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10:18 AM
Sebastian Pokutta
Sebastian Pokutta

When a Liquidity Diet for Banks Makes Sense

The balance sheets of many of the big banks that failed or teetered on the brink in the financial crisis actually looked fine. On paper, their assets were sufficient to cover liabilities.

Sebastian Pokutta
The balance sheets of many of the big banks that failed or teetered on the brink in the financial crisis actually looked fine. On paper, their assets were sufficient to cover liabilities.

Their problem was liquidity. At the end of each day, banks must have sufficient liquid assets to meet demands. If they don't, the bank heads for failure, which is what happened at Bear Stearns and other Wall Street institutions in the fall of 2008.

As a bank becomes global, its liquidity risks increase. An institution with headquarters in one country and subsidiaries around the world may not be able to get liquid assets to outlying branches fast enough when demand threatens to outstrip supply. Sending assets across currency zones, national boundaries, and time zones simply can take too long when a large number of the bank's customers are demanding cash.

An important way for banks to address liquidity risk is by opening special offices known as liquidity centers in outlying subsidiaries. These offices are staffed by experienced traders who can execute quick, overnight loans with other banks. If a situation arises in which loans cannot be found, these traders can sell off assets quickly. In a worst case scenario, they can go to their country's central bank for a loan. A liquidity center gives a bank access to fast, often cheap cash.

But how does a bank know when and where to open a liquidity center? Most big banks today have only a handful of liquidity centers. The financial crisis demonstrated how dangerous insufficient liquidity can be for a financial institution. Are banks putting themselves at risk again by not having sufficient liquidity in their subsidiaries?

To answer these questions, a colleague of mine, Christian Schmaltz of the Frankfurt School of Finance and Management, and I developed a mathematical model that banks can use to determine when a liquidity center makes sense. The model incorporates the many variables that affect a bank's risk of running short of liquidity, as well as the cost of opening and running a center. Liquidity centers can be expensive operations for a bank, since staff must be hired, trained, and equipped.

Our model simulates a large bank with subsidiaries in countries and regions around the world. The model accounts for such things as the regulatory environment, currency fluctuations, country instability, salaries for new employees, and past demand for liquidity. A bank that wants to know whether opening a liquidity center would be a wise move can use our model to help make that determination.

In testing the model, we discovered that the key factor in a bank's decision to open a liquidity center is the volatility of demand the bank faces for liquid assets. This finding contradicts a widespread assumption in the banking industry that the overall amount of demand for liquidity is the main reason to open such a center.

Before the financial crisis, banks did not pay a great deal of attention to liquidity management. They focused instead on their investments, loans, and other so-called "profit centers" in the bank. Since the crisis, banks and regulators are paying more attention to liquidity. In the fall of 2008, events might have unfolded very differently if banks had understood liquidity risk more clearly. A bank that has good balance sheets should not fail. For large banks with subsidiaries around the world, managing liquidity risk is like ordering pizza for a party. A host who invites 20 people might assume that each person would eat two slices and so would order pizza with 40 slices plus a few extra just in case. But if the host has no idea how much each person will eat, then it's good to have a pizza shop nearby with fast delivery.

Sebastian Pokutta is a Lecturer on Operations Research and Statistics at the MIT Sloan School of Management

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