Liquidity Management
• Outline
– Estimating liquidity needs
Sources and uses of funds method
Structure-of-deposits method
Funding and market liquidity needs
– Asset liquidity
Primary reserves
Managing the money position
Secondary reserves
– Liability management
– Funds management of liquidity
Liquidity ratios
Optimum bank liquidity
Regulatory view of bank liquidity
Estimating liquidity needs
• Sources and Uses of Funds Method:
– Calculate future changes over time in loans and deposits from past
experience and future expectations.
– Example of estimation:
Month
Estimated
Loans
Estimated
Change
Deposits Loans
Estimated
Change Liquidity
Deposits Needs
Dec
1000
1200
-----
-----
-----
Jan
1200
1000
200
(200)
400
Feb
1600
1200
400
200
200
March
1500
1600
(100)
400
(500)
Estimating liquidity needs
• Structure-of-Deposits Method:
– Example of estimation:
Amount Held
(in millions)
Probability of
Withdrawal in Expected
Next 3 Months Withdrawals
Short-term (unstable):
Demand deposits
Other transactions accounts
$2
$10
.90
.60
$ 1.8
$ 6.0
Medium-term:
Small time and
savings deposits
$50
.30
$15.0
$10
.20
$ 2.0
$24.8
Long-term (stable):
Large time deposits
Expected deposit withdrawals
Estimating liquidity needs
• Funding and market liquidity needs
– Funding-liquidity risk refers to maintaining sufficient cash to meet
investment needs.
– Market-liquidity risk is related to market disruptions that can
temporarily widen bid-ask spreads and make it difficult to close
out open positions in derivatives, securities, etc. without sustaining
losses.
• General definition of liquidity: Amount of liquidity
needed relative to ability to meet liquidity demands.
Asset liquidity
• Role of asset liquidity
– Liquid assets are an alternative source of funds.
– A reserve to protect the bank from financial market loss of
confidence that could threaten safety and soundness.
Primary reserves -- vault cash and cash held on deposit at the Federal
Reserve district bank.
Secondary reserves -- money market instruments held by the bank under
no formal regulatory requirements.
Asset liquidity
• Primary reserves
– Lagged reserve requirements (see next page)
Calculate daily average balances of transactions deposits during a 14day period (computation period).
Calculate average daily vault cash in the next 14-day period. Skip 3
days.
Maintain reserve balances at the Federal Reserve during a subsequent
14-day period (maintenance period). Thus, 17 days between end of
computation period and beginning of maintenance period.
LRR lowers management costs and improves the quality of information
on required balances.
Asset liquidity
• Managing the money position (minimize cash holdings which
generally means to meet reserve requirements).
CALCULATING RESERVE REQUIREMENTS FOR COMMERCIAL BANKS
Type of Deposit
and Deposit Interval
Net transactions accounts
a
$0 - $45.6 million
Over $46.5 million
Nonpersonal time deposits
Eurocurrency liabilities
Total reserves required
Less vault cash
Federal Reserve District Bank
a
Average Dollar
Amount (in
millions) in
Computation Period
$46.5
20.2
25.0
5.0
Average Dollar
Percentage
Reserves Required
Reserve
(in millions) in
Requirementa Maintenance Period
3%
10%
0%
0%
$1.248
2.020
0
0
$3.268
(0.418)
$2.850
a
The first $4.9 million of transactions accounts are exempt from reserve
requirements. This cutoff and the 3% reserve requirement cutoff are amended by
the Federal Reserve System from time to time. For an update, see
http://www.frbchi.org/banker/regulatory_update/
Asset management
• Secondary reserves
– T-bills, Federal agency securities, repurchase agreements (RPs or
Repos), bankers’ acceptances, negotiable certificates of deposit
(CDs), federal funds, and commercial paper.
– Aggressive liquidity approach
Yield curve relationships can be used to buy longer-term or short-term
securities (e.g., 30-day 2-year securities).
– Securitization of loans (asset-backed financing)
Loans are converted to securities with greater liquidity.
Credit risk is reduced.
Liability management
• Purchase the funds needed to meet loan demands and
deposit withdrawals.
– Correspondent balances of smaller banks with larger banks.
– Risks
Interest rate increases reduce interest rate margins.
Capital losses on securities and other assets can occur as interest rates
increase.
Loss of public confidence would prevent the bank from rolling over
purchased funds.
Increased borrowing causes financial risk to increase (i.e., variability of
earnings per share).
Capital market risk can occur when interest rates are low and investors
shift funds from deposits to higher earning capital assets in the
financial marketplace.
Funds management of liquidity
• Compare the total liquidity needs to total liquidity sources.
– Liquidity ratios
Loans/deposits
Loans/nondeposit liabilities
U.S. government securities/nondeposit liabilities
U.S. government securities/large denomination time deposits
Liquid assets and liabilities in period t/estimated liquidity needs in period t
(i.e., liquidity relative to needs)
– Optimum bank liquidity
Balance risks and returns … high enough liquidity to meet unexpected
needs but not so high to incur high opportunity costs of near-cash assets.
Uncertainty in forecasted needs and sources affects optimum also.
Funds management of liquidity
• Regulatory view of bank liquidity
– Adequacy of bank liquidity (not least cost or optimum liquidity
strategy).
The availability of assets readily convertible into cash
The structure and volatility of deposits
The reliance on interest-sensitive funds
The ability to sustain any level of borrowings over the business cycle
The bank’s formal and informal commitments for future lending
The ability to adjust rates on loans when rates on interest-sensitive
sources of funds fluctuate
The examiner-analyst