Play in predicting probability distribution of net deposit- Risk Management
1. What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?
2. What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains?
3. What are two ways a DI can offset the liquidity effects of a net deposit drain of funds? How do the two methods differ? What are the operational benefits and costs of each method?
4. What are two ways a DI can offset the effects of asset-side liquidity risk such as the drawing down of a loan commitment?
5. A DI with the following balance sheet (in millions) expects a net deposit drain of $15 million.
Assets Liabilities and Equity
Cash $10 Deposits $68
Loans 50 Equity 7
Securities 15
Total assets $75 Total liabilities and equity $75
Show the DI’s balance sheet if the following conditions occur
6. AllStarBank has the following balance sheet (in millions):
Assets Liabilities and Equity
Cash $30 Deposits $110
Loans 90 Borrowed funds 40
Securities 50 Equity 20
Total assets $170 Total liabilities and equity $170
All StarBank’s largest customer decides to exercise a $15 million loan commitment. How will the new balance sheet appear if AllStar uses the following liquidity risk strategies?7. A DI has assets of $10 million consisting of $1 million in cash and $9 million in loans. The DI has core deposits of $6 million, subordinated debt of $2 million, and equity of $2 million. Increases in interest rates are expected to cause a net drain of $2 million in core deposits over the year?
a. The average cost of deposits is 6 percent and the average yield on loans is 8 percent. The DI decides to reduce its loan portfolio to offset this expected decline in deposits. What will be the effect on net interest income and the size of the DI after the implementation of this strategy?
b. If the interest cost of issuing new short-term debt is expected to be 7.5 percent, what would be the effect on net interest income of offsetting the expected deposit drain with an increase in interest-bearing liabilities?
c. What will be the size of the DI after the drain if the DI uses this strategy?
d. What dynamic aspects of DI management would further support a strategy of replacing the deposit drain with interest-bearing liabilities?
8. A DI has $10 million in T-bills, a $5 million line of credit to borrow in the repo market, and $5 million in excess cash reserves (above reserve requirements) with the Fed. The DI currently has borrowed $6 million in fed funds and $2 million from the Fed discount window to meet seasonal demands.a. What is the DI’s total available (sources of) liquidity?
b. What is the DI’s current total uses of liquidity?
c. What is the net liquidity of the DI?
d. What conclusions can you derive from the result?
9. Plainbank has $10 million in cash and equivalents, $30 million in loans, and $15 in core deposits.
a. Calculate the financing gap.
b.What is the financing requirement?
c. How can the financing gap be used in the day-to-day liquidity management of the bank?
10. What is a bank run? What are some possible withdrawal shocks that could initiate a bank run? What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run?
11. The following is the balance sheet of a DI (in millions):
Assets Liabilities and Equity
Cash $ 2 Demand deposits $50
Loans 50
Premises and equipment 3 Equity 5
Total $55 Total $55
The asset-liability management committee has estimated that the loans, whose average interest rate is 6 percent and whose average life is three years, will have to be discounted at 10 percent if they are to be sold in less than two days. If they can be sold in 4 days, they will have to be discounted at 8 percent. If they can be sold later than a week, the DI will receive the full market value. Loans are not amortized; that is, principal is paid at maturity.
a. What will be the price received by the DI for the loans if they have to be sold in two days. In four days?
b. In a crisis, if depositors all demand payment on the first day, what amount will they receive? What will they receive if they demand to be paid within the week? Assume no deposit insurance.
12. What government safeguards are in place to reduce liquidity risk for DIs?
