Liquidity Risk Management

Liquidity Risk Take-Home Assignment Setting A bank has two strategies: retail lending and corporate bond investment. The retail lending business is managed as follows. Every 3 months, the bank lends $200mm for 9 months to various customers, financed by selling 9-month CP. Just after these new loans are made, therefore, it has $200mm each of 3-month, 6- month, and 9-month loans outstanding, financed by $200mm each of 3-month, 6- month, and 9-month CP. The CP can be successfully sold because, with some of the interest income on its loan book, the bank buys letters of credit on its CP from a larger, creditworthy bank. The bank’s plan for the retail lending business in a liquidity crisis, i.e., defined as not being able to sell CP for 9 months, is simple. It will not make any new loans until its capacity to borrow returns. The corporate bond investment business is managed as follows. The bank carries an inventory of $200mm long-term, A-rated bonds, against which it borrows $180 through overnight repo, i.e., at a haircut of 10%. To manage the liquidity risk of its bond invesments, the bank has raised $57.50mm in equity, and rolls $30mm in 1-month CP to fund a liquidity reserve. In a liquidity crisis the bank plans to use this liquidity to sell $30mm of its bond portfolio gradually over the course of a month, thus avoiding any fire sales mode. The bank’s liquidity stress scenario is defined as follows: i) bond prices fall 10%; ii) repo haircuts increase to 25%; iii) repo lines are cut so that the bank can post only $150mm of its corporates. These conditions are expected to persist for 9 months. Note that, under these assumptions, the bank’s portfolio would fall in value to 90% x $200mm, or $180mm, and that the bank’s repo borrowing capacity would fall to 75% x $150mm, or $112.50. The bank’s initial balance sheet is as follows. The relevant RSF (required stable funding) and ASF (amount of stable funding) percentages from the NSFR (Net Stable Funding Ratio) are included. $millions Asset Amount RSF Liability Amount ASF Cash 67.50 0% Corp. Repo 180.00 0% 3mo loans 200.00 85% 1mo CP 30.00 50% 6mo loans 200.00 85% 3mo CP 200.00 50% 9mo loans 200.00 85% 6mo CP 200.00 50% Corporates 200.00 50% 9mo CP 200.00 50% Equity 57.50 100% Total 867.50 867.50 Problems: 1. Please compute the NSFR for this bank. (You may refer to Saunders and Cornett (2014), pp. 364-367.) Is the bank in compliance? 2. Assume that the bank experiences a liquidity shock exactly along the lines of its assumptions and that it can take actions exactly according to its plan. What will the bank’s balance sheet look like at the end of 9 months? 3. In 300 words or less, please comment on the juxtaposition of your answers to problems 1. and 2.

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