FIN 683
Financial Institutions Management
Liquidity Management and Deposit
Insurance
Professor Robert B.H. Hauswald
Kogod School of Business, AU
Bank Runs
• Can arise due to concern about:
– Bank solvency
– Failure of a related FI
– Sudden changes in investor preferences
• Demand deposits are first come, first served
– Depositor’s place in line matters
• Where do bank runs occur these days?
– why?
• Bank panic: Systemic or contagious bank run
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Liquidity and Liability Management © Robert B.H. Hauswald
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Liquidity Risk
• Faced by all FIs: trading short-term claims
– deposits, CDs, interbank: reason?
• High exposure
– Depository institutions
– Loss of confidence in bank-to-bank lending affects
liquidity in other markets
• Regulation: how can you control a risk which is
– impossible to define
– hard to measure?
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Liquid Asset Management
• Examples: T-bills, T-notes, T-bonds
• Requirements differ across FIs and across
countries
– Benefits of holding large quantities of liquid assets
– Costs of holding liquid assets
• Regulatory requirements for minimum levels of
liquid assets
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Liquid Asset Regulation
• Monetary policy: multiplier effect of changes in reserve
requirements
• Taxation: noninterest bearing reserves represent transfer of a
resource to the central bank.
– Higher inflation rate increases this “tax” burden
– Note DI responses such as sweep programs
• Liquid assets ratio
– Cash and government securities in countries such as U.K.
– Similar case for U.S. life insurance companies (regulated at state level)
– U.S. banks: Cash-based, but banks view government securities as
secondary, or buffer, reserves
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Return-Risk Trade-off
• Cash immediacy versus reduced return
• Constrained optimization
– Privately optimal reserve holdings
– Regulator imposed reserve holdings
• Regulation: incremental reserve
requirements for transaction accounts:
– First $10.3 million
0.0%
– $10.3 million to $44.4 million 3.0%
– Over $44.4 million
10.0%
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Computation Period
• Computation period runs from a Tuesday to a
Monday, 14 days later.
– Average daily reserves are computed as a fraction
of the average daily deposits over the period.
– This means that Friday deposit figures count 3
times in the average for each week.
• In the past, “Weekend Game”
• Sweep accounts
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Liquidity and Liability Management © Robert B.H. Hauswald
Maintenance Period
• The reserve maintenance period, begins 17
days after the end of the computation period
– or 30 days after the start of the computation
period
• Lagged reserve accounting as of July 1998
– Previously, contemporaneous (2-day lag)
– Benefits of lagged reserve accounting
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Undershooting/Overshooting
• Allowance for up to a 4% error in average
daily reserves without penalty
– Surplus reserves required for next 2-week period
• Undershooting by more than 4% penalized by
a 2% markup on rate charged against shortfall
• Frequent undershooting likely to attract
scrutiny by regulators
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Undershooting
• Two options at end of the maintenance period
– Liquidate assets
– Borrow reserves: Fed funds, repurchase agreements
• Discount Window: reserve shortfalls in the past
– Discount window borrowing at a rate lower than fed
funds target
– January 2003, rate increased on discount window
lending and terms eased
– Primary credit
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Overshooting
• First 4 percent can be carried forward to next
period: rarely happens
• Excess reserves typically low due to opportunity
costs: what is it?
– Impact of Fed’s liquidity enhancement measures (late
2008) offset by
– introduction of interest payments on reserve holdings:
no longer any opportunity cost to excess reserves
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Liquidity and Liability Management © Robert B.H. Hauswald
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Liquidity Management
• Important role of securities portfolio in liquidity
management
• Securitization and loan sales
– Risk during crisis: Fire-sale prices
• Liquidity management as a knife-edge problem
– the mirage of external liquidity provision: lender of
last resort and its costs
• Changes in technology alter the problem
– Check Clearing For the 21st Century Act
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Liquidity and Liability Management © Robert B.H. Hauswald
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Funding Risk versus Cost
Funding Cost
Funding Risk
18-13
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Liquidity and Liability Management © Robert B.H. Hauswald
Liability Management
• Note the tradeoff between funding risk and
funding cost
– Demand deposits are a source of cheap funds
– but there is high risk of withdrawal
– NOW accounts: adjust rate, implicit rate, and
minimum balance requirements
• What about other liquidity sources?
– what are the tradeoffs?
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Fed Funds and Repos
• Interbank market for excess reserves
– 90% have maturities of 1 day
• Fed funds rate very variable: demand and supply
– Very volatile prior to 1998 under contemporaneous
reserve accounting
• Rollover risk: extreme during 2008-2009 crisis
• Repurchase Agreements: collateralized fed funds
transactions backed by government securities
− more difficult to arrange than simple fed funds loans
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Historical Trends
• Since 1960, ratio of liquid to illiquid assets
has fallen from 44% to about 18.8% in 2009
– but, loans themselves have also become more
liquid
– Securitization and sales of DI loans
• Since 1960s, a shift away from sources of
funds that have a high risk of withdrawal
– but the core problem remains:
– so, same old story:
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Intermediaries are Special
• Banks are special: intermediaries
– reduce informational frictions through
– screening, monitoring, and contracting
• But: acquire information monopoly
– reducing one friction, creating another one
– competition is imperfect
– moral hazard in banking: regulation
• Moral hazard and holdup: systemic risk
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Bank Runs and Systemic Risk
© Robert B.H. Hauswald
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Liquidity Risk
• Definition: asset owner unable to recover full
value of asset when sale desired, or
– for borrower, that credit is not rolled over
• Alternative definition – risk of being unable to
satisfy claims without impairment of financial or
reputational capital
• Defining liquidity mathematically: L1=Pi/P*;
L2=∑ i=0…n Pi/P*, L3=E(P)/P* where P* is full
value price and Pi is realised price
• Bank liquidity – ability of institution to meet
obligations under normal business conditions
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Bank Runs and Systemic Risk
© Robert B.H. Hauswald
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Liquidity Risk Leads to
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Bank Runs and Systemic Risk
© Robert B.H. Hauswald
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Spillovers and Externalities
• Bank runs can serve a useful purpose
– how?
– contagion has more serious consequences
• FDIC created in 1933
• Securities Investors Protection Corporation
(SIPC) created in 1970
• Pension Benefit Guaranty Corporation
(PBGC) created in 1974
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Deposit Insurance © Robert B.H. Hauswald
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Creditors May be Fooled by Accounting Façade
that Weak Banks Erect to Keep Capital Looking
Good Long After it is First Exhausted
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Deposit Insurance © Robert B.H. Hauswald
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A Run on A Bank
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Bank Runs and Systemic Risk
© Robert B.H. Hauswald
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FDIC: The Past
• FDIC created in wake of banking panics
1930-1933
– 10,000 failed commercial banks
– Original coverage was $2,500, now $250,000
– Between 1945-1980, FDIC worked well
• Failures accelerated in 1980
– why?
– open question: is (some) failure good?
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Deposit Insurance © Robert B.H. Hauswald
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FDIC: The Present
• In 1991: Borrowed $30 billion from Treasury
and still generated a $7 billion deficit
– FDIC Improvement Act 1991
• FDIC reserves in March 2008: 52.8 billion
• Sep 2009, reserves were at a deficit of $8.2bn
– Rate increases
– Prepayments
– $500 billion in additional funding via the Treasury
Department
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Causes of Depository Fund
Insolvency
• Financial and economic environment
– Rise in interest rates
– Collapse in oil, real estate, and commodity prices
– Increased competition: domestic and foreign
• Late 2000s:
– housing market collapse
– demise of high profile FIs
– mortgaged, consumer loan defaults
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Deposit Insurance © Robert B.H. Hauswald
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Insurance Problem: Moral hazard
• Todd buys theft insurance for his laptop.
– Because he buys the insurance, he is more likely
to leave the laptop in his car.
• Ideally, he would like to commit to not
leaving the computer in his car.
– Sometimes but not always we can contract on it
– what do insurance companies do?
• Do we have a moral hazard problem with
deposit insurance?
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Banking Regulation
© Robert B.H. Hauswald
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Of Course!
• Marc is the manager of a Springfield S&L.
– Marc pays higher interest than a bigger and safer bank
claiming his small size helps him cut costs.
– Springfield has deposit insurance (100%).
• Todd puts his money on deposit with Springfield.
– Springfield lends money to a dodgy financial economist
teaching at Springfield State University at a higher rate.
