1. Liquidity Risk Management
Copyright 2016 by Diane Scott Docking

2. Copyright 2016 by Diane Scott Docking
Learning Objectives
Understand the types of liquidity risks banks face.
Understand why commercial banks are subject to reserve requirements.
Be able to apply Reg D.
Copyright 2016 by Diane Scott Docking

3. Liquidity Risk Management
One type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claims
FIs must meet the withdrawals with stored or borrowed funds
Alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices
A second type of liquidity risk arises from the exercise of off-balance-sheet commitments made by the FI
Unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes
FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down
Copyright 2016 by Diane Scott Docking 3 3

4. Liquidity Risk and Depository Institutions
DI managers monitor net deposit drains—i.e., the amount by which cash withdrawals exceed additions; a net cash outflow
DIs manage liquidity needs by two methods:
Stored liquidity
Maintaining liquid assets to meet cash needs
Primary method for community banks
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5. Liquidity Risk and Depository Institutions
DIs manage liquidity needs by two methods: (continued)
Purchased liquidity
Rely on the ability to acquire funds from brokered deposits and borrowings
Used primarily by the largest banks with access to the money market and other nondeposit sources of funds
Most DIs utilize a combination of stored and purchased liquidity management
Copyright 2016 by Diane Scott Docking 5 5

6. Measuring Liquidity Risk Exposure
New Liquidity Risk Measures by BIS
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio
Intraday liquidity requirements for large internationally active banks
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7. Example: Stored vs. Purchased Liquidity Management
A bank has the following balance sheet:
Increases in interest rates are expected to cause a net drain (run-off) of $2 million in core deposits over the next 30 days. The loans are AAA to corporations.
Show how the balance sheet changes and the effect on net interest income if the bank uses (a) stored liquidity management or (b) purchased liquidity management.
Compute the liquidity coverage ratio and net stable funding ratio at beginning of the period.
Assets
(millions)
Avg. Yield
Liabilities
Avg. Rate
Cash
$ 1
Core deposits
$ 6 6%
Loans 9 8%
Subordinated debt 2
7.5%
Capital
Total
$10
Copyright 2016 by Diane Scott Docking

8. Solution to Example: Stored vs. Purchased Liquidity Management
If use stored liquidity management to meet $2 million of deposit withdrawals, bank will have to sell loans. Dr) Cash $1 million Cr) Loans $1 million Dr) Deposits $2 mill. Cr) Cash $2 mill. New balance sheet:
I assume bank used $1 million of cash on hand to meet customer withdrawals.
Assets
(millions)
Avg. Yield
Liabilities
Avg. Rate
Cash
$ 0
Core deposits
$ 4 6%
Loans 8 8%
Subordinated debt 2
7.5%
Capital
Total
$ 8
$ 8
Copyright 2016 by Diane Scott Docking

9. Solution to Example: Stored vs. Purchased Liquidity Management
If use stored liquidity management to meet $2 million of deposit withdrawals, bank will have to sell loans. Decrease in interest income $1 mill. x .08 = - $ 80,000 Decrease in interest expense $2 mill. x .06 = +$120,000 Change in NII + $ 40,000 I assume bank used $1 million of cash on hand to meet customer withdrawals.
Copyright 2016 by Diane Scott Docking

10. Solution to Example: Stored vs. Purchased Liquidity Management
If use purchased liquidity management to meet $2 million of deposit withdrawals, bank will have to borrow S-T debt. Dr) Cash $1 million Cr) Subordinated $1 million Dr) Deposits $2 mill. Cr) Cash $2 mill. New balance sheet:
I assume bank used $1 million of cash on hand to meet customer withdrawals.
Assets
(millions)
Avg. Yield
Liabilities
Avg. Rate
Cash
$ 0
Core deposits
$ 4 6%
Loans 9 8%
Subordinated debt 3
7.5%
Capital 2
Total
$ 9
$ 9
Copyright 2016 by Diane Scott Docking

11. Solution to Example: Stored vs. Purchased Liquidity Management
If use purchased liquidity management to meet $2 million of deposit withdrawals, bank will have to borrow S-T debt. Increase in interest expense debt $1 mill. x .075 = - $ 75,000 Decrease in interest expense core deposits $2 mill. x .06 = +$120,000 Change in NII +$ 45,000 I assume bank used $1 million of cash on hand to meet customer withdrawals.
Copyright 2016 by Diane Scott Docking

