Answers to Chapter 21
Questions:
1. Due to the nature of their asset and liability contracts, depository institutions are the FIs most exposed to liquidity
3. Liquidity risk occurs because of situations that develop from economic and financial transactions that are
reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset side risk
b. If the DI has a net deposit drain, it needs to either increase its purchased liquidity (by borrowing funds or issuing
equity) or reduce its stored liquidity. An institution can reduce its assets by drawing down on its cash reserves,
5. Core deposits are those deposits that will stay with the DI over an extended period of time. These deposits are
6. They are likely to be positively related. During times when cash or credit is short, corporations may draw down
c. The entire distribution shifts to the right and may have a positive mean value as withdrawals average more than
8. If the DI has a net deposit drain, it needs to either increase its liabilities (by borrowing funds or issuing equity,
i.e., purchased liquidity management) or reduce its assets (i.e., stored liquidity management). An institution can
9. A DI can use either purchased liquidity management or stored liquidity management. Purchased liquidity
10. a. This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with
little price risk and at low cost, the amount of funds the DI can borrow in the money/purchased funds market, and
b. DIs can easily compare their liquidity with peer group institutions by looking at several easy to calculate ratios.
High levels of the loan to deposit and borrowed funds to total asset ratios and/or a low level of the core
c. The liquidity index measures the amount of potential losses suffered by a DI from a fire-sale of assets compared
d. The financing gap can be defined as average loans minus average deposits, or alternatively, as negative liquid
11. A liquidity plan requires forward planning so that an optimal mix of funding can be implemented to reduce costs
and unforeseen withdrawals. In general, a plan could incorporate the following:
i) Assigning a team that will take charge in the event of a liquidity crisis.
ii) Identifying the account holders that will most likely withdraw funds in the event of a crisis.
12. A bank run is an unexpected increase in deposit withdrawals from a DI. Bank runs can be triggered by several
economic events including (a) concerns about solvency relative to other DIs, (b) failure of related DIs, and (c)
13. Because of the serious effects that a contagious run on DIs could have on the economy (e.g., inability to transfer
wealth from period to period, inability to implement monetary policy, inability to allocate credit to various sectors of
the economy in special need of financing—see Chapter 1), government regulators of depository institutions have
established guarantee programs offering deposit holders varying degrees of insurance protection to deter runs.
14. The Fed took additional unprecedented steps, expanding the usual function of the discount window, to address
the financial crisis. While the discount window had traditionally been available to DIs, in the spring of 2008 (as
Bears Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer
15. P&C insurers’ greatest liquidity exposure occurs when policyholders cancel or fail to renew policies with an
insurer because of pricing, competition, or safety and solvency reasons. This may cause an insurer’s premium cash
16. In the case of a liquidity crisis in DIs and insurance firms, there are incentives for depositors and policyholders
to withdraw their money or cash in their policies as early as possible. Late comers will be penalized because the
Problems:
4. a. The DI’s available resources for liquidity purposes are $10m + $5m + $5m = $20 million.
b. This differs from a run on a bank in that the claimants of the assets all receive the same amount, as a percentage
of their investments. In the case of bank runs, the first to withdraw receives the full amount, leaving the likelihood
9. a. NAV = Market value of shares/number of shares = $10m/1m = $10 per share
b. At the current NAV, it can absorb up to $1 million (from cash), i.e. 100,000 shares.
10. Liquidity Run-off
The liquidity coverage ratio for Central Bank is calculated as follows:
Cash outflows:
Stable retail deposits $190 x 0.03 = $5.70
Less stable retail deposits $70 x 0.10 = 7.00
11. Liquidity Run-off
The liquidity coverage ratio for WallsFarther Bank is calculated as follows:
Liquidity coverage ratio = $218.4m/$194.55m = 112.26%. The bank is in compliance with liquidity requirements
based on the LCR.
12. Required stable Available stable
Funding funding
Assets factor Liabilities and Equity factor
The net stable funding ratio for FirstBank is calculated as follows:
Available amount of stable funding =
Required amount of stable funding =
13. Required stable Available stable
funding funding
Assets factor Liabilities and Equity factor
Calculate the NSFR for BancTwo.
The net stable funding ratio for BancTwo is calculated as follows: