Managing Liquidity

Managing Liquidity Chapter 4

The Roles of Money Management and Savings • If you can’t manage your checking and savings accounts properly, you’ll have trouble managing more complicated investments, such as retirement accounts • Why maintain cash balances? • It’s expensive (because you’re forgoing interest income) • But we like the convenience

The Roles of Money Management and Savings • Why savings are so important • Very liquid • Serves as an emergency fund • Allows us to achieve a certain goal (vacation, car down payment, etc.) • Americans save less than 2.5% of their income • Europeans save about 10%+

The Roles of Money Management and Savings • How much savings do you need? • Emergency fund • Should have amount equal to about 3 to 6 months of after-tax income • Additional amount depends on your goals (short- and long-term) • Do you want to buy a house soon? Need to save for the down payment • Have money automatically transferred to your savings account from each paycheck • Treat it as a fixed expense

The Roles of Money Management and Savings • How fast your savings will grow depends upon: • What interest rate your savings earn (stated or nominal rate) • Frequency of compounding • How much money you deposit periodically • How your account balance is determined

What Determines How Fast Your Savings Will Grow? • The impact of time on interest earned • If interest is being compounded (earning interest on interest), time can have a significant impact • The frequency of compounding • The more frequently money is compounded, the more often interest is paid—so money grows faster • Your effective interest rate is greater the more often interest is compounded • The treatment of deposits and withdrawals • Most financial institutions use the day-of-deposit-to-day-of-withdrawal method of computing interest • Interest is based on the exact number of days the money is in your account • Other methods include minimum balance (will earn less interest this way)

Figure 4.1: The Relationship Between Time and Interest Earned

Figure 4.2: Simple and Compound Interest

Choosing a Financial Institution • Financial institutions include banks and credit unions • Factors influencing your decision • How important is convenience to you? • Do you choose a bank just because it’s right around the corner from your house? • Convenience is important, but nowadays with electronic banking it’s not nearly as important • Direct deposit, online-banking, epay, etc.

Choosing a Financial Institution • What services do you expect? • Electronic banking • Safe deposit box • Do you want good, personal service where the tellers know you by name? • What insurance safeguards are present? • Most financial institutions (banks, credit unions) are federally insured up to $100,000

Choosing a Financial Institution • How much does it cost? • Before deregulation financial institutions offered many services for ‘free’ • Charged a basic fee for having an account • Provided free checks, help with reconciliation, etc. • Banks competed on the basis of service because basically all banks paid customers same interest rate on deposits • The spread between interest paid to customers and interest charged on loans was large • Since deregulation banks compete for deposits based on interest rates • Spread on interest paid vs. charged has narrowed • Banks have eliminated ‘free’ services and now charge fees (sometimes very HIGH fees) • Banks collect about $20 billion in fees (up 200% from 10 years ago) • Fees vary widely from bank to bank • Shop around

What are the Major Financial Institutions? • Commercial banks (AKA full-service banks) • Offer: • Checking and savings accounts • Personal and business loans • Trust services • Safe-deposit boxes • Mortgage loans • Discount brokerage serves (maybe) • Convenient (Over 65,000 branch offices across U.S.)

What are the Major Financial Institutions? • Savings Banks (S&Ls) • Traditionally serve consumers • Mortgage loans (make about 40% of all mortgage loans) • Today are more similar to commercial banks • Credit Unions • Cooperative venture owned by depositors and borrowers • Organized to serve specific groups of people • Non-profit so offer lower interest rates on loans, pay higher interest rates on deposits • Generally don’t want to take a great deal of risk

What are the Major Financial Institutions? • Brokerage Firms • Offer central asset management accounts • Combines a checking account, debt/credit card, and a money market fund with a traditional brokerage account • Cash earned from dividends, interest, etc. is automatically swept into a money market account • You start earning interest on your money immediately • You can write a check (or use debit/credit card) to access your funds • Minimum investment required, which varies across brokerage firms • Check out minimum investment amount and fees (if any), customer service, choice of money market funds, credit/debit card features, margin rates

Checking Accounts • Regular checking accounts • Some banks require a minimum balance (average is $500) which give you unlimited check writing privileges • Some banks charge no fee unless you exceed a certain number of checks per month • Banks can pay interest on checking accounts but rarely do • Special checking accounts • Require no minimum balance • Most banks charge a per check fee ($0.10-$0.15 per check) plus monthly maintenance fee • May be a good choice for college student if write only a few checks

Checking Accounts • Overdraft Protection • If you write a check for an amount greater than the balance in your checking account it is still covered • You pay a fee (essentially interest on a short-term loan) • NOW Accounts (Negotiable Order of Withdrawal) • Combined checking and savings account • Pays interest on balance (but lower rate than savings account) • Can write checks (actually are authorizations to take money from savings) • Minimum balance of about $1,000 • If balance drops below the minimum a fee is charged • Shop around! • NOW accounts at credit unions are called Share-Draft Accounts

