1. Liquidity Management

2. Why Banks Face Significant Liquidity Problems Imbalances between maturity dates of their assets and liabilities Higher proportion of liabilities subject to immediate repayment, more short term deposits Sensitivity of bank to changes in interest rates Central role in the payment process Technology has impacted liquidity requirements (no such thing as holidays)

3. Essence of Liquidity Management Rarely are the demands for liquidity equal to the supply of liquidity at any particular moment. The bank must continually deal with either a liquidity deficit or surplus There is a trade-off between bank liquidity and profitability. The more bank resources are tied up in readiness to meet demands for liquidity, the lower is the bank’s expected profitability.

4. Essence of Liquidity Management Asset Liquidity issue: You have an investment opportunity but no funds Liabilities liquidity issue: not able to pay back deposits

5. Liquidity versus Profitability There is a trade-off between liquidity and profitability  The more liquid a bank is, the lower are its return on equity and return on assets, all other things equal In a bank’s loan portfolio, the highest yielding loans are typically the least liquid The most liquid loans are typically government-guaranteed loans

6. 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

7. Demands for Bank Liquidity Customer Deposit Withdrawals Credit Requests from Quality Loan Customers Repayment of Nondeposit Borrowings Operating Expenses and Taxes Payment of Stockholder Dividends

8. Potential liquidity needs Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses New Loan Demand  Unused commercial credit lines outstanding  Consumer credit available on bank-issued cards  Business activity and growth in the bank’s trade area  The aggressiveness of the bank’s loan officer call programs Potential deposit losses are affected by:  The composition of liabilities  Deposit ownership  Large deposits held by any single entity  Seasonal or cyclical patterns in deposits  The sensitivity of deposits to changes in the level of interest rates

9. Liquidity Risk: Approaches The Stock Approach: Monitoring through select ratios and stock of various liquidity instruments The Cash flow Approach: The bank attempts to match cash outflows and inflows.  The cash flow matching approach may be applied using solely contractual cash flows or using adjusted cash flows.  Adjusted cash flows adjust the contractual cash flows to take account of the likely behaviour of counterparties and/or non-contractual cash outflows needed to preserve the business franchise.  These adjustments may be made either on the basis of expected normal conditions or assuming stress conditions.

10. Stock approach Cash to deposit ratio Core deposits to Total deposits Loans to Total assets (Advances + Investments) to Total deposits

11. The Cash flow approach Balance sheet of a bank is viewed as outflows and inflows These outflows and inflows (including off-balance sheet items) are categorized under various maturity buckets on the basis of behavioral pattern Gaps are identified under different time buckets Focus more on gaps of short term buckets and articulate liquidity management strategies

12. Critical Issues Core and volatile portion of current and savings account deposits Behavioral maturity of various term deposits and decomposition of these deposits into various time buckets Behavioral pattern of pre-mature deposits, renewal of time deposits, and overdue deposits Utilization pattern of cash credit and overdraft limits Behavioral pattern of devolvement of Letters of credit Behavioral pattern of invocation of guarantees

13. Strategies for Liquidity Managers Asset liquidity Management/Asset Conversion Strategy This Strategy Calls for Storing Liquidity in the Form of Liquid Assets 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 a Bank’s Liquidity Needs

14. Asset liquidity Management/Asset Conversion Strategy

15. 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

16. 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 Bankers’ Acceptances Commercial Paper Eurocurrency Loans

17. Costs of Asset Liquidity Management Loss of Future Earnings on Assets That Must Be Sold Transaction Costs 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

18. Borrowed Liquidity Management

19. 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

20. Balanced Liquidity Management Strategy

21. 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

22. Estimating Bank’s Liquidity Needs 1. Sources and Uses of Funds Approach 2. Structure of Funds Approach 3. Liquidity Indicator Approach 4. Signals from the Marketplace

23. 1. 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

24. Contd… Sources and Uses of Funds Method: – Calculate future changes over time in loans and deposits from past experience and future expectations. – Example of estimation:

25. 2. Structure of Funds Approach Structure-of-Deposits Method:  Example of estimation:

26. 3. Liquidity Indicator Approach Cash Position Indicator Liquid Security Indicator Net Federal Funds Position Capacity Ratio Pledging Securities Ratio Hot Money Ratio Short-Term Investments to Sensitive Liabilities Ratio Deposit Brokerage Index Core Deposit Ratio Deposit Composition Ratio

27. 4. 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

28. Traditional Measures of Liquidity Risk Asset Liquidity Measures  The most liquid assets mature near term and are highly marketable  Any security or loan with a price above par, in which the bank could report a gain at sale, is viewed as highly liquid  Liquidity measures are normally expressed in percentage terms as a fraction of total assets

29. Traditional Measures of Liquidity Risk Highly Liquid Assets  Cash and due from banks in excess of required holdings  Federal funds sold and reverse RPs.  U.S. Treasury securities and agency obligations maturing within one year  Corporate obligations and municipal securities maturing within one year and rated Baa and above  Loans that can be readily sold and/or securitized

30. Liability Liquidity Measures Liability Liquidity  The ease with which a bank can issue new debt to acquire clearing balances at reasonable costs.  Measures typically reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities.

31. Liability Liquidity Measures The following measures are commonly used:  Total equity to total assets  Risk assets to total assets  Loan losses to net loans  Reserve for loan losses to net loans  The percentage composition of deposits  Total deposits to total liabilities  Core deposits to total assets  Federal funds purchased and RPs to total liabilities  Commercial paper and other short-term borrowings to total liabilities.

32. The Relationship Between Liquidity, Credit, and Interest Rate Risk Liquidity risk for a poorly managed bank closely follows credit and interest rate risk  Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired

33. Longer-Term Liquidity Planning Projections are separated into:  Base Trend  Short-Term Seasonal  Cyclical Liquidity Needs  Equals Forecasted change in loans + change in required reserves – forecasted change in deposits

34. Forecasts of trend, seasonal, and cyclical components of deposits and loans Deposit forecast

35. Forecasts of trend, seasonal, and cyclical components of deposits and loans Loan forecast

36. Monthly liquidity needs The bank’s monthly liquidity needs are estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits:  Liquidity needs =Forecasted  loans +  required reserves - forecasted  deposits

37. Estimates of Liquidity Needs

38. Liquidity GAP measures Management can supplement this information with projected changes in purchased funds and investments with specific loan and deposit flows. The bank can calculate a liquidity GAP by classifying potential uses and sources of funds into separate time frames according to their cash flow characteristics. The Liquidity GAP for each time interval equals the dollar value of uses of funds minus the dollar value of sources of funds.