Liquidity and Reserves Management: Strategies and Policies Chapter Eleven Liquidity and Reserves Management: Strategies and Policies Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Key Topics Sources of Demand for and Supply of Liquidity 11-2 Key Topics Sources of Demand for and Supply of Liquidity Why Financial Firms Have Liquidity Problems Liquidity Management Strategies Estimating Liquidity Needs The Impact of Market Discipline Legal Reserves and Money Management Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

11-3 Introduction One of the most important tasks the management of any financial institution faces is ensuring adequate liquidity at all times A financial firm is considered to be “liquid” if it has ready access to immediately spendable funds at reasonable cost at precisely the time those funds are needed This suggests that a liquid financial firm either has The right amount of immediately spendable funds on hand when they are required They can raise liquid funds in timely fashion by borrowing or selling assets Lack of adequate liquidity can be one of the first signs that a financial institution is in trouble A financial firm can be closed if it cannot raise sufficient liquidity even though, technically, it may still be solvent Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

The Demand for and Supply of Liquidity 11-4 The Demand for and Supply of 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 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 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

The Demand for and Supply of Liquidity (continued) 11-5 The Demand for and Supply of Liquidity (continued) These various sources of liquidity demand and supply come together to determine each financial firm’s net liquidity position at any moment in time That net liquidity position (L) at time t is Liquidity Deficit is Lt < 0 and Liquidity Surplus is Lt > 0 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

The Demand for and Supply of Liquidity (continued) 11-6 The Demand for and Supply of Liquidity (continued) The essence of liquidity management problems for financial institutions Rarely are demands for liquidity equal to the supply of liquidity at any particular moment in time The financial firm must continually deal with either a liquidity deficit or a liquidity surplus. There is a trade-off between liquidity and profitability The more resources are tied up in readiness to meet demands for liquidity, the lower is that financial firm’s expected profitability (other factors held constant) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Why Financial Firms Often Face Significant Liquidity Problems 11-7 Why Financial Firms Often Face Significant Liquidity Problems Imbalances between maturity dates of their assets and liabilities High proportion of liabilities (especially demand deposits and money market borrowings) are 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 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Strategies for Liquidity Managers 11-8 Strategies for Liquidity Managers Think about what is a liquid asset? Liquid assets have a ready market, stable price and are reversible Identify strategies for liquidity management Asset Liquidity Management or Asset Conversion Strategy 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 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 Balanced Liquidity Strategy The combined use of liquid asset holdings (Asset Management) and borrowed liquidity (Liability Management) to meet liquidity needs Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Strategies for Liquidity Managers (continued) 11-9 Strategies for Liquidity Managers (continued) Guidelines for Liquidity Managers Keep track of all fund-using and fund-raising departments Know in advance withdrawals by the biggest credit or deposit customers Priorities and objectives for liquidity management should be clear Liquidity needs must be evaluated on a continuing basis Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs 11-10 Estimating Liquidity Needs Sources and Uses of Funds Approach Structure of Funds Approach Liquidity Indicator Approach The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-11 Estimating Liquidity Needs (continued) Sources and Uses of Funds 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 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-12 Estimating Liquidity Needs (continued) Sources and Uses of Funds Approach Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-13 Estimating Liquidity Needs (continued) Sources and Uses of Funds Approach Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-14 Estimating Liquidity Needs (continued) Sources and Uses of Funds Approach Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-15 Estimating Liquidity Needs (continued) 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 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-16 Estimating Liquidity Needs (continued) Structure of Funds Approach For example, the manager may decide to set up A 95 percent liquid reserve behind all hot money funds (less any required legal reserves held behind hot money deposits) 30 percent in liquid reserves for vulnerable deposit and nondeposit liabilities 15 percent or less in liquid reserves for stable (core) funds sources Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.