Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Liquidity and Reserve
Management Strategies and
Policies
Chapter
12
The purpose of this chapter is to explore the reason’s why banks
often face heavy demands for immediately spendable funds
(liquidity) and learn about the methods banks can use to prepare
for meeting their cash needs.
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Liquidity
The Availability of Cash in the Amount and
at the Time Needed at a Reasonable Cost
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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 Bank 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 Bank’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
Bank Must Continually Deal with Either a Liquidity
Deficit or Surplus
 There is a Trade-Off Between Bank Liquidity and
Profitability. The More Bank Resources are Tied Up in
Readiness to Meet Demands for Liquidity, the Lower is
the Bank’s Expected Profitability.
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Why Banks Face Significant Liquidity
Problems
 Imbalances
Between Maturity Dates of Their Assets
and Liabilities
 High Proportion of Liabilities Subject to Immediate
Repayment
 Sensitivity of Bank to Changes in Interest Rates
 Central Role in the Payment Process
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Strategies for Liquidity Managers
 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 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Options for Storing Liquidity
 Treasury
Bills
 Fed Funds Sold to Other
Banks
 Purchasing Securities for
Resale (Repos)
 Deposits with
Correspondent Banks
 Municipal
Bonds and
Notes
 Federal Agency
Securities
 Bankers’ Acceptances
 Commercial Paper
 Eurocurrency Loans
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Costs of Asset Liquidity Management
 Loss
of Future Earnings on Assets That Must Be Sold
 Transaction Costs 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Borrowed Liquidity 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
 Borrowing Reserves from the Discount Window of the
Federal Reserve
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Balanced Liquidity Management
Strategy
The Combined Use of Liquid Asset
Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet a Bank’s Liquidity
Needs
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Guidelines for Liquidity Managers
 They
Should Keep Track of All Fund-Using and FundRaising 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 a Bank’s 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
 A Bank’s
Deposits and Other Sources of Funds
Divided Into Categories. For Example:
 ‘Hot
Money’ Liabilities
 Vulnerable Funds
 Stable Funds
 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
 Cash
Position Indicator
 Liquid Security Indicator
 Net Federal Funds Position
 Capacity Ratio
 Pledging Securities Ratio
 Hot Money Ratio
 Short-Term Investments to Sensitive Liabilities Ratio
 Deposit Brokerage Index
 Core Deposit Ratio
 Deposit Composition Ratio
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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
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U.S. Legal Reserve Requirements
3
Percent of End-of-the-Day Daily Average for a Two
Week Period For Transaction Accounts Up To $44.3
Million
 10 Percent of End-of-the-Day Daily Average for a Two
Week Period For Transaction Accounts For Amounts
Over $44.3 Million
 Transaction Accounts Include Checking Accounts,
NOW Accounts and Other Deposits Used to Make
Payments
 The $44.3 Million Amount is Adjusted Annually
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Sweep Account
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
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Reserve Computation Period
The Period of Time Over Which a bank
Calculates its Legal Reserve Requirement
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Reserve Maintenance Period
The Period of Time Over Which a Bank
Must Hold the Required Amount of Legal
Reserves that the Law Demands
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Factors to Consider When 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 and Shape of the Yield Curve
 Monetary Policy Outlook and Government Borrowing
 Hedging Capability
 Regulations Applicable for Liquidity Sources
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.