Liquidity and Reserve Management : Strategies and Policies

1. Liquidity and Reserve Management: Strategies and Policies

2. 11-2 Liquidity • The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost • The size and volatility of cash requirements affect the liquidity position of the bank • Examples of transaction that affect the bank’s cash balance and liquidity position: Deposits and withdrawals; loan disbursements and loan payments

3. 11-3 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. 11-4 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. 11-5 A Financial Firm’s Net Liquidity Position L = Supplies of Liquid Funds - Demands for Liquidity

6. 11-6 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. 11-7 Why Banks and Their Competitors Face Significant Liquidity Problems • Imbalances Between Maturity Dates of Their Assets and Liabilities • High Proportion of Liabilities (especially demand deposits and money market borrowings) 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. 11-8 Strategies for Liquidity Managers • Think about what is a liquid asset? • Identify strategies for liquidity management. • Asset Liquidity Management or Asset Conversion Strategy • Borrowed Liquidity or Liability Management Strategy • Balanced Liquidity Strategy

9. 11-9 Asset Liquidity Management 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

10. 11-10 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

11. 11-11 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 • Negotiable Certificates of Deposits • Eurocurrency Loans

12. 11-12 Asset Liquidity Management is Not Costless and Include Opportunity Cost: • Loss of Future Earnings on Assets That Must Be Sold • Transaction Costs (Commissions) 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

13. 11-13 Borrowed Liquidity (Liability) Management This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs

14. 11-14 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

15. 11-15 Borrowed Liquidity (Liability) Management Strategy Advantages Disadvantages • Borrow Only When There is a Need for Funds • Volume and Composition of the Investment Portfolio Can Remain Unchanged • The Institution Can Control Interest Rates in Order to Borrow Funds (raise offer rates when needs requisite amounts of funds) • Highest Expected Return But Carries the Highest Risk Due to Volatility of Interest Rates and Possible Rapid Changes in Credit Availability • Borrowing Cost is Always Uncertain-> Uncertain Earnings • Borrowing Needs Can Be Interpreted as a Signal of Financial Difficulties

16. 11-16 Balanced Liquidity Management Strategy The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs

17. 11-17 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

18. 11-18 Methods for Estimating Liquidity Needs • Sources and Uses of Funds Approach • Structure of Funds Approach • Liquidity Indicator Approach • Signals from the Marketplace

19. 11-19 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. 11-20 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

21. 11-21 Customer Relationship Doctrine Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships

22. 11-22 Liquidity Indicator Approach(Based on Experience and Industry Averages) • 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

23. 11-23 The Ultimate Standard: 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

24. 11-24 Legal Reserves (SRR) • Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities • Only 2 Kinds of Assets Can Be Used for This Purpose: 1) Cash in the Vault; 2) Deposits Held in a Reserve Account With the central bank.

25. 11-25 Calculating Required Reserves Any deficit above 4% may be assessed an interest penalty equal to the Federal Reserve’s discount (primary credit) rate at the beginning of the month plus 2 percentage points applied to the amount of the deficiency. Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its efficiency.

26. 11-26 Quick Quiz • What are the principal differences among asset liquidity management, liability management, and balanced liquidity management? • What guidelines should management keep in mind when it manages a financial firm’s liquidity position? • What is money position management? • What is the principal goal of money position management? • What factors should a money position manager consider in meeting a deficit in a depository institution’s legal reserve account?