Managing liabilities as a means of managing liquidity risk involves the trade-off between lower funding cost and higher risk of withdrawals.

Question

BlackTom AI · Accepted Answer

Statement being evaluated: 'Managing liabilities as a means of managing liquidity risk involves the trade-off between lower funding cost and higher risk of withdrawals.'

Option 1: True. The core idea is that using liabilities (such as deposits or wholesale funding) to influence liquidity can reduce funding costs by exploiting longer or cheaper funding profiles, while simultaneously introducing or increasing withdrawal risk if depositors anticipate or experience uncertainty about the bank’s ability to meet obligations. In liquidity management, elongating liability maturities or relying more on stable insured deposits can lower immediate funding costs, but it may expose the institution to higher rollover risk or increased sensitivity to outflows if customers react to perceived funding fragility. This aligns with typical liquidity risk management trade-offs where cost efficiency can come at the expense of resilience to sudden withdrawals.

Option 2: False. If we interpret the statement as claiming there is no trade-off between funding cost and withdrawal risk when using liabilities for liquidity management, it would ignore fundamental liquidity risk dynamics. In practice, optimizing liability structure often involves balancing cheaper but potentially more fragile funding against more robust but costlier funding sources. Saying there is no trade-off overlooks scenarios like sudden depositor withdrawals, market stress, or confidence shocks that can elevate withdrawal risk even when funding costs appear favorable. Therefore, this option would be incorrect if the assertion is that no trade-off exists.

Note on conceptual nuances: The claim emphasizes a trade-off between lower funding cost and higher withdrawal risk, which is a common theme in liquidity risk literature. The correctness hinges on recognizing that liability-driven strategies can reduce costs but may increase susceptibility to outflows, especially under stress or reputation impacts. The alternative perspective would ignore important behavioral and market factors that drive liquidity dynamics, making it less plausible in real-world settings.

FINS5530-Financial Institution Mgmt - T3 2025

Managing liabilities as a means of managing liquidity risk involves the trade-off between lower funding cost and higher risk of withdrawals.

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