12. Example: Stored vs. Purchased Liquidity Management
Compute the liquidity coverage ratio at beginning of the period.
Level 1 assets = cash $ 1 mill.
Level 2 assets = loans $9 mill. (capped at 40% of level 1) mill.
Stock of highly liquid assets $1.4 mill.
Over next 30 days:
Cash outflows
Core deposit run-off $2 mill.
Debt and deposit interest payments (6 x .06/12) + (2 x .075/12)
$2.0425
Cash inflows Loan revenue (9 x .08/12) $0.06 net cash outflows over next 30 days $1.9825
Not in compliance
Copyright 2016 by Diane Scott Docking

13. Example: Stored vs. Purchased Liquidity Management
Compute the net stable funding ratio at beginning of the period.
Assets
RSF factor
RSF
Liabilities
ASF factor
ASF
Cash
$ 1 0%
$ 0
Core deposits
$ 4
90%
$3.6
Loans 9
65%
5.85
Expected runoff 2
80%
1.6
Subordinated debt
100%
Capital
Total
$10
$5.85
$9.2
IN compliance
Copyright 2016 by Diane Scott Docking

14. Managing Required Reserves
Reg D
Copyright 2016 by Diane Scott Docking

15. Reg D – Deposit Reporting Categories
Deposit Reporting Categories, Sept 2016 – Sept 2017
Nonexempt Institutions
(Detailed Reporting)
Exempt Institutions
(Reduced Reporting)
Net transaction accts > Exemption amount1 OR
Total deposits4 ≥ Reduced reporting limit2
Net transaction accts ≤ Exemption amount
AND
Total deposits4 < Reduced reporting limit
Total deposits4 ≥ Nonexempt deposit cutoff3
Total deposits4 < Nonexempt deposit cutoff
Total deposits4 > Exemption amount
Total deposits4 ≤ Exemption amount
Category 1
Category 2
Category 3
Category 4
Weekly reports
FR2900
Quarterly reports
Annual reports
FR2910a each June 30
No reports
1 Exemption amount = $15.2 million as of 11/12/15
2 Reduced reporting limit = $1.901 billion as of 11/12/15
3 Nonexempt deposit cutoff = $416.9 million as of 11/12/15
4 Total deposits = Sum of transaction accounts, savings deposits, and small time deposits
Copyright 2016 by Diane Scott Docking

16. Reg D - Determining Legal Reserves
Summary of Reg D Requirements (as of 11/12/15) is effective for maintenance period beginning 1/21/16:
All depository institutions with reservable deposits above $15.2 million must file FR2900
This dollar cut-off is known as the “reserve requirement exemption amount.”
FR2900 must be filed weekly (Tues. – Mon.) by all commercial banks with total reservable deposits at or above $416.9 million.
This dollar cut-off is known as the “non-exempt deposit cutoff level.”
Copyright 2016 by Diane Scott Docking

17. Reg D - Determining Legal Reserves (cont.)
Summary of Reg D Requirements (cont.):
The 2-Week “Reserve Computation period” goes from Tuesday to following second Monday (day 1 – 14) for transaction deposits and for or vault cash
Look at deposit balances during this period on which to base reserve requirements
Form FR2900.html
Copyright 2016 by Diane Scott Docking

18. Reg D - Determining Legal Reserves (cont.)
Summary of Reg D Requirements (cont.):
“Reserve Maintenance period” is 2 weeks and begins 30 days (on a Thursday) after the 1st Tuesday in the Reserve Computation period (days 31 – 44).
Reserves include: vault cash, balances at Fed (Due from Fed)
Copyright 2016 by Diane Scott Docking

