EXPERIENCING THE ULTIMATE LIQUIDITY CRISIS

Few events in the management of a financial firm are as scary as a "bank run" in which flocks of

customers either come in to withdraw their money or transfer large amounts of funds by wire to

other, presumably "safer" institutions. And it's not just depositors who may take their money and

run; borrowers too may switch to other lenders when they are scared their current lender may be

losing its creditworthiness. During the Great Depression of the 1930s thousands of failures occurred,

sometimes doing in not only those depository institutions that were in real trouble, but also sound

institutions which had the misfortune of being in the wrong place at the wrong time. The "run" is the

ultimate liquidity crisis for management and stockholders of a financial firm.

Bank runs recorded in history go all the way back to the Roman Empire. In modern times the failure

of Continental Illinois National Bank of Chicago in 1984 was one of the biggest, losing $10 billion

in deposits over a 60-day period. Ultimately the Federal Deposit Insurance Corporation (FDIC) put

together a rescue program that, for all intents and purposes, "nationalized" this huge money-center

bank. Continental's chief errors were allowing excessively rapid growth in its business loans, many

of which turned out to be bad, and growing so fast it had to rely on "hot money" (i.e., negotiable CDs

and nondeposit borrowings in the money market) rather than more stable deposits for its funding.

When money market investors heard that Continental was experiencing trouble in its loan portfolio

the "hot money" suddenly left and the bank was forced to borrow from government agencies in order

to survive.

A similar combination of events greeted the British bank Northern Rock PLC in 2007. Rumors the

bank was on the verge of serious trouble (in part stemming from its large mortgage loan portfolio) led

to depositors lining up atthe bank's branches, demanding their money, while others sought recovery

of their funds through the bank's website. Within hours losses approached $2 billion. As explained by

Milne and Wood , the Bank of England quickly stepped in as a "lender of last resort" and several

large banks expressed interest in a possible takeover.

In short, liquidity crises- especially lack of available funds, rising funding costs, and bad loans

that reduce cash flow-can be lethal in sinking even the largest of financial institutions. Liquidity

managers need to pay special attention to the changing cost and composition of their institution's

funding and also to what is happening to quality and composition in the asset portfolio.

1. What steps are needed to carryout the structure of funds approach to liquidity management? (5 marks)
2. What guidelines should management keep in mind when it manages a financial firm liquidity position? (5marks)