Liquidity Mismatch Helps Predict Bank Failure and Distress

Liquidity mismatch compares the saleability (liquidity) of a bank’s assets to the stability of its funding. Assets such as cash and Treasury bonds are highly saleable and one can expect a ready market even in times of crisis. Residential mortgages are less liquid, but still saleable at a discount, while development and construction loans may prove unsaleable at any price when the market is under stress.

In terms of funding, long-term deposits offer stability but are far more expensive than short-term wholesale sources and call deposits. The latter, however, are highly unstable and were instrumental in the collapse of Northern Rock (UK) and Washington Mutual (US) during the global financial crisis (GFC).

The challenge facing bank regulators is to monitor liquidity mismatch to ensure bank health. The more illiquid and speculative the assets are, the more stable (illiquid) the bank’s funding sources must be to avoid a liquidity crisis during a market down-turn.

Liquidity mismatch =
(Liquidity-weighted liabilities – Liquidity-weighted assets) / Total assets

This paper by J.B. Cooke, Christoffer Koch and Anthony Murphy at the Dallas Fed (Liquidity Mismatch Helps Predict Bank Failure and Distress) suggests that large banks suffer from higher levels of liquidity mismatch and that liquidity mismatch is as important as capital ratios in determining bank health:

Precrisis Rise in Mismatch
Liquidity mismatch rose significantly between 2002 and 2007. The median level of mismatch climbed about 6 percentage points. Most of this rise was driven by changes in liquidity-weighted assets rather than liquidity-weighted liabilities. Banks pursued higher returns on riskier, less-liquid assets. To a lesser extent, banks relied less on stable core deposits and more on “unstable” wholesale funding. The rise in liquidity mismatch before the financial crisis is noteworthy because equity capital (as a percentage of assets)—the ultimate buffer against losses—changed little. The rise in mismatch was faster and more persistent at the largest banks, representing the top 25 percent of institutions (Chart 2). Among those banks, the median mismatch rose about 8.5 percentage points between 2002 and 2007, while at the 25 percent representing the smallest banks, the increase was only 3 percentage points.

Early-Warning Sign?
Bank regulators look for early-warning signs of distress. Is liquidity mismatch one? Comparing the fourth quarter 2007 mismatch levels of commercial banks that failed or became distressed in 2008 or 2009 with those that did not may provide an indication. The average levels of liquidity mismatch for the two groups were significantly different. Failed or distressed banks generally had much higher levels of liquidity mismatch, as shown by the final entry in the liquidity mismatch row of Table 1.

While the timing of the changes in liquidity mismatch (as seen in Chart 2) and the difference in levels of mismatch at any one time (as seen in Table 1) suggest that liquidity mismatch is important, they do not necessarily imply that a rise in liquidity mismatch helps predict future bank failure or distress. Higher levels of liquidity mismatch may be correlated with lower levels of equity capital and higher proportions of brokered deposits and construction and land development loans as well as with nonperforming assets or lower returns on assets—all well-known predictors of failure or distress.

Modeling Failure and Distress
Statistical models were used to disentangle the effects of changes in liquidity mismatch from the effects of changes in equity capital and the other predictors of bank failure and distress between 2006 and 2011.9 This period was chosen because it followed a time when there were very few failures or cases of distress, the early 2000s. Failure or distress up to two years ahead was considered. For example, fourth quarter 2007 data were used to predict failure or distress any time in 2008.10 The results suggest that recent failure and distress rates are explained or predicted by many of the same factors as in 1985–92, when large numbers of commercial banks and savings and loans failed. These factors include too little equity capital, a high ratio of nonperforming assets and a high share of construction and land development lending……

Liquidity Mismatch Matters
Liquidity mismatch rose significantly before the financial crisis, especially at large banks, our research shows. The rise in mismatch contributed to the rise in bank failures and cases of distress. Liquidity mismatch helps predict bank failure or distress one year ahead, even accounting for equity capital and the other indicators at which regulators look.

Cooke is an economic analyst, Koch is a research economist and Murphy is an economic policy advisor and senior economist in the Research Department of the Federal Reserve Bank of Dallas.

Hat tip to Barry Ritholz.