Liquidity & Reserve Management Strategies

1. Chapter: 11 Liquidity & Reserve Management Strategies & Policies

2. Supplies of Liquidity Flowing into Banks. • Incoming deposits. • Revenues from the sale of nondeposit services. • Customer loan repayments. • Sales of bank assets. • Borrowings from the money market.

3. Demands on the Bank for Liquidity • Deposits withdrawals. • Volume of acceptable loan requests. • Repayment of bank borrowings. • Other operating expenses. • Dividend payments to bank stockholders.

4. Net Liquidity Position (Lt) • The difference between the total supply of liquidity flowing into a bank & the demands made upon the bank for liquidity. The most pressing demands for spendable funds come from two sources: • Customers withdrawing money from their deposit. • Credit requests from customers.

5. Implications of Liquidity Management • Rarely are the the demands for bank liquidity equal to the supply of liquidity at any particular point of time. • There is a trade-off between bank liquidity & profitability. High degree of liquidity will reduce the bank’s expected profitability.

6. Why banks face significant liquidity problem? • Imbalance between the maturity dates on their assets & the maturity dates attached with their liabilities, i.e, high proportion of demand deposit & high proportion of long-term lending. • Sensitivity to changes of interest rates. If other banks offer high interest rate, some customer will withdraw their funds for better returns elsewhere. • Bank’s attitude towards lending & providing services to the depositors.

7. Strategies for Liquidity Managers • Providing liquidity from assets (Asset Liquidity Management). • Relying on borrowed liquidity to meet cash demands (Liability Management). • Balanced Liquidity Management (Asset & Liability).

8. 1) Asset Liquidity Management Strategies • Reliance on liquid assets that can be readily sold for cash to meet a bank’s liquidity needs. A liquid asset must have three characteristics: • Ready Market. • Stable Price. • Reversible. • This strategy is used mainly by small banks that find it a less risky approach than relying on borrowings.

9. Implications of Asset Liquidity Management Strategies • Selling assets means the bank loses the future earnings possibility. • Selling assets involve transaction cost paid to the security brokers. • Asset in question may need to be sold in a market experiencing declining prices. (capital loss possibility) • Selling assets tends to weaken the appearance of the bank’s balance sheet. • Liquid assets generally holds lowest rate of return,i.e, by investing in liquid assets, banks are ignoring the possibility of higher return on other financial assets.

10. 2)Borrowed Liquidity Management Strategies • Reliance upon borrowed funds to meet a bank’s liquidity needs. The sources of borrowed funds: • Federal funds borrowing. • Repos. • Issuing large negotiable CDs to major corporation, government & wealth individuals. • Issuing Eurocurrency deposits. • Borrowing reserves from the discount of the central bank. • This is the most risky approach to solving liquidity problems because of the volatility of money market interest rates & the rapidity with which the availability of credit can change.

11. 3) Balanced Liquidity Management Strategies • The combined use of liquid asset holdings & borrowed liquidity to meet a bank’s liquidity needs.

12. Estimating A Bank’s Liquidity Needs • Three approaches in measuring or estimating a bank’s liquidity needs: • The sources & uses of fund approach. • The structure of funds approach. • Liquidity indicator approach.

13. 1) The Sources & Uses of fund approach. • A method for estimating a bank’s liquidity requirements by focusing primarily on expected changes in deposits & loans. The approach begins with two simple facts: • Bank liquidity rises as deposits increase & loans decrease. • Bank liquidity declines when deposits decrease & loans increase. • Estimated liquidity deficit (-) or surplus (+) for the coming period = estimated changes in total deposits (D) – estimated change in total loans (L)

14. 2) The Structure of Funds Approach • A method for estimating a bank’s liquidity needs by dividing its borrowed funds into categories based upon their probability of withdrawal. The categories are: • “Hot Money Liabilities”: Deposits & Non Deposit Borrowed funds that are very interest sensitive & will be withdrawn during the current period. • Vulnerable Funds: Customer deposits of which a substantial portion (25%-30%) will probably be removed during the current period. • Stable Funds: Most unlikely to be removed during the current period.

15. The Structure of Funds Approach…contd. • Total Liquidity Requirement for a Bank = 0.95 X (Hot money funds – legal reserves held) + 0.30 X (Vulnerable deposits – legal reserves held) + 0.15 X (Stable deposits – legal reserves held) + 1.00 X (Potential loans outstanding – Actual Loans outstanding)

16. 3) Liquidity Indicator Approach • Cash position indicator = cash & deposits due from depository institutions / total assets. • Liquid securities indicator = government securities / total assets. • Net federal funds position = federal funds sold – federal funds purchased/ total asset • Capacity ratio = net loans & leases / total assets. • Pledged securities ratio = pledged securities / total securities holdings. • Hot money ratio = money market assets / money market liabilities.

17. Liquidity Indicator Approach…contd. • Deposit brokerage index = brokered deposits / total deposits. • Core deposit ratio = core deposits / total assets. • Deposit composition ratio = demand deposits / time deposits. • Loan Commitment Ratio= Unused loan Commitments/ Total Assets • These indicators are highly sensitive to the season of the year & the stage of the business cycle. Liquidity indicator often decline at boom period due to high loan demand & vice versa.

18. Legal Reserves & Money Position Management • Legal reserves are the assets that a central bank requires depository institutions to hold as a reserve behind their deposits or other liabilities. • Total required legal reserves = {reserve requirements on transaction deposits X daily average amount of net transaction deposits over a designated period} + {reserve requirements on nontransaction reservable liabilities X daily average amount of nontransaction reservable liabilities }