Chapter 17. Terms Prof.

Young Mentioned
liquidity risk - see below
fire sale prices - see below
core deposits - see below
net deposit drains - see below
purchased liquidity management - Liquidity arrangements that take place entirely on
the liability side of the balance sheet: liquidity obtained from the market, such as
through repo agreements (repurchase agreements) or the fed funds, or even selling
CDs or notes or bonds. Using a liability to finance liquidity for another liability.

stored liquidity management - liquidity arrangements that involve selling off assets

net liquidity position - sources and uses of liquidity showing net balance
calculating financing gap - Financing gap = average loans - average deposits
If the gap is positive, a DI must fund it with cash and liquidity:
Financing gap = - liquid assets + borrowed funds

video of bank runs - see below

demand deposit contracts - see below
pro-rata distribution - distribution proportional to a claim

Chapter 17. Book Questions

2.
Liquidity risk arises from either a liability side reason or an asset side reason.
- The liability side risk occurs when liability holders seek to cash in their financial claims
immediately.
- The asset side liquidity risk includes the ability of a Financial Institution to fund OBS
commitments like letters of credit that when drawn upon need to be funded immediately.
- A fire sale occurs when assets must be sold at short-term prices to meet liquidity
needs, when much higher prices could likely be obtained by negotiating a price over a
longer period of time.

3.
What are core deposits and how do they play a role in predicting the probability
distribution of net deposit drains?
Core deposits are relatively stable consumer deposits that provide the depository
institution with a source of long term funding.
Core deposits influence net deposit drains, which are inflows minus outflows from
deposit accounts, through predictable pattens of seasonal variation and weekly
variation.

16. How can an FI's liquidity plan help reduce the effects of liquidity shortages? What
are the components of a liquidity plan?
By identifying the timing and degree of liquidity shortages, managers can prioritize and
time borrowing decisions before liquidity becomes a problem, lowering the cost of funds
(emergency funds are expensive) and reducing the amount of excess reserves to an
optimal level.

A Liquidity plan:
1. identifies management roles,
2. a list of potential fund providers most likely to withdraw and their patterns of
withdrawal
3. id size of potential deposit and fund withdrawals over various time horizons.
4. establish internal controls on branch and subsidiary borrowings
5. establish a hierarchy for disposal of assets if necessary based on various
degrees of withdrawals

17. What is a bank run, and what are some withdrawal shocks that could precipitate
one, and what feature of the demand deposit contract provides deposit withdrawal
momentum that can cause a bank run?
- Demand contracts are first come first serve, and "all or nothing". This causes a
problem because when a Depository Institution's assets are less than their deposits (or
they have to sell them for less), not everyone will get paid in full. If this situation arises,
every depositor regardless of current need for their funds will want their funds
immediately. As a bank run progresses, the demand for net deposit withdrawals
increases, further exacerbating the bank's liquidity issues. As liquid assets are depleted,
illiquid assets must be sold at increasingly steeper discounts.

Chapter 18 Liability and Liquidi

1. What are the benefits and costs of holding a lot of liquid assets? Why are treasuries a
good example of a liquid asset?
- Benefits: easily converted into cash at a low transaction cost, reduces liquidity risk,
reduces chance of bank run. They can also be required by regulation.
- Costs: lower returns than more illiquid assets

- Treasuries have a very broad market making them very liquid

3. Which bank has better liquidity? Proft?

Bank A Assets
Cash 10
Treasuries 40
Commercial Loans 90
Total: 140

Bank B Assets
Cash 20
Treasuries 30
Commercial Loans 90
Total: 140

Bank B is more liquid because case is the most liquid asset. However, Bank A is more
profitable as Treasuries earn a return, and are still highly liquid.

6. Ranked by liquidity:
Cash, T-Bills, NYSE traded stocks, Corporate Bonds

Chapter 19 Book Questions - Deposit Insurance and other liability guarantees

2. FDIC provides a backstop to the individual depositor, so that they do not have to
worry about being first in line, reducing the odds of a bank run.However it creates moral
hazard -- and permits reduced depositor discipline. As far as others, the government
backs the FDIC.

5. Moral hazard is when risk is encouraged because an actor is partially shielded from
the consequences. Fixed rates: Until 1993, premiums were based on size, not risk,
encouraging risk taking. There were legitimate external events that stressed the banking
system as well. Banks in the 80s were able to get away with a number of risky activities
because of low levels of oversight.

6. A risk based premium reduces moral hazard by forcing banks to pay more for greater
risk. However, if banks pay the full cost of all of their risk, they will take no risk, and be
unable to be profitable.

11. Capital forbearance is when a regulator allows a bank to continue to operate despite
capital deficiencies (relative to some standard). Then if such an institution fails, they will
have an even lower capital base than if they had been forced to comply with capital
requirements. It also reduces the indications of problems to share holders.

15. FI of certain sizes and importance are essentially fully protected against failure. for
they are too big to close or liquidate without imposing systemic risk (significant).

Chapter 20. Capital Adequacy

1. The 5 functions of an FI's Capital:

1. Provide a margin in case of losses to guarantee a going concern
2. Protect uninsured depositors and creditors in the event of a liquidation.
3. Protect FI insurance funds and tax payers
4. by holding capital and reducing insolvency risk, an FI reduces their insurance
premiums
5. Fund branches and other investments