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MGT411 GDB Spring 2019 Solution & Discussion Last Date: 01-08-2019

Discussion Question:

Liquidity is a term used to describe the ease with which an asset can be converted into cash. This is an important phenomenon as most of the time businesses face a situation where they have to meet sudden demand of cash or liquid funds that creates liquidity risk. Financial institutions particularly banks required to keep more liquid assets in order to fulfill demand of their depositors. Banks face liquidity risk on both sides i.e. asset and liability side of their balance sheet. On liability side, it is due to sudden deposit withdrawals and on asset side it is due to failure of banks to provide loans to their customers when demanded. This can turn to the risk of banks’ failure even if they have positive net worth. One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required reserves mandated by the central bank) to accommodate customers’ withdrawals.

  • Keeping this in mind and on the basis of information provided in following balance sheets of Bank A and B; which bank have more liquidity risk?  (Explain your answer with logical reasoning).                                                                         
  • Also mention strategies for the banks to manage their liquidity risk.                         

Bank A

Bank B

Assets

Liabilities

Assets

Liabilities

Securities             100

Deposits               500

Securities               50

Deposits                500

Loans                   800

Borrowings          200

Loans                     800

Borrowings            200

Reserves                60

Reserves                30

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Liquidity Risk:

Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process.

Examples:

Liquidity risk generally arises when a business or individual with immediate cash needs, holds a valuable asset that it cannot trade or sell at market value due to a lack of buyers, or due to an inefficient market where it is difficult to bring buyers and sellers together. Suppose Consider a $1,000,000 home with no buyers. The home has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when market conditions improve and demand increases, the house may sell for well above that price. However, due to the home owner’s need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset.

1. The Below balance sheets of Bank A and B; which bank has more liquidity risk?

Bank A Bank B

Assets Liabilities Assets Liabilities

Securities 100 Deposits 500 Securities 50 Deposits 500

Loans 800 Borrowings 200 Loans 800 Borrowings 200

Reserves 60 Reserves 30

• Bank B has more liquid risk rather than Bank A because they have not sufficient Asset/reserve etc to fulfill the costumers demand.

• In Above Both Balance sheet Bank A has more Asset 960 rather than Bank B 880. Only the Liabilities are the same.

2. How banks to manage their liquidity risk.

There is two way the bank manages the liquidity risk

1. To Adjust the Assets

2. To Adjust liabilities

Example:

If bank to paid his customer so once they sold an asset to fulfill costumers demand so his liabilities will increase with the same amount and second they borrow from the central bank so his liabilities will increase with the same amount. But the bank does not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing so shrink the size of the bank. so bank borrows from the central bank or another bank like borrow 260 Million rupees.

Bank A

Assets Liabilities

Securities 100 Deposits 500

Loans 800 Borrowings 460

Reserves 60

MGT411 GDB Solution

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MGT411 GDB Solution

Req. 1) which bank has more liquidity risk?

i) On the basis of securities:

                                          If a customer makes 5 withdrawals, the bank can’t simply deduct from its securities. But the bank B has less securities as compare to bank A. so, bank B have more liquidity risk.

ii) On the basis of Reserve:

                                       If a customer makes 5 withdrawals, the bank can’t simply deduct from its Reserves. But the bank B has less Reserves as compare to bank A. So, the Bank B has more liquidity risk.

Req. 2) also mentions strategies for the banks to manage their liquidity risk?

There are two ways to manage Liquidity Risk. They are:

  • Adjusting Assets
  • Adjusting Liabilities

MGT411 GDB Solution Spring 2019

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MGT411 GDB Solution Spring 2019

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