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BUFN 722

BUFN 722 ch-18 Liability & Liquidity Management Overview

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BUFN 722

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  1. BUFN 722 ch-18 Liability & Liquidity Management BUFN722- Financial Institutions

  2. 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

  3. Liquid Asset Management • Examples: T-bills, T-notes, T-bonds • Benefits of holding large quantities of liquid assets • Costs of holding liquid assets BUFN722- Financial Institutions

  4. Liquid Asset Management • Reasons for regulating minimum holdings of liquid assets: • Monetary policy • Taxation BUFN722- Financial Institutions

  5. 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. BUFN722- Financial Institutions

  6. Return-Risk Trade-off • Cash immediacy versus reduced return • Constrained optimization • Privately optimal reserve holdings • Regulator imposed reserve holdings BUFN722- Financial Institutions

  7. 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% BUFN722- Financial Institutions

  8. 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

  9. 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 BUFN722- Financial Institutions

  10. 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 BUFN722- Financial Institutions

  11. Undershooting • DI has two options near the end of the maintenance period • Liquidate assets • Borrow reserves • fed funds • repurchase agreements BUFN722- Financial Institutions

  12. Discount Window • Reserve shortfalls in the past • Discount window borrowing • discount rate usually lower than market rates • Risks of gaming the system BUFN722- Financial Institutions

  13. Overshooting • First 4 percent can be carried forward to next period • Excess reserves typically low due to opportunity costs • Knife-Edge problem BUFN722- Financial Institutions

  14. Funding Risk versus Cost Funding Cost Funding Risk BUFN722- Financial Institutions

  15. 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. BUFN722- Financial Institutions

  16. 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. BUFN722- Financial Institutions

  17. 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. BUFN722- Financial Institutions

  18. 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 BUFN722- Financial Institutions

  19. 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 BUFN722- Financial Institutions

  20. Other Borrowings • Bankers acceptances • Commercial paper • Medium-term notes • Discount window loans BUFN722- Financial Institutions

  21. 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. BUFN722- Financial Institutions

  22. 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. BUFN722- Financial Institutions

  23. Liquidity Risk in Other FIs • Insurance companies • Diversify across contracts • Hold marketable assets • Securities firms • Example: Drexel Burnham Lambert BUFN722- Financial Institutions

  24. Pertinent Website For information on reserve requirements, visit Federal Reserve www.federalreserve.gov BUFN722- Financial Institutions

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