Liquidity Risk

Diamond & Dybvig Model

Game Theory
In many economic situations, agents
returns depend on the actions of other
agents. In such a situation, agents must
think strategically.
Economists use game theory to describe
such situations.
John (A Beautiful Mind) Nash developed
a concept called the Nash equilibrium.
 Nash Equilibrium
A Nash equilibrium occurs when every player in
a game is playing their best strategy given the
strategy that the other players play.
Economists believe that outcomes of strategic
situations are likely to be well-described by Nash
equilibrium.
Since every individual in a Nash eq. is playing there
best strategy given the actions of others, no one
has any incentive to change their strategy
individually.
 Bank Depositors Game
Banks have very illiquid assets (loans) and
obligations to repay their depositors in full at any
time.
If all of the depositors at a bank withdraw their
funds at the same time, the bank will have to sell
their loans at a discount, and they will not have
enough funds to pay all of their depositors.
If all of their depositors keep their money in the
bank, most banks will be able to repay all of their
depositors with interest.
Thus, the payoff to any individual depositor
depends on what other depositors decide to do.
 Bank Run Game: Withdraw or
Dont Withdraw
Depositors each deposit $1000 at 10%
interest.
They can choose to withdraw their funds Individual Depositors Decision
before collecting interest or keep their
funds with the bank.
The right hand table shows pay-offs for
each decision under two possible
situations.
1. All other depositors keep their funds in the bank
and the bank survives. All Withdraw Dont
2. All other depositors withdraw funds and the bank Other Withdraw
must liquidate. Depositors
Payoffs
1. If an individual keeps their funds with the bank
Decision
and everyone else does likewise, everyone gets
their funds with interest. Withdraw Payoff: Payoff:
2. If an individual doesnt withdraw, but everyone
else does, the bank will have nothing left to pay $500 $0
the individual who gets nothing.
3. If the individual depositor withdraws but no one
else does, the depositor loses only interest.
4. If an individual depositor withdraws and everyone
else does, they have some chance of getting Dont Payoff: Payoff:
some funds (say $500) back.
Withdraw 1100
$1000
 Bank Deposit Game has Multiple
Equilibria
If no one else withdraws their funds, the best
strategy of any individual is not to withdraw their
funds.
Thus, a situation in which no-one withdraws their
funds and the bank pays interest to all is a Nash
Equilibria.
If everyone withdraws their funds, an individuals
best strategy is to withdraw before everyone
else does.
Thus, a bank run, a situation in which everyone
withdraws their funds and a bank is forced to
liquidate its assets is also a Nash equilibrium.
 Bank Runs
The phenomenon in which all depositors compete to
withdraw their funds at the same time is called a bank
run or a bank panic.
Depositors lack complete information about the value
of banks assets.
If depositors believe that there is a significant fraction
of loans which will not be repaid, depositors may
have an incentive to immediately withdraw funds.
Bank deposits are first come, first serve. If you
withdraw your funds before the bank declares losses
you may not suffer at all.
Further, even if you believe that banks assets are
sound you may have an incentive to immediately
withdraw, if you believe that other depositors will also
withdraw their funds.
 Northern Rock
Northern Rock is a British bank with a
particular funding profile.
The bank lends heavily in mortgage
market and raises a large share of its
funds in commercial paper market and
other volatile liabilities.
In late 2007, with turmoil in commercial
paper market, depositors began to doubt
whether they would get their funds back.
 Source
BBC Report
Effects of Lender of Last Resort
The confidence brought by the knowledge that
the central bank will provide liquidity in the case
of a bank run, can actually reduce the chance
that a bank run will occur.
Conversely, the fears of depositors of
bankruptcies are an important source of
discipline in the economy. A lender of last resort
may encourage depositors to ignore the
excessive risk taking of their banks, encouraging
banks to take excessive risks.
Lenders of last resort encourages moral hazard.
 Liquidity is a product of banks
Banks are profitable as an enterprise through
their access to relatively cheap funding from
core deposits.
Depositors are willing to lend money to banks at
low interest rates because the banks offer
unique liquidity services that facilitate regular
transactions and protect liquidity position of
depositors wealth.
But if banks are unreliable in providing liquidity
services, their access to cheap funding and
ultimately their profits will disappear.
 Demand Accounts Savings Accounts Time Deposits
Monthly Monthly Monthly
Income / Income / Income /
Unit Cost Expenses Unit Cost Expenses Unit Cost Expenses
Income
Interest Income (estimated 7.5% earnings credit) $ 29.47 $ 34.04 $ 121.84
Non-Interest Income
Service Charges $ 2.80 $ 0.44 $ 0.11
Penalty Fees $ 4.32 $ 0.28 $ 0.27
Other $ 0.63 $ 0.16 $ 0.05
Total Non-Interest Income $ 7.75 $ 0.88 $ 0.42
Expenses
Activity Charges
Deposit - Electronic $ 0.0089 $ 0.02 $ 0.0502 $ 0.01 $ 0.1650 $ 0.1296
Deposit - Non Electronic $ 0.2219 $ 0.66 $ 0.7777 $ 0.46 $ 3.1425 $ 2.2016
Withdrawal - Electronic $ 0.1073 $ 0.43 $ 0.4284 $ 0.07 $ 0.5400 $ 0.2840
Withdrawal - Non Electronic $ 0.2188 $ 3.63 $ 0.7777 $ 0.39 $ 1.4933 $ 0.5875
Transit Check Deposited $ 0.1600 $ 1.71 $ 0.5686 $ 1.09
Transit Check Cashed $ 0.2562 $ 0.50
Account Opened $ 9.46 $ 0.20 $ 33.63 $ 0.53 $ 5.78 $ 1.73
Account Closed $ 5.67 $ 0.07 $ 20.18 $ 0.26 $ 3.38 $ 1.02
On-Us Checks Cashed $ 0.2412 $ 0.42
Account Maintenance (Truncated) monthly $ 2.42 $ 1.67 $ 4.10 $ 3.56 $ 1.99 $ 1.99
Account Maintenance (Non truncated) monthly $ 8.60 $ 7.03
Official check issued $ 1.02
Total Activity Expense $ 16.34 $ 6.37 $ 7.94
Net Indirect Expense $ 4.35 $ 1.81 $ 18.38
Total Non-Interest Expense $ 20.69 $ 8.18 $ 26.32
Interest Expense 1.25% $ 5.38 2.96% $ 13.45 5.18% $ 69.79
Total Expense $ 26.07 $ 21.63 $ 96.11

