Topic 7 - Managing Liabilities

Question 1

DEFINITION OF LIQUIDITY

Answer 1

Liquidity refers to the ability of an ADI to access funds to make payments as and when they fall due

Question 2

The two main types of payments that have to be made by an ADI are

Answer 2

withdrawals by depositors and drawdowns of loans by borrowers

Question 3

The main sources of liquidity for an ADI are

Answer 3

exchange settlement accounts, holdings of other liquid assets and access to borrowed funds

Question 4

LIQUIDITY RISK

Answer 4

Liquidity risk is the risk that the ADI will be unable to access sufficient funds to make a payment It arises from the difficulty in predicting payment requirements

Question 5

To protect itself against a shortfall, an ADI will

Answer 5

hold surplus liquid assets

Question 6

The level of an ADI’s liquidity risk is determined by

Answer 6

the size of this buffer relative to the unpredictability of its payment requirements

Question 7

A liquidity shortage can be costly:

Answer 7

The ADI may be forced to reduce its level of new lending, and hence it may miss out on profitable business 
It may be unable to honour a withdrawal request, endangering the ADI’s reputation and risking the possibility of a “bank run” 
It may have to pay additional costs to access extra liquidity, such as selling long-term assets at a loss or having to borrow at short notice and high cost

Question 8

From the mid-1980s until 1999, the two main liquidity requirements imposed on banks were:

Answer 8

Prime Asset Ratio (PAR) requirements

Non-callable deposits (NCDs)

Question 9

Prime Asset Ratio (PAR) requirements

Answer 9

these required banks to keep a certain percentage of total liabilities as “prime” or liquid assets, such as cash and government securities

Question 10

Non-callable deposits (NCDs

Answer 10

banks were required to keep 1% of their total liabilities on deposit with the reserve bank (which were paid 5% less than the market interest rate)

Question 11

An ADI’s liquidity management policy will include a range of strategies, including:

Answer 11

Setting limits an maturity mismatches 
Holding sufficient liquid assets to meet anticipated liquidity needs 
Diversifying liability sources so that the ADI is not unduly affected by changing economic circumstances Developing asset sales strategies, should this be required

Question 12

The two main components in the process of ensuring the provision of adequate liquidity involve:

Answer 12

Exchange settlement accounts (ESAs) which are designed to meet the current day’s payments Estimating future liquidity requirements and ensuring that the ADI will have access to sufficient funds as and when required

Question 13

DEFINITION OF ESAs

Answer 13

Exchange settlement accounts (ESAs) are accounts held by banks with the RBA, and are used to settle interbank payments on a daily basis

Question 14

Payments can be settled in two ways

Answer 14

deferred net settlementand real time gross settlement

Question 15

DEFERRED NET SETTLEMENT (DNS)

Answer 15

DNS is used to settle cheque payments and small-value, high-volume payments such as EFTPOS and bulk electronic payments
These transactions are aggregated each night by a clearing house
The next day the clearing house advises the RBA of the net amounts owed to or by each bank, and ESAs are credited and debited accordingly

Question 16

REAL TIME GROSS SETTLEMENT (RTGS)

Answer 16

RTGS is used to settle high-value, time-critical payments
The gross amount of each payment is debited and credited to the respective banks’ ESAs, as soon as they are entered into the system
This puts greater strain on bank liquidity because there must be sufficient funds in the ESA to cover the gross amount of each payment

Question 17

An ADI’s liquidity needs will vary over time. Some of the issues that must be taken into account when estimating future liquidity needs include:

Answer 17

1. Short-term or seasonal factors
2. Cyclical liquidity needs
3. Trend liquidity needs
4. Contingency liquidity needs

Question 18

SHORT-TERM OR SEASONAL FACTORS

Answer 18

Short-term factors might include unique meteorological, economic or political events that impact upon the level of deposits and borrowing
Seasonal factors are likely to affect monthly liquidity needs in a recurring pattern from year to year

