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BUFN 722 ch-18 Liability & Liquidity Management Overview

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BUFN 722

ch-18

Liability & Liquidity Management

BUFN722- Financial Institutions


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Overview

  • Depository institutions and life insurance companies are highly exposed to liquidity risk. This chapter discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.

BUFN722- Financial Institutions


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Liquid Asset Management

  • Examples: T-bills, T-notes, T-bonds

  • Benefits of holding large quantities of liquid assets

  • Costs of holding liquid assets

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Liquid Asset Management

  • Reasons for regulating minimum holdings of liquid assets:

    • Monetary policy

    • Taxation

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Composition

  • Composition of liquid asset portfolio

    • Liquid assets ratio

      • Cash and government securities in countries such as U.K.

      • Similar case for U.S. life insurance companies (regulated at state level)

      • U.S. banks: cash-based, but banks view government securities as buffer reserves.

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Return-Risk Trade-off

  • Cash immediacy versus reduced return

  • Constrained optimization

    • Privately optimal reserve holdings

    • Regulator imposed reserve holdings

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U.S. Cash Reserve Requirements

  • Incremental reserve requirements for transaction accounts:

    • First $5.5 million 0.0%

    • $5.5 million to $42.8 million 3.0%

    • $42.8 million + 10.0%

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Reserve Management Problem

  • Computation period runs from a Tuesday to a Monday, 14 days later. Average daily reserves are computed as a fraction of the average daily deposits over the period. This means that Friday deposit figures count 3 times in the average.

  • “Weekend Game”

  • Sweep accounts

BUFN722- Financial Institutions


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Reserve Management

  • The reserve maintenance period, differs from the computation period by 17 days.

    • Lagged reserve accounting as of July 1998.

    • Previously, contemporaneous (2-day lag).

      • Benefits of lagged reserve accounting

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Undershooting/Overshooting

  • Allowance for up to a 4% error in average daily reserves without penalty.

    • Surplus reserves required for next 2-week period

  • Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall.

  • Frequent undershooting likely to attract scrutiny by regulators

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Undershooting

  • DI has two options near the end of the maintenance period

    • Liquidate assets

    • Borrow reserves

      • fed funds

      • repurchase agreements

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Discount Window

  • Reserve shortfalls in the past

    • Discount window borrowing

      • discount rate usually lower than market rates

    • Risks of gaming the system

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Overshooting

  • First 4 percent can be carried forward to next period

  • Excess reserves typically low due to opportunity costs

  • Knife-Edge problem

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Funding Risk versus Cost

Funding Cost

Funding Risk

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Liability Management

  • Note the tradeoff between funding risk and funding cost.

    • Demand deposits are a source of cheap funds but there is high risk of withdrawal.

    • NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.

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Deposit Accounts

  • Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month.

  • Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.

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Time Deposits and CDs

  • Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable.

  • Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.

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Fed Funds

  • Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day.

  • Fed funds rate can be highly variable

    • Prior to July 1998: especially around the second Tuesday and Wednesday of each period. (as high as 30% and lows close to 0% on some Wednesdays).

  • Rollover risk

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Repurchase Agreements

  • RPs are collateralized fed funds transactions.

  • Usually backed by government securities.

  • Can be more difficult to arrange than simple fed funds loans.

  • Generally below fed funds rate

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Other Borrowings

  • Bankers acceptances

  • Commercial paper

  • Medium-term notes

  • Discount window loans

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Historical Notes

  • Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid.

  • Securitization of DI loans

  • In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.

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Historical Notes

  • During the period since 1960:

    • Noticeable differences between large and small banks with respect to use of low withdrawal risk funds.

    • Reliance on borrowed funds does have its own risks as with Continental Illinois.

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Liquidity Risk in Other FIs

  • Insurance companies

    • Diversify across contracts

    • Hold marketable assets

  • Securities firms

    • Example: Drexel Burnham Lambert

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Pertinent Website

For information on reserve requirements, visit

Federal Reserve www.federalreserve.gov

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