1. Liquidity and Reserves Management: Strategies and Policies
Chapter Eleven
Liquidity and Reserves Management: Strategies and Policies
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2. Key Topics Sources of Demand for and Supply of Liquidity
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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
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3. 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
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4. The Demand for and Supply of Liquidity
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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
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5. The Demand for and Supply of Liquidity (continued)
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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
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6. The Demand for and Supply of Liquidity (continued)
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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)
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7. Why Financial Firms Often Face Significant Liquidity Problems
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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
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8. Strategies for Liquidity Managers
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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
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9. Strategies for Liquidity Managers (continued)
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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
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10. Estimating Liquidity Needs
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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
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11. Estimating Liquidity Needs (continued)
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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
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12. Estimating Liquidity Needs (continued)
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Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach
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13. Estimating Liquidity Needs (continued)
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Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach
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14. Estimating Liquidity Needs (continued)
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Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach
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15. Estimating Liquidity Needs (continued)
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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
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16. Estimating Liquidity Needs (continued)
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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
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