Question 19

CYCLICAL LIQUIDITY NEEDS

Answer 19

Liquidity needs can vary cyclically, in response to economic conditions, interest rates and other factor
Recessions are typically periods of high liquidity, with growing deposits but flat demand for new loans
Boom periods typically result in greater liquidity needs, with declining deposits and high demand for loans

Question 20

TREND LIQUIDITY NEEDS

Answer 20

liquidity requirements due to fundamental changes in the community in which an ADI operates
For example, rapidly expanding communities are likely to generate increasing demand for new loans, whereas stable communities are likely to generate increasing deposits with flat demand for loans

Question 21

CONTINGENCY LIQUIDITY NEEDS

Answer 21

an ADI needs to plan for unexpected variations in liquidity
These could be caused by new demand for funds, or the closure of a source of liquidity, due to an unanticipated event Liquidity management policies (approved by APRA) must include planning for such contingencies

Question 22

Stored liquidity

Answer 22

Stored liquidityrefers to assets –generally, liquid assets which held on the balance as a source of liquidity

Question 23

Stored liquidity assets can be defined as:

Answer 23

Assets in which funds are invested that will mature before the funds are required, or 
Assets that are readily saleable, without material loss, before they mature

Question 24

The main examples of stored liquidity are:

Answer 24

Cash –Notes and coins available to meet payments 
Treasury notes and Commonwealth government securities –These can be sold into the market or can be used to access funds from the RBA with repurchase agreements 
Loans to short-term money market dealers
–e.g.: “11am cash” –an overnight loan that must be repaid by 11.00am or reinvested for another day “24-hour cash” –a short term loan requiring 24 hours’ notice for repayment
Bank accepted bills 
Certificates of deposit 
Commercial paper (promissory notes) 
Semi-government securities
Other securities (e.g. corporate bonds and equities)

Question 25

Purchased liquidity

Answer 25

refers to borrowing funds as needed to meet liquidity needs

Question 26

Purchased liquidity examples

Answer 26

Exchange settlement accounts –banks with surplus funds in their accounts are usually prepared to lend to those with a potential deficit  Interbank market –banks will often borrow from each other or from other financial institutions  Repurchase agreements –typically using government or semi-government securities as security for what is effectively a short-term loan Large certificates of deposit –CDs in excess of $100,000 can be issued to corporations with surplus cash  Euro$Adeposits –Deposits raised outside Australia denominated in Australia dollars  Other types of liabilities, such as long-term corporate bond

Question 27

Define liquid assets. 

Answer 27

Liquid assets are assets which can be sold quickly at a fair market price: that is, without  loss of value

Question 28

Define liquidity risk as it affects an ADI

Answer 28

ADI liquidity refers to an ADI’s access to liquid funds with which it can effect payments as  they  become  due.  These  payments  include  paying  depositors  who  wish  to  make  withdrawals and paying out on loans to borrower customers.    Liquidity risk is the risk that an ADI will have insufficient funds available as payments  become due. If an ADI has difficulty making these payments it may limit new lending  thereby  foregoing  profitable  business  or  it  may  acquire  additional  liquidity  but  at  a penalty cost. If, in fact, the ADI cannot make the promised payment this will threaten  confidence in the ADI and may lead to an ADI run.  

