CHAPTER TENLiquidity And Reserve
Management: Strategies And Policies
The purpose of this chapter is to explore the reason’s why financial institutions often face heavy demands for immediately spendable funds (liquidity) and learn about the methods they can use to prepare for meeting their cash needs.
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Liquidity
The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost
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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
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Demands for Liquidity
Customer Deposit Withdrawals
Credit Requests from Quality Loan Customers
Repayment of Nondeposit Borrowings
Operating Expenses and Taxes
Payment of Stockholder Dividends
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A Financial Firm’s Net Liquidity Position
L = Supplies of Liquid Funds
- Demands for Liquidity
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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 SurplusThere is a Trade-Off Between Bank Liquidity and Profitability. The More Resources are Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Financial Firm’s Expected Profitability.
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Why Banks and Their Competitors Face Significant Liquidity Problems
Imbalances Between Maturity Dates of Their Assets and LiabilitiesHigh Proportion of Liabilities Subject to Immediate RepaymentSensitivity to Changes in Interest RatesCentral Role in the Payment Process
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Strategies for Liquidity Managers
Asset Liquidity Management or Asset Conversion Strategy
Borrowed Liquidity or Liability Management Strategy
Balanced Liquidity Strategy
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Asset Liquidity Management
This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed
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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
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Options for Storing Liquidity
Treasury Bills
Fed Funds Sold to Other Banks
Purchasing Securities for Resale (Repos)
Deposits with Correspondent Banks
Municipal Bonds and NotesFederal Agency SecuritiesBankers’ AcceptancesCommercial PaperEurocurrency Loans
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Costs of Asset Liquidity Management
Loss of Future Earnings on Assets That Must Be SoldTransaction Costs on Assets That Must Be SoldPotential Capital Losses If Interest Rates are RisingMay Weaken Appearance of Balance SheetLiquid Assets Generally Have Low Returns
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Borrowed Liquidity Management
This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs
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Sources of Borrowed Funds
Federal Funds Purchased
Selling Securities for Repurchase (Repos)
Issuing Large CDs (Greater than $100,000)
Issuing Eurocurrency Deposits
Borrowing Reserves from the Discount Window of the Federal Reserve
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Balanced Liquidity Management Strategy
The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs
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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
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Methods for Estimating Liquidity Needs
Sources and Uses of Funds Approach
Structure of Funds Approach
Liquidity Indicator Approach
Signals from the Marketplace
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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
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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
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Customer Relationship Doctrine
Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships
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Liquidity Indicator Approach
Cash Position IndicatorLiquid Security IndicatorNet Federal Funds PositionCapacity RatioPledging Securities RatioHot Money RatioShort-Term Investments to Sensitive Liabilities RatioDeposit Brokerage IndexCore Deposit Ratio Deposit Composition Ratio
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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
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Legal Reserves
Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities
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U.S. Legal Reserve Requirements
3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $42.1 Million10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $42.1 MillionTransaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make PaymentsThe $42.1 Million Amount is Adjusted Annually
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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
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Reserve Computation Period
The Period of Time Over Which a bank Calculates its Legal Reserve Requirement
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Reserve Maintenance Period
The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands
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Factors to Consider When 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 and Shape of the Yield Curve
Monetary Policy Outlook and Government Borrowing
Hedging Capability
Regulations Applicable for Liquidity Sources