Chapter Eleven
Liquidity and Reserve 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
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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 Subject to
Immediate Repayment
• Sensitivity 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
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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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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
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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
Securing Advance from the Federal Home Loan
Bank
• Borrowing Reserves from the Discount Window
of the Federal Reserve
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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
• 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
• Pledged Securities
Ratio
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• Hot Money Ratio
• Deposit Brokerage
Index
• Core Deposit Ratio
• Deposit Composition
Ratio
• Loan Commitment
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
• First $7.8 Million have 0 Legal Reserves
• 3 Percent of End-of-the-Day Daily Average for a
Two Week Period For Transaction Accounts Up
To $48.3 Million
• 10 Percent of End-of-the-Day Daily Average for
a Two Week Period For Transaction Accounts
For Amounts Over $48.3 Million
• Transaction Accounts Include Checking
Accounts, NOW Accounts and Other Deposits
Used to Make Payments
• The $48.3 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 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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