Chapter Eleven
Liquidity and Reserves Management: Strategies
and Policies
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Liquidity
• The Availability of Cash in the Amount and at the
Time Needed at a Reasonable Cost
• The size and volatility of cash requirements affect the
liquidity position of the bank
▫ Examples of transaction that affect the bank’s cash
balance and liquidity position: Deposits and
withdrawals; loan disbursements and loan payments
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Supplies of Liquid Funds
• Incoming Customer Deposits
• Revenues from the Sale of Nondeposit Services
• Customer Loan Repayments
• Sales of Bank Assets
• Borrowings from the Money Market
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Demands for Liquidity
• Customer Deposit Withdrawals
• Credit Requests from Quality Loan Customers
• Repayment of Nondeposit Borrowings
• Operating Expenses and Taxes
• Payment of Stockholder Dividends
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A Financial Firm’s Net Liquidity Position
L = Supplies of Liquid Fund - Demands for Liquidity
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Quick Quiz: Comprehensive Problem
Suppose that a bank faces the following cash inflows and outflows during the
coming week:
a) deposit withdrawals are expected to total $33 million;
b) customer loan repayments are expected to amount to $108 million;
c) Operating expenses demanding cash payment will probably approach
$51 million;
d) Acceptable new loan requests should reach $294 million;
e) Sales of bank assets are projected to be $18 million;
f) New deposits should total $670 million;
g) Borrowings from the money market are expected to be about $43
million;
h) Nondeposit service fees should amount to $27 million;
i) Previous bank borrowings totaling $23 million are scheduled to be
repaid; and
j) A dividend payment to bank stockholders of $140 million is scheduled.
What is this bank’s projected net liquidity position for the coming week?
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Essence of Liquidity Management
• Rarely are the Demands for Liquidity Equal to the
Supply of Liquidity at Any Particular Moment. The
Financial Firm Must Continually Deal with Either a
Liquidity Deficit or Surplus
• There is a Trade-Off Between Liquidity and
Profitability. The More Resources Tied Up in
Readiness to Meet Demands for Liquidity, the Lower
is the Financial Firm’s Expected Profitability.
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Why Banks and Their Competitors Face
Significant Liquidity Problems
• Imbalances Between Maturity Dates of Their Assets and
Liabilities
• High Proportion of Liabilities (especially demand deposits and
money market borrowings) Subject to Immediate Repayment
• Sensitivity to Changes in Interest Rates
▫ May affect customer demand for deposits
▫ May affect customer demand for loans
• Central Role in the Payment Process, Reputation and Public
Confidence in the System
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Strategies for Liquidity Managers
1. Think about what is a liquid asset?
2. Identify strategies for liquidity management.
• Asset Liquidity Management or Asset Conversion
Strategy
• Borrowed Liquidity or Liability Management
Strategy
• Balanced Liquidity Strategy
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Asset Liquidity Management
This Strategy Calls for Storing Liquidity in the
Form of Liquid Assets (T-bills, fed funds
loans, CDs, etc.) and Selling Them When
Liquidity is Needed
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Liquid Asset
• Must Have a Ready Market So it Can Be
Converted to Cash Quickly
• Must Have a Reasonably Stable Price
• Must Be Reversible So an Investor Can
Recover Original Investment with Little Risk
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Options for Storing Liquidity
• Treasury Bills
• Fed Funds Sold to Other
Banks
• Purchasing Securities for
Resale (Repos)
• Deposits with
Correspondent Banks
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• Municipal Bonds and Notes
• Federal Agency Securities
• Negotiable Certificates of
Deposits
• Eurocurrency Loans
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Asset Liquidity Management is Not Costless and
Include Opportunity Cost:
• Loss of Future Earnings on Assets That Must Be Sold
• Transaction Costs (Commissions) on Assets That
Must Be Sold
• Potential Capital Losses If Interest Rates are Rising
• May Weaken Appearance of Balance Sheet
• Liquid Assets Generally Have Low Returns
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Borrowed Liquidity (Liability) Management
This Strategy Calls for the Bank to
Purchase or Borrow from the Money
Market To Cover All of Its Liquidity
Needs
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Sources of Borrowed Funds
• Federal Funds Purchased
• Selling Securities for Repurchase (Repos)
• Issuing Large CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home Loan Bank
• Borrowing Reserves from the Discount Window of
the Federal Reserve
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Borrowed Liquidity (Liability) Management
Strategy
Advantages
Disadvantages
• Borrow Only When There is
a Need for Funds
• Volume and Composition of
the Investment Portfolio
Can Remain Unchanged
• The Institution Can Control
Interest Rates in Order to
Borrow Funds (raise offer
rates when needs requisite
amounts of funds)
• Highest Expected Return But
Carries the Highest Risk Due to
Volatility of Interest Rates and
Possible Rapid Changes in
Credit Availability