Question 29

``` Outline three ways in which an ADI may respond to a projected shortage of  liquidity. Explain why each of these  three responses will have an adverse  effect on bank  profitability ```

Answer 29

If an ADI has a projected shortage of liquidity it may:    (I)limit new lending, but this means not making  profitable new loans thereby reducing  profitability.    (ii) Acquire additional liquidity by selling non‐liquid assets at a loss or by borrowing  funds  at an above market interest rate,  in both cases the bank’s costs would rise and  its profitability would fall.    (iii)Refuse withdrawal requests and refuse  to allow customers to draw down approved  loans. This is likely to trigger panic among depositors  and a run on the bank. This  would further  escalate the liquidity shortage  and threaten the viability of the bank,  in which case the bank would not be able to  carry out its normal business again  thereby threatening profitability. 

Question 30

Briefly  explain  the  approach  taken  to  liquidity  management  by  APRA  in  its  role  as  prudential supervisor of ADIs. 

Answer 30

APRA requires all banks to have in place an approved  liquidity management policy. This policy  must cater for management of day‐to‐day liquidity and it must include a policy for responding  to a crisis such as a bank run. 

Question 31

Why  might  ADI  management  impose  limits  on  maturities  as  part  of  its  liquidity  management process? 

Answer 31

If maturities of assets match maturities of liabilities then  funds received from maturing assets  should match funds payable on maturing liabilities  thereby minimising liquidity risk. 

Question 32

Outline the main features of exchange settlement accounts.  

Answer 32

Exchange settlement accounts are held by banks and special service providers with the Reserve  Bank of Australia. They earn interest at a rate equal to the RBA target cash rate minus 0.25%,  and they are not permitted to be overdrawn.  These accounts are used to settle payments  between ADIs. 

Question 33

Distinguish between stored liquidity and purchased liquidity. 

Answer 33

Asset liquidity (or stored liquidity) refers to holdings of liquid assets which can be sold if  the bank needs cash. Liability liquidity (or purchased  liquidity) refers to a bank’s ability to  borrow funds to provide itself with the required cash. 

Question 34

Distinguish between seasonal and cyclical liquidity needs. 

Answer 34

Seasonal liquidity needs reflect regular fluctuations  which occur at the same time and in  the same  direction each year. For example, when  tax payments are due there will typically  be an increase in withdrawals. In contrast when  tax refunds are received, there is an  increase in  deposits. These fluctuations can  generally be predicted from past experience  and the bank can manage its liquidity positions  accordingly.   Cyclical liquidity needs relate to the  economic cycle. For example, a bank is likely to  experience an increase in loan demand during  the expansionary phase of the economic  cycle. The resulting liquidity needs are difficult  to predict, some guidance may be taken  from (a) the proportion of lines of credit currently  drawn down — cyclical needs may be  predicted as being equal to the difference between  the current draw down rate and the  maximum rate experienced in the past (say 10 years),  (b) correlations between deposit  flows  and  other  indicators  such  as  interest  rates,  cyclical  liquidity  needs  should  be considered in light of the level of funding  diversification and reliability of different funding  sources, (c) statistical time series analysis.  

Question 35

Why are forecasts of seasonal liquidity needs generally believed to be more reliable  than forecasts of cyclical liquidity needs? 

Answer 35

Forecasts of seasonal liquidity needs are generally believed to be more reliable because  seasonal fluctuations can be estimated on the basis of past experience and are linked to  specific regular events such as the due date for tax  payments and the regular periods for  primary  producers’  expenses  and  income  receipts.  ADIs  can  also improve these projections by drawing on  information about the needs  and intentions of their large  customers.    On the other hand, cyclical liquidity needs are largely  related to broad movements in the economy.  These are related to a wide range of both domestic  and international factors.  Hence,  while  it  is  expected  that  the  economy  will  follow  a  cycle  of  expansion  and  contraction, it is very difficult to forecast the size of each movement and the turning  points of the cycle.

Question 36

In what sense could an ADI have an optimal level of liquidity? 

Answer 36

An ADI should aim for an optimal level of liquidity. This  position occurs when the marginal  benefit of reduced liquidity risk from an extra dollar of liquidity is equal to the marginal cost of that additional dollar of liquidity due to the reduced interest revenue. A bank would have too  much liquidity if it had in excess of this optimum and too little liquidity if it has less than this  optimum. 

Question 37

What are contingent liquidity needs? Why is it particularly difficult to provide for this form  of liquidity? 

Answer 37

Contingent liquidity needs are due to unusual events that are difficult to predict. For example, if  another bank becomes insolvent this may trigger a run on your bank.    It is difficult to plan for this type of liquidity firstly, because of the difficulty of predicting the  timing of these events and secondly, because the liquidity requirement is likely to be extremely  large even though it may only be for a relatively short period.