Consumer Loans • Car loans • Mortgage loans • College loans • Home improvement loans • Unsecured personal loan

Bank Credit Cards • Allow consumers to purchase items in lieu of cash or check • Can also get a cash advance • Even pay your taxes

Other Banking Services • Retirement Plans • IRAs and Keoghs • Trustee Services • Managing money for others • Estate planning and management • Safe-Deposit Boxes • Fees vary (up to $100) • Bank Wire Transfers • Send money to someone (quickly & long distances) • Debt Management and Counseling • Often free

Electronic Banking • Electronic Funds Transfer System (EFTS) • Paying bills, making withdrawals or depositing money electronically • Quick, easy, cheap • ATMs, direct deposit, debit cards, etc. • Automated Teller Machines • About 200,000 ATMs in U.S. • Over 11 billion transactions per year • Online banking • Expected to experience rapid growth • Convenient • Safety of EFTS • Can be difficult to resolve problems due to lack of paper records • Can’t stop payment on check since transfer is instantaneous

How to Write and Endorse a Check • Writing a check • Get into habit of completing stub or register before you write check • Helps prevent you from forgetting the amount of the check • Endorsing a check • Blank endorsement • Person to whom check was written signs name on back • Is able to be cashed by anyone once endorsed • Restrictive endorsement • Limits further negotiation of check • Use when mailing a check to bank for deposit • Special endorsement • Names a third party who can cash the check

Balancing Your Checkbook • Should reconcile checkbook every month when monthly statement is received • If you don’t contact bank about a bank error within a specified time period bank may not correct its mistake

Balancing Your Checkbook • Steps involved: • Note the number of checks that cleared the bank • Compare the dollar amount for each check to the amount written on the check and check register • Compare your record of deposits to the bank statement • Compare your record of ATM and other EFTS transactions to the bank statement • Subtract any fees and add any interest • Total all checks you’ve written and any ATM withdrawals not on statement • Subtract this amount from balance on statement • Total all deposits not yet processed and add to balance

Checks That Guarantee Payment • If you receive a check as payment the check could bounce and you wouldn’t get the cash • You may insist on a certified check • Guarantees payment • Cashier’s check • Customer buys a check from bank’s general fund • Bank won’t issue certified check until it’s paid for • Traveler’s checks • Guaranteed by issuer • Used primarily by business and vacation travelers

Savings Accounts • Those offered by banks and credit unions are federally insured • Non-fixed Time Deposits • Can add/withdraw money with basically no restrictions at any time • Passbook savings account • May require a minimum to open ($100 or less) • Interest rate is low • May charge a fee if balance drops below set amount or number of transactions exceed a certain amount • NOW account • Basically an interest-bearing checking account

Savings Options • Money Market Deposit Account (MMDA) • Interest rate fluctuates with the market rate • Initial deposit $1,000 • Only a certain number of withdrawals are allowed per month (penalty assessed if rules aren’t followed) • Fixed-Time Deposits • Saver agrees to keep money in account for a certain time period (earn higher interest) • Certificate of Deposit (CD) • Sacrifice liquidity • If interest rates are rising, and you’ve locked in a long-term CD, is it worth it to pay the interest penalty? • Some banks offer variable rate CDs • Shop around

Money Market Mutual Funds • Pool many investors’ funds and invest in short-term, low-risk investments • Not federally insured • In practice this risk is very small • Require a minimum initial deposit ($1,000) • Can write checks (minimum amount of check value is about $250) • Some funds limit the number of checks you can write each month

U.S. Treasury Bills and Notes • Issued by the U.S. government (very safe) • Can be sold prior to maturity • Interest income is not subject to state taxes • T-bills have 3, 6 and 12 months until maturity • Minimum face value of $10,000 • Interest is discounted • T-notes have 2, 3, 5, and 10 years to maturity • Pay fixed amount of interest 2x a year • Face value is as low as $1,000

U.S. Savings Bonds • Face amounts range from $50 to $30,000 • Can buy from financial institutions • Purchase price is ½ the face value • Bond will mature at some point (when exactly depends on the interest rate) • Interest accumulates (even after maturity) until 30 years after the issue date • Exempt from state taxes • Federal taxes are owed only when bond is cashed in or reaches 30 years from issue date • Series I bonds pay a fixed interest rate + the average rate of inflation

Choosing the Best Savings Option • Need to evaluate: • Minimum investment • Liquidity • Yield • Safety • Taxation

Managing Liquidity