Chapter Seventeen

Liquidity Risk

17-1 Mutual funds have less exposure to liquidity risk, as a rule, than do banks and thrifts.
T

17-2 The FI's most liquid asset is cash.

T

17-3 Demand deposits pose a liquidity risk for FIs because they are repayable upon demand.
T

17-4 A bank must be ready to pay out all demand deposit liabilities on any given day.
F

17-5 Liquidity risk for an FI includes the possibility of an unexpected inflow of funds.
T

17-6 Bank runs occur because customers know that banks will be forced to liquidate assets at
F fire-sale prices.

17-7 Asset-side liquidity risk may be a result of OBS lending commitments.

T

17-8 Core deposits represent a relatively short-term source of funds.

F

17-9 An expected net deposit drain on any given day means that deposit withdrawals are less
F than deposit inflows.

17-10 Purchased liquidity risk management usually involves purchased funds such as fed funds,
T repurchase agreements and CDs.

17-11 Purchased liquidity management carries the potential risk of significant increases in the
T cost of funds during periods of high interest rate volatility.

17-12 Because cash reserves at the Federal Reserve do not earn interest, DIs do not hold any
F excess cash reserves beyond the minimum requirements.

17-13 Managing asset-side liquidity risk can involve either purchased liquidity management or
T stored liquidity management.

17-14 Liquid funds can be obtained by a DI through unlimited borrowing in the money or
F purchased funds markets.

17-15 High loan commitment banks face less liquidity risk exposure than low commitment

17-1
F banks.

17-16 The liquidity index should be a number that is either greater than one or less than zero.
F

17-17 The greater is the difference between fair market prices and fire-sale asset prices, the less
T liquid is the DI’s portfolio of assets.

17-18 In terms of liquidity risk measurement, the financing gap is defined as rate sensitive
F assets minus rate sensitive liabilities.

17-19 Maturity ladder/scenario analysis is a method of measuring liquidity risk and net funding
T requirements.

17-20 The relative time frame for active liquidity management is 2 to 4 months.
F

17-21 Liquidity planning primarily is designed to assist management in dealing with relatively
T predictable events.

17-22 Abnormally large and unexpected deposit withdrawals can occur because of concerns by
T depositors about a bank’s solvency relative to other banks.

17-23 With proper planning, the future liquidity position of a DI should be accurately forecast
F even though some of the factors cannot be accurately predicted.

17-24 Deposit insurance is the only deterrent to bank runs, contagious runs, and bank panics.
F

17-25 A liquidity plan for a DI should provide a detailed list of fund providers who are most
T likely to withdraw in the case of a liquidity crisis.

17-26 Even with liquidity planning, net deposit withdrawals and/or the exercise of loan
F commitments pose significant liquidity problems for banks.

17-27 Liquidity planning should identify the size of potential deposit withdrawals over various
T time horizons in the future, as well as alternative emergency private funding sources to
meet those withdrawals.

17-28 In the event of a bank run, depositor claims on the bank are satisfied on a pro rata basis.
F

17-29 A contagious run, or bank panic, differs from a run on a bank in that a contagious run
T involves loss of faith in the entire banking system as opposed to just one bank.

17-30 The Fed discount window utilizes three lending programs as deterrents to DI liquidity

17-2
T problems.

17-31 For life insurance companies, the distribution of premium income minus policyholder
T liquidations normally is predictable.

17-32 Surrender value is the amount of cash a life insurance policy holder can receive by
T turning in the policy before it expires.

17-33 The assets of PC insurers are relatively short term and more liquid than those of life
T life insurance companies.

17-34 Insurance companies have had to deal with liability runs by policyholders.
T

17-35 Government securities represent the reserve asset fund for life insurance companies.
T

17-36 Liquidity risk for a life insurance company only occurs when asset returns do not provide
F sufficient cash flows to meet policyholder liquidations.

17-37 Open-end mutual funds issue a fixed number of shares as liabilities.

F

17-38 Net asset value is the current value of a mutual fund’s assets divided by the number of
T shares outstanding.

