Liquidity risk and bank runs
A bank can own more than it owes and still fail, because the people it owes can ask for their money back faster than it can turn its assets into cash. That is liquidity risk. This lesson explains maturity transformation, why a run feeds on itself, and how regulators measure a bank's ability to survive 30 days of stress. A calculator runs an invented bank through a run, and the case of Silicon Valley Bank in March 2023 shows how quickly it can happen when most deposits are uninsured.
- Level
- Beginner
- Reading time
- About 26 minutes
- Know this first
- Interest-rate risk and duration
By the end you will be able to:
- tell liquidity risk from insolvency
- explain maturity transformation and why it makes banks open to runs
- compute a liquidity coverage ratio from high-quality liquid assets and run-off rates
- work out the loss a bank takes when it must sell assets quickly at a discount
- describe how SVB's deposits left in March 2023
Owning enough is not the same as having cash
The previous lesson showed a bank whose assets had lost value because yields rose. This lesson is about a different danger. Liquidity risk is the risk that a firm cannot pay what it owes when it falls due, even if its assets are worth more than its debts. Insolvency means liabilities exceed assets. Illiquidity means the cash is not there at the moment it is needed. A firm can be one without the other, and a bank in trouble is often both, because the first can cause the second.
The liquidity ratios in the earlier module test whether a company can pay its bills over the next year. For a bank the time scale is days, because most of what it owes can be demanded at any time.
Why banks are open to runs
A bank takes deposits that can be withdrawn on demand and lends the money for years or buys securities that mature in years. This is called maturity transformation, and it is what lets a bank pay interest to savers and lend to borrowers. The lesson on how banks work describes the balance sheet. It works as long as depositors do not all ask for their money at once.
The weakness is that a bank pays withdrawals in the order they arrive, and its loans cannot be turned into cash quickly. A depositor who thinks others will withdraw has a reason to withdraw first, whether or not the bank is sound. If enough depositors think this way, the bank is run on, and the fear can become the cause of the failure. Deposit insurance reduces the reason to run, since an insured depositor is paid anyway. Money above the insurance limit has no such protection, and the Basel rules described below assume that uninsured money leaves faster.
The 30-day test
After the financial crisis of 2007 to 2009 the Basel Committee on Banking Supervision set a standard that tests a bank’s liquidity directly. The liquidity coverage ratio divides the bank’s stock of high-quality liquid assets by its total net cash outflows over the next 30 calendar days of stress. The ratio should be no lower than 100%, so that the liquid assets at least equal the expected outflows. High-quality liquid assets are those that can be turned into cash quickly with little loss: Level 1 assets are limited to items such as coins and banknotes, central bank reserves and qualifying government securities, and a 15% haircut applies to the market value of Level 2A assets.
The outflows are not guesses about a particular day. They come from fixed run-off rates for each kind of funding, the share assumed to leave within the 30 days.
| Funding | Run-off rate over 30 days of stress |
|---|---|
| Stable retail deposits | 5% (3% where criteria are met) |
| Less stable retail deposits | At least 10% |
| Operational deposits, where the customer depends on the bank | 25% |
| Deposits of non-financial corporations | 40% (20% if fully covered by deposit insurance) |
| Funds from other financial institutions | 100% |
The ranking follows how likely each kind of depositor is to leave. A household with an insured deposit is assumed to stay; a financial institution is assumed to take everything out. The 40% for the deposits of non-financial corporations falls to 20% where they are fully covered by deposit insurance, which shows how much the rules value insurance as a brake on runs.
When assets must be sold in a hurry
If liquid assets run out, the bank must sell other assets, and a quick sale gets less than the book value. Suppose such assets fetch only 85 cents on the dollar. To raise $8.5 the bank must sell $10 of assets at book value, which is $8.5 ÷ 0.85, and it takes a loss of $1.5. The loss comes out of equity. The more it needs to raise, the more it must sell and the more it loses, so a shortage of cash turns into a shortage of capital. That is why liquidity problems and solvency problems feed each other: the lesson on interest-rate risk showed securities that had lost value on paper, and the loss on them becomes real if they must be sold to meet withdrawals.
Silicon Valley Bank, March 2023
The Office of Inspector General of the Federal Reserve reviewed SVB’s failure. At the end of 2022 over 94% of the bank’s deposits were uninsured. On 9 March 2023 they withdrew $42 billion, and requests worth another $100 billion were pending for the next day. On 10 March the California regulator took possession of the bank and the FDIC was appointed receiver.
| SVB, 2022 and March 2023 | Figure |
|---|---|
| Share of deposits uninsured, end of 2022 | Over 94% |
| Deposits just before the run | About $166 billion |
| Withdrawn on 9 March 2023 | $42 billion |
| Requests pending for 10 March 2023 | $100 billion |
| FDIC estimate of the loss to the Deposit Insurance Fund | About $20 billion in March 2023, revised to about $16.1 billion |
Set against deposits of about $166 billion, the $42 billion that left in a single day is 25.3%, and the $100 billion pending for the next day is another 60.2%. The Basel rules assume that 40% of the deposits of non-financial corporations leave over a whole 30-day stress. The requests pending for the single next day were larger than that, although the Basel rate applies to a category of deposits and SVB’s customers were not all non-financial corporations. A bank whose liquid assets are sized for a 30-day outflow would struggle to meet demand on that scale in a day or two. The earlier lesson showed that SVB’s held-to-maturity securities carried an unrealized loss of $15.2 billion against equity of $16.0 billion at the end of 2022, so selling them to raise cash would have turned that loss into a real one.
