Why liquidity risks are relevant to banking and non-banking firms
On April 15, Fed Chair Janet Yellen made the opening remarks (via video conference) at the Federal Reserve Bank of Atlanta’s 19th Annual Financial Markets Conference, held on April 15–16, 2014, in Atlanta. In the last article of this series, we discussed aspects of her speech that referred to measures the Fed is considering in order to address liquidity and residual risks prevalent in financial markets that arise due to the maturity mismatch between short-term sources of funds and their (usually) longer-term deployment. In this concluding article, we’ll consider the impact of these measures on financial markets.
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Impact of the maturity mismatch on complex financial institutions
Banks such as Wells Fargo (WFC) and Bank of New York Mellon (BK) receive deposits from retail customers that can be withdrawn at short or no notice. But while banks may extend indefinite lines of credit and term loans to corporates, repayments can’t be made on demand and must be as per the contracted timeline. For example, the SPDR Barclays Capital High Yield Bond ETF (JNK) has an average maturity of 6.61 years. This implies that the corporate bonds included in JNK’s portfolio would reach their term after 6.61 years, on average. Another ETF, the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), has a weighted average maturity of 11.77 years. The top holdings in LQD include Verizon Communications 6.55% (VZ), with 0.73% of fund assets.
Maintaining adequate liquidity for banks becomes particularly important in times of market-wide liquidity stress when depositors seek withdrawals en masse. This usually happens during an economic downturn, when consumer confidence in the economy and financial institutions reaches a trough. At this time, the maturity mismatch may even be exacerbated by some borrowers being unable to make their scheduled payments due to the depressed economic scenario and may seek extensions from banks or may even default.
Liquidity risks for non-banking financial services firms
A bank run or other market-wide panic generally has a cascading effect throughout the economy. A general panic has people withdrawing not only deposits from banks, but this may also extend to a mass sell-off in market-traded securities like stocks, bonds, and ETFs. Mass withdrawals from open-ended ETFs would not only deplete their cash balances but might also force fund managers to sell securities at fire-sale prices in order to meet withdrawal requests. This would impact their returns and may induce even more withdrawals in the future.
So addressing liquidity risks and financial stability are important goals that Fed Chair Janet Yellen discussed.
To learn more about policies and releases that affect your ETF investments, check out Market Realist’s Fixed Income ETFs page.