It is necessary for you to understand the implications of liquidity risk. In order to do so, please complete the following steps for this unit’s assignment.
- Choose a bank that struggled during the financial crisis of 2008. Suggestions include Bank of America, Citicorp, and Wells Fargo.
- Click https://www.federalreserve.gov/releases/lbr/ to go to the Federal Reserve website, which is an excellent source for information on the monetary policy.
- Obtain and submit (as a part of your assignment) their financial statements from 2006, 2007, 2008, and 2016.
- Evaluate the liquidity (risk) over these 4 years. What happened to the bank’s liquidity before and after the financial crisis? Explain the causes of liquidity risk.
- Review the monetary policy, as we have discussed in this unit. How did the monetary policy affect the bank’s liquidity after the financial crisis?
- Create a visual representation (e.g., graphic, table, chart) of the liquidity risk of the bank you selected.
Introduction
Banks play a very crucial and central role in the financial system of an economy. For performing this role efficiently, the banks need to be safe, and their reputation should also be considered as safe for the clients. The most important assurance of the bank is its economic value of the assets being more than its liabilities. This difference if positive provides the cushion for the capital for covering of any potential losses. However, it has been evident that another type of buffer also known as liquidity is also important for the banks to cover its unexpected cash flows. It shows that even though a bank has excess assets over its liabilities in accounting and economic basis, it can still get a victim of sudden death if the funders and depositors of the bank lose the confidence in the bank. For the maintenance of safety, every bank and financial institution is needed by the regulatory authorities to maintain the level of liquidity.
Liquidity Risk
The liquidity of the bank is the measure of the ability of the bank to find cash readily to meet the requirements of the regulations. The measure can result from direct holdings of cash or their accounts in a central bank or Reserve. Usually, it comes from the securities held by the institution which can be readily sold with minimum loss. These include short-term maturities like government bills. The regulations require the banks to increase their liquidity by reducing their liquidity risk by taking the following steps.
- Improve the mean liquidity of the assets
- Issuance of more equity
- Obtain protection of liquidity
- Increasing the length of the liability maturities
- Reducing the maturities of assets
- Decreasing the contingent commitments (Elliott, 2014)’
Causes of Liquidity Risk
The 2008 financial crisis was the largest shock to the financial institutions which raised concerns over their liquidity risks. The global system raised urgent cash demand. With the fall of credit, the banks, which sharply cut back their liquidity were hit the hardest (Strahan, 2012). The crisis of Bank of America can be traced back to the two acquisitions which it made to get safe which became the cause of their failure in the end. In 2005, it bought MBNA for becoming the top retailer of the financial services. The bank bought it in fear of losing out to its rival Wachovia that has been considering its acquisition. The combined credit card division losses raised, and the bank had to write off $20 bill in bad card loan in 2008, $29 billion in the year 2009, and then $23 billion in the year 2010. In this mounting pressure, the company gave cards to those who couldn’t afford it. This pressure got worse when in 2008 it acquired Countrywide Financial who had long left any integrity of selling and underwriting mortgages. It inflated the values of homes. The officers of the institution help the applicants in fudging their assets and income. The quality of the mortgages was misrepresented to investors like Freddie Mac and Fannie Mae. It all resulted in loan losses, costly litigations, and bloated expenses. It was made even worse by the buying back of $40 million common stock of Bank of America, causing a reduction in its capital cushion (The New York Times, 2014).
Liquidity Risk of Bank of America
The Bank of America defines the liquidity as their ongoing ability to compile the deposit withdrawals, liability maturities, business operations, fund asset growth and meeting the obligations by unlimited access to the funding at moderate market prices. The company manages risk at two levels. Firstly, at the parent level and then on the banking subsidiaries level it is computed. For assessing the liquidity risk of the bank in the preceding years of financial crisis and 2016, the capital ratio of Tier 1 will be evaluated. As per Basel III rules, it has to be at least 6%, and about 4.5% of it should be risk-weighted assets. Looking at the Capital Ratios for Tier 1 in the years of 2006, 2007, 2008 and 2016, the difference in the reporting is noticed at first. After the financial crisis, the 2016 annual report shows the approach of the bank towards its better reporting and performance measurement through benchmarking. The Tier 1 in 2006 shows 8.64% of which total Tier 1 leverage is 6.36%. The Tier 1 in 2007 shows 6.87% of which total Tier 1 leverage is 5.04%. The Tier 1 in 2008 shows 9.15% of which total Tier 1 leverage is 6.44%.
In 2016, Tier 1 capital ratio is 13.6% out of which leverage ratio is 8.9%. It is compared to the regulatory minimum of 5.87% and 4% respectively. IF compared, this shows how much far Bank of America has come, and it has certainly learned its lessons from the liquidity risk it has faced in the financial crisis (Bank of America, 2007).
Figure 1: 2008 Tier 1 Capital Ratio
Figure 2: 2006-7 Tier 1 Capital Ratios
Figure 3: 2016 Tier 1 Capital Ratio
Conclusion
In the end, it is concluded that it is certainly evident, but not very specific from the annual reports of the Bank of America of 2006, 2007 and 2008 that something is wrong. The vast writing off of credit card losses, the huge, long maturity mortgages, the low Capital Tier 1 Ratios and Leverage all shows sign of high liquidity risk. The reduction of common stock, reduction of a capital cushion, longer maturities, untrustworthy reputations of clients all back up the financial crisis that it witnessed in 2008. In 2016, the reporting has improved; the regularized minimum requirements are mentioned in reporting for comparison of performance showing the better approach of the bank towards its monetary policy.
References
Bank of America. (2007). Annual Report 2007. Retrieved from http://media.corporate-ir.net/media_files/irol/71/71595/reports/2007_AR.pdf
Elliott, D. J. (2014, June 23). Bank Liquidity Requirements: An Introduction and Overview. Retrieved from https://www.brookings.edu/wp-content/uploads/2016/06/23_bank_liquidity_requirements_intro_overview_elliott.pdf
Strahan, P. E. (2012, May 14). Liquidity Risk and Credit in the Financial Crisis. Retrieved from https://www.frbsf.org/economic-research/publications/economic-letter/2012/may/liquidity-risk-credit-financial-crisis/
The New York Times. (2014, August 21). Bank of America and the Financial Crisis. Retrieved from https://www.nytimes.com/interactive/2014/06/10/business/dealbook/11bank-timelime.html#/#time333_8790
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