LO 54.2: Summarize the asset-liability management process at a fractional reserve

LO 54.2: Summarize the asset-liability management process at a fractional reserve bank, including the process of liquidity transformation.
Commercial bank assets are typically longer-term and less liquid than bank liabilities (e.g., deposits). Wholesale funding (i.e., non-deposit sources of funding like commercial paper, bonds, and so on) is generally longer term but deposits are sticky. Depositors generally change banks only if impelled to by a move or some other extenuating circumstance. Deposits make up approximately 60% of bank liabilities in the United States.
Banks only expect a fraction of deposits and other liabilities to be redeemed at any point in time. As a result, they do not hold all the deposits in liquid assets, but make loans with deposits instead. For example, a bank might take in $100 of deposits, hold$10 for redemptions, and lend the remaining \$90. This is known as a fractional-reserve bank and the process of using deposits to finance loans is known as asset-liability management (ALM).
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
The bulk of banks in history have been fractional-reserve banks. The alternative to a fractional-reserve system is one in which the bank uses owners money (i.e., equity) or money raised in capital markets to make loans, and keeps in reserve cash or highly liquid assets equal to its deposits.
If withdrawals are greater than the banks reserves, the bank is forced into a suspension of convertibility. This means the bank will not be able to, as expected by depositors, convert deposits immediately into cash. In the extreme, there may even be a run on the bank. In the case of a bank run, depositors who are concerned about bank liquidity may attempt to get money out of the bank before other depositors and lenders. While rollover risk associated with other short-term financing is less extreme than bank runs, it does increase the fragility of banks. Higher capital reduces bank fragility.
Frozen commercial paper markets in the wake of the Lehman Brothers failure illustrated the fragility of bank funding. Commercial funding couldnt be placed and thus fell dramatically after the Lehman bankruptcy. It became nearly impossible to roll over longer term paper and very short-term paper rose to account for approximately 90% of the market. The Federal Reserve stepped in after the Lehman bankruptcy and created the Commercial Paper Funding Facility (CPFF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF).
S t r u c t u r e d C r e d i t P r o d u c t s a n d O f f – B a l a n c e S h e e t V e h i c l e s
Structured credit products, such as asset-based securities (ABSs) and mortgage-backed securities (MBSs), match investor funding needs with pooled assets. Because these products are maturity matched, they are not subject to funding liquidity issues. However, investor financing for structured credit products can create liquidity risk when investors rely on short-term financing. This type of financing was one of the main drivers of the recent subprime crisis and the increase in leverage in the financial system leading up to the crisis. Two types of short-term financing include: (1) securities leading (i.e., applying structured credit products as collateral to short-term loans), and (2) off-balance sheet vehicles.
Special-purpose vehicles (SPVs) serve as off-balance sheet vehicles by issuing secured debt in the form of asset-backed commercial paper (ABCP). ABCP conduits finance purchases of assets, such as securities and loans, with ABCP. They receive liquidity and credit support via credit guarantees. Structured investment vehicles (SIVs) differ slightly from ABCP conduits because they do not receive full liquidity and credit support.
Prior to the subprime crisis, both ABCP conduits and SIVs profited from the spread between funding costs and asset yields. The assets held by these vehicles typically had longer maturities than the ABCP that fund the assets. In addition to maturity transformation, these vehicles also provided liquidity transformation. This was accomplished by creating ABCP that was more liquid and had shorter terms than the assets held in the conduit and SIV. However, despite being off-balance sheet, which permitted firms to hold less capital, these vehicles did not entirely transfer risk. As a result, they still contributed to the leverage issues and fragility of the financial system during the recent subprime crisis.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
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