19. Reserve Maintenance and Computation Periods
Copyright 2016 by Diane Scott Docking

20. Reserve Maintenance and Computation Periods
Copyright 2016 by Diane Scott Docking

21. Reg D - Determining Legal Reserves (cont.)
Summary of Reg D Requirements:
Two penalty free bands:
Top band = RBR + (maximum of $50,000 or 10% of RBR)
Bottom band = RBR – (maximum of $50,000 or 10% of RBR)
RBR = Reserve balance requirement
If maintained balance at Fed is between bands, then in compliance
If maintained balance at Fed > Top band, then have an “excess balance”.
If maintained balance at Fed < Bottom band, then have an “reserve deficiency amount”.
Interest and penalties
Penalty of 1% + primary credit rate on the deficiency amount.
Fed pays interest on average & excess balance maintained at the Fed.
Copyright 2016 by Diane Scott Docking

22. Interest Payments on Fed Balances
Copyright 2016 by Diane Scott Docking

23. Interest Payments on Fed Balances
Copyright 2016 by Diane Scott Docking

24. Legal Reserve Requirements
Sec Reserve requirement ratios. (effective 11/12/15)
The following reserve requirement ratios are prescribed for all depository institutions, banking Edge and agreement corporations, and United States branches and agencies of foreign banks:
Category
Reserve Requirement
Net transaction accounts:
$0 to $15.2 million
0 percent of amount.
Over $15.2 million and up
to $110.2 million
3 percent of amount
Over $110.2 million
$2,850,000 plus 10 percent of amount
over $110.2 million.
Nonpersonal time deposits
0 percent.
Eurocurrency liabilities
0 percent
$15.2 million is the exemption amount.
$110.2 million is the amount of the low reserve tranche
Copyright 2016 by Diane Scott Docking

25. Example in Appx 13 B: Calculating Reserve Requirement
CALCULATING RESERVE REQUIREMENTS FOR COMMERCIAL BANKS
(Total Net Transaction Deposits = $1, million) Table in text redone with current regs
Type of Deposit
and Deposit Interval
Average Dollar Amount (in millions) in Computation Period
Percentage Reserve Requirement
Average Dollar Reserves Required (in millions) in Maintenance Period
Net transactions accounts:
Exempt up to $15.2 mill. $ 0% $
Over $15.2 and up to
$110.2 mill. $ 3% $
Over $110.2 million
$1,240.50
10% $
Total
$1,350.70
Gross reserves requirement $
Less vault cash
( )
Reserve balance requirement (RBR) $
* The first $15.2 million of transactions accounts are exempt from reserve requirements. This cutoff and the 3% reserve requirement cutoff are amended by the Federal Reserve System from time to time. For an update, see
Copyright 2016 by Diane Scott Docking

26. Example in Appx 13 B: Calculating Reserve Requirement (cont.)
The following information is available:
(in millions)
RBR $
Top penalty-free band
$ *
Bottom penalty-free band
$ **
DAB at Fed during reserve mtnce period $
Balance maintained to satisfy RBR
Excess balance
$ -
Reserve deficiency amount
* x (1.10) = $
** x (.90) = $
10% x mill. > $50,000, so use 10%
Interest paid $32,368
Copyright 2016 by Diane Scott Docking

27. Example 1: Calculating Reserve Requirement
At the close of Business on Tuesday, January 17, 2017, Garden National Bank is concerned if it will meet its legal reserve requirements. The following information is available:
Daily Average Balances during 2-week Reserve Computation period from Dec , 2016 (in thousands):
  Gross Transaction accounts $416,500
Demand deposits due from U.S. depository institutions ,145
Cash items in the process of collection ,600
Vault cash ,552
Copyright 2016 by Diane Scott Docking

28. Example 1: Calculating Reserve Requirement (cont.)
The following information is available:
Copyright 2016 by Diane Scott Docking

29. Example 1: Calculating Reserve Requirement (cont.)
Answer the following questions:
What is the amount of Net transaction accounts?
What is the Gross reserve requirement?
What is the Reserve Balance Requirement?
As of close of day on Tuesday, Jan. 17, 2017, is the Bank over- or under-reserved? By how much?
If the bank is under-reserved, what must it do to remedy the situation on Wednesday, Jan. 18, 2017 to avoid any penalties?
Copyright 2016 by Diane Scott Docking

30. Solution to Example 1: Calculating Reserve Requirement
What is the amount of Net transaction accounts?
$395,755,000 or
$ million
Deductions
Copyright 2016 by Diane Scott Docking

