1. Liquidity and Reserves Management: Strategies and Policies
Chapter Eleven
Liquidity and Reserves Management: Strategies and Policies

2. 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

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

4. 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

5. 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

6. 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)

7. 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

8. 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

9. 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

10. 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

11. 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

12. Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach

13. Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach

14. Estimating Liquidity Needs (continued)
Sources and Uses of Funds Approach

15. 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

16. 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

17. Estimating Liquidity Needs (continued)
Structure of Funds Approach
Combining both loan and deposit liquidity requirements, this institution’s total liquidity requirement would be

18. Estimating Liquidity Needs (continued)
Structure of Funds Approach
Many financial firms like to calculate their expected liquidity requirement, based on the probabilities they assign to different possible outcomes

19. Estimating Liquidity Needs (continued)
Liquidity Indicator Approach
Cash position indicator
Liquid securities indicator
Net federal funds and repurchase agreements position
Capacity ratio
Pledged securities ratio
Hot money ratio
Deposit brokerage index
Core deposit ratio
Deposit composition ratio
Loan commitments ratio

20. Estimating Liquidity Needs (continued)
The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace
Liquidity managers should closely monitor the following market signals:
Public confidence
Stock price behavior
Risk premiums on CDs and other borrowings
Loss sales of assets
Meeting commitments to credit customers
Borrowings from the central bank

21. Legal Reserves and Money Position Management
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

22. EXHIBIT 11–1 Federal Reserve Rules for Calculating a Weekly Reporting Depository Institution’s Required Legal Reserves

23. Legal Reserves and Money Position Management (continued)
Only two kinds of assets can be used for this purpose
Cash in the vault
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

24. Legal Reserves and Money Position Management (continued)
Calculating Required Reserves
The largest depository institutions must hold the largest percentage of legal reserves
Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement

25. Legal Reserves and Money Position Management (continued)
Calculating Required Reserves
The largest depository institutions must hold the largest percentage of legal reserves
Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement

26. Legal Reserves and Money Position Management (continued)
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
Assuming a 360-day year for ease of computation, this bank could apply up to $2, to offset any fees charged to the bank for its use of Federal Reserve services

27. Legal Reserves and Money Position Management (continued)
Factors Influencing the Money Position

28. Legal Reserves and Money Position Management (continued)
Sweep Accounts
Volume of legal reserves held at the Fed has declined in recent years largely due to sweep accounts
A contractual account between a bank and a customer that permits the bank to move funds out of a customer’s checking account overnight in order to generate higher returns for the customer and lower reserve requirements for the bank
Retail Sweep
Business Sweep
The sweeps market is likely to change in form and importance due to the recent passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009

29. Legal Reserves and Money Position Management (continued)
Other Factors to Influence Legal Reserves
Use of Fed Funds Market
The cheapest source
But very volatile
Managers rely on the Fed funds target rate (the most volatile on the settlement date)
Other Options
Sell liquid securities
Draw upon excess correspondent balances
Enter into repurchase agreements for temporary borrowings
Sell new time deposits
Borrow in the Eurocurrency market

30. EXHIBIT 11–2 Movements in the Effective Federal Funds Rate, Its Target (the Intended Federal Funds) Rate, and the Discount (Primary Credit) Rate for Depository Institutions Seeking Credit from the Federal Reserve Banks

31. Factors in Choosing among the Different Sources of Reserves
In choosing which source of reserves to draw upon to cover a legal reserve deficit, managers must carefully consider several aspects of their institution’s need for liquid funds:
Immediacy of need
Duration of need
Access to the market for liquid funds
Relative costs and risks of alternative sources of funds
The interest rate outlook
Outlook for central bank monetary policy
Rules and regulations applicable to a liquidity source

32. Central Bank Reserve Requirements around the Globe
Not all central banks impose legal reserve requirements on the depository institutions they regulate
For example, the Bank of England has not established official reserve requirements for its banks
There is a trend among central banks around the globe to eliminate, suspend, or at least make less use of the reserve requirement tool, in part because it is so difficult to control
A notable exception is the European Central Bank (ECB)
Even if central banks imposed no reserve requirements, managers of depository institutions would still have a demand for cash reserves
All depository institutions at one time or another need immediately available funds to handle customer withdrawals, meet new loan demand, and satisfy other emergency cash needs

33. Quick Quiz
What are the principal sources of liquidity demand for a financial firm? What are the principal sources from which the supply of liquidity comes?
Why do financial firms face significant liquidity management problems?
What are the principal differences among asset liquidity management, liability management, and balanced liquidity management?
How does the sources and uses of funds approach help a manager estimate a financial institution’s need for liquidity?
How can the discipline of the marketplace be used as a guide for making liquidity management decisions?
What are sweep accounts? Why have they led to a significant decline in the total legal reserves held at the Federal Reserve banks by depository institutions operating in the United States?
What impact has recent financial reform legislation had on raising short- term cash?