17-39 Liquidation of a mutual fund would cause the asset to be liquidated to the shareholders
on
F a first come, first served basis.

17-40 Which of the following are potential causes of liquidity risk for a DI?
E a. The decrease in the DI’s stock price caused by market factors.
b. Requests to fund large amounts of loan commitments.
c. Requests by depositors to withdraw large amounts of deposits.
d. All of the above will cause liquidity problems.
e. Only b and c above are considered causes of liquidity risk.

17-41 Which type of financial intermediaries are more highly exposed to liquidity risk?
D a. Property–casualty insurance companies
b. Life insurance companies
c. Mutual funds
d. Depository institutions
e. Pension funds

17-42 What is a fire-sale price?

B a. Market value of an asset.

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 b. Price received for an asset that has to be liquidated immediately.
c. Maximum price that will be received on sale of an asset irrespective of the time
of sale.
d. Replacement value of an asset.
e. Book value of an asset.

17-43 A bank's net deposit drain

A a. is negative if deposits exceed withdrawals.
b. is positive if deposits exceed withdrawals.
c. decreases during holiday and vacation periods.
d. in unaffected by holiday and vacation periods.
e. fluctuates unpredictably on any given day.

17-44 Which of the following is a condition for a DI to be growing?

C a. Net positive drain on deposits
b. Peak of the net deposit drain probability distribution should lie at a point to the
right of zero.
c. Average deposit drain such that new deposit funds more than offset deposit
withdrawals.
d. The liability side of its balance sheet should contract.
e. Both b and d are correct.

17-45 Which of the following balance sheet entries is not a part of liability management?
C a. Bonds
b. Federal fund
c. Demand deposit
d. Repurchase agreement
e. Subordinated note

17-46 Which of the following observations is NOT true?

A a. Traditionally, DI managers have relied on purchased liquidity management as the
primary mechanism of liquidity management.
b. Today, many DIs rely on purchased liquidity management to deal with the risk of
cash shortfalls.
c. The largest banks with access to the money market and other nondeposit markets
for funds rely on liability management to deal with the risk of cash shortfalls.
d. Purchased liquidity management and stored liquidity management are ways of
managing a drain on deposits.
e. Both a and d.

17-47 A disadvantage of using liability management to manage a FI's liquidity risk is

B a. the resulting shrinkage of the FI's balance sheet.
b. the high cost of purchased liabilities.
c. the accessibility of international money markets.
d. tax considerations.
e. loss of flexibility as a result of dependence upon purchased liabilities.

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17-48 A disadvantage of using asset management to manage a FI's liquidity risk is
A a. the resulting shrinkage of the FI's balance sheet.
b. the high cost of purchased liabilities.
c. the accessibility of international money markets.
d. tax considerations.
e. loss of flexibility as a result of dependence upon purchased liabilities.

17-49 Which of the following statements is NOT true?

E a. Stored liquidity management involves liquidation of assets.
b. Traditionally DIs have stored cash reserves at the Federal Reserve and in their
vaults to overcome liquidity risk.
c. When the DI uses its cash as the liquidity adjustment mechanism, both sides of
its balance sheet contract.
d. DIs hold cash reserves in excess of the minimum required to meet liquidity
drains.
e. Bank sustains no cost under stored liquidity risk management.

17-50 Why have purchased liquidity management techniques become very popular in spite of
its limitations?
A a. Because it insulates the assets of an FI from normal drains on liability liquidity.
b. Because funds can be easily raised in the eventuality of a liquidity crunch.
c. Because of decrease in the cost of funds during periods of high interest rate
volatility.
d. Because the funds are covered by deposit insurance.
e. Because the adjustment to the deposit drain occurs on the liability side of the
balance sheet.

17-51 What is the asset adjustment to a bank's balance sheet if the bank sold a five-year, 7
C percent annual coupon $100,000 bond acquired at par, but now yielding 8 percent? The
bond was not in the mark-to-market portfolio.
a. A $96,007 reduction in assets.
b. A $96,007 increase in assets.
c. A $100,000 reduction in assets.
d. A $100,000 increase in assets.
e. A $100,000 increase in liabilities.