Net Income (expense) Before Earnings Credit $ (18.32) $ (20.75) $ (95.69)

Net Revenue Per Month $ 11.15 $ 13.29 $ 26.16

Average Account Balance $5,515.00 $5,557.00 $19,495.00

a
Average Annual Net Cost 4.66% 4.57% 5.89%
Average Interest Cost 1.37% 2.96% 4.30%
Average Non-interest Cost 5.27% 1.80% 1.62%
Average Non-interest Income 1.97% 0.19% 0.03%
a
Required reserves are assumed to be 10 percent for demand accounts and zero for others. Float is assumed to be 5
percent for demand accounts, 2 percent for savings accounts and zero for time accounts.
Source: Functional Cost and Profit Analysis, Based on data furnished by participating banks in
twelve Federal Reserve Districts, 1999 National Average Report,
 Liquidity Services
Banks provide a number of liquidity
services
Cash Withdrawal

Checking These require

Electronic Payments Interbank transactions:
Payments
Electronic Transfers between banks
 Cash Demand is relatively
predictable, though subject to
seasonal factors.
HK: Monetary Base: Before Discount Window : Certificates o f Indebtedness
HKD m n HK Currency
170000 subject to sharp
160000
annual rises in
demand.
150000

140000

130000

120000 Source: HKMA,

110000
CEIC

100000

90000

80000
21-Mar-1999 2-Aug-2000 15-Dec-2001 29-Apr-2003 10-Sep-2004 23-Jan-2006
 Transactions at Hong Kong
Interbank Clearance Ltd.
Jan 2006: HK$12trillion (approx.)
Aggregate Transactions/Aggregate Clearing Balances

