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Managing Liquidity

Managing Liquidity. Chapter 4. The Roles of Money Management and Savings. If you can’t manage your checking and savings accounts properly, you’ll have trouble managing more complicated investments, such as retirement accounts Why maintain cash balances?

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Managing Liquidity

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  1. Managing Liquidity Chapter 4

  2. The Roles of Money Management and Savings • If you can’t manage your checking and savings accounts properly, you’ll have trouble managing more complicated investments, such as retirement accounts • Why maintain cash balances? • It’s expensive (because you’re forgoing interest income) • But we like the convenience

  3. The Roles of Money Management and Savings • Why savings are so important • Very liquid • Serves as an emergency fund • Allows us to achieve a certain goal (vacation, car down payment, etc.) • Americans save less than 2.5% of their income • Europeans save about 10%+

  4. The Roles of Money Management and Savings • How much savings do you need? • Emergency fund • Should have amount equal to about 3 to 6 months of after-tax income • Additional amount depends on your goals (short- and long-term) • Do you want to buy a house soon? Need to save for the down payment • Have money automatically transferred to your savings account from each paycheck • Treat it as a fixed expense

  5. The Roles of Money Management and Savings • How fast your savings will grow depends upon: • What interest rate your savings earn (stated or nominal rate) • Frequency of compounding • How much money you deposit periodically • How your account balance is determined

  6. What Determines How Fast Your Savings Will Grow? • The impact of time on interest earned • If interest is being compounded (earning interest on interest), time can have a significant impact • The frequency of compounding • The more frequently money is compounded, the more often interest is paid—so money grows faster • Your effective interest rate is greater the more often interest is compounded • The treatment of deposits and withdrawals • Most financial institutions use the day-of-deposit-to-day-of-withdrawal method of computing interest • Interest is based on the exact number of days the money is in your account • Other methods include minimum balance (will earn less interest this way)

  7. Figure 4.1: The Relationship Between Time and Interest Earned

  8. Figure 4.2: Simple and Compound Interest

  9. Choosing a Financial Institution • Financial institutions include banks and credit unions • Factors influencing your decision • How important is convenience to you? • Do you choose a bank just because it’s right around the corner from your house? • Convenience is important, but nowadays with electronic banking it’s not nearly as important • Direct deposit, online-banking, epay, etc.

  10. Choosing a Financial Institution • What services do you expect? • Electronic banking • Safe deposit box • Do you want good, personal service where the tellers know you by name? • What insurance safeguards are present? • Most financial institutions (banks, credit unions) are federally insured up to $100,000

  11. Choosing a Financial Institution • How much does it cost? • Before deregulation financial institutions offered many services for ‘free’ • Charged a basic fee for having an account • Provided free checks, help with reconciliation, etc. • Banks competed on the basis of service because basically all banks paid customers same interest rate on deposits • The spread between interest paid to customers and interest charged on loans was large • Since deregulation banks compete for deposits based on interest rates • Spread on interest paid vs. charged has narrowed • Banks have eliminated ‘free’ services and now charge fees (sometimes very HIGH fees) • Banks collect about $20 billion in fees (up 200% from 10 years ago) • Fees vary widely from bank to bank • Shop around

  12. What are the Major Financial Institutions? • Commercial banks (AKA full-service banks) • Offer: • Checking and savings accounts • Personal and business loans • Trust services • Safe-deposit boxes • Mortgage loans • Discount brokerage serves (maybe) • Convenient (Over 65,000 branch offices across U.S.)

  13. What are the Major Financial Institutions? • Savings Banks (S&Ls) • Traditionally serve consumers • Mortgage loans (make about 40% of all mortgage loans) • Today are more similar to commercial banks • Credit Unions • Cooperative venture owned by depositors and borrowers • Organized to serve specific groups of people • Non-profit so offer lower interest rates on loans, pay higher interest rates on deposits • Generally don’t want to take a great deal of risk

  14. What are the Major Financial Institutions? • Brokerage Firms • Offer central asset management accounts • Combines a checking account, debt/credit card, and a money market fund with a traditional brokerage account • Cash earned from dividends, interest, etc. is automatically swept into a money market account • You start earning interest on your money immediately • You can write a check (or use debit/credit card) to access your funds • Minimum investment required, which varies across brokerage firms • Check out minimum investment amount and fees (if any), customer service, choice of money market funds, credit/debit card features, margin rates

  15. Checking Accounts • Regular checking accounts • Some banks require a minimum balance (average is $500) which give you unlimited check writing privileges • Some banks charge no fee unless you exceed a certain number of checks per month • Banks can pay interest on checking accounts but rarely do • Special checking accounts • Require no minimum balance • Most banks charge a per check fee ($0.10-$0.15 per check) plus monthly maintenance fee • May be a good choice for college student if write only a few checks