Use the following balance sheet (values in thousands of dollars) to answer questions 52-56.

Assets Liabilities and Equity

Cash Required Reserves 21 Demand Deposits 550
Short-term Securities 369 Fed Funds Borrowed 151
Loans 400 Equity 89
Total 790 Total 790

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17-52 If the bank's expected net deposit drain is +4 percent, what is the bank's expected
liquidity
D requirement?
a. $7,560
b. $6,040
c. $16,000
d. $22,000
e. $14,760

17-53 What are the possible ways that the bank can meet an expected net deposit drain of +4
E percent using purchased liquidity management techniques?
a. Utilize further the Fed funds market
b. Utilize repurchase agreements
c. Liquidate all cash holdings
d. All of the above
e. Only a and b of the above

17-54 What are the possible ways that the bank can meet an expected net deposit drain of +4
C percent using stored liquidity management techniques?
a. Liquidate all cash holdings.
b. Utilize further the Fed funds market.
c. Liquidate some securities and/or loans.
d. Liquidate all cash and use more Fed funds.
e. All of the above are suitable techniques.

17-55 If the bank decides to cut down on interest expenses by reducing its dependence upon
A borrowed funds, what policy must the bank follow?
a. Manage liquidity risk exclusively through reserve asset management.
b. Manage liquidity risk exclusively through liability management.
c. Reduce the bank's dependence upon demand deposits.
d. Increase interest income by increasing lending.
e. Increase interest income by increasing securities holdings.

17-56 If the bank experiences a $50,000 sudden liquidity drain caused by a loan commitment
B draw down, what will be the impact on the balance sheet if stored liquidity management
techniques are used?
a. A reduction in cash of $21,000 and an increase in demand deposits of $29,000.
b. A reduction in securities and/or current loans totaling $50,000.
c. A reduction in cash of $21,000 and a decrease in securities holdings of $29,000.
d. A decrease in equity of $50,000.
e. A decrease in lending of $50,000.

17-57 An open-end bond mutual fund is holding a three-year, $1 million par value 5 percent
D annual coupon bond. What is the impact on the total asset value of the fund of a 1
percent decrease in interest rates?
a. A decrease of $10,000.

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 b. An increase of $10,000.
c. A decrease of $26,730.
d. An increase of $27,751.
e. The answer depends upon the number of mutual funds shares outstanding.

17-58 What is the impact of a 50 basis point increase in interest rates on the net asset value of
B an open-end bond mutual fund holding a seven year, $100 million par value 7 percent
annual coupon bond? The fund has 10 million shares.
a. An increase of $0.24 per share.
b. A decrease of $0.265 per share.
c. An increase of $0.05 per share.
d. A decrease of $0.05 per share.
e. An increase of $0.265 per share.

17-59 In the event of FI financial distress, open-ended mutual fund investors

B a. have an incentive to cash in their shares quickly since they are paid on a first
come, first served basis.
b. have an incentive to avoid a run since that will deplete fund net asset value.
c. have an incentive to cash in their shares quickly since that will increase fund
net asset value.
d. will switch into low risk bank deposits.
e. have an incentive to avoid a run since the Federal Reserve guarantees mutual
fund holdings.

17-60 The surrender value of an insurance policy is

B a. its promised payoff.
b. normally a portion of the contract’s face value.
c. its value upon bankruptcy.
d. the value of the junk bonds in the insurance company's portfolio.
e. its holdup value.

17-61 Which intermediation function results in the FI's exposure to liquidity risk?
B a. Information production.
b. Asset transformation.
c. Conduit for monetary policy.
d. Lender of last resort.
e. Brokering between funds deficit units and funds surplus units.

17-62 How does liability management affect profitability?

D a. By its impact on the interest rate sensitivity of assets.
b. By its impact on the interest rate sensitivity of liabilities.
c. By determining the default risk of investment securities.
d. By its impact on the cost of purchased funds.
e. By enhancing the liquidity of assets held.

The following information is for questions 63-66.

