Managing Liquidity Risk on the Balance Sheet

Liquidity risk is the potential for a financial institution to be unable to meet its obligations as they come due. It arises from both liability-side (deposit withdrawals) and asset-side (loan funding) pressures, and managing it involves strategies like stored and purchased liquidity management.

Core Principles

Liquidity risk is a normal aspect of financial institution management.
Extreme liquidity risk can lead to insolvency.
Depository institutions (DIs) face higher liquidity risk than other financial entities.
Stored liquidity involves liquidating assets to meet obligations.
Purchased liquidity involves borrowing funds to meet obligations.
A positive financing gap indicates a need for external liquidity.
Regulatory measures like LCR and NSFR aim to ensure liquidity resilience.

Action Steps

Identify the causes of liquidity risk (liability and asset sides).
Define management strategies: stored vs. purchased liquidity.
Measure liquidity risk using financing gap, liquidity index, LCR, and NSFR.
Develop a comprehensive liquidity plan with clear responsibilities.
Monitor net deposit drains and potential funding shortfalls.
Understand the liquidity needs of different financial institutions (DIs, insurers, investment funds).

Formulas

Financing gap = Average loans - Average deposits
Financing gap = - Liquid Assets + Borrowed funds
I = \sum_{i=1}^{N} (w_i \frac{P_i}{P_i^*})
Liquidity Coverage Ratio = \frac{Stock\ of\ high\ quality\ assets}{Total\ net\ cash\ outflows\ over\ the\ next\ 30\ days} \ge 100\%
Net\ Stable\ Funding\ Ratio = \frac{Available\ amount\ of\ stable\ funding}{Required\ amount\ of\ stable\ funding} \ge 100\%

Key Terms

Liquidity Risk: The risk that a financial institution cannot meet its obligations as they come due.
Stored Liquidity Management: Meeting liquidity needs by liquidating assets.
Purchased Liquidity Management: Meeting liquidity needs by borrowing funds.
Financing Gap: The difference between a bank's average loans and average core deposits.
Liquidity Index: Measures potential losses from a fire-sale disposal of assets.
Liquidity Coverage Ratio (LCR): Ensures banks hold sufficient high-quality liquid assets to cover net cash outflows over 30 days.
Net Stable Funding Ratio (NSFR): Promotes resilience over a longer time horizon by requiring a minimum amount of stable funding.
Bank Run: Abnormally large and unexpected deposit drains leading to major liquidity problems.