BANK3011 · Bank Financial Management
Liquidity Risk
In BANK3011 Bank Financial Management at the University of Sydney, liquidity risk is the risk that a bank cannot meet its cash obligations — depositor withdrawals and committed loan drawdowns — as they fall due, without selling illiquid assets at a loss. It is inherent in asset transformation: a bank funds long-dated, illiquid loans with short-dated, callable deposits, so a timing mismatch is built into the business model. Pushed to the extreme, a liquidity problem becomes a solvency problem — forced fire-sales crystallise real losses. This chapter covers the two causes, the purchased-vs-stored management approaches, the measurement tools (liquidity index and financing gap), bank runs, and the Basel III ratios LCR and NSFR.
What this chapter covers
- 011. Liquidity risk and asset transformation — why funding illiquid loans with callable deposits makes the risk structural, not optional
- 022. Liability-side vs asset-side causes — net deposit drains versus loan-commitment drawdowns and portfolio value falls
- 033. Net deposit drain — withdrawals minus new deposits; core deposits are stable, so normal drains are predictable
- 044. Purchased vs stored liquidity — borrowing (balance sheet size unchanged) versus selling liquid assets (balance sheet shrinks)
- 055. Net liquidity statement and peer-group ratios — measuring sources against uses and benchmarking loan/deposit and borrowed-funds ratios
- 066. The liquidity index — I = Σ wᵢ (Pᵢ / Pᵢ*), the fire-sale-to-fair-value haircut, with 0 < I ≤ 1 and higher = more liquid
- 077. Financing gap and financing requirement — average loans minus deposits, plus the liquid-asset buffer that must itself be funded
- 088. Bank runs — the first-come-first-served demand-deposit contract, contagion, and why runs are self-reinforcing
- 099. Basel III liquidity — the LCR (30-day acute stress) and NSFR (1-year structural funding), each required to be ≥ 100%
Financing gap and financing requirement
- +1Formula. Financing gap = average loans − average core deposits; financing requirement = financing gap + liquid assets. Core deposits are netted first because most demand deposits stay for years and act as stable funding.
- +1(a) Financing gap. Gap = 96 − 70 = $26m — the part of the loan book not covered by stable core deposits.
- +1(b) Financing requirement. Requirement = gap + liquid assets = 26 + 12 = $38m — the total money-market borrowing the bank must rely on.
- +1(c) Why they differ. The gap is loans − deposits; the requirement adds liquid assets on top because those assets must themselves be funded. Reporting one as the other is the classic lost mark.
- +1(d) A widening gap. signals rising liquidity strain — deposits leaving and/or loans growing — so the bank must borrow more in wholesale markets.
- +1The danger. as borrowing climbs, sophisticated lenders may charge higher risk premia or cut credit limits; if the requirement exceeds those limits the bank can be pushed toward insolvency. A negative gap (deposits > loans) would be comfortable.
Key terms
- Liquidity risk
- The risk that a bank cannot meet cash demands — deposit withdrawals and committed loan drawdowns — as they fall due without selling illiquid assets at a loss. It is inherent in asset transformation, where illiquid long-term loans are funded by liquid, callable short-term deposits.
- Net deposit drain
- Deposit withdrawals minus new deposit inflows over a period. Because only a small fraction of deposits is withdrawn on any day and most demand deposits behave as stable core deposits, the net drain is normally small and predictable; the danger is the tail event when that predictability breaks down.
- Purchased liquidity management
- Meeting a cash outflow by borrowing — interbank funds, repos or wholesale CDs. It is a liability-for-liability swap, so the balance sheet stays the same size and the asset side is insulated, but it pays higher wholesale rates and can dry up in a crisis.
- Stored liquidity management
- Meeting a cash outflow by running down cash or selling liquid assets. It does not rely on market funding, but the balance sheet shrinks by the drain and the bank forgoes the yield it could earn on higher-return assets. Banks typically combine stored and purchased liquidity.
- Liquidity index
- A measure of forced-sale loss: I = Σ wᵢ (Pᵢ / Pᵢ*), where wᵢ is the fair-value weight of asset i, Pᵢ its fire-sale price and Pᵢ* its fair value. Each ratio is fire-sale over fair, so 0 < I ≤ 1; a higher index means a smaller haircut and a more liquid portfolio.
- Financing gap and financing requirement
- The financing gap = average loans − average core deposits measures the loan book not covered by stable deposits. The financing requirement = financing gap + liquid assets is the total money-market borrowing needed, because liquid assets must themselves be funded.
