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Chapter Eleven

Liquidity and Reserve Management:Strategies and Policies

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McGraw-Hill/IrwinBank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Liquidity

The Availability of Cash in the Amount andat the Time Needed at a Reasonable Cost

The size and volatility of cash requirementsaffect the liquidity position of the bank

Examples of transaction that affect the bankscash balance and liquidity position: Depositsand withdrawals; loan disbursements andloan payments

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Supplies of Liquid Funds

Incoming Customer Deposits

Revenues from the Sale of NondepositServices

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 LoanCustomers

Repayment of Nondeposit Borrowings

Operating Expenses and Taxes

Payment of Stockholder Dividends

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A Financial Firms Net Liquidity

Position

L = Supplies of Liquid Funds

- Demands for Liquidity

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Quick Quiz: Comprehensive ProblemSuppose 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 $108million;

c) Operating expenses demanding cash payment will probablyapproach $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 $43million;

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 isscheduled.

What is this banks projected net liquidity position for the comingweek?

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Essence of Liquidity Management

Rarely are the Demands for Liquidity Equalto the Supply of Liquidity at Any ParticularMoment. The Financial Firm MustContinually Deal with Either a LiquidityDeficit or Surplus

There is a Trade-Off Between Liquidity andProfitability. The More Resources Tied Up

in Readiness to Meet Demands for Liquidity,the Lower is the Financial Firms ExpectedProfitability.

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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 demanddeposits and money market borrowings) Subject toImmediate 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 andPublic Confidence in the System

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Strategies for Liquidity Managers1. Think about what is a liquid asset?2. Identify strategies for liquidity

management.

Asset Liquidity Management or AssetConversion Strategy

Borrowed Liquidity or LiabilityManagement Strategy

Balanced Liquidity Strategy

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Asset Liquidity Management

This Strategy Calls for StoringLiquidity in the Form of Liquid Assets(T-bills, fed funds loans, CDs, etc.)and Selling Them When Liquidity isNeeded

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Liquid Asset

Must Have a Ready Market So it Can BeConverted to Cash Quickly

Must Have a Reasonably Stable Price

Must Be Reversible So an Investor CanRecover Original Investment with LittleRisk

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Options for Storing Liquidity Treasury Bills

Fed Funds Sold toOther Banks

Purchasing Securitiesfor Resale (Repos)

Deposits withCorrespondent Banks

Municipal Bonds andNotes

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 MustBe Sold

Transaction Costs (Commissions) on AssetsThat 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 toPurchase or Borrow from the

Money Market To Cover All of ItsLiquidity 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

Borrow Only When There

is a Need for Funds Volume and Composition

of the InvestmentPortfolio Can RemainUnchanged

The Institution CanControl Interest Rates inOrder to Borrow Funds(raise offer rates whenneeds requisite amounts

of funds)

Highest Expected ReturnBut Carries the HighestRisk Due to Volatility ofInterest Rates and PossibleRapid Changes in CreditAvailability

Borrowing Cost is AlwaysUncertain-> UncertainEarnings

Borrowing Needs Can BeInterpreted as a Signal of

Financial Difficulties

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Balanced Liquidity Management

Strategy

The Combined Use of Liquid Asset

Holdings (Asset Management) andBorrowed Liquidity (LiabilityManagement) 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 orDeposit Customers

Their Priorities and Objectives for

Liquidity Management Should be Clear Liquidity Needs Must be Evaluated on aContinuing Basis

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Methods for Estimating LiquidityNeeds

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 aGiven Liquidity Planning Period

The Estimated Change in Loans andDeposits Must Be Calculated for the SamePlanning Period

The Liquidity Manager Must Estimate the

Banks Net Liquid Funds By Comparing theEstimated Change in Loans to the EstimatedChange in Deposits

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Structure of Funds Approach

A Banks Deposits and Other Sources ofFunds Divided Into Categories. ForExample:

Hot Money Liabilities (volatile liabilities) Vulnerable Funds

Stable Funds (core deposits or core liabilities)

Liquidity Manager Set Aside Liquid FundsAccording 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 CustomerRelationships

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Liquidity Indicator Approach

(Based on Experience and Industry Averages) Cash Position Indicator

Liquid Security Indicator

Net Federal Funds Position

Capacity Ratio

Pledged Securities Ratio

Hot Money Ratio

Deposit Brokerage Index

Core Deposit Ratio

Deposit Composition Ratio

Loan Commitment Ratio

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The Ultimate Standard: MarketSignals 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 RequiresDepository Institutions to Hold as a

Reserve Behind Their Deposits orOther Liabilities

Only 2 Kinds of Assets Can Be Usedfor This Purpose: 1) Cash in the Vault;2) Deposits Held in a Reserve AccountWith the Regional Fed.

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U.S. Legal Reserve Requirements

In 2007-2008, first $9.3 Million have 0 LegalReserves

3 Percent of End-of-the-Day Daily Average fora Two Week Period For Transaction AccountsUp To $43.9 Million ($43.9 million is known as

thereserve tranche

and changes every year) 10 Percent of End-of-the-Day Daily Averagefor a Two Week Period For TransactionAccounts For Amounts Over $43.9 Million

Transaction Accounts Include CheckingAccounts, NOW Accounts and Other Deposits

Used to Make Payments The $43.9 Million Amount is Adjusted Annually The Money Position Manager Oversees the

Institutions Legal Reserve Account

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Calculating Required Reserves

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Any deficit above 4% may be assessed an interest penalty equal to the Federal

Reserves 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 FedHas Declined in Recent Years Largely Due toSweep Accounts

A Contractual Account Between Bank andCustomer that Permits the Bank to MoveFunds Out of a Customers CheckingAccount Overnight in Order to Generate

Higher Returns for the Customer and LowerReserve Requirements for the Bank Retail Sweep Business Sweep

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Other Factors to Influence LegalReserves 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 temporaryborrowings

Sell new time deposits And borrow in the Eurocurrency market

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Factors in Choosing Among DifferentSources of Reserves

Immediacy of Banks Needs

Duration of Banks Needs

Banks 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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McGraw-Hill/IrwinB k M d Fi i l S i 7/ 2008 The McGraw-Hill Companies Inc All Rights Reserved

Quick Quiz

What are the principal differences among assetliquidity management, liability management,and balanced liquidity management?

What guidelines should management keep in

mind when it manages a financial firmsliquidity 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 depositoryinstitutions legal reserve account?

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