Chapter Eleven

Liquidity and Reserves Management:

Strategies and Policies
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 11-2

Liquidity

• The Availability of Cash in the Amount and

at the Time Needed at a Reasonable Cost

• The size and volatility of cash requirements

affect the liquidity position of the bank
▫ Examples of transaction that affect the
bank’s cash balance and liquidity position:
Deposits and withdrawals; loan
disbursements and loan payments
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 11-3

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

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 11-4

Demands for Liquidity

• Customer Deposit Withdrawals

• Credit Requests from Quality Loan

Customers

• Repayment of Nondeposit Borrowings

• Operating Expenses and Taxes

• Payment of Stockholder Dividends

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 11-5

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 11-6

A Financial Firm’s Net Liquidity

Position

L = Supplies of Liquid Funds

- Demands for Liquidity

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 11-7

Quick Quiz: Comprehensive Problem

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 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?
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 11-8

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 Liquidity and
Profitability. The More Resources Tied Up in
Readiness to Meet Demands for Liquidity,
the Lower is the Financial Firm’s Expected
Profitability.

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 11-9

Why Banks and Their Competitors

Face Significant Liquidity Problems
• Imbalances Between Maturity Dates of Their Assets and
Liabilities

• High Proportion of Liabilities (especially demand

deposits and money market borrowings) Subject to
Immediate Repayment

• Sensitivity to Changes in Interest Rates

▫ May affect customer demand for deposits
▫ May affect customer demand for loans

• Central Role in the Payment Process, Reputation and

Public Confidence in the System
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 11-10

Strategies for Liquidity Managers

1. Think about what is a liquid asset?
2. Identify strategies for liquidity
management.

• Asset Liquidity Management or Asset

Conversion Strategy

• Borrowed Liquidity or Liability

Management Strategy

• Balanced Liquidity Strategy

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 11-11

Asset Liquidity Management

This Strategy Calls for Storing

Liquidity in the Form of Liquid Assets
(T-bills, fed funds loans, CDs, etc.)
and Selling Them When Liquidity is
Needed

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 11-12

Liquid Asset

• 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
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 11-13

Options for Storing Liquidity

• Treasury Bills • Municipal Bonds and
• Fed Funds Sold to Notes
Other Banks • Federal Agency
• Purchasing Securities Securities
for Resale (Repos) • Negotiable Certificates
• Deposits with of Deposits
Correspondent Banks • Eurocurrency Loans

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 11-14

Asset Liquidity Management is Not

Costless and Include Opportunity Cost:

• Loss of Future Earnings on Assets That Must

Be Sold
• Transaction Costs (Commissions) 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
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 11-15

Borrowed Liquidity (Liability)

Management

This Strategy Calls for the Bank to

Purchase or Borrow from the
Money Market To Cover All of Its
Liquidity Needs
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 11-16

Sources of Borrowed Funds

• Federal Funds Purchased

• Selling Securities for Repurchase (Repos)
• Issuing Large CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home
Loan Bank
• Borrowing Reserves from the Discount
Window of the Federal Reserve

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 11-17

Borrowed Liquidity (Liability)

Management Strategy
Advantages Disadvantages

• Borrow Only When There • Highest Expected Return

is a Need for Funds But Carries the Highest
• Volume and Composition Risk Due to Volatility of
of the Investment Interest Rates and Possible
Portfolio Can Remain Rapid Changes in Credit
Unchanged Availability
• The Institution Can • Borrowing Cost is Always
Control Interest Rates in Uncertain-> Uncertain
Order to Borrow Funds Earnings
(raise offer rates when • Borrowing Needs Can Be
needs requisite amounts Interpreted as a Signal of
Financial Difficulties
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 11-18

Balanced Liquidity Management

Strategy

The Combined Use of Liquid Asset

Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet Liquidity
Needs

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 11-19

Guidelines for Liquidity Managers

• 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
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 11-20

Methods for Estimating Liquidity

Needs
• Sources and Uses of Funds Approach

• Structure of Funds Approach

• Liquidity Indicator Approach

• Signals from the Marketplace

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Sources and Uses of Funds

• 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

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Structure of Funds Approach

• A Bank’s Deposits and Other Sources of
Funds Divided Into Categories. For
Example:
▫ ‘Hot Money’ Liabilities (volatile liabilities)
▫ Vulnerable Funds
▫ Stable Funds (core deposits or core liabilities)
• Liquidity Manager Set Aside Liquid Funds
According to Some Operating Rule

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 11-24

Customer Relationship Doctrine

Management Should Strive to Meet All

Good Loans that Walk in the Door in
Order to Build Lasting Customer
Relationships

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 11-25

Liquidity Indicator Approach

(Based on Experience and Industry Averages)
• Cash Position Indicator • Hot Money Ratio

• Liquid Security Indicator • Deposit Brokerage Index

• Net Federal Funds Position • Core Deposit Ratio

• Capacity Ratio • Deposit Composition Ratio

• Pledged Securities Ratio • Loan Commitment Ratio

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 11-26

The Ultimate Standard: Market

Signals of Liquidity Management
• Public Confidence

• Stock Price Behavior

• Risk Premiums on CDs

• Loss Sales of Assets

• Meeting Commitments to Creditors

• Borrowings from the Central Bank

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 11-27

Legal Reserves

• Assets That a Central Bank Requires

Depository Institutions to Hold as a
Reserve Behind Their Deposits or
Other Liabilities

• Only 2 Kinds of Assets Can Be Used

for This Purpose: 1) Cash in the Vault;
2) Deposits Held in a Reserve Account
With the Regional Fed.
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 11-28

U.S. Legal Reserve Requirements

• In 2007-2008, first $9.3 Million have 0 Legal
Reserves
• 3 Percent of End-of-the-Day Daily Average for
a Two Week Period For Transaction Accounts
Up To $43.9 Million ($43.9 million is known as
the reserve tranche and changes every year)
• 10 Percent of End-of-the-Day Daily Average
for a Two Week Period For Transaction
Accounts For Amounts Over $43.9 Million
• Transaction Accounts Include Checking
Accounts, NOW Accounts and Other Deposits
Used to Make Payments
• The $43.9 Million Amount is Adjusted Annually
• The Money Position Manager Oversees the
Institution’s Legal Reserve Account
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 11-29

Calculating Required Reserves

Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserve’s discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
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 11-30

Factors Influencing the Money Position

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Sweep Account
• Volume of Legal Reserves Held at the Fed
Has Declined in Recent Years Largely Due to
Sweep Accounts

• 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
▫ Retail Sweep
▫ Business Sweep
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 11-32

Other Factors to Influence Legal

Reserves
• Use of Fed Funds Market
▫ The cheapest source
▫ But very volatile
▫ Managers rely on the Fed funds target rate (the
most volatile on the settlement date)
• Other Options
▫ Sell liquid securities
▫ Draw upon excess correspondent balances
▫ Enter into repurchase agreements for temporary
borrowings
▫ Sell new time deposits
▫ And borrow in the Eurocurrency market
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 11-33

Factors in 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

• Outlook for Central Bank Monetary Policy

• Regulations Applicable for Liquidity Sources

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 11-34

Quick Quiz
• What are the principal differences among asset
liquidity management, liability management,
and balanced liquidity management?
• What guidelines should management keep in
mind when it manages a financial firm’s
liquidity position?
• What is money position management?
• What is the principal goal of money position
management?
• What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account?
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