CHAPTER TENLiquidity And Reserve

Management: Strategies And Policies

The purpose of this chapter is to explore the reason’s why financial institutions often face heavy demands for immediately spendable funds (liquidity) and learn about the methods they can use to prepare for meeting their cash needs.

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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 SurplusThere is a Trade-Off Between Bank Liquidity and Profitability. The More Resources are 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 LiabilitiesHigh Proportion of Liabilities Subject to Immediate RepaymentSensitivity to Changes in Interest RatesCentral 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

Municipal Bonds and NotesFederal Agency SecuritiesBankers’ AcceptancesCommercial PaperEurocurrency Loans

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Costs of Asset Liquidity Management

Loss of Future Earnings on Assets That Must Be SoldTransaction Costs on Assets That Must Be SoldPotential Capital Losses If Interest Rates are RisingMay Weaken Appearance of Balance SheetLiquid 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

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 IndicatorLiquid Security IndicatorNet Federal Funds PositionCapacity RatioPledging Securities RatioHot Money RatioShort-Term Investments to Sensitive Liabilities RatioDeposit Brokerage IndexCore 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 $42.1 Million10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $42.1 MillionTransaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make PaymentsThe $42.1 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