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

2. Liquidity
The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost

3. 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

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

5. A Financial Firm’s Net Liquidity Position
L = Supplies of Liquid Funds
- Demands for Liquidity

6. Essence of Liquidity Management
Rarely are the Demands for Liquidity Equal to the Supply of Liquidity at Any Particular Moment. The Financial Firm Must Continually Deal with Either a Liquidity Deficit or Surplus
There is a Trade-Off Between Liquidity and Profitability. The More Resources Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Financial Firm’s Expected Profitability.

7. Why Banks and Their Competitors Face Significant Liquidity Problems
Imbalances Between Maturity Dates of Their Assets and Liabilities
High Proportion of Liabilities Subject to Immediate Repayment
Sensitivity to Changes in Interest Rates
Central Role in the Payment Process

8. When is a financial institution adequately liquid?
A financial institution is adequately liquid if it has adequate cash available precisely when cash is needed at a reasonable cost. Management can monitor the cash position over time and monitor as well what is happening to its cost of funds. One indicator of the adequacy of the liquidity position is its cost - a rising interest cost may reflect greater perceived risk for the borrowing bank as viewed by capital-market investors.

9. Strategies for Liquidity Managers
Asset Liquidity Management or Asset Conversion Strategy
Borrowed Liquidity or Liability - Management Strategy
Balanced Liquidity Strategy

10. Asset Liquidity Management
This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed

11. 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

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

13. 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

14. Borrowed Liquidity Management
This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs

15. Sources of Borrowed Funds
Federal Funds Purchased
Selling Securities for Repurchase (Repos)
Issuing Large CDs (Greater than $100,000)
Issuing Eurocurrency Deposits
Securing Advance from the Federal Home Loan Bank
Borrowing Reserves from the Discount Window of the Federal Reserve

16. Balanced Liquidity Management Strategy
The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs

17. 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
Liquidity managers should know what other departments within the institution are doing

18. Methods for Estimating Liquidity Needs
Sources and Uses of Funds Approach
Structure of Funds Approach
Liquidity Indicator Approach
Signals from the Marketplace

19. 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

20. Liquidity management – using sources and uses of funds
Suppose that a bank estimates its total deposits for the next six months in millions of dollars will be, respectively $112, $132, $121, $147, $151 and $139, while its loans (also in millions of dollars will total as estimated $87, $95, $201, $113, $101 and $124, respectively, over the same six months. Under the sources and uses of funds approach, when does this bank face liquidity deficits, if any?

21. Sources and Uses of Funds approach
Deposits
Loans
Δ depo
Δ loans
Deficit/
surplus
112 87
D - L
132 95 20 8 12
121
102
-11 7
-18
147
113 26 11 15
151
101 4
-12 16
139
124 23
-35

22. Structure of Funds
A Bank’s Deposits and Other Sources of Funds Divided Into Categories. For Example:
‘Hot Money’ Liabilities
Vulnerable Funds
Stable Funds
Liquidity Manager Set Aside Liquid Funds According to Some Operating Rule

23. Structure of funds
Suppose that a thrift institution’s liquidity division estimates that it holds $19 million in hot money deposits and other IOUs against which it will hold an 80 percent liquidity reserve, $54 million in vulnerable funds against which it plans to hold a 25 percent reserve, and $112 million in stable or core funds against which it will hold a 5 percent liquidity reserve. The thrift expects its loans to grow 8 percent annually; its loans currently stand at $117 million, but have recently reached $132 million. If reserve requirements on liabilities currently stand at 3 percent, what is this depository institution’s total liquidity requirement?

24. Structure of funds Total Liquidity
Requirement = 0.80 ($19 million x $19 million)
($54 million x $54 million)
($112 million x $112 million)
+ ($132 million +O.08 x $132 million - $117 million)
= $58.83 million

25. Steps needed for the structure of funds approach
In the first step, the institution's deposits and other funds sources are divided into categories based on their estimated probability of being withdrawn and, therefore, lost to the bank. Second, the liquidity manager must set aside liquid funds according to some desired operating rules for those categories. Categories can include "hot money" liabilities, vulnerable funds, and stable funds.

26. Problem on liquidity requirement
Suppose Abigail Savings Bank's liquidity manager estimates that the bank will experience a $430 million liquidity deficit next month with a probability of 10 percent, a $300 million liquidity deficit with a probability of 40 percent, a $230 million liquidity surplus with a probability of 30 percent, and a $425 million liquidity surplus bearing a probability of 20 percent. What is this savings bank’s expected liquidity requirement? What should management do?

27. Liquidity requirement answer
The bank's expected liquidity requirement is:
Expected Liquidity Requirement = 0.10 *(-$430 million) * (-$300 million) +
0.30* ($230 million) * (+$425 million)
= -$43 million - $120 million + $69 million + $85 million
= -$9 million

28. The liquidity indicator approach to liquidity management?
The liquidity indicator approach uses tell-tale financial ratios (e.g., total loans/total assets or cash assets/total assets) whose changes over time may reflect the changing liquidity position of the financial institution. The ratios are used to estimate liquidity needs and to monitor changes in the liquidity position.

29. Liquidity Indicator Approach
Cash Position Indicator
Liquid Security Indicator
Net Federal Funds Position
Capacity Ratio
Pledged Securities Ratio
Hot Money Ratio
Deposit Brokerage Index
Core Deposit Ratio
Deposit Composition Ratio
Loan Commitment Ratio

30. Liquidity indicator approach
First National Bank has the following balance sheet cash = 633, Govt. sec= 185, net loans = 3502, fed funds sold = 48. Fed funds purchased = 62, DD= 988, time deposits =2627. How many liquidity indicators can be calculated from these figs.

