1. Fin 464 Chapter 11: Liquidity and Reserves Management

2. 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 11-2

3. 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 11-3

4. The Demand for and Supply of Liquidity (cont) 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) Liquidity Deficit is L t 0 11-4

5. The Demand for and Supply of Liquidity (cont) The essence of liquidity management problems for financial institutions 1.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. 2.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) 11-5

6. Why Financial Firms Often Face Significant Liquidity Problems 1.Imbalances between maturity dates of their assets and liabilities 2.High proportion of liabilities (especially demand deposits and money market borrowings) are subject to immediate repayment 3.Sensitivity to changes in interest rates □ May affect customer demand for deposits □ May affect customer demand for loans □ May affect the market value of assets the firm may need to sell in order to liquidate 11-6

7. Strategies for Liquidity Managers What is a liquid asset? 1.Liquid assets have a ready market 2.Stable price without significant decline in price 3.Reversible so that can recover original investment with little loss 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 ▫ Mainly used by smaller financial institutions considering borrowing risky ▫ Borrowed Liquidity or Liability Management Strategy ▫ This strategy calls for the bank to purchase or borrow from the money market ( CDs, federal funds borrowing, repurchase agreements, Eurocurrency borrowings) to cover all of its liquidity needs ▫ It is a costless approach compare to asset liquidity management ▫ This is the most risky approach to solving liquidity problems because of the volatility of money market interest rates & the rapidity with which the availability of credit can change. ▫ Balanced Liquidity Strategy ▫ The combined use of liquid asset holdings (Asset Management) and borrowed liquidity (Liability Management) to meet liquidity needs 11-7

8. Options for Storing Liquidity  Treasury Bills  Fed Funds Sold to Other Banks  Purchasing Securities for Resale (Repos)  Deposits with Correspondent Banks  Municipal Bonds and Notes  Federal Agency Securities  Negotiable Certificates of Deposits  Eurocurrency Loans 11-8

9. 9 Implications of Asset Liquidity Management Strategies  Selling assets means the bank loses the future earnings possibility.  Selling assets involve transaction cost paid to the security brokers.  Asset in question may need to be sold in a market experiencing declining prices. (capital loss possibility)  Selling assets tends to weaken the appearance of the bank’s balance sheet.  Liquid assets generally holds lowest rate of return,i.e, by investing in liquid assets, banks are ignoring the possibility of higher return on other financial assets.

10. Sources of Borrowed Funds  Federal Funds Purchased  Selling Securities for Repurchase (Repos)  Issuing Large CDs (Greater than $100,000)  Issuing Eurocurrency Deposits  Borrowing Reserves from the Discount Window of the Federal Reserve 11-10

11. Estimating Liquidity Needs Three approaches in measuring or estimating a bank’s liquidity needs: Sources and Uses of Funds Approach Structure of Funds Approach Liquidity Indicator Approach 11-11

12. 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. Sources of liquidity> uses of liquidity = positive liquidity gap & vice versa □ 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 11-12

13. Sources and Uses of Funds Approach (cont)  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

14. 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. 11-14

15. 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. 11-15

16. Signals from the Marketplace The Ultimate Standard for Assessing Liquidity Needs is this approach ▫ Liquidity managers should closely monitor the following market signals: 1.Public confidence 2.Stock price behavior 3.Risk premiums on CDs and other borrowings 4.Loss sales of assets 5.Meeting commitments to credit customers 6.Borrowings from the central bank 11-16

17. 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 11-17

18. Legal Reserves and Money Position Management (cont) ▫ Only two 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 ▫ 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 ▫ Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement 11-18

19. Legal Reserves and Money Position Management (cont) 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 $1000000*0.055*(14/360)=2138.89 11-19