Run an invented bank
The calculator uses a bank with $100 of assets, $92 of deposits and $8 of equity. Set the share of the deposits that is uninsured, the liquid assets it holds, and the share of uninsured deposits that is withdrawn. Insured deposits are assumed to leave at 5%, the Basel rate for stable retail deposits. Liquid assets are paid out at face value, and every other asset can be sold quickly only at a 15% discount. The ratio shown applies the Basel rates, 5% to the insured and 40% to the uninsured deposits, which is a simplification.
A bank with $100 of assets, $92 of deposits of which 60% are uninsured, $8 of equity and $25.0 of liquid assets loses 30% of its uninsured deposits and 5% of its insured ones, a total of $18.4. Its liquid assets cover this with $6.6 to spare, and it sells nothing. The liquidity coverage ratio on the Basel run-off rates is 104.52%.
Five experiments. First, leave the settings alone: 60% of deposits uninsured, $25 of liquid assets and 30% of the uninsured deposits withdrawn. Withdrawals are $18.4, which the liquid assets cover with $6.6 to spare, and the coverage ratio is 104.52%, just above the 100% line. Second, raise the uninsured share to 94%, as at SVB. Withdrawals rise to $26.2, more than the liquid assets, so the bank sells $1.4 of other assets to raise the $1.2 it lacks, and loses $0.2. Equity is $7.8, and the coverage ratio falls to 71.70%. Third, raise the withdrawals to 50%. Withdrawals are $43.5, the shortfall $18.5, the bank sells $21.8 and loses $3.3, and equity falls to $4.7. Fourth, cut the liquid assets to $10 and raise the withdrawals to 60%. Withdrawals are $52.2 and the shortfall $42.2, so the bank loses $7.4 on forced sales and has $0.6 of equity left, with a coverage ratio of 28.68%. It survived the run on these numbers, but with almost nothing to spare. Fifth, go back to $25 of liquid assets, set the uninsured share to 30% and the withdrawals to 50%. Withdrawals are only $17.0, the liquid assets cover them with $8.0 to spare, and the coverage ratio is 175.32%. The same run does little harm to a bank whose depositors are mostly insured.
How to read the result
The coverage ratio and the run test answer the same question from two sides. The ratio says whether liquid assets cover a standard outflow. The run test says what happens beyond it. Three things drive the result: how much of the funding can leave quickly, how much of the asset side can be turned into cash without a loss, and how deep the discount is when the bank has to sell. Equity matters too, because it absorbs the loss on forced sales. Notice that a bank can pass the ratio and still be hurt by a faster run, as the second experiment shows with a ratio of 71.70% and a loss, and that holding more liquid assets costs the bank income, since cash earns less than loans. That trade-off is why liquidity is regulated rather than left to each bank. The tail measures of the first lesson in this module describe losses in market prices. A run is a different kind of tail event, in which the loss depends on how fast people leave.
What this lesson leaves out
- An invented bank. Its balance sheet, the 5% run-off of insured deposits and the 15% discount are assumptions. Real banks hold many kinds of assets and funding.
- A simplified ratio. The calculator treats liquid assets as Level 1 assets, insured deposits as stable retail deposits at 5% and uninsured deposits as non-financial corporate deposits at 40%. The real rule has more categories, inflows and caps.
- One round of withdrawals. A real run unfolds over hours or days, and the bank can borrow against its assets or from the central bank, which the calculator does not allow.
- One fire-sale discount. In practice the discount depends on the asset and on how many sellers there are at the same time.
- No behaviour. The calculator takes the share withdrawn as given. What makes depositors run is not modelled.
- SVB facts are limited to the review cited. The lesson uses only the figures in the Inspector General’s report and does not tell the whole story of the failure.
- No advice. The lesson explains a risk. It does not assess any bank now operating.
Common mistakes
Treating liquidity risk and insolvency as the same
A bank can have more assets than liabilities and still fail to pay on time. The reverse is also true for a short while.
Assuming all deposits behave alike
The Basel rates range from 5% to 100% because insured households and large corporate or financial depositors behave differently.
Counting every asset as cash
Only assets that can be sold quickly at little loss count. A forced sale of other assets costs the discount.
Reading a ratio of 100% as safe
It covers a standard 30 days. A faster run can exceed it.
Forgetting the link to capital
Losses on forced sales reduce equity, so liquidity problems can create solvency problems.
