Chapter Eleven
Liquidity and Reserves Management:
Strategies and Policies
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11-2
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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11-4
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 Funds
- 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
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week?
11-8
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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11-9
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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11-11
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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11-14
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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11-15
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
• 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
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Disadvantages
• 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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11-18
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 FundUsing 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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11-25
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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11-27
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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