FIN 683 Financial Institutions Management Liquidity Management and Deposit Insurance

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1 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 2

2 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? 3 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 4

3 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 5 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% 6

4 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 18-7 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 8

5 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 9 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 10

6 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 11 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 21 st Century Act 12

7 Funding Risk versus Cost Funding Cost Funding Risk 3/2/ 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? 14

8 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 crisis Repurchase Agreements: collateralized fed funds transactions backed by government securities more difficult to arrange than simple fed funds loans 15 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: 16

9 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 3/2/2016 Bank Runs and Systemic Risk Robert B.H. Hauswald 17 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: L 1 =P i /P*; L 2 = i=0 n P i /P*, L 3 =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 3/2/2016 Bank Runs and Systemic Risk Robert B.H. Hauswald 18

10 Liquidity Risk Leads to 3/2/2016 Bank Runs and Systemic Risk Robert B.H. Hauswald 19 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

11 Creditors May be Fooled by Accounting Façade that Weak Banks Erect to Keep Capital Looking Good Long After it is First Exhausted 21 A Run on A Bank 3/2/2016 Bank Runs and Systemic Risk Robert B.H. Hauswald 22

12 FDIC: The Past FDIC created in wake of banking panics ,000 failed commercial banks Original coverage was $2,500, now $250,000 Between , FDIC worked well Failures accelerated in 1980 why? open question: is (some) failure good? 23 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 24

13 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 25 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? 3/2/2016 Banking Regulation Robert B.H. Hauswald 26

14 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. 3/2/2016 Banking Regulation Robert B.H. Hauswald 27 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) 28

15 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 29 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? 30

16 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 31 Risk Categories & Initial Assessment Rates * Assessment rates are in cents per $100 of deposits 32

17 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? 33 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 34

18 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 3/2/ 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 36

19 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 37 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 38

20 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 39 Bank Runs only Occur in Developing Countries 3/2/2016 Bank Runs and Systemic Risk Robert B.H. Hauswald 40

21 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 41

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