31. Liquidity indicator answers
The liquidity indicators that we can construct from the foregoing figures include:
Cash Position Indicator:
Cash and Deposits Due from Other Banks $633/Total Assets $4496 = 14.08%
Net Federal Funds Position:
(Federal Funds Sold – Federal Funds Purchases)=($48 - $62)/Total Assets $4496= -.31%

32. Liquidity indicators answers
Capacity Ratio:
Net Loans and Leases $3,502/Total Assets $4496 = percent
Deposit Composition Ratio:
Demand Deposits $988/Time deposits $2,627 =37.61 percent
Liquid Securities Indicator:
U.S. Government Securities $185/total assets $4496=4.11 percent

33. 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
No financial institution can tell for sure if it has sufficient liquidity until it has passed the market's test.

34. What is money position management?
A money position manager is responsible for ensuring that the institution maintains an adequate level of legal reserves.

35. Legal Reserves
Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities

36. What is the principal goal of money position management?
The money-position manager wants to insure the bank has sufficient legal reserves to meet its reserve requirements as imposed by the central bank but holds no more than the legal minimum requirement because excess legal reserves yield no income for the bank.

37. How is the legal reserve requirement determined?
Each reservable liability item is multiplied by the stipulated reserve requirement percentage set by the Federal Reserve Board to derive the bank's total legal reserve requirements.
Thus, total required legal reserves equal the reserve requirement on transaction deposits times the daily average amount of net transaction deposits over a designated period plus the reserve requirement on nontransaction reservable liabilities times the daily average amount of nontransaction reservable liabilities.
Currently nontransaction liabilities have a reserve requirement of zero.

38. U.S. Legal Reserve Requirements
First $7.8 Million have 0 Legal Reserves
3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $48.3 Million
10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $48.3 Million
Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments
The $48.3 Million Amount is Adjusted Annually

39. Required reserves
First National Bank finds that its net transactions deposits average $140 million over the latest reserve computation period. Given the reserve requirement ratios imposed by the Federal Reserve as given in the textbook, what is the bank's total required legal reserve?

40. Reserve requirement answer
Reserve Requirement= 0.03 * [First $48.3-$7.8 million of Transaction Deposits] + .10*[Amount of Transaction Deposits in Excess of $48.3 million]
= .03 * $ * ($140 - $48.3)= $1.215 million + $9.17 million= $ million

41. Reserve requirement
A U.S. savings bank has a daily average reserve balance at the Federal Reserve Bank in its district of $25 million during the latest reserve maintenance period. Its vault cash holdings have averaged $1 million and the bank's total transaction deposits (net of interbank deposits and cash items in collection) averaged $200 million daily over the latest reserve maintenance period. Does this depository institution have a legal reserve deficiency? How would you recommend that its management responds to the current situation?

42. Reserve requirements - answer
The bank's total required legal reserves must be:
Required Legal Reserves = 0.03 x [First $48.3 – $7.8 million of Transactions Deposits] x [Transactions Deposits Over $48.3 million]
= $1.215 million + $15.17 million = $ million
The average vault cash of $1 million plus the $25 million at the district Reserve Bank indicates total maintained reserves of $26 million, meaning the bank is over required reserves by $9,615,000. Management will have to plan how to invest this excess reserve taking into account any anticipated drain on funds in the near future and taking into account any reserve deficit in the previous period.

43. Factors to consider in meeting a deficit in legal reserve account?
Several factors must be taken into account by the liquidity manager, including current and expected future levels of interest rates, projected changes in monetary policy, the bank's borrowing capacity and current holdings of liquid assets, the bank's forecast of future deposit growth and loan demand, the expected size and duration of any liquidity deficits or surpluses, and his or her knowledge of the future plans of the bank's largest depositors and borrowers with credit lines.

44. Reserve Maintenance Period
The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands

45. Reserve Computation Period
The Period of Time Over Which a Bank Calculates its Legal Reserve Requirement

46. Factors in Choosing Among Different Sources of Reserves
Immediacy of Bank’s Needs
Duration of Bank’s Needs
Bank’s Access to Market for Liquid Funds
Relative Costs and Risks of Alternatives
Interest Rate Outlook
Outlook for Central Bank Monetary Policy
Regulations Applicable for Liquidity Sources

47. What are clearing balances?
Of what benefit can clearing balances be to a depository that uses the Federal Reserve System’s check-clearing network?
Any financial institution using the Federal Reserve check clearing system has to maintain a minimum balance with the Federal Reserve. The amount is determined by its estimated check clearing needs and its recent record of overdrafts. The clearing balance can be a benefit because the institution earns credits from holding this balance with the Fed and this credit can be used to pay the fees the Fed charges for services.

48. Clearing balances
Suppose a bank maintains an average clearing balance of $5 million during a period in which the Federal funds rate averages 6 percent. How much would this bank have available in credits at the Federal Reserve Bank in its district to help offset the charges assessed against the bank for using Federal Reserve services?
Reserve Credit = Avg. Clearing Balance x Annualized Fed Funds Rate x 14 days/360 days
= $5,000,000 x .06 x 14/360 = $11,666.67

49. Sweep Account
A Contractual Account Between Bank and 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

50. Customer Relationship Doctrine
Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships