Banks make money by taking risks. Some of these risks are relatively easy to assess and are specific to particular assets. For instance, the likelihood of a certain type of loan defaulting can be determined fairly easily based on the bank’s experience with similar loans. This type of risk doesn’t depend on which bank makes the loan. Other types of risk, however, are more subtle and complex and don’t depend solely on the properties of any single asset or liability. Rather, they can only be assessed by considering a bank’s balance sheet as a whole. Liquidity and market risk fall into this category.

The next agenda item is a report from the Asset and Liability Committee (ALCO). (This committee may also be known as the Asset and Liability Management Committee, or ALM committee). The ALCO has responsibility for managing a bank’s assets and liabilities to balance its many risk exposures and thereby help it achieve its operating objectives. Thus, Insights Bank’s ALCO focuses primarily on managing the bank’s liquidity and market risks.

Liquidity
Market Risk
The Relationship Between Liquidity and Market Risk
The Task of the Asset and Liabilities Committee

This section of the course lays out the basic issues involved in liquidity and market risk, presents some simple tools for analyzing these risks at your bank, and provides some general guidelines for managing these risks through the ALCO.

Liquidity

Liquidity is a bank’s ability to generate cash quickly and at a reasonable cost. Thus, liquidity risk is the risk that a bank will not be able to generate enough cash to meet its short-term needs without incurring large costs.

Banks need liquidity in order to meet routine expenses, such as interest payments and overhead and unexpected “liquidity shocks,” such as large deposit withdrawals or heavy loan demand. The most extreme example of a liquidity shock is a bank run. If all depositors attempt to withdraw their money at once, almost any bank will be unable to cover their claims and will fail—even though it might otherwise be in sound financial condition. Thanks to the federal safety net (which includes deposit insurance and the ability to borrow from the Federal Reserve’s discount window), bank runs have been virtually nonexistent since the Great Depression. Poor liquidity rarely leads to outright failure anymore. However, if a bank does not plan carefully, it may be forced to turn to high-cost sources of funding to cover liquidity shocks, thus cutting into profitability.

Again, no single balance-sheet category or ratio is sufficient to assess liquidity risk. It involves the entire balance sheet and off-balance-sheet activity as well. Liquidity management is largely about being sure that adequate, low-cost sources of funding are available on short notice. This might include holding a portfolio of assets that can easily be sold, acquiring a large volume of stable liabilities or maintaining lines of credit with other financial institutions. However, this effort must be balanced against the impact on profitability. In general, more liquid assets earn lower rates of return and certain types of stable funding may cost more than those that are more volatile. A bank can be perfectly liquid by holding only cash as an asset, but this would be an unprofitable strategy because cash doesn’t earn any income.

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Market risk

Market risk is the risk that changes in the market values of assets and liabilities will affect earnings and capital. In practice, the most important type of market risk for many banks —and the only one we focused on here—is interest-rate risk.

Sudden changes in interest rates can affect banks in a variety of ways.

• First, an increase in rates means that banks will begin earning more interest income on their assets and paying more interest expense on their liabilities. However, because banks’ liabilities typically tend to roll over or reprice faster than their assets, interest expense typically changes more than interest income in the short run, potentially squeezing profits.
• Second, changes in interest rates directly alter the market value of interest-bearing assets and liabilities. When interest rates rise, for example, the value of both assets and liabilities fall, but the effect is likely to be larger for assets than for liabilities, leading to a decline in net value. Although these changes in value do not pass through earnings, they do affect banks’ capital positions.
• Finally, there is the risk (known as “basis risk”) that not all interest rates will move together. The impact of rate changes on capital and earnings will then depend upon what types of assets and liabilities a bank has on its books and how the rates on these instruments change relative to one another.

Needless to say, assessing and managing market risk is a complicated enterprise. In general, the idea is to structure the balance sheet—and perhaps use off-balance-sheet instruments such as interest-rate derivatives—in such a way that moderate, unexpected changes in rates will affect interest income and interest expense by about the same amount and have only small effects on capital. This is much easier said than done, however, especially when profitability concerns are taken into account.

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The Relationship Between Liquidity and Market Risk

Although they are separate conceptual issues, liquidity and market risk overlap in a variety of ways. Often, attempts to manage one of these risks also help to alleviate the other type, but sometimes they come into conflict. For this reason, the Asset and Liability Committee is charged with overseeing both risks simultaneously. This process is best thought of as a series of balancing acts: potential sources of funds should be balanced against the likely need for funds; the interest-rate sensitivity of assets should be balanced against that of liabilities; and both of these concerns should be balanced against the bank’s profitability goals.

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The Task of the Asset and Liabilities Committee

Banks derive much of their earnings from the typical spread between short- and long-term interest rates. By “borrowing short and lending long,” they are able to take advantage of the fact that long-term rates typically exceed short-term rates by at least a percentage point or so. However, the values of long-term instruments are much more sensitive to interest-rate changes than the values of short-term instruments, setting up a tradeoff between the expected return and interest-rate risk.

In practice, evaluating market and liquidity risk involves the consideration of different possible scenarios going forward. For example:

• What if the bank experiences an unexpectedly large volume of deposit withdrawals?
• What if loan repayments occur faster than anticipated?
• What happens if interest rates suddenly rise by 100 basis points (or one percent)?

The ALCO ’s challenge is to assess the probability that these events will occur and position the bank to handle the most likely scenarios with a minimum of deterioration in performance and condition.