17-7
 Cash Required Reserves $2 million Deposits $8 million
Loans $10 million Long-term Debt $2 million
Equity $2 million
Total $12 million Total $12 million

The average interest earned on the loans is 6 percent and the average cost of deposits is 5
percent. Rising interest rates are expected to reduce the deposits by $3 million. Borrowing more
debt will cost the bank 5.5 percent in the short term.

17-63 What will be the size of the bank if a stored liquidity management strategy is adopted?
A a. $9 million
b. $11 million
c. $12 million
d. $14 million
e. $15 million

17-64 What will be the cost of using a strategy of reducing its asset base to meet the expected
C decline in deposits? Assume that the bank intends to keep $2 million in cash as a
liquidity precaution.
a. $10,000
b. $15,000
c. $30,000
d. $40,000
e. $50,000

17-65 What will be the cost of using a strategy of purchased liquidity management to meet the
B expected decline in deposits? Assume that the bank intends to keep $2 million in cash as
a liquidity precaution.
a. $10,000
b. $15,000
c. $30,000
d. $40,000
e. $50,000

17-66 What will be the size of the bank if a purchased liquidity management strategy is
C adopted?
a. $9 million
b. $11 million
c. $12 million
d. $14 million
e. $15 million

The following information is for questions 67-70. An FI has $5 million in cash reserves with the
Fed in excess of its reserve requirements, $5 million in T-Bills, and a credit line of $10 million

17-8
to borrow in the repo market. It currently has lent $2 million in the Fed Funds market and
borrowed $1 million from the Federal discount window to meet its seasonal needs.

17-67 What are the bank’s total available sources of liquidity?

E a. $17 million
b. $18 million
c. $20 million
d. $21 million
e. $22 million

17-68 What are the bank’s current total uses of liquidity?

A a. $1 million
b. $3 million
c. $8 million
d. $10 million
e. $15 million

17-69 What is the net liquidity of the bank?

D a. $7 million
b. $12 million
c. $17 million
d. $21 million
e. $22 million

17-70 Assume that the T-Bills can only be sold at a 10 percent discount, what is the net
liquidity
D of the bank given this information?
a. $6.5 million
b. $11.5 million
c. $16.5 million
d. $20.5 million
e. $21.5 million

17-71 When comparing banks and mutual funds,

B a. mutual funds have more liquidity risk than banks because all shareholders share
the loss of value on a pro rata basis.
b. mutual funds have less liquidity risk than banks because all shareholders share the
loss of value on a pro rata basis.
c. mutual funds have more liquidity risk than banks because all shareholders have
the ability to withdraw their money on a first-come first basis.
d. mutual funds have less liquidity risk than banks because all shareholders have the
ability to withdraw their money on a first-come first basis.
e. mutual funds have the same liquidity risk as banks because both shareholders and
depositors share the fall in the loss of value on a pro rata basis.

17-72 Which of the following is not a primary source of liquidity?

17-9
D a. Excess cash reserves over and above regulatory reserve requirements.
b. Borrowings in the money market.
c. Borrowings in the purchased funds market.
d. Capital notes and other long-term financing alternatives.
e. Cash-type assets that can be sold with little price risk and low transaction costs.

17-73 Which of the following is not a method of measuring liquidity?

E a. Net liquidity statement
b. Liquidity index
c. Financing gap and financing requirement
d. Peer group ratio comparison
e. Current ratio

17-74 What information does the net liquidity statement provide?

B a. Maturity ladder
b. Sources and uses of liquidity
c. Net asset value
d. Liquidity index information
e. Peer group ration comparison

17-75 Which of the following is a measure of the potential losses an FI could suffer as the
result B of fire-sale disposal of assets?
a. Quick ratio
b. Liquidity index
c. Financing gap and financing requirement
d. Peer group ratio
e. Current ratio

17-76 A DI has two assets: 50 percent in one-month Treasury bills and 50 percent in real estate
C loans. If the DI must liquidate its T-bills today, it receives $98 per $100 of face value; if
it can wait to liquidate them on maturity (in one month’s time), it will receive $100 per
$100 of face value. If the DI has to liquidate its real estate loans today, it receives $90
per $100 of face value liquidation at the end of one month will produce $92 per $100 of face
value. The one-month liquidity index value for this DI’s asset portfolio is:
a. .973
b. .940
c. .979
d. 1.06
e. 1.10

17-77 What does a high ratio of loans to deposits indicate?