– When there is no default, everyone wins.
– When there is a default, Todd still gets paid.
• Without insurance, Todd would not invest if he
saw Springfield’s risky lending behavior.
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Banking Regulation
© Robert B.H. Hauswald
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Moral Hazard
• Deposit insurance encouraged underpricing of
risk and reduced depositor discipline
– one-way bet: excessive risk taking
– what disciplining force is missing?
• Premiums not linked to risk: political economy
– Role of implicit premiums
• Inadequate monitoring: bank examination
• Prompt Corrective Action (1992)
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Crunch Time
• Trade-off: Moral Hazard vs. Bank Run Risk
– one as bad as the other: where have we come down?
– EU example: industry-run insurance schemes
• Insurance was not actuarially fairly priced
– Reduced incentive for runs: reduced incentives for
depositors to monitor DIs
– Increased moral hazard.
• FDICIA 1993 intended to increase stockholder,
depositor, and regulator discipline
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Controlling DI Risk Taking
• Stockholder discipline
– Links insurance premiums to risk
– option analysis similar to default probability
• Practical problems in applying option pricing to
insurance premiums
– DI’s asset values and risk are not easily observable
– FDIC adopted risk-based premiums 1993
• Split in industry: who is against? who is for?
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Risk-Based Deposit Insurance
• Categories and concentrations of assets
• Categories and concentrations of liabilities
– Insured, uninsured, contingent, noncontingent
• Other factors that affect probability of loss
• Deposit insurer’s revenue needs
• Since Jan 2007, FDIC calculating risk premia
in more a aggressive risk-based manner
– Basel II with its own problems
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Risk Categories & Initial Assessment Rates
* Assessment rates are in cents per $100 of deposits
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Consequences
• Increased capital requirements, stricter DI
closure rules
– Controls forbearance
– Requires lower leverage
• Five capital zones
– Prompt corrective action
• Criticisms of
– inadequate depositor discipline
– who said inadequate supervision?
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Depositor Discipline
• Insurance cap can be bypassed by
– altering structure of deposit funds and
– spreading deposits across banks
• Higher interest rates provided incentive to
deposit in riskier banks, up to coverage limit
• Limits on brokered deposits
• TARP: Deposit coverage cap raised to $250,000
• Implicit 100% coverage from “too big to fail”
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Failure Resolution Post-FDICIA
• In January 1995, FDICIA required leastcost resolution
– Systemic risk exception
– Criticisms related to “too big to fail” remain
– Insured depositor transfer (IDT) or “haircut”
method encourages depositor vigilance
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Deposit Insurance © Robert B.H. Hauswald
Regulatory Discipline
• Two major weaknesses in regulatory practices:
– Frequency and thoroughness of examinations
– Forbearance for weakly capitalized banks pre-1991
• Examinations: independent audits
– Improved accounting standards including market
valuation of assets and liabilities
– Annual on-site examination of every bank
• Capital forbearance: Prompt Corrective Action
– Transition to rules rather than discretion
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Lender of Last Resort
• Traditionally: central bank acts as lender of last
resort through discount window to problem banks
– Short-term, non-permanent: “need to borrow basis”
– Requires high-quality liquid assets as collateral
• Implemented in January 2003:
– Primary credit available on short-term basis even to
sound banks
– Secondary credit (seasonal program)
– Easing of availability but with increased rate
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Discount Window
• Unprecedented steps taken after 9/11 to
ease liquidity
– unfortunate because?
• Not permanent support for unsound banks
– where does that come from?
• Loans to troubled banks limited to no more
than 60 days in any 120 day period
– unless authorized by FDIC and institution’s
primary regulator
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Why Can’t
Government
Officials Rely on
the Market to Tell
Them When an
FSF is Truly Dead?
Government
Guarantees Negate
the Pin-Prick Test
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Bank Runs only Occur in
Developing Countries
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Bank Runs and Systemic Risk
© Robert B.H. Hauswald
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Other Guaranty Programs
• National Credit Union Administration
provides up to $250,000 coverage
– Lower risk due to asset diversification
– Substantial portion of assets in form of
government securities rather than mortgages
• Changes in Deposit Insurance Reform Act
of 2005 apply to NCUIF-insured credit
unions as well
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