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Chapter Eleven
Liquidity and Reserve Management: Strategies and Policies

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 banks 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 Firms Net Liquidity Position

L =

Supplies of Liquid Funds - Demands for Liquidity

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Quick Quiz: Comprehensive Problem

Suppose 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 $108 million; c) Operating expenses demanding cash payment will probably approach $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 $43 million; 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 is scheduled. What is this McGraw-Hill/Irwin banks projected net liquidity position for the coming 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Management and Financial Services, 7/e week?

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 Firms 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 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 Disadvantages

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 McGraw-Hill/Irwin Bankof funds) Financial Services, 7/e Management and

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 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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 Banks 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 Banks 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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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 (Based on Experience and Industry Averages)

Cash Position Indicator
Liquid Security Indicator

Hot Money Ratio

Deposit Brokerage Index

Net Federal Funds Position

Capacity Ratio

Core Deposit 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 Institutions Legal Reserve Account
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Calculating Required Reserves

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 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 Customers 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) 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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Other Options

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Factors in Choosing Among Different Sources 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
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Regulations Applicable for Liquidity Sources

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Quick Quiz
What are the principal differences among asset liquidity management, liability management, and balanced liquidity management? What guidelines should management keep in mind when it manages a financial firms liquidity 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 depository institutions legal reserve account?
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