- Bank run
- A sudden, unexpected surge in deposit withdrawals. Because demand deposits are paid first-come, first-served, each withdrawal raises the incentive for the next depositor to run, so the queue is self-reinforcing and can force an otherwise-solvent bank into insolvency. A systemic, contagious run is a bank panic.
- LCR and NSFR
- The two Basel III liquidity ratios. The Liquidity Coverage Ratio = high-quality liquid assets / net cash outflows over 30 days measures survival of a 30-day acute stress. The Net Stable Funding Ratio = available stable funding / required stable funding checks that long assets are funded with stable money over one year. Both must be ≥ 100%.
Liquidity Risk FAQ
What is liquidity risk in BANK3011?
It is the risk that a bank cannot meet its cash obligations — depositor withdrawals and committed loan drawdowns — as they fall due, without dumping illiquid assets at a loss. It is inherent in asset transformation: banks fund long-dated, illiquid loans with short-dated, callable deposits, so a timing mismatch is built into the business model. Left unmanaged, a liquidity problem can turn into a solvency problem when forced fire-sales crystallise real losses.
What is the difference between purchased and stored liquidity management?
Purchased liquidity means borrowing to replace lost deposits — interbank funds, repos or wholesale CDs. It is a liability swap, so the balance sheet stays the same size and the asset side is insulated, but it costs more and can vanish in a crisis. Stored liquidity means running down cash or selling liquid assets; it needs no market access, but the balance sheet shrinks and the bank gives up yield. The tested distinction is whether the balance sheet shrinks: purchased keeps it constant, stored shrinks it.
How do I compute the liquidity index, and which way means more liquid?
Use I = Σ wᵢ (Pᵢ / Pᵢ*): weight each asset by its fair value, multiply by its fire-sale-price-over-fair-value ratio, and sum. Every ratio is fire-sale divided by fair, so it is at most 1 and the index sits in [0, 1]. A higher index means a smaller forced-sale discount, so it is more liquid; a lower index means a deeper haircut and less liquidity. Two common slips are inverting the ratio (fair over fire-sale, which gives a nonsense number above 1) and weighting by fire-sale instead of fair value.
What is the difference between the financing gap and the financing requirement?
The financing gap = average loans − average core deposits measures the part of the loan book not covered by stable deposits. The financing requirement = financing gap + liquid assets adds the liquid-asset buffer, because those assets must themselves be funded, giving the total money-market borrowing the bank leans on. Do not report the gap as the requirement; a widening gap over time warns of future borrowing pressure and costlier wholesale funding.
What is the difference between the LCR and the NSFR?
Both are Basel III minimum liquidity ratios that must be at least 100%, but they test different horizons. The LCR = high-quality liquid assets / net cash outflows over 30 days checks survival of a short, sharp 30-day stress. The NSFR = available stable funding / required stable funding checks, over a full year, that long-term assets are funded with stable money. The favourite exam trap swaps the two — remember LCR is 30-day with HQLA on top, NSFR is 1-year with stable funding on top.
Can AI help me with liquidity risk?
Yes — ask Sia to walk through any liquidity risk problem or concept step by step, the way University of Sydney tests it. Sia is an AI tutor that explains each move — computing a liquidity index, separating the financing gap from the requirement, netting inflows before an LCR, or reasoning through why a bank run is self-reinforcing — so you learn how to reach the answer yourself rather than just seeing a number.
Studying with AI? Sia — free AI financial modeling tutor works through BANK3011 step by step.
Exam move
Treat liquidity risk as three linked skills the exam tests together. First, the classification skill: for any cash-demand scenario, name the side (liability-side net deposit drain or asset-side commitment drawdown) and then the management approach — purchased liquidity keeps the balance sheet the same size, stored liquidity shrinks it. Drill the before-and-after balance-sheet panels until you can state which method leaves total assets unchanged. Second, the numerical skill: practise the three signature calculations — the liquidity index I = Σ wᵢ (Pᵢ / Pᵢ*) weighted by fair value, the financing gap and requirement (loans − deposits, then add liquid assets), and an LCR or NSFR ratio, always netting 30-day inflows against outflows first. Third, the conceptual skill: be ready to explain in a sentence why a bank run is self-reinforcing (first-come, first-served) and how deposit insurance and the LCR/NSFR buffers break the loop. LCR and NSFR are printed on the provided formula sheet, so those marks are for correct application, not recall. Work one full financing-gap question and one liquidity-index question end to end, then ask Sia to check your working step by step before the end-of-semester exam.