31. Solution to Example 1: Calculating Reserve Requirement (cont.)
What is the Gross reserve requirement?
What is the Reserve Balance Requirement?
Type of Deposit
and Deposit Interval
Average Dollar Amount (in millions) in Computation Period
Percentage Reserve Requirement
Average Dollar Reserves Required (in millions) in Maintenance Period
Net transactions accounts:
Exempt up to $15.2 mill. $ 0%
$ 0.0
Over $15.2 up to $110.2 mill. $ 3% $
Over $110.2 million $
10% $
Total $
Gross reserves requirement $
Less vault cash
( )
Reserve Balance Requirement $
Copyright 2016 by Diane Scott Docking

32. Solution to Example 1: Calculating Reserve Requirement (cont.)
As of close of day on Tuesday, Jan. 17, 2017, is the Bank over- or under-reserved? By how much?
Bank has a reserve deficiency of $548,080
Copyright 2016 by Diane Scott Docking

33. Solution to Example 1: Calculating Reserve Requirement (cont.)
If the bank is under-reserved, what must it do to remedy the situation on Wednesday, Jan. 18, 2017 to avoid any penalties?
Bank must borrow enough money on Wednesday to bring the closing balance at the Fed on Wednesday =
, which will give the bank a DAB at the Fed over the 14 –day maintenance period = $25, (in thousands), the bottom penalty-free band.
Can use SOLVER or GOAL SEEK in Excel to do this. (See next slide)
*in thousands
$7,673*
Copyright 2016 by Diane Scott Docking

34. Solution to Example 1: Calculating Reserve Requirement (cont.)
Copyright 2016 by Diane Scott Docking

35. Example 2: Calculating Reserve Requirement
At the close of Business on Wednesday, January 18, 2017, Hillcrest National Bank wants to know if it met its legal reserve requirements. The following information is available:
Daily Average Balances during 2-week Reserve Computation period from Dec , 2016 (in thousands):
  Gross Transaction accounts $416,500
Demand deposits due from U.S. depository institutions ,145
Cash items in the process of collection ,600
Vault cash ,552
Copyright 2016 by Diane Scott Docking

36. Example 2: Calculating Reserve Requirement (cont.)
The following information is available:
Copyright 2016 by Diane Scott Docking

37. Example 2: Calculating Reserve Requirement (cont.)
Answer the following questions:
What is the amount of Net transaction accounts?
What is the Gross reserve requirement?
What is the Reserve Balance Requirement?
As of close of day on Wednesday, Jan. 18, 2017, is the Bank over- or under-reserved? By how much?
What is the penalty paid (if any) and interest earned (if any)?
Copyright 2016 by Diane Scott Docking

38. Solution to Example 2: Calculating Reserve Requirement
What is the amount of Net transaction accounts?
$395,755,000 or
$ million
Deductions
Copyright 2016 by Diane Scott Docking

39. Solution to Example 2: Calculating Reserve Requirement (cont.)
What is the Gross reserve requirement?
What is the Reserve Balance Requirement?
Type of Deposit
and Deposit Interval
Average Dollar Amount (in millions) in Computation Period
Percentage Reserve Requirement
Average Dollar Reserves Required (in millions) in Maintenance Period
Net transactions accounts:
Exempt up to $15.2 mill. $ 0%
$ 0.0
Over $15.2 up to $110.2 mill. $ 3% $
Over $110.2 million $
10% $
Total $
Gross reserves requirement $
Less vault cash
( )
Reserve Balance Requirement $
Copyright 2016 by Diane Scott Docking

40. Solution to Example 2: Calculating Reserve Requirement (cont.)
As of close of day on Wednesday, Jan. 18, 2017, is the Bank over- or under-reserved? By how much?
Bank has a reserve deficiency of $476,650
Copyright 2016 by Diane Scott Docking

41. Solution to Example 2: Calculating Reserve Requirement (cont.)
What is the penalty paid (if any) and interest earned (if any)?
Bank has a reserve deficiency of $476,650
Penalty paid: $476,650 x (.0225/360) x 14 = <$417.07>
Interest earned: $24,591,500 x (.0075/360) x 14 = $7,172.52
Current IORR & IOER = 0.75%
Current Primary Discount rate = 1.25%
Current Penalty Rate = = 2.25%
Copyright 2016 by Diane Scott Docking