• Borrowing Cost is Always
Uncertain-> Uncertain Earnings
• Borrowing Needs Can Be
Interpreted as a Signal of
Financial Difficulties
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Balanced Liquidity Management Strategy
The Combined Use of Liquid Asset
Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet Liquidity Needs
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Guidelines for Liquidity Managers
• They Should Keep Track of All Fund-Using
and Fund-Raising Departments
• They Should Know in Advance Withdrawals
by the Biggest Credit or Deposit Customers
• Their Priorities and Objectives for Liquidity
Management Should be Clear
• Liquidity Needs Must be Evaluated on a
Continuing Basis
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Methods for Estimating Liquidity Needs
• Sources and Uses of Funds Approach
• Structure of Funds Approach
• Liquidity Indicator Approach
• Signals from the Marketplace
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Sources and Uses of Funds
• Loans and Deposits Must Be Forecast for a Given
Liquidity Planning Period
• The Estimated Change in Loans and Deposits Must
Be Calculated for the Same Planning Period
• The Liquidity Manager Must Estimate the Bank’s Net
Liquid Funds By Comparing the Estimated Change in
Loans to the Estimated Change in Deposits
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Structure of Funds Approach
• A Bank’s Deposits and Other Sources of Funds
Divided Into Categories. For Example:
▫ ‘Hot Money’ Liabilities (volatile liabilities)
▫ Vulnerable Funds
▫ Stable Funds (core deposits or core liabilities)
• Liquidity Manager Set Aside Liquid Funds According
to Some Operating Rule
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Customer Relationship Doctrine
Management Should Strive to Meet All Good
Loans that Walk in the Door in Order to Build
Lasting Customer Relationships
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Liquidity Indicator Approach
(Based on Experience and Industry Averages)
• Cash Position Indicator
• Hot Money Ratio
• Liquid Security Indicator
• Deposit Brokerage Index
• Net Federal Funds Position
• Core Deposit Ratio
• Capacity Ratio
• Deposit Composition Ratio
• Pledged Securities Ratio
• Loan Commitment Ratio
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The Ultimate Standard: Market Signals of
Liquidity Management
• Public Confidence
• Stock Price Behavior
• Risk Premiums on CDs
• Loss Sales of Assets
• Meeting Commitments to Creditors
• Borrowings from the Central Bank
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Legal Reserves
• Assets That a Central Bank Requires
Depository Institutions to Hold as a Reserve
Behind Their Deposits or Other Liabilities
• Only 2 Kinds of Assets Can Be Used for This
Purpose: 1) Cash in the Vault; 2) Deposits
Held in a Reserve Account With the Regional
Fed.
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U.S. Legal Reserve Requirements
• In 2007-2008, first $9.3 Million have 0 Legal Reserves
• 3 Percent of End-of-the-Day Daily Average for a Two
Week Period For Transaction Accounts Up To $43.9
Million ($43.9 million is known as the reserve tranche
and changes every year)
• 10 Percent of End-of-the-Day Daily Average for a Two
Week Period For Transaction Accounts For Amounts
Over $43.9 Million
• Transaction Accounts Include Checking Accounts, NOW
Accounts and Other Deposits Used to Make Payments
• The $43.9 Million Amount is Adjusted Annually
• The Money Position Manager Oversees the Institution’s
Legal Reserve Account
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Calculating Required Reserves
Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserve’s discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
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Factors Influencing the Money Position
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Sweep Account
• Volume of Legal Reserves Held at the Fed Has
Declined in Recent Years Largely Due to Sweep
Accounts
• A Contractual Account Between Bank and
Customer that Permits the Bank to Move Funds
Out of a Customer’s Checking Account
Overnight in Order to Generate Higher Returns
for the Customer and Lower Reserve
Requirements for the Bank
▫ Retail Sweep
▫ Business Sweep
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Other Factors to Influence Legal Reserves
• Use of Fed Funds Market
▫ The cheapest source
▫ But very volatile
▫ Managers rely on the Fed funds target rate (the most volatile
on the settlement date)
• Other Options
▫ Sell liquid securities
▫ Draw upon excess correspondent balances
▫ Enter into repurchase agreements for temporary borrowings
▫ Sell new time deposits
▫ And borrow in the Eurocurrency market
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Factors in Choosing Among Different
Sources of Reserves
• Immediacy of Bank’s Needs
• Duration of Bank’s Needs
• Bank’s Access to Market for Liquid Funds
• Relative Costs and Risks of Alternatives
• Interest Rate Outlook
• Outlook for Central Bank Monetary Policy
• Regulations Applicable for Liquidity Sources
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Quick Quiz
• What are the principal differences among asset
liquidity management, liability management, and
balanced liquidity management?
• What guidelines should management keep in mind
when it manages a financial firm’s liquidity position?
• What is money position management?
• What is the principal goal of money position
management?
• What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account?
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