Liquidity Risk: A case of Wells Fargo Bank

The 2008 financial crisis marked the beginning of adverse financial strain for the banking industry. For banks such as wells Fargo, the year presented losses of millions of dollars that threatened stability. As Scannella (2016) asserts, the 2008 financial crisis put more emphasizes on the importance of liquidity risk to the functionality of the banking industry. Such risk can either be in the form of funding or market liquidity risk that determines the capability of financial institutions to meet and adhere to their needs financially. Nonetheless, although the financial crisis year negatively affected earnings and liquidity risk of most banks, wells Fargo managed to maintain a stable liquidity risk. However, the subsequent years after the crisis, such as 2016, the liquidity risk continued to decline. Despite mitigations, the liquidity risk was caused by imminent bank runs, existing of low-level co-funding (illiquidity funding) and lack of stable credit supply. 

The 2006 financial year was a successful year in terms of earnings per share income, and liquidity risk that was attributed to an increase in the number of securities available and an increase in access to loans and deposits. The average loans were up by 8%, and the deposits were up by 15 % influencing liquidity ratio stability of 1.06 (McDonald, 2006). With such, there is an indication that the bank was earning more cash than it was lending out, thus creating a balance. Moreover, the assets for the institution grew exponentially in comparison with the previous years hence the ability to convert the same into cash was high due to high net income to average assets. On the contrary, the 2007 financial year for Fargo marked inferior liquidity and overall performance levels for the company. In terms of liquidity, the previous years provided a high amount of money for lending which resulted in high borrowing and investments in areas that were not paying back the bank its interest on time or the right amount. Many debt categories were overvalued, leading to non-payment for credit risk. With many people accessing loans, primarily mortgage debts, many could not afford to pay back, leading to a lack of an unstable cash supply for the bank. For instance, with an average loan of $ 344,775 and average deposits ranging at$ 303, 091, the net interest margin dropped significantly due to the unbridged gap between income and the loans. 

Unlike many banks, 2008 was a profitable year for the bank with increased revenues and increased average loans. Indeed, the merger with Wachovia saw the bank earn additional customers that provided additional capital for the institution. Since the bank was and is still the leading lender in the United States, many depositors that were unsure of their banks withdrew their monies from their banks and deposited in wells Fargo for security purposes. Such increased current assets to $ 998B while current liabilities stood at 940B, leading to a liquidity rate increase from 1.00-1.06. The new depositors provided stable earnings and credit supply at the time when many institutions were experiencing adverse financial losses due to bank runs. However, in 2016, there was a decline in liquidity risk due to low growth-rate of the economy and low rates of interest. The average short-run loans and long-run deposits were high. Although the Bank average loans grew by 16%, core deposits only grew by 7% which indicated a possibility in illiquidity funding since over $ 16billion were tied in housing loss the flow of cash and ability to convert the same into cash decreased. 

During the 2008 financial crisis, the monetary policy played a role in bringing back the balance to financial markets through interest rates cut, targeted assets purchasing and forward guidance on interest rates to solve the illiquidity funding. In 2007, the Federal Reserve decided to cut down on interest rates that are payed by banks for overnight loans so as to increase the money supply available (Yglesias, 2014). The move makes even lending institutions to lower their interest rates to help netizens to afford to fund for innovations and investments. For instance, as outlined the 2016 financial year for Wells Fargo saw an increase in revenue despite low-interest rates set by the Federal Reserve. Also, quantitative easing allowed the reserve to purchase assets and ease on the long-term interest rates and mortgage markets. For instance, in the year 2012-2014, the reserve spent over $40 billion asset purchases. This made the supply for cash to be more convenient for banks such as wells Fargo that needed the injection to support its lending capabilities. For forward guidance, the Fed used the policy to direct the behaviour of institutions to make informed decisions on lending and investments. After the crisis, the Federal Open Market Committee (FOMC) reduced rates and later on applied guidance forward to provide information on future monetary policy changes while depending on the 2% inflation rate (The Federal Reserve, 2020). 

References 

Scannella, E. (2016). Theory and regulation of liquidity risk management in banking. International Journal of Risk Assessment and Management , 19 (1-2), 4-21. 

The Federal Reserve. (2020). Retrieved from https://www.federalreserve.gov/faqs/what-is-forward-guidance-how-is-it-used-in-the-federal-reserve-monetary-policy.htm 

Yglesias, M. (2014, June 21). The Fed and the 2008 financial crisis. Retrieved from https://www.vox.com/2014/6/20/18079946/fed-vs-crisis 

McDonald, J. L. (2006). Guide to financial statement analysis: basis for management advice. 

Kondor, P., & Vayanos, D. (2019). Liquidity risk and the dynamics of arbitrage capital. The Journal of Finance , 74 (3), 1139-1173.