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    Chapter Eleven

    Liquidity and Reserve Management:Strategies and Policies

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    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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    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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