35000.00

30000.00

25000.00

20000.00
Ratio

15000.00

10000.00 Electronic Checks

Payment 5%
16%

5000.00

0.00
M 0

M 01

M 2

M 03

M 4

M 05
Ja 0

Ja 1

Ja 2

Ja 3

Ja 4

05
Se 0

Se 1

Se 2

Se 3

Se 4

Se 5
0

0
0

0
-0

-0

-0

-0

-0

-0
n-

n-

n-

n-

n-

n-
p-

p-

p-

p-

p-

p-
ay

ay

ay

ay

ay

ay
Ja

Transfer
79%

Large and Volatile Fluctuations in Transactions

Volume and Available Reserves
 Interbank Transactions
Most payments (by value) are done through
checks, credit cards, debit cards, and electronic
transfers.
Final settlement of these transactions will be
done through the accounts that banks hold at
the HKMA, called clearing balances.
Unlike USA, banks face no minimum reserve
requirement on accounts at central bank. Only
requirement is must meet obligations.
 Daily Liquidity Management
Banks are able to borrow intraday liquidity
interest free from the central bank.
Banks may borrow overnight liquidity from:
Other banks at HIBOR rate
Central bank discount window
Discount Window Rate: 150 points above base
rate
 Hong Kong InterBank Offered Rate: The rate
on which one bank deposits money at another
reason for short-term lending.
HK: Interbank Offered Rate: 3 Month
% pa

16

14

12

10

0
Dec-1984 Dec-1987 Dec-1990 Dec-1993 Dec-1996 Dec-1999 Dec-2002 Dec-2005
 Repo Operations
Borrowing from central bank and other short-
term interbank borrowing is done with repo
operations with Exchange Fund Paper. .
Repurchase Agreements: A technique for short-
term lending. A borrower will sell government
securities to a lender and simultaneously agree
to repurchase them at a later date at a higher
price thereby paying interest.
 Exchange Fund Bills
Exchange Fund Bills and Notes are Hong Kong dollar
debt securities issued by the Hong Kong Monetary
Authority (HKMA). The Exchange Fund Bills and Notes
constitute direct, unsecured, unconditional and general
obligations of the Hong Kong SAR
The Exchange Fund Bills and Notes Issuance
Programme ensures the supply of a significant amount
of high quality Hong Kong dollar debt paper, which can
be employed as trading, investment and hedging
instruments.
Authorized Institutions that maintain Hong Kong dollar clearing
accounts with the HKMA can use their holdings of Exchange
Fund papers to borrow overnight Hong Kong dollar from the
Discount Window.
An active primary and secondary market for the trading
of Exchange Fund Bills and Notes, and the
establishment of a reliable benchmark yield curve for up
to 10 years has facilitated the development of a
sophisticated Hong Kong dollar debt market.
Source: HKMA Website
 Liquidity Ratio:
All authorized institutions in Hong Kong are required to
meet a minimum monthly average liquidity ratio of 25%.
This is calculated as the ratio of liquefiable assets (e.g.
marketable debt securities and loans repayable within
one month subject to their respective liquidity
conversion factors) to qualifying liabilities (basically all
liabilities due within one month).
-GUIDE TO HONG KONG MONETARY AND BANKING TERMS
Liquidity Ratio

2003

2004

43 43.5 44 44.5 45 45.5 46 46.5 47 47.5

Hang Seng BEA

Determinants of Banks Liquidity
Banks will have a set of liquid assets (cash,
securities, etc.) and illiquid assets (loans,
tangible & intangible)
Deposits/Liabilities are divided into two types
1. Core Deposits Checking & Savings Accounts, MMDA,
Small Time Deposit
2. Non Core Funding Large Time Deposit/Jumbo CDs,
Borrowings, Bond Securities, etc.
Volatile Liabilities: Short-term (Maturity < 1 Year) Non-Core
 Liquidity Risk & Profits
Banks liabilities are available to depositors on demand.
Banks must wait long time for repayment for their loans.
Banks face risk that many depositors will withdraw funds
at the same time forcing the bank to liquidate assets at
high cost.
Banks also keep some liquid assets such as cash, short-
term deposits, or government bonds but these earn low
interest.
Core deposits are thought to be more stable and unlikely
to be withdrawn quickly.
Acquisition costs of non-core liabilities are much lower.
May be relied to close liquidity gap.
 Measuring Liquidity Risk
Asset Indicators
Loans are the least liquidity type of asset.
Banks with relatively high amounts of
loans are illiquid.
Net Loans to Assets,
Banks facing a liquidity shortfall sell short-
term securites for cash. Firms with lots of
such securities are relatively liquid.
Short-Term Investments to Assets.
Cash to Assets
See Page 5 & 10 of UBPR
 Liabilities Indicators

