Chapter Seventeen

Liquidity Risk
Solutions for End-of-Chapter Questions and Problems: Chapter Seventeen

8. A DI with the following balance sheet (in millions) expects a net deposit drain of $15
million.
Assets Liabilities and Equity
Cash $10 Deposits $68
Loans $50 Equity $7
Securities $15
Total Assets $75 Total Liabilities & Equity $75

Show the DI's balance sheet if the following conditions occur.

a. The DI purchases liabilities to offset this expected drain.

If the DI purchases liabilities, then the new balance sheet is:

Cash $10 Deposits $53
Loans $50 Purchased liabilities $15
Securities $15 Equity $7

b. The stored liquidity management method is used to meet the liquidity shortfall.

If the DI uses reserve asset adjustment, a possible balance sheet may be:
Loans $50 Deposits $53
Securities $10 Equity $7

DIs will most likely use some combination of these two methods.

10. A DI has assets of $10 million consisting of $1 million in cash and $9 million in loans. The
DI has core deposits of $6 million, subordinated debt of $2 million, and equity of $2
million. Increases in interest rates are expected to cause a net drain of $2 million in core
deposits over the year?

a. The average cost of deposits is 6 percent and the average yield on loans is 8 percent.
The DI decides to reduce its loan portfolio to offset this expected decline in deposits.
What will be the net effect on interest income and the size of the firm after the
implementation of this strategy?

Assuming that the decrease in loans is offset by an equal decrease in deposits, the cost of
the drain = (0.08 – 0.06) x $2 million = $40,000. The average size of the firm will be $8
million after the drain.

200
 b. If the interest cost of issuing new short-term debt is expected to be 7.5 percent, what
would be the effect on net interest income of offsetting the expected deposit drain with
an increase in interest-bearing liabilities?

Cost of the drain = (0.075 – 0.06) x $2 million = $30,000.

c. What will be the size of the DI after the drain using this strategy?

The average size of the firm will be $10 million after the drain.

d. What dynamic aspects of bank management would further support a strategy of

replacing the deposit drain with interest-bearing liabilities?

Purchasing interest-bearing liabilities may cost significantly more than the cost rate on
deposits that are leaving the bank. However, using interest-bearing deposits protects the
bank from decreasing asset size or changing the composition of the asset side of the
balance sheet.

12. A DI has $10 million in T-Bills, a $5 million line of credit to borrow in the repo market,
and $5 million in excess cash reserves (above reserve requirements) with the Fed. The DI
currently has borrowed $6 million in fed funds and $2 million from the Fed discount
window to meet seasonal demands.

a. What is the DI’s total available (sources of) liquidity?

The DI’s available resources for liquidity purposes are $10 + $5 + $5 = $20 million.

b. What is the DI’s current total uses of liquidity?

The DI’s current use of liquidity is $6 + $2 = $8 million.

c. What is the net liquidity of the DI?

The DI’s net liquidity is $12 million.

d. What conclusions can you derive from the result?

The net liquidity of $12 million suggests that the DI can withstand unexpected withdrawals
of $12 million without having to reduce its less liquid assets at fire-sale prices.

13. A DI has the following assets in its portfolio: $20 million in cash reserves with the Fed,
$20 million in T-Bills, $50 million in mortgage loans, and $10 million in fixed assets. If the
assets need to be liquidated at short notice, the DI will receive only 99 percent of the fair
market value of the T-Bills and 90 percent of the fair market value of the mortgage loans.
Estimate the liquidity index using the above information.

201
 n
I =  wi P
*
i
where wi = weights of the portfolio,
i Pi
Pi = fire-sale prices,
Pi* = fair market value of assets

Thus, and assuming that fixed assets will not be disposed on short notice:

I = (20/100)(1.00/1.00) + (20/100)(0.99/1.00) + (50/100)(0.90/1.00) + (10/100)(1/1.00)

= 0.848

15. Plainbank has $10 million in cash and equivalents, $30 million in loans, and $15 in core
deposits.

a. Calculate the financing gap.

Financing gap = average loans – average deposits = $30 million - $15 million = $15 million
b. What is the financing requirement?

Financing requirement = financing gap + liquid assets = $15 million + $10 million = $25 m

c. How can the financing gap be used in the day-to-day liquidity management of the
bank?

A rising financing gap on a daily basis over a period of time may indicate future liquidity
problems due to increased deposit withdrawals and/or increased exercise of loan
commitments. Sophisticated lenders in the money markets may be concerned about these
trends, and they may react be imposing higher risk premiums for borrowed funds or stricter
credit limits on the amount of funds lent.

18. The following is the balance sheet of an DI in millions:

Assets Liabilities and Equity

Cash $ 2 Demand deposits $50
Loans $50
Plant and equipment $ 3 Equity $ 5
Total $55 Total $55

The asset-liability management committee has estimated that the loans, whose average
interest rate is 6 percent and whose average life is 3 years, will have to be discounted at 10
percent if they are to be sold in less than two days. If they can be sold in 4 days, they will
have to be discounted at 8 percent. If they can be sold later than a week, the DI will
receive the full market value. Loans are not amortized; that is, principal is paid at maturity.

a. What will be the price received by the DI for the loans if they have to be sold in two
days. In four days?

202
Price of loan = PVAn=3,k=10(3) + PVn=3, k=10(50) = $45.03 if sold in two days.
Price of loan = PVAn=3,k=8(3) + PVn=3, k=8(50) = $47.42 if sold in four days.

b. In a crisis, if depositors all demand payment on the first day, what amount will they
receive? What will they receive if they demand to be paid within the week? Assume no
deposit insurance.

If depositors demand to withdraw all their money on the first day, the bank will have to
dispose of its loans at fire-sale prices of $45.03 million. With its $2 million in cash, it will
be able to pay depositors on a first-come basis until $47.03 million has been withdrawn.
The rest will have to wait until liquidation to share the remaining proceeds.

Similarly, if the run takes place over a five-day period, the bank may have more time to
dispose of its assets. This could generate $47.42 millions. With its $2 million in cash it
would be able to satisfy on a first-come basis withdrawals up to $49.42 million.

203