Chapter ten liquidity and reserve management strategies and policies
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Chapter ten liquidity and reserve management strategies and policies

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.


The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost

Supplies of liquid funds
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

Demands for liquidity
Demands for Liquidity

  • Customer Deposit Withdrawals

  • Credit Requests from Quality Loan Customers

  • Repayment of Nondeposit Borrowings

  • Operating Expenses and Taxes

  • Payment of Stockholder Dividends

A financial firm s net liquidity position
A Financial Firm’s Net Liquidity Position

L = Supplies of Liquid Funds

- Demands for Liquidity

Essence of liquidity management
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 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.

Why banks and their competitors face significant liquidity problems
Why Banks and Their Competitors Face Significant Liquidity Problems

  • Imbalances Between Maturity Dates of Their Assets and Liabilities

  • High Proportion of Liabilities Subject to Immediate Repayment

  • Sensitivity to Changes in Interest Rates

  • Central Role in the Payment Process

Strategies for liquidity managers
Strategies for Liquidity Managers Problems

  • Asset Liquidity Management or Asset Conversion Strategy

  • Borrowed Liquidity or Liability Management Strategy

  • Balanced Liquidity Strategy

Asset liquidity management
Asset Liquidity Management Problems

This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed

Liquid asset
Liquid Asset Problems

  • 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

Options for storing liquidity

Treasury Bills Problems

Fed Funds Sold to Other Banks

Purchasing Securities for Resale (Repos)

Deposits with Correspondent Banks

Municipal Bonds and Notes

Federal Agency Securities

Bankers’ Acceptances

Commercial Paper

Eurocurrency Loans

Options for Storing Liquidity

Costs of asset liquidity management
Costs of Asset Liquidity Management Problems

  • Loss of Future Earnings on Assets That Must Be Sold

  • Transaction Costs 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

Borrowed liquidity management
Borrowed Liquidity Management Problems

This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs

Sources of borrowed funds
Sources of Borrowed Funds Problems

  • 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

Balanced liquidity management strategy
Balanced Liquidity Management Strategy Problems

The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs

Guidelines for liquidity managers
Guidelines for Liquidity Managers Problems

  • 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

Methods for estimating liquidity needs
Methods for Estimating Liquidity Needs Problems

  • Sources and Uses of Funds Approach

  • Structure of Funds Approach

  • Liquidity Indicator Approach

  • Signals from the Marketplace

Sources and uses of funds
Sources and Uses of Funds Problems

  • 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

Structure of funds
Structure of Funds Problems

  • 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

Customer relationship doctrine
Customer Relationship Doctrine Problems

Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships

Liquidity indicator approach
Liquidity Indicator Approach Problems

  • Cash Position Indicator

  • Liquid Security Indicator

  • Net Federal Funds Position

  • Capacity Ratio

  • Pledging Securities Ratio

  • Hot Money Ratio

  • Short-Term Investments to Sensitive Liabilities Ratio

  • Deposit Brokerage Index

  • Core Deposit Ratio

  • Deposit Composition Ratio

Market signals of liquidity management
Market Signals of Liquidity Management Problems

  • Public Confidence

  • Stock Price Behavior

  • Risk Premiums on CDs

  • Loss Sales of Assets

  • Meeting Commitments to Creditors

  • Borrowings from the Central Bank

Legal reserves
Legal Reserves Problems

Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities

U s legal reserve requirements
U.S. Legal Reserve Requirements Problems

  • 3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $42.1 Million

  • 10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $42.1 Million

  • Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments

  • The $42.1 Million Amount is Adjusted Annually

Sweep account
Sweep Account Problems

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

Reserve computation period
Reserve Computation Period Problems

The Period of Time Over Which a bank Calculates its Legal Reserve Requirement

Reserve maintenance period
Reserve Maintenance Period Problems

The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands

Factors to consider when choosing among different sources of reserves
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