Liquidity Management Outline Estimating liquidity needs Sources and uses of funds method Structure-of-deposits method Funding and market liquidity needs Asset liquidity Primary reserves Managing the money position Secondary reserves Liability management Funds management of liquidity Liquidity ratios Optimum bank liquidity Regulatory view of bank liquidity

Estimating liquidity needs Sources and Uses of Funds Method: Calculate future changes over time in loans and deposits from past experience and future expectations. Example of estimation:

Estimating liquidity needs Structure-of-Deposits Method: Example of estimation:

Estimating liquidity needs Funding and market liquidity needs Funding-liquidity risk refers to maintaining sufficient cash to meet investment needs. Market-liquidity risk is related to market disruptions that can temporarily widen bid-ask spreads and make it difficult to close out open positions in derivatives, securities, etc. without sustaining losses. General definition of liquidity: Amount of liquidity needed relative to ability to meet liquidity demands.

Asset liquidity Role of asset liquidity Liquid assets are an alternative source of funds. A reserve to protect the bank from financial market loss of confidence that could threaten safety and soundness. Primary reserves -- vault cash and cash held on deposit at the Federal Reserve district bank. Secondary reserves -- money market instruments held by the bank under no formal regulatory requirements.

Asset liquidity Primary reserves Lagged reserve requirements (see next page) Calculate daily average balances of transactions deposits during a 14-day period (computation period). Calculate average daily vault cash in the next 14-day period. Skip 3 days. Maintain reserve balances at the Federal Reserve during a subsequent 14-day period (maintenance period). Thus, 17 days between end of computation period and beginning of maintenance period. LRR lowers management costs and improves the quality of information on required balances.

Asset liquidity Managing the money position (minimize cash holdings which generally means to meet reserve requirements).

Asset management Secondary reserves T-bills, Federal agency securities, repurchase agreements (RPs or Repos), bankers’ acceptances, negotiable certificates of deposit (CDs), federal funds, and commercial paper. Aggressive liquidity approach Yield curve relationships can be used to buy longer-term or short-term securities (e.g., 30-day 2-year securities). Securitization of loans (asset-backed financing) Loans are converted to securities with greater liquidity. Credit risk is reduced.

Liability management Purchase the funds needed to meet loan demands and deposit withdrawals. Correspondent balances of smaller banks with larger banks. Risks Interest rate increases reduce interest rate margins. Capital losses on securities and other assets can occur as interest rates increase. Loss of public confidence would prevent the bank from rolling over purchased funds. Increased borrowing causes financial risk to increase (i.e., variability of earnings per share). Capital market risk can occur when interest rates are low and investors shift funds from deposits to higher earning capital assets in the financial marketplace.

Funds management of liquidity Compare the total liquidity needs to total liquidity sources. Liquidity ratios Loans/deposits Loans/nondeposit liabilities U.S. government securities/nondeposit liabilities U.S. government securities/large denomination time deposits Liquid assets and liabilities in period t/estimated liquidity needs in period t (i.e., liquidity relative to needs) Optimum bank liquidity Balance risks and returns … high enough liquidity to meet unexpected needs but not so high to incur high opportunity costs of near-cash assets. Uncertainty in forecasted needs and sources affects optimum also.

Funds management of liquidity Regulatory view of bank liquidity Adequacy of bank liquidity (not least cost or optimum liquidity strategy). The availability of assets readily convertible into cash The structure and volatility of deposits The reliance on interest-sensitive funds The ability to sustain any level of borrowings over the business cycle The bank’s formal and informal commitments for future lending The ability to adjust rates on loans when rates on interest-sensitive sources of funds fluctuate The examiner-analyst