Core Deposits are the most stable and

least likely to leave unpredictably. Short-
term non-core funding is the least stable
Core Deposits to Assets
S.T. Non Core Funding to Assets
Trends in Demand Deposits in HK
History of Deposit Liabilities

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Demand Deposits Savings Time Deposits NCDs

1980 1990 2005

 Structure of Liabilities
Banks can control the flow of Liabilities Bank of East Asia 2004
deposits by offering only Deposits from Banks 5.39%
products with specific Demand Deposits 6.72%
maturities and minimum
balances and varying the
Savings Deposits 27.46%
relative rates paid according to Time Depocits 58.08%
these terms. NCDs 2.35%
Maturity Structure of Time Deposits - Bank of East Asia 2004

100.00%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Demand 3 Months 3Mo-1Year 1-5 Years
 Loan-Deposit Ratio
Headline measure of liquidity is ratio of
Net Loans to Deposits. Fraction of stable
funding which is being used to finance
illiquid assets. As this increases, stable
funding is used up and the bank becomes
less liquid.
 Source
S & P Report 2007
 Measure of Dependence
Noncore Dependence is a key indicator of
potential liquidity problems.
Fraction of illiquid assets which are being
financed by

Noncore Dependence =

(S.T.) Noncore Funding - Short - term Investments

Long - term Assets
 Liquidity Risk Measures
UBPR HSBC USA vs. Banks w/ Assets > US$10B

100
90
80
70
60
HSBC
%

50
PG1
40
30
20
10
0
Loan/Deposit NonCore Dependence S.T. NonCore Dependence
 Banks and Liquidity

Liquidity Deficit = Gap between liquid

liabilities and assets
Banking firms especially likely to face a liquidity
deficit because of mortgage lending (non-liquid
assets) and short-term deposits (liquid
liabilities) [Maturity Mismatch]
Reliance on Time Deposits which are sensitive
to changes on interest rates relative to other
assets or on risk relative to other assets.
Strategies for Liquidity Management
I. Asset management
Asset Conversion Strategy: Maintain an
inventory of liquid assets convertible to
cash.
Liquid assets must have
ready market,
reasonably steady price
or, reversible so original investment can be
easily obtained.
Strategies for Liquidity Management
Liability management
Borrowed Liability Strategy: Maintain lines of
credit to make up for temporary cash short-falls.
Accessing money market requires some prior
planning and potentially lines of credit.
Sources of funds
Borrowing in Interbank market
Issuing large CDs to money market mutual funds or
large depositors. (Brokered deposits)
Borrowing from central bank.
 Liquidity Planning
1. Short-term Planning: Maintaining
balances at central bank for transactions.
2. Long-term Planning:
A. Forecast liquidity needs over next 1-2 years
B. Identify Liquidity Gap
C. Compare Potential Funding Sources and
Extraordinary Funding Needs
 Loan Securitization
Much of a banks business is making
standardized loans to particular borrowers
(mortgage, student loan, auto, etc.)
Banks may face liquidity risk because it is
difficult to quickly find customers for loans.
Public policy decision to encourage this type of
retail lending by creation of Government
Sponsored Enterprises.
Pioneered by FNMA, GNMA, FHLMC in USA
HKMC begun in 1997
HKMC Mortgage Backed Securities
homepage

HKMC Hong Kong Mortgage

Corporation
SPC: Special Purpose Corporation
 Issuing Banks are often best
customers for mortgage securities
 Reading List
Douglas Diamond, Spring 2007, Banks
and Liquidity Creation: A Simple
Exposition of the Diamond & Dybvig Model
Richmond FED
Goodstadt, Leo F, 2007, Profits, politics
and panics : Hong Kong's banks and
the making of a miracle economy, 1935-
1985