Chapter 12 Ans
Chapter 12 Practice Problems
1.
Bankers hold more liquid assets than most business firms. Why?
The liabilities of business firms (money owed to others) is very rarely “callable” (meaning that it is required that the business pay its obligation on demand from the creditor). Since their liabilities are not callable, most businesses can afford to invest in assets that are illiquid. Indeed, this is what is known as matching the liquidity of assets and liabilities. Since most business assets are illiquid businesses can afford to hold illiquid assets as well.
Historically bank liabilities have been very liquid. Checking accounts are “demand” deposits meaning that banks are required to pay the value of checking accounts on demand; hence these deposits are as liquid as cash. Because liabilities (plus net worth) must sum to assets, a bank needs to hold liquid assets to meet unexpected withdrawals (reductions in liabilities). Hence, a bank contends with a liquidity mismatch between its assets (low liquidity) and its liabilities (high liquidity). Diminishing this mismatch enables a bank to meet its depositors demands but at a cost (less liquid assets must pay a higher rate of return, ceteris paribus, than highly liquid assets).
2.
How do banks minimize liquidity risk? Is there a tradeoff between liquidity risk and interest rate risk?
Banks and other depository institutions share liquidity risk because transactions deposits and savings accounts can be withdrawn at any time. Thus when withdrawals signficiantly exceed new deposits over a period, banks must scramble to replace the shortfall in funds. For years bankers solved this liquidity problem by having lots of government bonds on hand that they could easily sell for cash. It is not surprising, therefore, that the ratio of reserves plus securities to total assets is a traditional measure of bank liquidity. Since 1980 this ratio fell by more than half as banks found ways to make their liabilities less liquid (selling
1.
Bankers hold more liquid assets than most business firms. Why?
The liabilities of business firms (money owed to others) is very rarely “callable” (meaning that it is required that the business pay its obligation on demand from the creditor). Since their liabilities are not callable, most businesses can afford to invest in assets that are illiquid. Indeed, this is what is known as matching the liquidity of assets and liabilities. Since most business assets are illiquid businesses can afford to hold illiquid assets as well.
Historically bank liabilities have been very liquid. Checking accounts are “demand” deposits meaning that banks are required to pay the value of checking accounts on demand; hence these deposits are as liquid as cash. Because liabilities (plus net worth) must sum to assets, a bank needs to hold liquid assets to meet unexpected withdrawals (reductions in liabilities). Hence, a bank contends with a liquidity mismatch between its assets (low liquidity) and its liabilities (high liquidity). Diminishing this mismatch enables a bank to meet its depositors demands but at a cost (less liquid assets must pay a higher rate of return, ceteris paribus, than highly liquid assets).
2.
How do banks minimize liquidity risk? Is there a tradeoff between liquidity risk and interest rate risk?
Banks and other depository institutions share liquidity risk because transactions deposits and savings accounts can be withdrawn at any time. Thus when withdrawals signficiantly exceed new deposits over a period, banks must scramble to replace the shortfall in funds. For years bankers solved this liquidity problem by having lots of government bonds on hand that they could easily sell for cash. It is not surprising, therefore, that the ratio of reserves plus securities to total assets is a traditional measure of bank liquidity. Since 1980 this ratio fell by more than half as banks found ways to make their liabilities less liquid (selling