Bank Liquidity Management
Chapter Eleven
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 Funds
- Demands for Liquidity
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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
• 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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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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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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Functions of a Bank’s Security
Portfolio
•
•
•
•
•
•
•
•
•
Stabilize the Bank’s Income
Offset Credit Risk Exposure
Provide Geographic Diversification
Provide Backup Source of Liquidity
Reduce Tax Exposure
Serve as Collateral
Hedge Against Interest Rate Risk
Provide Flexibility
Dress Up a Bank’s Balance Sheet
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Federal Regulators Require Written
Investment Policy
• The Quality or Degree of Default Risk
Exposure the Institution is Willing to Accept
• The Desired Maturity Range and Degree of
Marketability Sought for All Securities
• The Goals Sought for its Investment
Portfolio
• The Degree of Portfolio Diversification the
Institution Wishes to Achieve with its
Investment Portfolio
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Investment Instruments Available to
Financial Firms
• Money Market Instruments
▫ Reach Maturity Within One Year
▫ Low Risk
▫ Ready Marketability
• Capital Market Instruments
▫ Maturity Beyond One Year
▫ Higher Expected Rate of Return
▫ Capital Gains Potential
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Money Market Instruments Used by a
Bank
•
•
•
•
•
•
•
•
Treasury Bills
Short-Term Treasury Notes and Bonds
Federal Agency Securities
Certificates of Deposit
Eurocurrency Deposits
Banker’s Acceptances
Commercial Paper
Short-Term Municipal Obligations
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Capital Market Instruments Used by
a Bank
• Treasury Notes and Bonds Over One
Year to Maturity
• Municipal Notes and Bonds
• Corporate Notes and Bonds
• Asset Backed Securities
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Other More Recent Investment
Instruments
• Structured Notes
▫ Basic Characteristics
▫ Benefits
▫ Recent Problems During Financial Crisis
• Securitized Assets
▫ Pass-through securities
▫ CMOs
▫ Mortgage-backed bonds (guarantees from government
agencies; higher average yields; lack of good-quality
assets; superior liquidity)
• Stripped Securities
▫ PO and IO securities
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Dominant Investments Held By Banks in
2007
• Obligations of the U.S. Government and
Government Agencies
▫ About 60% of Banks’ Investments Overall
▫ Smaller Banks Hold a Higher Ratio Compared to
Large Banks
• State and Local Government Obligations
• Nonmortgage-Related-Asset-Backed Securities
• Hold Relatively Few Private-Sector Securities
Overall, Investment Securities Account for Less
20% of Total Assets
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Factors Affecting the Choice of
Securities
• Expected Rate of
Return
• Tax Exposure
• Interest Rate Risk
• Credit Risk
• Business Risk
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• Liquidity Risk
• Call Risk
• Prepayment Risk
• Inflation Risk
• Pledging
Requirements
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Expected Rate of Return
n
CPt
FVn
PV
Yield
Maturity t 

Bond to
(1  YTM) n
t 1 (1  YTM)
where CP are the annual coupon payments on the security and
where FV is the face value of the security
Holding Period Return
HP
CPt
P
PV  

HP
(1

HPR)
(1

HPR)
t 1
where P is the price the security can be sold for and
where HP is the number of years the security is held
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Tax Exposure
• The Tax Status of State and Local
Government Bonds
• Bank Qualified Bonds
• Tax Swapping Tool
• The Portfolio Shifting Tool
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Interest Rate Risk
• Rising Interest Rates Lowers the Value of
Previously Issued Bonds
• Longest –Term Bonds Suffer the Greatest
Losses
• Many Interest Rate Risk Tools Including
Futures, Options, and Swaps Exist Today
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Default Risk
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Business Risk
• Risk that the Economy of the Market Area
they Serve May Turn Down
• Security Portfolio Can Offset This Risk
• Securities Can be Purchased From Outside
Market Area Served
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Liquidity Risk
• Breadth and Depth of Secondary Market
▫ Number of Traders on an Given Day
▫ Volume of Trades on Any Given Day
• Treasury Securities are Generally the Most
Liquid
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Call Risk
• Corporations and Some Governments
Reserve the Right to Retire the Securities in
Advance of Their Maturity
• Generally Called When Interest Rates a Have
Fallen
• Investor Must Find New Security – Often
with a Lower Return
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Prepayment Risk
• Specific to Asset-Backed Securities
• Most Consumer Mortgages and Loans Can
Be Paid Off Early
• Caused by Loan Refinancing Which
Accelerate When Interest Rates Fall
• Caused by Asset Turnover When Borrowers
Move or are Not Able to Meet Loan
Payments and Asset is Sold
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Inflation Risk
• Purchasing Power from a Security or Loan
May be Eroded by Rising Prices
• Recently Developed Inflation Risk Hedge –
Treasury Inflation Protected Securities
• Both Coupon Payments and Principal
Adjusted Annually for Inflation Based on
Consumer Price Index
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Pledging Requirements
• Depository Institutions Cannot Accept
Federal, State and Local Government
Deposits Unless Acceptable Collateral is
Pledged
• Generally Treasury Securities, Government
Agency Securities and Selected Municipal
Securities Can Be Used as Collateral
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Investment Maturity Strategies
•
•
•
•
•
The
The
The
The
The
Ladder or Spaced-Maturity Policy
Front-End Load Maturity Policy
Back-End Load Maturity Policy
Barbell Strategy
Rate Expectation Approach
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Maturity Management Tools
• The Yield Curve
▫ Picture of How Market Interest Rates Differ Across
Differing Maturities
▫ Constructed Most Easily with Treasury Securities
▫ Provides Information About Under and Over Priced
Securities
▫ Provides Information About the Risk Return TradeOff
• Duration
▫ Present Value Weighted Average Maturity of the
Cash Flows
▫ Can Be Used to Insulate the Securities From Interest
Rate Changes
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