Section 12 Practice Problems
Bankers keep more liquid assets than many business organizations. Why? The liabilities of business companies (money owed to others) is very rarely " callableвЂќ (meaning that it must be required that the business pay the obligation upon demand through the creditor). Seeing that their debts are not callable, most businesses can afford to purchase assets which have been illiquid. Indeed, this is what is called matching the liquidity of assets and liabilities. Since most organization assets will be illiquid businesses can afford to support illiquid assets as well. In the past bank liabilities have been incredibly liquid. Looking at accounts are " demandвЂќ deposits which means that banks are required to pay the importance of checking accounts on demand; hence these deposits are as liquefied as funds. Because financial obligations (plus net worth) need to sum to assets, a bank needs to hold liquid assets to meet unforeseen withdrawals (reductions in liabilities). Hence, a bank disagrees with a fluid mismatch among its possessions (low liquidity) and its financial obligations (high liquidity). Diminishing this kind of mismatch allows a traditional bank to meet the depositors needs but at a cost (less liquid assets must pay a higher rate of go back, ceteris paribus, than very liquid assets). 2 .
How do banks decrease liquidity risk? Is there a tradeoff between liquidity risk and interest rate risk?
Banks and also other depository institutions share fluid risk since transactions deposit and personal savings accounts can be withdrawn whenever you want. Thus once withdrawals signficiantly exceed new deposits over the period, banks must scramble to replace the shortfall in funds. For many years bankers solved this fluidity problem by having lots of authorities bonds accessible that they can easily cost cash. It is not necessarily surprising, consequently , that the ratio of reserves plus securities to total property is a classic measure of bank liquidity. Seeing that 1980 this ratio fell by over fifty percent as banking companies found strategies to make all their liabilities less liquid (selling negotiable CDs) or through alternative methods of acquiring cash (federal money loans and repurchase agreements). Interest rate risk occurs as a result of one side of the balance sheet (usually liability side) being more prone to interest rate alterations than the additional. In a standard case, an increase in interest rates enhances the cost to the bank of holding liabilities while the same increase in interest rates changes the revenues earned from the asset side fewer (because the asset aspect tends to possess longer term financial loans with fixed rates).
Most of the time, interest rate risk and liquidity risk may be mitigated together so presently there may not be a tradeoff. For instance, a lender can reduce liquidity risk by holding many securities. If these securities will be short-term bills, then the lender will also include little interest risk as, when interest rates change, the importance of the immediate bills improvements by a bit. So , it will be easy to simultaneously reduce liquidity and rate of interest risk nevertheless this comes at the cost of possessing assets (short term bills) that very likely pay little or no interest to the bank. Another solution strategy can be through proper liability managing where the financial institution buys debris in the form of significantly less liquid Cd albums rather than more liquid require deposits. Using this method, the bank decreases liquidity risk and boosts the duration of it is liabilities to more tightly match the duration of its assets. Once again, there is no tradeoff but rather both hazards are together mitigated.
Using T-accounts, describe what are the results when Anne Doe writes a $50 check on her account in the First National Bank to pay her friend Steve Deer who also in turn deposit the examine in his bank account at the Second National Traditional bank.
First National Bank
Second National Lender
(assuming a required hold ratio of 10%).