Chapter 4

LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES

(Book Chapter-12)
Q: What are the principal sources of liquidity demand for a financial firm?

Demands for Liquidity

1. Customer deposit withdrawals

2. Credit requests from quality loan customers

3. Repayment of non-deposit borrowings

4. Operating expenses and taxes

5. Payment of stockholder dividends

Q: What are the principal sources from which the supply of liquidity comes?

Supplies for Liquidity

1. Incoming customer deposits

2. Revenues from the sale of nondeposit services

3. Customer loan repayments

4. Sales of bank assets

5. Borrowings from the money market

Q: Why Banks Face Significant Liquidity Problems?

1. Imbalances Between Maturity Dates of Their Assets and Liabilities

2. High Proportion of Liabilities Subject to Immediate Repayment

3. Sensitivity of Bank to Changes in Interest Rates

4. Central Role in the Payment Process

5. Inaccessibility to the money market

6. Lack of cautious and close observations to deposits and loans behavior

Q: What are the Strategies for Liquidity Managers?

1. Asset liquidity Management or Asset Conversion Strategy

2. Borrowed Liquidity or Liability Management Strategy

3. Balanced Liquidity Strategy

1. Asset liquidity Management or Asset Conversion Strategy: This Strategy Calls for
Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is
Needed.
2. Borrowed Liquidity or Liability Management Strategy: This Strategy Calls for the Bank to
Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs.
3. Balanced Liquidity Strategy: The Combined Use of Liquid Asset Holdings (Asset Management)
and Borrowed Liquidity (Liability Management) to Meet a Bank’s Liquidity Needs.

Q: What are the strong liquidity in bank asset – The principle option?

1. Treasury Bills

2. Fed Funds Sold to Other Banks

3. Purchasing Securities for Resale (Repos)

4. Deposits with Correspondent Banks

5. Municipal Bonds and Notes

6. Federal Agency Securities

7. Negotiable Certificates of Deposits

8. Eurocurrency Loans

Q: What are the borrowing liquidity – The Principle Options ?

1. Federal Funds Purchased

2. Selling Securities for Repurchase (Repos)

3. Issuing Large CDs (Greater than $100,000)

4. Issuing Eurocurrency Deposits

5. Borrowing Reserves from the Discount Window of the Federal Reserve

Q: Sources and Uses of Funds Approach?

A method for estimating a bank’s liquidity requirements by focusing primarily on expected changes in
deposits & loans. The approach begins with two simple facts arising liquidity gap concept:

• Bank liquidity rises as deposits increase & loans decrease.

• Bank liquidity declines when deposits decrease & loans increase.

Steps in this approach:

• 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

Another approach for estimating future deposits and loans is to divide into three components:

1. Trend Component: construct trend line

2. Seasonal Component: expected to behave due to seasonal factors

3. Cyclical Component: positive or negative deviation upon the economy condition

Q: Liquidity Indicator Approach?

1. Cash position indicator = cash & deposits due from depository institutions / total assets.

2. Liquid securities indicator = government securities / total assets.

3. Net federal funds and repurchase agreements position = federal funds sold – federal
funds purchased / Total asset

4. Capacity ratio = net loans & leases / total assets.

5. Pledged securities ratio = pledged securities / total securities holdings.

6. Hot money ratio = money market assets (cash+ short-term securities+ federal funds
sold+ Reverse repurchase agreements) / money market liabilities (CDs+ Eurocurrency
deposits+ federal funds borrowings+ repurchase agreements)

7. Deposit brokerage index = brokered deposits / total deposits.

8. Core deposit ratio = core deposits / total assets.

9. Deposit composition ratio = demand deposits / time deposits.

Q: Structure of Funds Approach?

A method for estimating a bank’s liquidity needs by dividing its borrowed funds into categories based
upon their estimated probability of withdrawal.

The deposit and nondeposit liabilities divided into three categories are:

1. “Hot Money Liabilities” (volatile liabilities): Deposits & Non Deposit Borrowed funds
that are very interest sensitive & will be withdrawn during the current period.

2. Vulnerable Funds: Customer deposits of which a substantial portion (25%-30%) will

probably be removed during the current period.

3. Stable Funds (core deposits or core liabilities) : Most unlikely to be removed during the
current period.

Liquidity Manager Set Aside Liquid Funds According to Some Operating Rule

Combining both loan and deposit liquidity requirements, this institution’s total liquidity requirement
would be to consider hot money, vulnerable funds, stable funds as well as amount required for potential
loan demands.

Q: Why do financial firms face significant liquidity management problems?

Financial institutions are prone to liquidity management problems due to:

1. A maturity mismatch situation in which most depository institutions hold an unusually high
proportion of liabilities subject to immediate payment, especially demand (checkable) deposits
and money market borrowings;
2. The sensitivity of changes to their assets and liabilities values towards market interest-rate
movements; and
3. Their central role in the payments process.

Q: What guidelines should management keep in mind when it manages a financial firm’s liquidity
position?

It is important for a liquidity manager to:

1. They Should Keep Track of All Fund-Using and Fund-Raising Departments.

2. They Should Know in Advance Withdrawals by the Biggest Credit or Deposit Customers.

3. Their Priorities and Objectives for Liquidity Management Should be Clear.

4. Liquidity Needs Must be Evaluated on a Continuing Basis.

Q: What are the Sources and Uses of Funds Approach?

1. Loans and deposits must be forecast for a given planning period.

2. The estimated change in loans and deposits must be calculated for that same period.
3. The liquidity manager must estimate the net liquid funds’ surplus or deficit for the planning
period by comparing the estimated change in loans (or other uses of funds) to the estimated
change in deposits (or other funds sources).

Q: When is a financial institution adequately liquid?

A financial institution is adequately liquid if it has adequate cash available precisely when cash is needed
at a reasonable cost. Management can monitor the cash position over time, and also monitor what is
happening to its cost of funds. One indicator of the adequacy of the liquidity position is its cost - a rising
interest cost may reflect greater perceived risk for the borrowing bank as viewed by capital-market
investors.
 MATH

Q: Suppose that a thrift institution’s liquidity division estimates that it holds $19 million in hot money
deposits and other IOUs against which it will hold an 80 percent liquidity reserve, $54 million in
vulnerable funds against which it plans to hold a 25 percent reserve, and $112 million in stable or core
funds against which it will hold a 5 percent liquidity reserve. The thrift expects its loans to grow 8
percent annually; its loans currently stand at $117 million, but have recently reached $132 million. If
reserve requirements on liabilities currently stand at 3 percent, what is this depository institution’s
total liquidity requirement?
Solution :

Q: Suppose that a bank faces the following cash inflows and outflows during the coming week: (a)
deposit withdrawals are expected to total $33 million, (b) customer loan repayments are expected to
amount to $108 million, (c) operating expenses demanding cash payment will probably approach $51
million, (d) acceptable new loan requests should reach $294 million, (e) sales of bank assets Concept
Check are projected to be $18 million, (f) new deposits should total $670 million, (g) borrowings from
the money market are expected to be about $43 million, (h) nondeposit service fees should amount to
$27 million, (i) previous bank borrowings totaling $23 million are scheduled to be repaid, and (j) a
dividend payment to bank stockholders of $140 million is scheduled. What is this bank’s projected net
liquidity position for the coming week?

Solution :