Estimating Liquidity Needs (continued) 11-1 Estimating Liquidity Needs (continued) Structure of Funds Approach Many financial firms like to calculate their expected liquidity requirement, based on the probabilities they assign to different possible outcomes Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-2 Estimating Liquidity Needs (continued) Liquidity Indicator Approach Cash position indicator Liquid securities indicator Net federal funds and repurchase agreements position Capacity ratio Pledged securities ratio Hot money ratio Deposit brokerage index Core deposit ratio Deposit composition ratio Loan commitments ratio Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Estimating Liquidity Needs (continued) 11-3 Estimating Liquidity Needs (continued) The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace Liquidity managers should closely monitor the following market signals: Public confidence Stock price behavior Risk premiums on CDs and other borrowings Loss sales of assets Meeting commitments to credit customers Borrowings from the central bank Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management 11-4 Legal Reserves and Money Position Management Legal Reserves Those assets that law and central bank regulation say must be held during a particular time period The current system of accounting for legal reserves is called lagged reserve accounting (LRA) The daily average amount of deposits and other reservable liabilities are computed using information gathered over a two- week period stretching from a Tuesday through a Monday two weeks later This interval of time is known as the reserve computation period The daily average amount of vault cash each depository institution holds is also figured over the same two-week computation period Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

11-5 EXHIBIT 11–1 Federal Reserve Rules for Calculating a Weekly Reporting Depository Institution’s Required Legal Reserves Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-6 Legal Reserves and Money Position Management (continued) Legal Reserves Only two kinds of assets can be used for this purpose Cash in the vault Deposits held in a reserve account with the regional Fed The reserve requirement in 2010 was 3 percent of the end-of-the-day daily average amount held over a two-week period, from $10.7 million up to $58.8 million The first $10.7 million have zero legal reserves The $58.8 million figure is known as the reserve tranche and changes every year based on deposit growth Transaction deposits over $58.8 million held by the same depository institution carried a 10 percent legal reserve requirement This annual legal reserve adjustment is designed to offset inflation Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-7 Legal Reserves and Money Position Management (continued) Calculating Required Reserves The largest depository institutions must hold the largest percentage of legal reserves Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-8 Legal Reserves and Money Position Management (continued) Calculating Required Reserves The largest depository institutions must hold the largest percentage of legal reserves Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-9 Legal Reserves and Money Position Management (continued) Clearing Balances In addition to holding a legal reserve account at the central bank, many depository institutions also hold a clearing balance with the Fed to cover any checks or other debit items drawn against them For example, suppose a bank had a clearing balance averaging $1 million during a particular two-week maintenance period and the Federal funds interest rate over this same period averaged 5.50 percent Then it would earn a Federal Reserve credit of Assuming a 360-day year for ease of computation, this bank could apply up to $2,138.89 to offset any fees charged to the bank for its use of Federal Reserve services Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-10 Legal Reserves and Money Position Management (continued) Factors Influencing the Money Position Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-11 Legal Reserves and Money Position Management (continued) Sweep Accounts Volume of legal reserves held at the Fed has declined in recent years largely due to sweep accounts A contractual account between a bank and a 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 The sweeps market is likely to change in form and importance due to the recent passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009 Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Legal Reserves and Money Position Management (continued) 11-12 Legal Reserves and Money Position Management (continued) 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 Borrow in the Eurocurrency market Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

11-13 EXHIBIT 11–2 Movements in the Effective Federal Funds Rate, Its Target (the Intended Federal Funds) Rate, and the Discount (Primary Credit) Rate for Depository Institutions Seeking Credit from the Federal Reserve Banks Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Factors in Choosing among the Different Sources of Reserves 11-14 Factors in Choosing among the Different Sources of Reserves In choosing which source of reserves to draw upon to cover a legal reserve deficit, managers must carefully consider several aspects of their institution’s need for liquid funds: Immediacy of need Duration of need Access to the market for liquid funds Relative costs and risks of alternative sources of funds The interest rate outlook Outlook for central bank monetary policy Rules and regulations applicable to a liquidity source Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Central Bank Reserve Requirements around the Globe 11-15 Central Bank Reserve Requirements around the Globe Not all central banks impose legal reserve requirements on the depository institutions they regulate For example, the Bank of England has not established official reserve requirements for its banks There is a trend among central banks around the globe to eliminate, suspend, or at least make less use of the reserve requirement tool, in part because it is so difficult to control A notable exception is the European Central Bank (ECB) Even if central banks imposed no reserve requirements, managers of depository institutions would still have a demand for cash reserves All depository institutions at one time or another need immediately available funds to handle customer withdrawals, meet new loan demand, and satisfy other emergency cash needs Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

11-16 Quick Quiz What are the principal sources of liquidity demand for a financial firm? What are the principal sources from which the supply of liquidity comes? Why do financial firms face significant liquidity management problems? What are the principal differences among asset liquidity management, liability management, and balanced liquidity management? How does the sources and uses of funds approach help a manager estimate a financial institution’s need for liquidity? How can the discipline of the marketplace be used as a guide for making liquidity management decisions? What are sweep accounts? Why have they led to a significant decline in the total legal reserves held at the Federal Reserve banks by depository institutions operating in the United States? What impact has recent financial reform legislation had on raising short- term cash? Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.