Try it yourself
1. A bank has $25 of liquid assets, $36.8 of insured deposits and $55.2 of uninsured deposits. Using 5% and 40% run-off rates, what is the coverage ratio?
Show the working
Outflows = 0.05 × 36.8 + 0.40 × 55.2 = 1.84 + 22.08 = 23.92. The ratio is 25 ÷ 23.92 = 104.52%.
2. In the same bank, 30% of uninsured deposits and 5% of insured deposits are withdrawn. What is the total, and do the liquid assets cover it?
Show the working
0.30 × 55.2 + 0.05 × 36.8 = 16.56 + 1.84 = $18.4. The liquid assets of $25 cover it with $6.6 to spare.
3. A bank needs $8.5 in cash and can sell assets at a 15% discount. How much must it sell at book value, and what does it lose?
Show the working
8.5 ÷ 0.85 = $10 of assets at book value. The loss is 10 × 0.15 = $1.5.
4. SVB had about $166 billion of deposits and customers withdrew $42 billion on 9 March 2023. What share is that?
Show the working
42 ÷ 166 = 25.3%.
5. Requests for another $100 billion were pending for 10 March. What share of the $166 billion is that, and how does it compare with the 40% Basel run-off rate for corporate deposits over 30 days?
Show the working
100 ÷ 166 = 60.2%, which is above 40%, and it was due in one day instead of 30. The Basel rate applies to a category of deposits, so the comparison is only a rough one.
Where this is used
- A bank’s treasury computes the liquidity coverage ratio daily and holds liquid assets against it.
- A supervisor looks at how much of a bank’s funding is uninsured and concentrated when judging its liquidity risk.
- A bank stress-tests how many assets it would have to sell, and at what loss, if a share of deposits left.
- A company treasurer keeps cash and credit lines to cover payments that cannot wait, as the liquidity ratios measure.
- A depositor with a balance above the insurance limit weighs the bank’s liquidity along with the interest it pays.
Key terms
- Liquidity risk
- The risk of being unable to pay obligations when they fall due.
- Maturity transformation
- Funding long-term assets with short-term liabilities.
- Bank run
- A rush of depositors to withdraw money because they expect others to do the same.
- Uninsured deposit
- A deposit above the limit covered by deposit insurance.
- High-quality liquid assets
- Assets that can be turned into cash quickly with little loss, such as cash and government securities.
- Liquidity coverage ratio
- High-quality liquid assets divided by net cash outflows over 30 days of stress.
- Run-off rate
- The share of a kind of funding assumed to leave during the stress period.
- Haircut
- A reduction applied to the market value of an asset when it is counted or pledged.
- Fire sale
- A sale made in a hurry at a price below fair value.
Questions people ask
Can a solvent bank fail?
Yes. If it cannot raise cash fast enough to pay withdrawals, it can fail even though its assets are worth more than its liabilities.
Why does deposit insurance matter for runs?
An insured depositor is paid either way, so has less reason to withdraw first. The Basel rules cut the run-off rate on fully insured corporate deposits from 40% to 20%.
Why not hold only cash?
Cash earns little. A bank that held only cash could not lend, and would not earn enough to pay interest on deposits.
Is a ratio above 100% a guarantee?
No. It covers a standard 30-day stress. A faster or larger run can exceed it.
Sources and review
- Office of Inspector General, Board of Governors of the Federal Reserve System and Consumer Financial Protection Bureau, Material Loss Review of Silicon Valley Bank (Evaluation Report 2023-SR-B-013, 25 September 2023), for the uninsured share of SVB’s deposits at the end of 2022, deposits of about $166 billion before the run, withdrawals of $42 billion on 9 March 2023, pending requests of $100 billion for the following day, the possession of SVB by the California regulator on 10 March 2023 and the FDIC’s loss estimates of about $20 billion and later $16.1 billion.
- Basel Committee on Banking Supervision, Basel Framework, LCR40: Cash inflows and outflows (version effective 15 December 2019), for the 30-day horizon and the run-off rates of 5% (or 3% where criteria are met) for stable retail deposits, at least 10% for less stable retail deposits, 25% for operational deposits, 40% for non-financial corporate deposits (20% where fully covered by deposit insurance) and 100% for funds from other financial institutions.
- Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools (January 2013), for the ratio of the stock of high-quality liquid assets to total net cash outflows over the next 30 calendar days, which should be no lower than 100% (paragraphs 17 and 22), the limitation of Level 1 assets to items such as coins and banknotes, central bank reserves and qualifying sovereign securities (paragraph 50), and the 15% haircut on Level 2A assets (paragraph 52).
How the numbers were checked: the run, the forced sale, the loss, the equity left and the coverage ratio were recomputed in plain code for the five experiments, and the calculator, which runs separately, was compared with that code for every combination of settings it allows. The SVB figures and the Basel rates are quoted from the cited documents, and the percentages of SVB’s deposits are calculated from them. The bank in the calculator, its run-off assumption for insured deposits and the 15% discount are invented.