A a. DI relies heavily on the short-term money market to fund loans.
b. High degree of loan commitments.
c. DI has large amounts of asset-side liquidity.
d. Liquidity concerns are at a bare minimum for the FI.
e. DI relies heavily on core deposits to fund loans.

17-10
17-78 In terms of liquidity risk measurement, the financing gap is defined as
E a. total deposits minus core deposits.
b. financing requirement plus liquid assets.
c. rate sensitive assets minus rate sensitive liabilities.
d. total assets minus total liabilities.
e. average loans minus average deposits.

17-79 In terms of liquidity risk measurement, the financing requirement is defined as

B a. total deposits minus core deposits.
b. financing gap plus liquid assets.
c. rate sensitive assets minus rate sensitive liabilities.
d. total assets minus total liabilities.
e. average loans minus average deposits.

17-80 In a crisis, which of the following are more likely to withdraw funds quickly from banks
D and thrifts?
a. Correspondent banks
b. Small business corporations
c. Individual depositors
d. Mutual funds
e. Both a and b

17-81 In a crisis, which of the following are relatively less likely to withdraw funds quickly
C from banks and thrifts?
a. Correspondent banks
b. Small business corporations
c. Individual depositors
d. Mutual funds
e. Pension funds

17-82 Which of the following observations concerning the Fed’s discount window is true?
C a. The facility is provided to meet DIs’ permanent liquidity needs.
b. Four lending programs are offered through the Fed’s discount window.
c. Primary credit is available to sound depository institutions on a very short-term
basis.
d. Secondary credit is available only to depository institutions that are eligible for
primary credit.
e. Eligible institutions for seasonal credit are big banks located in urban areas.

17-83 What are the two major liquidity risk insulation devices available?
A a. Deposit insurance and discount window
b. Liquidity planning and maturity ladder
c. Scenario analysis and liquidity index
d. Financing gap and the financing requirement
e. Secondary credit and seasonal credit

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17-84 What is the drawback of deposit insurance facility?
B a. Even when the DI is in trouble, the deposit holder has no incentive to run.
b. DIs are more likely to increase the liquidity risk on their balance sheets.
c. Deposit holder’s place in line affects his or her ability to obtain the funds.
d. Deposit insurance does not deter contagious runs and panics.
e. Deposit holders are less likely to panic if there is a perceived bank solvency
problem.

17-85 Which of the following is NOT a component of liquidity planning?

C a. Establishing internal limits on subsidiary and branch borrowings.
b. Detailed list of funds providers who have seasonal patterns of funds usage.
c. A calculation of the value of assets at fire-sale prices relative to the fair market
value of those assets.
d. A detailed itemization of managerial responsibilities.
e. A summary of the size of potential net deposit drains over various time horizons.

17-86 A liquidity plan will include

E. a. the size of potential deposit and fund withdrawals.
b. a list of fund providers that are most likely to withdraw funds.
c. the pattern of potential withdrawals.
d. the details and responsibilities of management.
e. all of the above.

17-87 Which of the following statements is true?

E a. Closed-end funds issue an unlimited number of shares as liabilities.
b. Open-end funds supply limited number of shares to investors.
c. Open-end funds need not stand ready to buy back previously issued shares from
investors at the current market price for the fund’s shares.
d. At a given market price, the supply of open-end fund shares is perfectly inelastic.
e. The number of outstanding shares of a closed-ended fund may change when the
issuing fund chooses to repurchase them.

17-88 Consider a mutual fund with 100 shareholders who invested $10 for a total of $1,000. If
B the assets of the mutual fund are worth $900, what is the net asset value for each one of
them?
a. $0.9
b. $9
c. $90
d. $10
e. $0.10

17-89 The price at which an open-end investment fund stands ready to redeem existing shares is
D the
a. strike price.
b. face value.

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c. book value.
d. net asset value.
e. net worth.

17-13