 10: Liquidity and Liability Management

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.

Answer 1

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.

Answer 2

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.

Answer 3

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.

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?

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?

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.

Question 8

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

Question 9

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

Question 10

What are sources of borrowing for credit unions?

Question 11

What are different goals for banks for holding securities?

Question 12

What are different stored liquidity strategies for depository institutions?

Question 13

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

Question 14

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

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.

Question 16

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

Question 17

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

Question 18

Explain how the yield on commercial paper is calculated.

Question 19

Discuss liquidity risks at other financial institutions.

Question 20

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

A) Fed Funds Purchased
B) Repurchase Agreements
C) Eurodollar CDs
D) Selling marketable securities
E) All of the above

Question 21

Eurodollar CDs allow which of the following for large financial institutions?

A) Obtain funds by creating dollar-denominated securities abroad
B) Obtain funds by creating deposits in the U.S. denominated in a foreign currency
C) Earn interest on forward contracts for exchanging a foreign currency
Into U.S. dollars
D) None of the above.

Question 22

Purchased or often called volatile liabilities differ from core "insured deposits" by which of the following?

A) Purchased funds are more likely to leave a bank if other banks offer higher rate.
B) Purchased funds have higher rates than core deposits.
C) Purchased funds may leave a bank if there is bad news about the bank.
D) All of the above.

Question 23

Which of the following financial institutions is more likely to engage in liability management?

A) A large international commercial bank
B) A large credit union
C) A small community bank
D) A savings institution
E) All of the above

Question 24

Which of the following is correct for brokered deposits?

A) Brokered deposits involve deposit brokers who place different types
Of jumbo CDs or other deposits with large denomination with investors.
B) Banks sell deposits or CDs with large denominations to brokers who divide large amounts into smaller denominations that are resold to investors.
C) Brokered deposits tend to offer higher rates and are more volatile than core deposits.
D) All of the above.

Question 25

Which of the following statements is false for bank investment maturity strategies?

A) A ladder investment strategy attempts to get the best yield possible on investments by having a ladder of securities of different maturities.
B) A barbell strategy is based on anticipating interest-rate movements, so generally needs good forecasts to be implemented.
C) A buffer strategy involves investing in short-term securities and holding medium and long-term securities as secondary reserves for liquidity.
D) None of the above.

Question 26

Which of the following types of securities are U.S. banks generally not allowed to invest in?

A) Investment Grade (BBB) or better bonds
B) Mortgage-backed Securities
C) U.S. Treasury Securities
D) Common Stock of Fortune 500 companies

Question 27

Which of the following is false concerning the Check Clearing Act for the 21^st Century?

A) Check 21 allows banks to convert checks into a digital form and to
Transmit them between banks and individuals electronically.
B) Under Check 21, banks can no longer use paper checks.
C) Check 21 speeds up check processing.
D) None of the above.

Question 28

A NOW account for a bank has a 2% interest rate, a 2% servicing cost, and reserve requirements of 10%, which of the following is its correct marginal cost?

A) 4.10%
B) 5.32%
C) 4.44%
D) 5.44%

Question 29

A large finance company issues $3 million of commercial paper with a 50-day maturity at a discount rate of 5%. The paper is sold through a dealer for a charge of .05% of the face value of the commercial paper. There is also a backup line of credit that has a charge of 0.50% of the face value of the paper. Be sure to adjust annual rates for fees by multiplying by 50/360 (i.e. N/360). What is the effective annual cost of issuing the commercial paper?

A) 5.93%
B) 5.67%
C) 5.23%
D) 5.14%

Question 30

A firm has a $10,000 surplus cash balance and is thinking of putting it in a 91-day T-bill. If the T-bill is selling for a discount rate of 5%, and has a par (face) value of $10,000, what is the purchase price for the T-bill, and what is its bond equivalent yield and annual compound yield?

A) $9,900.81 and 5.23% and 5.30%
B) $10,000 and 5.13% and 5.15%
C) $10,000 and 5.00% and 5.05%
D) $9,873 and 5.13% and 5.23%

Question 31

Which of the following is not a form of short-term borrowing?

A) Bankers Acceptance
B) Reverse Repurchase Agreement
C) Letter of Credit
D) Commercial Paper
E) None of the above

Question 32

Under Basel III large international financial institutions are required to meet a liquidity coverage ratio (LCR) requirement, which is the ratio of an institution's high quality liquid assets (HQLA) relative to its projected net cash outflows over a 30-day period, and a net stable funding ratio (NSFR) requirement, where the NSFR ratio is the amount of stable funding available divided by the required amount of stable funding required requirement for a specific institution based on the liquidity characteristics and residual maturities of various assets held by the institution as well as off-balance sheet exposures.

Question 33

If a large commercial bank has liquid assets of $500 million and loan demand expected of $100 million and purchased (volatile) funds of $400 million, what is the bank's liquidity surplus or deficit?

A) $100 million surplus
B) $0 (No surplus or deficit)
C) $100 million deficit
D) None of the above

Question 34

A large bank is issuing negotiable CDs of $1 million for 90 days with an interest rate of 2%. What is the amount received at maturity by the investor, and what is the annual effective compound yield (y*)?

A) $1 million and 2%
B) $1.005 million and 2.05%
C) $1.05 million and 2.50%
D) None of the above

Question 35

Insurance companies, securities firms, and mutual funds, in contrast to depository institutions, do not have to engage in liquidity management.

Question 36

Which of the following is false for Collateralized Mortgage Obligations (CMOs)?

A) CMOs are created from mortgage pass-through securities with more favorable characteristics than plain vanilla pass-throughs.
B) CMOs take a pool of mortgages and convert them into different maturities with different tranches for different investors preferences for maturities based on expected payments for a particular tranche.
C) CMOs allow investors to have less prepayment uncertainty than they would with an ordinary pass-through security.
D) A-class or first class tranche bonds are repaid their principal payments first, then B-class investor, and then C-class and so on with the A-class having the shortest maturity.
E) None of the above are false.

Question 37

Stripped mortgage backed securities separate securities into classes of interest only (IO) and principal only (PO) securities which both have very low interest rate sensitivity.

Question 38

Reserve requirements are requirements for banks to hold reserves based on a percentage of transaction type deposits as a tool for central banks to use for monetary policy. Reserve requirements increase the marginal cost of a bank's transaction deposits.

Question 39

Only U.S. savings institutions can be FHLB members and get financing through FHLB Advances.

Question 40

Sources of borrowing for liquidity needs for U.S. Credit Unions include which of the following:

A) Central Liquidity Facility (CLF) loans for liquidity purposes only.
B) FHLB Advances for credit unions that are FHLB members.
C) Fed discount window loans on an emergency basis with collateral.
D) Credit Union members of a Corporate Credit Union (CCU) can borrow from the CCU.
E) All of the above

Question 41

Liability management versus Stored Liquidity management poses a risk/return tradeoff with liquid assets having a low return but less risk and liability management having more risk, but allowing a financial institution to hold fewer low yielding liquid assets.