  16. Checking Accounts • Overdraft Protection • If you write a check for an amount greater than the balance in your checking account it is still covered • You pay a fee (essentially interest on a short-term loan) • NOW Accounts (Negotiable Order of Withdrawal) • Combined checking and savings account • Pays interest on balance (but lower rate than savings account) • Can write checks (actually are authorizations to take money from savings) • Minimum balance of about $1,000 • If balance drops below the minimum a fee is charged • Shop around! • NOW accounts at credit unions are called Share-Draft Accounts

  17. Consumer Loans • Car loans • Mortgage loans • College loans • Home improvement loans • Unsecured personal loan

  18. Bank Credit Cards • Allow consumers to purchase items in lieu of cash or check • Can also get a cash advance • Even pay your taxes

  19. Other Banking Services • Retirement Plans • IRAs and Keoghs • Trustee Services • Managing money for others • Estate planning and management • Safe-Deposit Boxes • Fees vary (up to $100) • Bank Wire Transfers • Send money to someone (quickly & long distances) • Debt Management and Counseling • Often free

  20. Electronic Banking • Electronic Funds Transfer System (EFTS) • Paying bills, making withdrawals or depositing money electronically • Quick, easy, cheap • ATMs, direct deposit, debit cards, etc. • Automated Teller Machines • About 200,000 ATMs in U.S. • Over 11 billion transactions per year • Online banking • Expected to experience rapid growth • Convenient • Safety of EFTS • Can be difficult to resolve problems due to lack of paper records • Can’t stop payment on check since transfer is instantaneous

  21. How to Write and Endorse a Check • Writing a check • Get into habit of completing stub or register before you write check • Helps prevent you from forgetting the amount of the check • Endorsing a check • Blank endorsement • Person to whom check was written signs name on back • Is able to be cashed by anyone once endorsed • Restrictive endorsement • Limits further negotiation of check • Use when mailing a check to bank for deposit • Special endorsement • Names a third party who can cash the check

  22. Balancing Your Checkbook • Should reconcile checkbook every month when monthly statement is received • If you don’t contact bank about a bank error within a specified time period bank may not correct its mistake

  23. Balancing Your Checkbook • Steps involved: • Note the number of checks that cleared the bank • Compare the dollar amount for each check to the amount written on the check and check register • Compare your record of deposits to the bank statement • Compare your record of ATM and other EFTS transactions to the bank statement • Subtract any fees and add any interest • Total all checks you’ve written and any ATM withdrawals not on statement • Subtract this amount from balance on statement • Total all deposits not yet processed and add to balance

  24. Checks That Guarantee Payment • If you receive a check as payment the check could bounce and you wouldn’t get the cash • You may insist on a certified check • Guarantees payment • Cashier’s check • Customer buys a check from bank’s general fund • Bank won’t issue certified check until it’s paid for • Traveler’s checks • Guaranteed by issuer • Used primarily by business and vacation travelers

  25. Savings Accounts • Those offered by banks and credit unions are federally insured • Non-fixed Time Deposits • Can add/withdraw money with basically no restrictions at any time • Passbook savings account • May require a minimum to open ($100 or less) • Interest rate is low • May charge a fee if balance drops below set amount or number of transactions exceed a certain amount • NOW account • Basically an interest-bearing checking account

  26. Savings Options • Money Market Deposit Account (MMDA) • Interest rate fluctuates with the market rate • Initial deposit $1,000 • Only a certain number of withdrawals are allowed per month (penalty assessed if rules aren’t followed) • Fixed-Time Deposits • Saver agrees to keep money in account for a certain time period (earn higher interest) • Certificate of Deposit (CD) • Sacrifice liquidity • If interest rates are rising, and you’ve locked in a long-term CD, is it worth it to pay the interest penalty? • Some banks offer variable rate CDs • Shop around

  27. Money Market Mutual Funds • Pool many investors’ funds and invest in short-term, low-risk investments • Not federally insured • In practice this risk is very small • Require a minimum initial deposit ($1,000) • Can write checks (minimum amount of check value is about $250) • Some funds limit the number of checks you can write each month

  28. U.S. Treasury Bills and Notes • Issued by the U.S. government (very safe) • Can be sold prior to maturity • Interest income is not subject to state taxes • T-bills have 3, 6 and 12 months until maturity • Minimum face value of $10,000 • Interest is discounted • T-notes have 2, 3, 5, and 10 years to maturity • Pay fixed amount of interest 2x a year • Face value is as low as $1,000

  29. U.S. Savings Bonds • Face amounts range from $50 to $30,000 • Can buy from financial institutions • Purchase price is ½ the face value • Bond will mature at some point (when exactly depends on the interest rate) • Interest accumulates (even after maturity) until 30 years after the issue date • Exempt from state taxes • Federal taxes are owed only when bond is cashed in or reaches 30 years from issue date • Series I bonds pay a fixed interest rate + the average rate of inflation

  30. Choosing the Best Savings Option • Need to evaluate: • Minimum investment • Liquidity • Yield • Safety • Taxation

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